Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa

Slides prepared by Muni Perumal, University of Canberraand Jay Bandaralage, Griffith University

14–1

Chapter 14

Monetary Policy



14–2

Learning Objectives

• Discuss the objectives of monetary policy.• Describe the roles of the participating institutions and the

route by which monetary policy affects the operation of the economy.

• Examine the balance sheet of the Reserve Bank of Australia, through which monetary policy is largely implemented.



14–3

Learning Objectives (cont.)

• Analyse the techniques of monetary policy—the major instruments and how they function.

• Discuss the cause–effect chain through which monetary policy functions, and evaluate its effectiveness.



14–4

Learning Objectives (cont.)

• Using the aggregate demand–aggregate supply framework, examine monetary policy in an open economy.

• Provide a restatement of employment theory and policy.



14–5

Objectives of Monetary Policy

• Monetary policy– influencing interest rates and credit availability to stabilise real

GDP, employment and the price level

• Fundamental objectives– full employment– non-inflationary level of total output

• The Reserve Bank of Australia has responsibility for managing monetary policy



14–6

Cause-Effect Chain of Monetary Policy

• Cash rate– interest rate charged for exchange settlement account

funds

• Other short-term interest rates– the cash rate sets the cost of short-term funds for banks– influences the rate at which banks are willing to lend



14–7

Cause-Effect Chain of Monetary Policy (cont.)

Aggregate demand• Availability of bank credit, which impacts on

interest-sensitive spending (and therefore output, employment and prices), is impacted through monetary policy



14–8

Monetary Policy and Aggregate Demand

• Easy money policy– RBA reduces the cash rate, lowering the cost and

increasing the availability of bank credit, to expand spending

• Tight money policy– RBA increases the cash rate, increasing the cost of credit,

reducing the availability of credit, to reduce spending in the economy



14–9

Monetary Policy and Investment

• Increases in interest rate reduce the viability of many investments and the quantity of investment spending falls

• Increases in interest rate make the purchase of financial assets more attractive



14–10

Balance Sheet of the RBA

• Assets:– gold and foreign exchange– government securities

• Liabilities:– notes on issue– non-callable deposits– exchange settlement account (ESA) funds



14–11

Changes in ESA Funds and Monetary Policy

• Funds flow to and from government accounts• Banks must maintain a positive balance in their

ESAs with the RBA– may borrow funds from other banks, or– trade in either government securities or repurchase

agreements (repos)



14–12

The Yield Curve

• The yield curve is a summary of the interest rates that apply at any given point in time to interest-bearing securities

• Shows the link between the cash rate and other short-term interest rates

• Changes in the cash rate change the cost of funds for banks



14–13

Monetary Policy Tools

• Two major tools used by the RBA to determine the cash rate:– Open market operations– Foreign exchange swaps and intervention in the

foreign exchange market



14–14

Open-Market Operations

• Buying and selling of Commonwealth government securities by the RBA in the cash or short-term money market

• The objective of OMOs is to ensure that the demand and supply of ESA funds are such that they are in balance at the target cash rate



14–15

Open-Market Operations (cont.)

• Buying and selling of Commonwealth government securities by the RBA affects the cash rate

• Cash rate provides an indication of the RBA’s monetary policy stance

– Sustained increases in cash rate target level: tightening of monetary policy

– Sustained decreases in cash rate target level:easing of monetary policy



14–16

Open-Market Operations:Buying Securities

• Banks sell some of their securities• RBA pays for securities by increasing banks’ exchange

settlement accounts (ESAs)– ESAs form part of the banks’ prime assets ratio (PAR)

requirement

• Bank reserves increase– Causing the monetary base and the banks’ lending ability to

increase



14–17

Open-Market Operations:Selling Securities

• The RBA sells securities to the banks• Banks pay for securities by decreasing their

exchange settlement accounts (ESAs)• Bank reserves decrease

– Causing the monetary base and the banks’ lending ability to decrease



14–18

D2

The Market for Exchange Settlement Funds and the Cash Rate

S1

Tar

get

cas

h r

ate

ESA funds

D1

S2



14–19

Foreign Exchange Swaps

• RBA may use foreign exchange swaps to supplement or substitute for OMO

• Foreign exchange market intervention—either selling or buying Australian dollars

– purchase/sale of dollars is equivalent to purchase/sale of government securities, and has similar impact on banks’ ESA funds



14–20

Rediscount Rate and Monetary Policy

• The rate at which the RBA buys or sells short-term securities under repurchase agreement

• Can be used as a central tool of monetary policy



14–21

Easy Monetary Policy

• Implemented when the economy is faced with the prospects of substantial unemployment or deflationary pressure

• RBA announces its intention to reduce the cash rate• RBA acts to bring the ESA funds market into balance



14–22

Easy Monetary Policy (cont.)

Cas

h r

ate

ESA funds

S1

D1In

tere

st r

ate

3-year funds

CR1

S2

CR2

SF1D1

R1

SF2

R2



14–23

Tight Monetary Policy

• Enacted when the economy is facing significant inflationary pressures

• RBA announces its intention to increase the target cash rate

• ESA funds are brought into balance at this new target cash rate



14–24

Monetary Policy and Equilibrium GDP

Cause–Effect Chain of Monetary Policy:• Money supply impacts interest rates

• Interest rates affect investment

• Investment is a component of AD

• Equilibrium GDP is changedEquilibrium GDP is changed



14–25

Pri

ce le

vel

Real domestic output, GDP

D1

Investmentdemand

Rea

l rat

e o

f in

tere

st, i

10

8

6

0

10

8

6

0Quantity of money demanded and supplied Amount of investment, i

SF1

ASAD1

P1

ASLR

Monetary Policy and Equilibrium GDP (cont.)



14–26

Pri

ce le

vel


D1

Investmentdemand

Rea

l rat

e o

f in

tere

st, i

10

8

6

0

10

8

6


SF1

ASAD1

P1

ASLR

SF2

AD2

Easy Monetary Policy


AD3



14–27

Pri

ce le

vel


D1

Investmentdemand

Rea

l rat

e o

f in

tere

st, i

10

8

6

0

10

8

6


SF2

AS

AD1

P1

ASLR

SF1





14–28

Pri

ce le

vel


D1

Investmentdemand

Rea

l rat

e o

f in

tere

st, i

10

8

6

0

10

8

6


SF2

AS

AD2

P1

ASLR

SF1


AD1




14–29


Refinements and Feedback Effects• Policy effectiveness depends on

– shape of the demand for money curve– shape of the investment demand curve

• Feedback effects– Reductions in GDP tend to reduce business profits,

causing business to reduce investment



14–30

Monetary Policy and the Open Economy

• Net Export Effect– Changes in interest rate affect the value of the exchange

rate under floating exchange rate.An increase in interest rate appreciates the currency, resulting in lower net exports

– A decrease in interest rate leads to currency depreciation and a rise in net exports



14–31

Monetary Policy and the Open Economy (cont.)

• External shocks may adversely impact upon the RBA’s monetary policy objectives

– e.g. Assume economy is in recession. RBA attempts to stimulate economy through easy money. At the same time, there may be increased demand for Australian goods.End result: Over-stimulation



14–32

Shortcomings of Monetary Policy

• Cyclical asymmetry• Conflict with Treasury goals• Cost-push inflation• Investment insensitivity

– Some question how sensitive investment actually is



14–33

Strengths of Monetary Policy

• Flexible and speedy to implement, relative to fiscal policy

• Politically acceptable, due to its broad impact



14–34

Next Chapter:

Macroeconomic Debates

Documents

Copyright 2004 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles by Jackson, McIver, Bajada and Hettihewa Slides prepared by Muni Perumal, University