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7/28/2019 The Reserve Bank and Monetary Policy
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What is the Role of the ReserveBank?
All countries have a
Central Bank. In
Australia it is known
as the Reserve Bank
(RBA). The role of the
Reserve Bank
involves:
Prudential
Supervision of the
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What is Monetary Policy?
Monetary Policyis
the Reserve Bank s
use ofchanges ininterest ratesto
influence the level of
the Money Supplyand
economic activity to
achieve the4 basic
economic objectives.
Reserve Bank targetsinterest rates
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WHAT DETERMINES THE RATE
OF INTEREST?
An interest rateis thepercentage yield on afinancial security such asa bond or a share.
It is also a charge forborrowing money or areturn for lending money.
It is basically a price formoneyand as such isdetermined by theDemand for and theSupply of money.
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WHAT DETERMINES THE RATE
OF INTEREST? If the Reserve Bank increases
or decreases the moneysupply, the supply curve willmove.
The Reserve Bank increasesthe money supply by printingand issuing more currency tothe banks.
This will shift the Supply curve
to the right from S1 to S2. Thiswill tend to lower interestrates.
To reduce the money supply
the Reserve Bank withdrawscurrency from circulation.
0
5
10
15
20
25
0 5 10 15 20
r
Q. of Money
d
S1 S2
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WHAT DETERMINES THE RATE
OF INTEREST?
The Supply of Money isthe sum of the currencyand deposits in banksand other major financialorganisations.
The interaction of the Dand S curves determinesthe general level ofinterest.
0
5
10
15
20
25
0 5 10 15 20
r
Q. of Money
d
s
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WHAT DETERMINES THE RATE
OF INTEREST?
Changes in demand orsupply will change theinterest rate.
For example a reductionin the budget deficit willreduce demand formoney and shift thedemand curve to the left.
This will lower theinterest rate.
In this case, the interest
rate fell from 9% to 6%.
0
5
10
15
20
25
0 5 10 15 20
r
Q. of money
S
d1d2
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What are the Goals of Monetary
Policy?
Under the requirements of theReserve Bank Act,the RBA is expected to aim to achieve a number ofgoals they are:
- The stability of Australias currency,- The maintenance offull employment and
- Theeconomic prosperity and welfare of thepeople of Australia.
These are thelong term goalsfor the RBA to aim atand to design policies in regard to achieving thesegoals.
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POLICY?
The main instrument ofMonetary Policy is MarketOperations.
This involves the Reserve
Bank buying or selling secondhand Government Securitiesand Australian dollarsecurities issued by somesupranational organisationsinthe official money market, toaffect the Cash Rate.
The cash rate is the interestrate in the official money
market.
10
0
5
10
15
20
25
1986199019941998200220062008200920112012
Prime rate
Cash rate
r
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HOW DOES THE RBAAFFECT
INTEREST RATES ?
If theRBA wants toreduce demandin theeconomy, they will
increase interest rates. This is known as a
ContractionaryMonetary Policy.
To increase interest ratesthe RBAwill initiallyannouncethat they will beincreasing the cash rate.
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HOW DOES THE RBAAFFECT
INTEREST RATES ?
The RBA will then sellSecuritiesin the officialmoney market. The official
money market is comprisedofbankswith exchangesettlement funds (CASH).
The RBA will offer a highyield (or interest rate)toget the banks to give uptheir excess funds (CASH).
$
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HOW DOES THE RBAAFFECT
INTEREST RATES ?
This will reduce thesupply of cash in theofficial money market,
shifting the supplycurve to the left.
This will lead to anincrease in the cash
(interest) rate.
In this case, the cashrate rose from 8% to
12%.
0
5
10
15
20
25
0 5 10 15 20
cashrate%
Q. of cash
S2 S1
D
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HOW DOES THE RBA AFFECT
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HOW DOES THE RBAAFFECT
INTEREST RATES ?
The rise in the cash rate will flow on to other interest
rates. The higher the level of risk the greater the interest
rate margintends to be.
Initially short term interest rateswill rise, eg at calldeposit rates, 90 day bankbills.
Then the longer term rateswill rise, eg. 10 year bond
rates and housing loan interest rates.
Interest rates in the economy will rise due to competition
between various lenders and borrowers for funds.
Higher interest rates will discourage spending and
eventually the growth in the money supplywill decline.
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Interest Rate changes in
Australia15
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Interest Rate changes in
Australia
As you can see from the previous slide. A
change in thecash rateflows on toother
interest rates.
Thedifferences and volatilityof the various
rates depend on a number of factors including:
the duration of the loans or depositsand
theriskinvolved.
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HOW CAN THE RBA LOWER
INTEREST RATES?
To expand the economythe RBA will lowerinterest rates.
The RBA announces thatthey will be lowering thecash rateand enters the
official money market andbuys back the securitiesfrom the banks.
s
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HOW CAN THE RBA LOWER
INTEREST RATES?
To do this the RBA offersa higher price for thebonds. This effectivelylowers the yield on the
bonds. The banks take the
money from the RBA.This increases the supply
of cash, shifting the Scurve from S1 to S2.
The cash rate falls from12% to 8%.
This rate cut ofofficialinterest rates then flows
0
5
10
15
20
25
0 5 10 15 20
cash
rate
%
Q. of cash
D
S1 S2
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HOW DO CHANGES IN INTEREST RATES
AFFECT THE ECONOMY?
Changes in interest rates and the money supply affectthe economyin a number of ways. A risein interestrates will:-
INCREASE SAVINGS
REDUCE AGGREGATE DEMAND
LOWER INFLATION
REDUCE IMPORTS
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HOW DO CHANGES IN INTERESTRATES AFFECT THE ECONOMY?
ATTRACT FOREIGN INVESTMENT seeking
high interest rates.
This capital inflow may act to push up the value of
the Australian dollarand make our exports lesscompetitive overseas.
A rising$Awill also make imports cheaper.
This creates a conflict,whereby Monetary Policy and
interest rate changes are not suitablefor solving
current account deficitproblems.
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HOW DOES A RISE IN INTERESTRATES AFFECT INVESTMENT?
0
5
10
15
20
25
0 5 10 15 20
0
5
10
15
20
25
0 5 10 15 20
cashrate%
Q. of cash I
D
S2 S1
MEC
r
A rise in the interest rate from 8% to 12% will reduce I from 12 to 9
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INTEREST RATES AND THE
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INTEREST RATES AND THE
ECONOMY
The rise in the cash ratewould flow-on to other interestrates. This will reduce investmentas r > MEC.
The MEC is the marginal efficiency of capital. It is thereturn on purchasing one more unit of capital.
This decline in investment will reduce aggregateexpenditure leading to a downward shift in the aggregateexpenditure curve and a fall in incomeby a multipliedamount.
A rise in interest rates is very effectiveat reducing I andAggregate expenditure.
The rise in the cash rate to 18% in Australia in the late1980s led to a fall in economic growth from 6% to -2% ofGDP in 1992.
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INTEREST RATES AND THE
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INTEREST RATES AND THE
ECONOMY
At the same time, business Ifell from 14% of GDP to8% of GDP.
A reductionin interest rates is notas effective at
increasing Iand aggregate expenditureas there areother factors that influence the decision.
A business will not I if there is excess capacity, or ifdemand is low, or if there is economic uncertainty.
So tight monetary policyis very effective at reducingdemandand inflation (but may lead to higherunemployment).
Cutting interest rates is much less effectiveat
increasing growth and solving unemployment.
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Wh t th t f t
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What are the current factors
influencing Monetary Policy?
The RBA policy throughout 2008/09 was tolower interest rates slowly to increasedemand.
The factors that influenced the RBAsdecisions were:
The global financial crisis and global
recession. Australias falling economic growth.
Rising unemployment.
Discouraged investment and spending.
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Wh t th t f t
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What are the current factors
influencing Monetary Policy?
The RBA policy throughout the second halfof 2009 and into 2011 was to increase interestrates slowly to decrease demand.
The factors that influenced the RBAsdecisions were:
Reduced concerns of the global financial
crisis and signs of global recovery Australias rising economic growth rate
Rising employment
An increase in the inflation rate
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influencing Monetary Policy in
2012? In 2012 the RBA decided to decreaseinterest rates to increase demand.
The factors that influenced the RBAs
decisions were: increased concerns of lower global
demand due to sovereign debt issues
especially in Europe Australias 2 SPEED ECONOMY
Rising unemployment in some areas
A decrease in the inflation rate below 2%.
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Where to Now?27
The RBA will monitor the state of theAustralian economy and global
economy in determining the need to
alter interest rates.
It should be remembered that the LAGfor Monetary Policy is about 18
months so it is possible the RBA will
change policy before it appears
necessary.
The likely scenario would be for
interest rates to increase in 2013.
The underlying concern isglobal
sovereign debt issues and worldoil prices.
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THE LIMITATIONS OF MONETARY AND
FISCAL POLICY
Monetary and Fiscal Policies are useful instopping demand inflation,but with problems ofstagflation and current account deficits andforeign debt, other policies have been used in
conjunction with these two.
These other policies are more specifically aimed atreducing costs and promoting trade. They are:-
Prices and Incomes Policy
Trade Policy
Microeconomic Reform
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