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Chapter 14 Monetary Policy 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 Canberra and Jay Bandaralage, Griffith University 14–1 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. 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 Canberra and Jay Bandaralage, Griffith University 14–2 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. 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 Canberra and Jay Bandaralage, Griffith University 14–3 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. 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 Canberra and Jay Bandaralage, Griffith University 14–4 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 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 Canberra and Jay Bandaralage, Griffith University 14–5 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 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 Canberra and Jay Bandaralage, Griffith University 14–6 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 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 Canberra and Jay Bandaralage, Griffith University 14–7 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 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 Canberra and Jay Bandaralage, Griffith University 14–8 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 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 Canberra and Jay Bandaralage, Griffith University 14–9 Balance Sheet of the RBA • Assets: – – gold and foreign exchange government securities • Liabilities: – – – notes on issue non-callable deposits exchange settlement account (ESA) funds 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 Canberra and Jay Bandaralage, Griffith University 14–10 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) 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 Canberra and Jay Bandaralage, Griffith University 14–11 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 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 Canberra and Jay Bandaralage, Griffith University 14–12 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 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 Canberra and Jay Bandaralage, Griffith University 14–13 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 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 Canberra and Jay Bandaralage, Griffith University 14–14 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 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 Canberra and Jay Bandaralage, Griffith University 14–15 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 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 Canberra and Jay Bandaralage, Griffith University 14–16 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 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 Canberra and Jay Bandaralage, Griffith University 14–17 The Market for Exchange Settlement Funds and the Cash Rate S2 Target cash rate S1 D2 D1 ESA funds 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 Canberra and Jay Bandaralage, Griffith University 14–18 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 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 Canberra and Jay Bandaralage, Griffith University 14–19 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 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 Canberra and Jay Bandaralage, Griffith University 14–20 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 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 Canberra and Jay Bandaralage, Griffith University 14–21 S1 S2 Interest rate Cash rate Easy Monetary Policy (cont.) CR1 SF1 D1 SF2 R1 R2 CR2 D1 ESA funds 3-year funds 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 Canberra and Jay Bandaralage, Griffith University 14–22 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 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 Canberra and Jay Bandaralage, Griffith University 14–23 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 changed 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 Canberra and Jay Bandaralage, Griffith University 14–24 Real rate of interest, i Monetary Policy and Equilibrium GDP (cont.) SF1 10 10 8 8 6 6 D1 0 0 Quantity of money demanded and supplied ASLR Amount of investment, i AS Price level AD1 Investment demand P1 Real domestic output, GDP 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 Canberra and Jay Bandaralage, Griffith University 14–25 Real rate of interest, i Monetary Policy and Equilibrium GDP (cont.) SF1 SF2 10 10 8 8 6 6 D1 0 0 Quantity of money demanded and supplied ASLR P1 Amount of investment, i AS Price level AD1 Investment demand Easy Monetary Policy AD3 AD2 Real domestic output, GDP 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 Canberra and Jay Bandaralage, Griffith University 14–26 Real rate of interest, i Monetary Policy and Equilibrium GDP (cont.) SF2 SF1 10 10 8 8 6 6 Price level D1 0 0 Quantity of money demanded and supplied ASLR AS Investment demand Amount of investment, i Tight Monetary Policy P1 AD1 Real domestic output, GDP 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 Canberra and Jay Bandaralage, Griffith University 14–27 Real rate of interest, i Monetary Policy and Equilibrium GDP (cont.) SF2 SF1 10 10 8 8 6 6 Price level D1 0 0 Quantity of money demanded and supplied ASLR AS Investment demand Amount of investment, i Tight Monetary Policy P1 AD1 AD2 Real domestic output, GDP 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 Canberra and Jay Bandaralage, Griffith University 14–28 Monetary Policy and Equilibrium GDP (cont.) 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 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 Canberra and Jay Bandaralage, Griffith University 14–29 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 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 Canberra and Jay Bandaralage, Griffith University 14–30 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 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 Canberra and Jay Bandaralage, Griffith University 14–31 Shortcomings of Monetary Policy • Cyclical asymmetry • Conflict with Treasury goals • Cost-push inflation • Investment insensitivity – Some question how sensitive investment actually is 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 Canberra and Jay Bandaralage, Griffith University 14–32 Strengths of Monetary Policy • Flexible and speedy to implement, relative to fiscal policy • Politically acceptable, due to its broad impact 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 Canberra and Jay Bandaralage, Griffith University 14–33 Next Chapter: Macroeconomic Debates 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 Canberra and Jay Bandaralage, Griffith University 14–34