Download 14–5 Objectives of Monetary Policy

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