MONETARY POLICY - PRACTICAL ELEMENTS

Monetary policy is a government policy of changing economic activity by managing

the money supply and interest rate
- As with fiscal policy, it adjusts AE or AD
- In brief, to increase AD (or Ae), interest rates are reduced, and to decrease
AD (or AE), interest rates are increased.
Put those effects on the AD/AS (or AE/Y) diagrams, and you have the economies of
monetary policy

The Role of the RBA

The Federal Government gave responsibility for monetary policy to the RBA
- In recent decades, many countries have done the same. The main reason is
to prevent monetary policy being affected by electoral concerns or the
pressure of public opinion
- The RBA is owned by the government, and governments could change the
law that defines their role and objectives. However, doing this would be seen
as very bad policy. So it is really just a hypothetical possibility.
+ In other words, the RBA effectively operates monetary policy
independently of the government.
- RBA’s objectives:
+ Stability of currency (ie price stability / low inflation)
+ Full employment
+ Economic prosperity (high sustainable economic growth)

The RBA’s inflation target

The RBA’s main strategy for achieving these goals is to meet its inflation target
(average about 2%-3%)
This was set out in the Statement on Monetary Policy issued by the Government and
the RBA in the early 1900s

The Cash Rate

In turn, the RBA meets its inflation target by setting the level of a special interest
rate, called the cash rate
* The RBA doesn’t control the interest rate that people and businesses use. Those
are set by the banks. But the cash rate does affect all other interest rates.
- The cash rate is the interest rate on overnight loans between banks in the
cash
+ Cash refers to balances that banks hold in special accounts (Exchange
settlement accounts) with the RBA in order to make payments to each
other and the RBA
- THE RBA sets the level of the cash rate by changing interest rates that it sets
when lending cash to, and accepting deposits from the banks.
 + It then maintains the cash rate at this level by using and selling
government bonds, and doing other similar financial transactions.
+ For simplicity, buying and selling government bonds is often used to
explain how the RBA changes the cash rate as well
(eg. when the RBA increase the cash rate, it will end up selling bonds
to the banks and vice versa)
* Banks can deal with each other, or with the RBA, but RBA pays less than the cash
rate on deposits and charges more than cash rate on loans
→ so banks prefer to deal with each other (at cash rate)
* The RBA controls the supply of cash . As they increase the supply of money, the
cash rate is cut
* All the RBA does to change the cash rate is to change those two limits
* Because the banks’s demand for cash changes, so the RBA has to adjust the
supply to keep the cash rate at its target, by buying and selling bonds (often called
open market operations or OMOs)
* How do selling government bonds reduce the supply of money in the cash market?
→ The banks buy the bonds from the RBA. They pay with cash, which the RBA basically
hides / buries / takes out of the cash market.
⇒ Voila, less chas in the banks special exchange settlement accounts, vice versa when the
RBA buys bonds from the banks

The Cash Rate and Interest Rates

Firms and consumers do not use the cash rate. The cash rate only applies to
transactions between the banks to settle their overnight cash balances.
Regular interest rates, such as home loan interest rates and small business loan
rates, are affected by the cash rate
- If the cash rate goes up, these other interest rates nearly always go up, and
vice versa.
- Although the RBA only sets the cash rate, we often describe monetary policy
in terms of the RBA changing interest rate.
The cash rate has gone down this century, down to historically unprecedented levels
(RBA’s cash rate =0/1% pa)

The Cash Rate and Business Lending Rates

Although quite higher, business lending rates follow the same pattern as the cash
rate. So changing the cash rate effectively changes interest rates.

The basics of Monetary Policy

On the first Tuesday of each month (except January - as it’s Australia's annual
christmas and New Year’s break, so there’s rarely any need to change monetary
policy at that time)
- A decision is announced that day and takes effect the next day (Implement in
1 day and decision made less than a month. The longest possible it can take
 is 2 month, from December to early February as the Board does not meet on
January)
- The RBA Board can meet more often than this, if it wants to
Monetary policy has short decision lags

How the RBA conducts monetary policy

If the RBA thinks that economic activity is too low, it will reduce the cash rate
- This will cause interest rates to fall, and hence increase AD
If the Rba thinks hat economic activity is too high, it will increase the cash rate
- This will cause interest rates to rise, and hence decrease AD
(The RBA doesn’t want economic activity to be too high as it can cause inflation)
Actually, The RBA’s decisions are forward looking
- They base their decisions on what they think will happen to economic activity
(and how that will respond to changing the cash rate)
This is because monetary policy has long effect lag
The RBA does not ignore current economic activity because it is a very useful guide
for future economic activity.
- They use a wide range of economic indicators to guide their estimates of
future economic activity.

The Monetary Policy Transmission Mechanism

The diagram outlines how changes to the cash rate affect GDP and inflation

Step 1: From the Cash Rate to Interest Rate

Banks can borrow and lend to each other in the overnight cash market, as the cash
rate
 - So this is an alternative source of funds to getting deposits from businesses
and customers
- It is also an alternative use of funds to lending them to businesses and
customers.
As a result, the cash rate influences commercial interest rates (they’re moving
together)
In other words, lending at cash rate is a substitute for lending to customers
- This is a supply substitute
+ For example, the supply of wheat or corn - farmers can supply more of
one only by supplying less of other.
Borrowing at the cash rate is a substitute for accepting deposits from customers.
- This is a demand, like the demand for mangoes and bananas
A higher cash rate increases the demand for accepting deposits for cash from
customers.
- This increases the interest rate for deposits
A higher cash rate reduces the supply of cash to lend to customers
- The higher deposit rate also reduces the supply of cash for lending.
- This increases the interest rate for commercial loans.
So commercial interest rates for deposits and loans will go up when the cash rate
goes up.
A lower cash rate reduces the demand for accepting deposits for cash from
customers
- This reduces the interest rate for deposits
A lower cash rate increases the supply of cash to lend to customers.
- The lower deposit rate also increases the supply of cash for lending.
- This reduces the interest rate for commercial loans
So commercial interest rates for deposits and loans will go down when the cash rate
goes down

Step 2:The four Channels of the Transmission Mechanism

When interest rates go up, consumption, investment and net exports (C, I, X-M) all
go down, and vice versa - when interest rates go down, C, I and X-M all go up.
→ There are 4 reasons for this. These reasons are called channels.

● The Saving and investment channel

This channel covers the explanation for how interest rates affect C and I
- Changes to interest rates affect the profitability of borrowing for investment
- For households, changes to interest rates change the returns from saving and
therefore change the level of consumption
The direction of the effect is the same in both cases (higher interest rates reduce C
and I, and vice versa)

● The Cash Flow Channel

Higher interest rates require higher home loan (aka mortgages - thế chấp)
repayments, so there is less money to spend on consumption.
Loans repayments are S, not C ⇒ So C FALLS
A similar effect happens for firms, because many firms have some debt
- So changes to interest affect how much firms have to spend servicing their
debt
So changes in interest rates therefore affect how much spare money firms have to
spend on investment
- Firms would much rather use their own money for investment, rather than
borrow
- Therefore, the higher interest, the less money they have, and the less
investment they do
● The Asset Prices and Wealth Channel
Higher interest rates tend to reduce asset prices
- They make firms less profitable, so share prices tend to fall
- The falling demand for housing tends to make house pisces fall too
Therefore the higher the interest rate, the less wealthy people are
- so they consume less and save more

● The Exchange rate Channel

Changes to interest rates encourage changes in foreign investment
- This changes the exchange rate, which chanes net exports
So higher interest rates lead to inflows of foreign investment, causing the currency to
appreciate (so import prices get cheaper, imports will rise), making X-M falls (and
vice versa)

Overall, the channels outlined above affect the level of AD. This then changes
domestic and import prices, which in turn changes the rate of inflation.
- The main way this occurs is through demand pull inflation
+ Essentially, lowering AD stops this happening, reducing inflation.
- But there is a direct cost push factor, which is the effect of changing exchange
rates on import prices.

Inflationary Expectations
Monetary policy is much more effective at controlling inflation if the RBA has
credibility.
If people expect the RBA to meet its inflation target, they will more quickly respond to
changes in the cash rate
Inflation expectations affect the wage rises people bargain for, and price rises firms
think they can pass on
- Which in turn has a big impact on actual inflation.
MONETARY POLICY STANCES AND OTHER ISSUES

Monetary Policy Stances

Just like fiscal policy, the conduct of monetary policy can be described as having
stances
- As with fiscal policy, they are expansionary, neutral, or contractionary, based
on their impact on AE or AD
- Expansionary: cutting the cash rate and keeping it low
+ The lowers interest rate (or keeps them low) to encourage C, I and X-
M, thereby increasing AE (or AD)
+ Also described as loosening or loose monetary policy (depending
on whether the cash rate is cut or kept at a low level)
+ The long effect lag of monetary policy explains why keeping the cash
rate at a low level is considered to be expansionary
- Neutral: leaving the cash rate at a moderate level
+ Doesn’t change the level of C, I and X-M, or therefore AE (or AD)
+ There is no standard level of the cash rate that is neutral
+ These days, with low inflation and very low interest rates, neutral
monetary policy has a relatively low cash rate
- Contractionary: raising cash rate and keeping it high
+ This increasing interest rates (or keeps them high) to reduce C, I and
X-M, thereby decreasing AE (or AD)
+ Also described as tightening or tight monetary policy (depending on
whether the cash rate is raised or kept at a high level)

Strengths of Monetary Policy

1. Short recognition and decision lags - the RBA meets every month (except
Jan) and can meet more often than that
- As with fiscal policy, the recognition lag is short (the RBA and the
government both see the same data and have the staff to analyse it)
- But once the Board has decided what to do with monetary policy, any
changes are implemented the next day. (The longest possible decision
lag for monetary policy is 2 months. If the issue arises in early
December, they might not make a decision on it until they meet in early
Feb, but it is usually 1 month.)
- That said, it will take time for the full effect to happen
2. Monetary policy is independent of the political process
- The RBA makes their decision solely on the basis of their objectives
+ They do not consider their impact on the government or what
the government would like them to do
- In particular, the RBA is seen as independent as well, which means
RBA cash rate decisions influence people’s inflationary expectations
3. Monetary policy is board, affecting all parts of the economy (C, I, X-M)
 - It does not favour particular groups or regions in the economy
+ The ability to target fiscal policy is a strength, but the board
effect of monetary policy helps ensure that it is seen as impartial
and independent, and avoid criticism. (the RBA affects the
whole community at the same time, so people don’t accuse it of
being biased)
4. Monetary policy is very flexible, meaning that it can be easily changed as
circumstances change
- This is because of its short decision lag
- The RBA can make changes gradually, seeing the effect of changes it
has already made before deciding if more change is needed.
(* like how often the cash rate was changed when the RBA tightened or
loosened monetary policy, a bit more or a bit less)

5. Monetary policy is very effective in booms

- Not only because the changes to the cash rate reduce AE (or AD) , but
also because the RBA has credibility
+ Firms and consumers know that further increases will follow if
initial changes are not enough. Therefore, increases in the cash
rate signal to firms and consumers that economic conditions will
get worse (This will further encourage falls in economic activity,
such as by affecting business and consumer confidence)
Weaknesses of Monetary Policy
1. Monetary policy has a long and uncertain effect lag
 - Firms can take a long time to change their investment plans. You can’t
easily bring forward a large construction project, or easily delay it once
work has started
- For similar reasons, net exports can take a long time to respond to
exchange rate changes. Even though the effect of interest changes on
the exchange rate happens very quickly
- This is another reasons why monetary policy changes are phased in
2. Monetary policy is very broad, as the cash rate applies to the entire country
- While usually a strength, this can hurt some regions more than others
- This is especially true when there is a two speed economy (The Dutch
Disease)
+ During the mining boom, the mining states of WA and
Queensland boomed (called for relatively tight monetary policy)
+ But Victoria and SA performed less well, where looser monetary
policy would have been more suitable.
3. Monetary policy does not work well in recessions
- If confidence is low, low interest rates are not enough incentive to
invest or spend (why invest if you don’t think you’ll have customers in
the future?)
- In addition, its long effect lag means any recovery caused by loose
monetary policy will be slow
- Monetary policy in recessions has been described as like pushing on a
piece of string
(* This is in contrast with fiscal policy. Fiscal policy is worst at expansion and booms.
Fiscal policy has long decision lag and short effect lag, while monetary has short
decision lag but long effect lag. Fiscal policy is inflexible, while monetary policy is
flexible)
(During a recession, political issues are less of an issue for fiscal policy. It’s because
a recession affects everyone so it’s likely that no politicians are going to go against a
policy that is trying to bring the economy back up. Also, the best policy based on
economics is also the best political policy.)

Contemporary Monetary Policy in Aus

Since the end of the mining boom nearly 10 years ago, the RBA has had an
expansionary stance
- The cash rate now is at 0.1%, the lowest it has ever been.
- This reflects a sluggish economy throughout that decade
The stances was neutral from 2017 until 2019
- But then monetary policy was loosened again
- The pandemic led to a further loosening of monetary policy
+ This saw the cash rate being cut to its lowest ever level
+ In other words, this is the limit of monetary policy using the cash rate.
The very expansionary monetary policy was possible because inflation was low
throughout the decade
 - The current almost 4% inflation should not be a concern, because it is a
recovery of prices from falling last year. Although certainly something for the
RBA to watch closely.

Unconventional Monetary Policy (not part of the syllabus, but we still have to
have an idea about it)
Recently, the cash rate has actually been below the RBA’s target cash rate. (the
orange is the ACTUAL cash rate.)
- Just after this graph was made, the final cut of the cash rate target to 0.1%
was made (on 4/11/2020)
- The actual cash rate is below even 0.1%

-
The inability to use the cash rate to further reduce interest rates has led the RBA to
use what it calls unconventional monetary policy
- It first began to do this March 2020
Unconventional monetary policy involves using measures other than the cash rate to
affect interest rates
- For ex, negative interest rates (you pay the bank to deposit money), but the
RBA has not tried this
One measure the RBA has used is asset purchases
- It buys existing government bonds from the financial sector (not just the
banks, as with the cash rate)
- This is not the same as funding government deficits by printing money; the
RBA only buys existing government bonds (printing money to pay for a deficit
means the RBA buys newly issued bonds)
+ The RBA has explicitly ruled out buying new bonds from the
government to pay for budget deficits
(*conventional monetary policy: change interest rates by changing the cash rate;
unconventional monetary policy: change interest rates in other ways)