Explain the causes and effects of Monetary policy tightening.

Monetary policy is a macroeconomic policy conducted by the Reserve Bank of Australia, to

influence the supply and cost of credit in the economy. The Reserve Bank of Australia (RBA)
has a responsibility for the conduct of Monetary Policy and the maintenance of financial system
stability, including the stability of the payment system. The main tool of Monetary policy is the
Reserve Bank’s use of open market operations, for example: the buying and selling of
Commonwealth Government Securities to influence the official cash rate or interest rate paid to
borrow funds in the cash market. By influencing the official cash rate, the Reserve Bank of
Australia is able to indirectly affect the term structures of interest rates in the financial system.
As a result, changes in the term structure of interest rates will further impact the levels of
spending, output, inflation and employment within the economy. The Reserve Bank of Australia
has an operating target of 2-3% consumer price inflation over the economic cycle, and utlitzises
monetary policy to achieve this objective. Monetary policy tightening usually occurs due to the
concerns of rising inflations and is conducted by the RBA to decelerate an overheating
economic growth, further constricting the spending of a rapidly accelerating economy. A
tightening monetary policy would further impact consumers, businesses, foreign sectors and
overall decrease the aggregate demand in the economy and its rising inflation.

In a tightening monetary policy environment, the Reserve Bank of Australia would conduct
market operations to achieve a shortage of cash in the cash market. RBA would sell new CGS
in the cash market, further causing banks to withdraw funds from their ESAs for the availability
to create payments for the CGS. As demonstrated in figure 11.2, it would lead to a fall in the
supply of cash from S to S1relative to demand, and cause the cash rate to increase from r to r 1 .

Monetary policy tightening is usually conducted by the RBA when the economy is at its peak of
the business cycle to slow down the rapidly accelerating economic growth due to the concern of
the colossal increase in consumer inflation. Business cycle refers to the type of fluctuation of the
economy between periods of expansion (growth) and contraction (recession). Factors such as
gross domestic product (GDP), interest rates, total employment, and consumer spending, can
help to determine the current stage of the economic cycle. The aim of tight monetary policy is
usually to reduce inflation. With higher interest rates there will be a slowdown in the rate of
economic growth. This occurs due to the factor of higher interest rates increasing the cost of
borrowing, and therefore reducing consumer spending and investment, leading to lower
economic growth. Tight monetary policy will typically be chosen when inflation is above the
inflation target (of 2%) or policymakers fear inflation is likely to rise without a tightening of
monetary policy. In a hypothetical economy for example, the Reserve Bank of Australia
increases interest rates through monetary policy tightening in response to higher inflation, this
will further result in the inflation to decrease.

Monetary policy tightening would have major impacts on consumer spending as boosting
interest rates increases the cost of borrowing and effectively reduces its attractiveness. An
increase in rates also makes saving more attractive, as savings rates also increase in an
environment with a tightening policy, which further incentivizes consumers to save rather than
spend. Thus, resulting in the slow down of a rapid economic growth acceleration. In addition, a
tightening monetary policy would also affect businesses and the foreign sectors as the rise in
interest rate makes borrowing less attractive as interest payments increase. This further affects
all types of borrowing including personal loans, mortgages, and interest rates on credit cards.
As a consequence of this, businesses would be discouraged to invest in its business operations,
and the unemployment rate would rise as businesses and firms’ financial inability in sustaining
the funding of its human resources due to the combination of factors of existing debts and the
substantial decrease in business revenue. On the contrary, if interest rates increase, Australian
currency becomes more attractive to foreign investors. Consequently, this further increases
demand for the Australian dollar and increases the value of the Australian currency. As this
occurs there will be an increased level of foreign investment in Australia. Conversely, as the
currency rises it becomes easier for consumers to purchase goods from overseas and more
difficult for businesses to sell goods and services to foreigners.

Overall, contractionary monetary policy is driven by increases in the various base interest rates
controlled by modern central banks or other means producing growth in the money supply. The
objective is to reduce inflation by limiting the amount of active money circulating in the economy,
due to the rapid acceleration of economic growth and concerns of rising inflations. As a result,
this further impacts the factors of consumer spending, businesses, foreign sectors and overall
aggregate demand within the economy.