The Reserve Bank and Monetary Policy

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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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

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10

15

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25

0 5 10 15 20

r

Q. of Money

d

S1 S2

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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

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10

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0 5 10 15 20

r

Q. of Money

d

s

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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

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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.

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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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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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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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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

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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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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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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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The Reserve Bank and Monetary Policy

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