MONETARY POLICY

BEFORE WE EXAMINE MONETARY POLICY WE NEED TO UNDERSTAND

WHAT IS MEANT BY THE FINANCIAL

SECTOR AND THE SUPPLY OF MONEY

THE FINANCIAL SECTOR

The financial sector consists of:Banks: Financial institutions act as

intermediaries between borrowers and lenders. (Includes RBA, and Australian and foreign owned banks)

Non-Bank Financial Institutions (NBFIs): Merchant banks, building societies, credit unions, finance companies, superannuation funds, Insurance and short-term money market dealers.

MONEY Money is any commodity that is accepted universally

as a medium of exchange for goods and services. Money has four functions:

It is a medium of exchangeActs as a measure of valueIs used to settle debtsIs a store of value

MONEY SUPPLYThere are two measures of the supply of

money in the economy.M3 = notes and coins held by the non-bank

public plus any current and fixed bank deposits, made by the public

Broad Money = M3 + net deposits of savings in Non-Bank financial institutions.

WHAT IS MONETARY POLICY

Monetary policy refers to the actions of the Reserve Bank of Australia (RBA) to influence the supply and cost of credit in the economy by manipulating the cash rate in the short term money market.

Monetary policy aims to promote low inflation, full employment and maximisation of the economic prosperity and welfare of Australian citizens.

Known as a ‘swing instrument’ or counter cyclical policy to maintain a sustainable rate of economic growth.

ACHIEVEMENT OF LOW INFLATIONThe primary aim of monetary policy is to achieve

the goal of low inflation over the medium term.Low Inflation – 2-3% inflation rate (CPI) over the

business cycle (7 – 10 years).This policy is referred to as inflation targeting –

the RBAs adjustment of monetary policy to achieve and maintain low inflation.

INFLATION TARGETING

Involves:A focus on medium term low inflationA pre-emptive of forward looking approach to likely

inflation trends (12-18 month lag)Aims of strong and sustainable eco growthConsideration of short term factors in policy settings

such as exchange rate, eco growth and o/s i-ratesSome emphasis on asset price growth, levels of

household debt and credit growth.

INFLATION TARGETING

Many of the worlds central banks use inflation targeting to conduct monetary policy.

The advantages of inflation targeting are:Provides an anchor point for people’s inflationary

expectationsMakes the conduct of monetary policy credible if

target achieved over timeProvides operational basisEnables coordination between countries to control

inflation

MEASURES OF INFLATION

Headline Inflation: the measure of the average price changes across the full regime or basket of goods and services (CPI).

Underlying Inflation: inflation rate which is calculated by removing volatile items from the calculation of average price changes. (exclude one off price changes that tend to be temporary e.g. bananas in 2011)

USING MONETARY POLICY TO PURSUE DOMESTIC STABILITY AND BETTER

LIVING STANDARDS

Domestic stability is a desirable situation where the government achieves the goals of:Low inflationFull employmentStrong and sustainable economic growth

in order to maximise living standards

USING MONETARY POLICY TO PURSUE DOMESTIC STABILITY AND BETTER

LIVING STANDARDS

Monetary policy is usually seen as the main stabilising instrument in the short to medium term, to help lessen the harshness of inflationary booms or recessions.

Monetary policy does this by regulating the strength of AD in a countercyclical way using either an expansionary stance or a contractionary stance.

This approach tries to smooth out fluctuations in the level of AD and economic activity to avoid recessions or unsustainable booms.

CASH RATE Interest rates are central to monetary policy and

are set by the RBA to regulate the level of aggregate demand

Interest rates represent the cost or price of credit (borrowing)

The cash rate is the interest rate in the short term money market or overnight money market.

MONETARY POLICY STANCE Monetary policy effects economic activity in two ways: The level of interest rates:

Cash rate less than 4.5% is expansionary, Cash rate between 4.5% - 5.5% neutral stance, Cash rate greater than 5.5% contractionary.

 Changes in interest rates: rises in interest rates are referred to as a tightening of

monetary policy falls in interest rate are an easing of monetary policy

CURRENT MONETARY POLICY STANCE