MONETARY POLICY

WHAT IS MONETARY POLICY

Lending by the financial sector allows consumption and investment in an economy to occur without having to pay the money there and then.

However, there is a cost to receiving the money for the borrower. This is called the “Interest Rate”.

The cost of this money, the interest rate, determines how much more will be paid back by the borrower – the principal plus interest.

WHAT IS MONETARY POLICY

The Interest rate in a economy is set by the Reserve Bank. This base rate is the minimum interest rate charged. Banks and other financial institutions lend money at the base rate plus a margin.

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 Interest rate.

WHAT IS MONETARY POLICY

A low interest rate means the cost of money is cheap and this will encourage sectors of the economy to borrow to consume goods or services or to invest and thus increase aggregate demand.

A high interest rate means the cost of money is expensive and this will mean those sectors of the economy that borrow or have borrowed will have to pay more interest on their loans thus reducing consumption and investment.

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 Interest rate (also called the cash rate)

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

ACHIEVEMENT OF LOW INFLATIONThe primary aim of monetary policy is to

achieve the goal of low inflation over the medium term.

Monetary policy is effective in combating inflation but less effective in other areas of the economy.

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.

CURRENT MONETARY POLICY STANCE