1. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 10-1 Monetary Policy and the Financial System 2012

2. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 10-2 Learning Objectives To introduce the monetary system in Australia. To explore the mechanics and role of monetary policy in Australia

3. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 10-3 The Functions of Money What is money? Anything that performs the function of money is money Money is what money does

4. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 10-4 The Functions of Money Medium of exchange Unit of account Store of value Standard of deferred payment

5. Characteristics of money Any thing can serve as money, but it helps if it is; – Portable – Durable – Divisible – Relatively scarce – Universally acceptable Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 10-5

6. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 10-6 Money Defined Three components: – Currency (coins and notes) also called High Powered Money of the Money Base, only about 5% of the money supply! – Current deposits in banks upon which cheques can be drawn – Non-current accounts such as savings, deposits account for 95% of money in Australia

7. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 10-7 The Money Market The combination of the money demand and money supply determines the equilibrium interest rate The interest rate represents the opportunity cost of holding money balances MS curve is vertical because at any point in time the value of notes and coins on issue is fixed.

8. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 10-8 Equilibrium Interest Rate Rate of interest, i (per cent) Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DmDm ieie 0 50 100 150 200 250 300 SmSm Equilibrium Interest Rate

9. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-9 Objectives of Monetary Policy Monetary policy – influencing interest rates and credit availability to stabilise real GDP, employment and the price level Fundamental objectives – full employment – non-inflationary level of total output The Reserve Bank of Australia has responsibility for managing monetary policy not the Government 

10. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-10 Cause-Effect Chain of Monetary Policy Cash rate – interest rate charged for exchange settlement account funds – Also the interest rate the commonwealth pays on its debt, lowest rate in the country Other short-term interest rates – the cash rate sets the cost of short-term funds for banks – All other rates add a risk premium to the cash rate – influences the rate at which banks are willing to lend

11. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-11 Cause-Effect Chain of Monetary Policy (cont.) Aggregate demand – Availability of bank credit, which impacts on interest- sensitive components of household spending and investment (and therefore output, employment and prices), is impacted through monetary policy – Changes in MP also affect the exchange rate and hence imports and exports  Lower interest rates lead to a depreciation, exports increase and imports fall, AD and AE increase  Higher interest rates lead to an appreciation, exports falland imports increase, AD and AE increase

12. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-12 Monetary Policy and Aggregate Demand Easy money policy – RBA expands the money supply, this reduces the cash rate, lowering the cost and increasing the availability of bank credit, to expand spending Tight money policy – RBA reduces the money supply, this increases the cash rate, increasing the cost of credit, reducing the availability of credit, to reduce spending in the economy

13. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-13 Monetary Policy and Investment Increases in interest rate reduce the viability of many investments and the quantity of investment spending falls Increases in interest rate make the purchase of financial assets more attractive Let’s look at the investment schedule, but also consumption and exports as they are also interest sensitive

14. i I Investment schedule i C Consumption schedule i Exports schedule An inverse relationship between interest rates and GDP

15. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-15 Monetary Policy Tools The major tool used by the RBA to determine the cash rate: Open market operations, but thanks to the Howard Costello government, there are very few Aussie bonds in the market, so the RBA now also buys and sells commercial paper assests (e.g. debentures) to change the money supply

16. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-16 Open-Market Operations Buying and selling of Commonwealth government securities (and commercial paper assets) by the RBA in the cash or short-term money market The objective of OMOs is to ensure that the demand and supply of ESA funds are such that they are in balance at the target cash rate

17. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-17 Open-Market Operations (cont.) Buying and selling of Commonwealth government securities by the RBA affects the cash rate Cash rate provides an indication of the RBA’s monetary policy stance – Sustained increases in cash rate target level: tightening of monetary policy – Sustained decreases in cash rate target level: easing of monetary policy

18. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-18 Open-Market Operations: Buying Securities Banks sell some of their securities RBA pays for securities by increasing banks’ exchange settlement accounts (ESAs) – ESAs form part of the banks’ prime assets ratio (PAR) requirement Bank reserves increase – Causing the monetary base and the banks’ lending ability to increase

19. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-19 Open-Market Operations: Selling Securities The RBA sells securities to the banks Banks pay for securities by decreasing their exchange settlement accounts (ESAs) Bank reserves decrease – Causing the monetary base and the banks’ lending ability to decrease

20. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-20 Easy Monetary Policy Implemented when the economy is faced with the prospects of substantial unemployment or deflationary pressure RBA announces its intention to reduce the cash rate RBA acts to bring the ESA funds market into balance The RBA does not set the cash rate, it can only intervene in the market to bring about desired changes to interest rates.

21. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-21 Easy Monetary Policy (cont.) Cash rate ESA funds S1S1 D1D1 Interest rate 3-year funds CR 1 S2S2 CR 2 SF 1 D1D1 R 1 SF 2 R 2

22. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-22 Tight Monetary Policy Enacted when the economy is facing significant inflationary pressures RBA announces its intention to increase the target cash rate ESA funds are brought into balance at this new target cash rate

23. 12-23 Tight Monetary Policy (cont.) Cash rate ESA funds S2S2 D1D1 Interest rate 3-year funds CR 1 S1S1 CR 2 SF 2 D1D1 R 1 SF 1 R 2

24. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-24 Monetary Policy and Equilibrium GDP Cause–Effect Chain of Monetary Policy: Money supply impacts interest rates Interest rates affect investment Investment is a component of AD Equilibrium GDP is changed Equilibrium GDP is changed

25. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-25 Price level Real domestic output, GDP D1D1 Investment demand Real rate of interest, i 10 8 6 0 10 8 6 0 Quantity of money demanded and suppliedAmount of investment, i SF 1 AS AD 1 P1P1 AS LR Monetary Policy and Equilibrium GDP (cont.)

26. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-26 Price level Real domestic output, GDP D1D1 Investment demand Real rate of interest, i 10 8 6 0 10 8 6 0 Quantity of money demanded and suppliedAmount of investment, i MS 1 AS AD 1 P1P1 AS LR MS 2 AD 2 Easy Monetary Policy Monetary Policy and Equilibrium GDP (cont.) AD 3

27. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-27 Price level Real domestic output, GDP D1D1 Investment demand Real rate of interest, i 10 8 6 0 10 8 6 0 Quantity of money demanded and suppliedAmount of investment, i AS AD 1 P1P1 AS LR MS 1 Tight Monetary Policy Monetary Policy and Equilibrium GDP (cont.)

28. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-28 Price level Real domestic output, GDP D1D1 Investment demand Real rate of interest, i 10 8 6 0 10 8 6 0 Quantity of money demanded and suppliedAmount of investment, i MS 2 AS AD 2 P1P1 AS LR MS 1 Tight Monetary Policy AD 1 Monetary Policy and Equilibrium GDP (cont.)

29. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-29 Shortcomings of Monetary Policy Cyclical asymmetry Conflict with Treasury goals Cost-push inflation Investment insensitivity – Some question how sensitive investment actually is

30. Copyright  2004 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics 7/e by Jackson and McIver Slides prepared by Muni Perumal, University of Canberra, Australia 12-30 Strengths of Monetary Policy Flexible and speedy to implement, relative to fiscal policy Politically acceptable, due to its broad impact