1. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-1 Chapter 11 Monetary policy

2. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-2 Learning objectives Discuss the objectives of monetary policy Describe the roles of the participating institutions and the route by which monetary policy affects the operation of the economy Examine the balance sheet of the Reserve Bank of Australia, through which monetary policy is largely implemented

3. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-3 Learning objectives (cont.) Analyse the techniques of monetary policy — the major instruments and how they function Discuss the cause–effect chain through which monetary policy functions and evaluate its effectiveness Using the aggregate demand–aggregate supply framework, examine monetary policy in an open economy Provide a restatement of employment theory and policy

4. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-4 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

5. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-5 Cause–effect chain of monetary policy Cash rate –Interest rate charged by the RBA for exchange settlement account funds Other short-term interest rates –The cash rate sets the cost of short-term funds for banks –Influences the rate at which banks are willing to lend

6. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-6 Cause-effect chain of monetary policy (cont.) Aggregate demand Availability of bank credit, which impacts on interest-sensitive spending (and therefore output, employment and prices), is impacted through monetary policy

7. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-7 Monetary policy and aggregate demand Easy money policy –RBA reduces the cash rate, lowering the cost and increasing the availability of bank credit, to expand spending and real GDP Tight money policy –RBA increases the cash rate, increasing the cost of credit, reducing the availability of credit, to reduce spending in the economy and reduce inflationary pressures

8. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-8 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, in preference to making investment expenditures

9. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-9 Balance sheet of the RBA Assets –Gold and foreign exchange –Government securities Liabilities –Notes on issue –Non-callable deposits –Exchange settlement account (ESA) funds

10. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-10 Changes in ESA funds and monetary policy Funds flow to and from government accounts Banks must maintain a positive balance in their ESAs with the RBA If a bank’s ESA goes into deficit, –it may borrow funds from other banks, or –trade in either government securities or repurchase agreements (repos)  Repos are agreement detailing the price, timing and conditions under which the banks and the RBA may exchange government securities

11. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-11 Yield curve The yield curve is a summary of the interest rates that apply at any given point in time to interest- bearing securities Shows the link between the cash rate and other short-term interest rates Changes in the cash rate change the cost of funds for banks, and change the cost of credit (loans) provided by the banks

12. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-12 Tools of monetary policy Two major tools used by the RBA to determine the cash rate: –Open market operations –Foreign exchange swaps and intervention in the foreign exchange market

13. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-13 Open-market operations Buying and selling of Commonwealth government securities by the RBA in the cash or short-term money market The objective of open-market operations (OMOs) is to ensure that the demand and supply of ESA funds are such that they are in balance at the target cash rate

14. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-14 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

15. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-15 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

16. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-16 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

17. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-17 S1S1 D2D2 S2S2 The market for exchange settlement funds and the cash rate Target cash rate ESA funds D1D1

18. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-18 Foreign exchange swaps RBA may use foreign exchange swaps to supplement or substitute for OMO Foreign exchange market intervention — either selling or buying Australian dollars –purchase/sale of dollars is equivalent to purchase/ sale of government securities, and has similar impact on banks’ ESA funds

19. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-19 Rediscount rate and monetary policy The rate at which the RBA buys or sells short-term securities under repurchase agreement Can be used as a central tool of monetary policy

20. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-20 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

21. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-21 Easy and tight monetary policy 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 (a) Market for ESA funds (b) Market for 3-year funds

22. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-22 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. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-23 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

24. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-24 S3S3 S2S2 Monetary policy and the money market Cash rate ESA funds S1S1 D1D1 Interest rate Money balances CR 1 CR 3 D1D1 R 1 R 2 (a) Market for ESA funds (b) Money market Sm 1 Sm 2 Sm 3 R 3 CR 2

25. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-25 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  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-26 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 SF 1 AS AD 1 P1P1 AS LR SF 2 AD 2 Easy monetary policy Monetary policy and equilibrium GDP (cont.) AD 3

27. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-27 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 SF 2 AS AD 1 P1P1 AS LR SF 1 Tight monetary policy Monetary policy and equilibrium GDP (cont.)

28. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-28 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 SF 2 AS AD 2 P1P1 AS LR SF 1 Tight monetary policy AD 1 Monetary policy and equilibrium GDP (cont.)

29. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-29 Monetary policy and equilibrium GDP (cont.) Refinements and feedback effects Policy effectiveness depends on –Shape of the demand for money curve –Shape of the investment demand curve Feedback effects –Reductions in GDP tend to reduce business profits, causing business to reduce investment

30. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-30 Monetary policy and the open economy Net export effect –Changes in interest rate affect the value of the exchange rate under floating exchange rate –An increase in interest rate appreciates the currency, resulting in lower net exports –A decrease in interest rate leads to currency depreciation and a rise in net exports

31. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-31 Monetary policy and the open economy (cont.) External shocks may adversely impact upon the RBA’s monetary policy objectives –E.g. Assume economy is in recession. RBA attempts to stimulate economy through easy money. At the same time, there may be increased demand for Australian goods. –End result: over-stimulation

32. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-32 Shortcomings of monetary policy Cyclical asymmetry Conflict with treasury goals Cost-push inflation Investment insensitivity –Some question how sensitive investment actually is

33. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Macroeconomics by Jackson and McIver Slides prepared by Muni Perumal 11-33 Strengths of monetary policy Flexible and speedy to implement, relative to fiscal policy Politically acceptable, due to its broad impact