15.

1 Introduction

Monetary policy: action by the RBA, on behalf of the government, to

influence the cost and availability of money and credit in the
economy
o Used to smooth the effects of fluctuations in the business
cycle and influence the level of economic activity,
employment and prices
The main instrument of monetary policy is domestic market
operations (DMO), which indirectly influence the level of interest
rates, achieving objectives relating to economic growth, inflation
and unemployment
o DMO: actions by RBA in the short-term money market (STMM)
to buy and sell second-hand Commonwealth Government
Securities in order to influence the cash rate and the general
level of interest rates
o E.g. In short term, tightening monetary policy through
upward pressure on interest rates will slow down economic
activity through reducing consumption, as consumers face
higher mortgage costs. Businesses also usually need to
borrow money in order to purchase new capital equipment.
Higher interest rates, more expensive to borrow, business
investment will decline. This results in lower AD and
economic activity
o E.g. In short term, loosening monetary policy by reducing
interest rates, increase consumer spending and business
investment

15.2 Objectives of monetary policy

Monetary policy is the primary macroeconomic policy used to
manage the level of economic growth:
o Expansionary (loosening): reducing interest rates if growth
rises too fast, inflationary pressures will also increase,
inconsistent with one of the governments long-term aims
o Contractionary (tightening): increasing interest rates reduce
inflation, slow down economic growth, increase
unemployment
RBA aims for:
o Stability of $A maintaining low inflation to minimise
currency fluctuations
o Maintain full employment reducing the level of
unemployment
o Promote economic prosperity and welfare encouraging
sustainable growth
15.3 Inflation targeting
Monetary policy is particularly suited to fighting inflation, which is
related to monetary factors
Interest rate movements can be distorted by political pressures
e.g. keeping interest rates low during election

Giving independence to a central bank helps minimise such

political distortions
In 1990s, RBA hoped to sustain low inflation and avoid the higher
interest rates (and higher unemployment) that may be necessary to
reduce high rates of inflation. Also, by targeting inflation, RBA will
reduce speculation, hence expectations which would contribute to
inflation
RBA targets 2-3% of inflation, not putting into account one-off
factors e.g. carbon tax, GST. At such times, RBA looks at underlying
inflation, instead of headline inflation
RBA considers several indicators in its implementation of monetary
policy:
o Inflation rate
o Inflationary expectations
o Wages growth
o Rate of unemployment
o Rate of economic growth
o Interest rates
o Exchange rate
o Commodity prices
o Terms of trade
o Global economic growth
E.g. if wages growth>productivity it can lead to cost-push inflation
E.g. depreciation of $A adds inflationary pressures through higher
prices for consumer imports and imported inputs to the production
process
E.g. strong economic growth, reductions in unemployment can add
to inflation as economy is approaching its supply capacity (NAIRU)
o

15.3 Implementation of monetary policy

Monetary policy involves influencing the cost and availability of

money:
o Control of money supply (monetary targeting): currency in
the hands of the public and RBA deposits in financial
institutions
o Influence of interest rates through short-run cash rate (ratesetting monetary policy)
Monetary targeting was used during 1970-80s however was not
successful as monetary targets were regularly missed and the
money supply figures were distorted by the movement of funds
from banks to other financial institutions that were not subject to
RBA regulation and control
Monetary targeting was abandoned mid-1980s. Monetary policy is
implemented through interest rate instrument where RBA sets
short-run cash rate to influence general level of market interest
rates
How DMO work
Cash rate interest rate paid on overnight loans in the STMM
The cash rate is determined by market forces of supply and
demand, but RBA can increase or decrease supply of funds in the
STMM through DMO thus target the cash rate

 RBA influences cash rate by Exchange Settlement Accounts (ESA)

o Banks need to hold a certain proportion of their funds with
the RBA in ES accounts in order to settle payments with other
banks and RBA
DMO: RBA buys or sells securities to a financial institution

15.4 Impact of changes in interest rates

Main effect of a change in interest rates is to change the demand
for credit (borrowings)
Transmission mechanism: explains how changes in the stance of
monetary policy pass through the economy to influence economic
objectives such as inflation and economic growth
o A fall in the level of interest rates should encourage
borrowing by both businesses and consumers, leading to
rising consumption and investment demand in the economy,
thus increasing the level of spending and raising the level of
economic activity
o Reducing interest rates also reduces the cost of servicing
existing loans, hence leading to additional spending
o Fall in interest rates discourages financial inflow leading to a
depreciation of $A, making Australian goods more
competitive in both domestic and overseas markets. This
unintended consequence of a fall in the level of interest rates
also has the effect of stimulating AD and economic growth,
adding inflation
o Increase in AD will also lead to either higher output and
employment or will spill over into higher prices and wages if
the economy is close to full employment
o Increase in aggregate spending that results from lower
interest rates, will increase demand for money, , which will be
accommodated by RBA raising the supply of money so that
(demand = supply)
Monetary policy can either be tightened or loosened depending on
whether the government wishes to dampen or boost economic
activity:
o Tightening of monetary policy: DMO increasing interest rates,
reducing consumer and investment economic activity, lower
economic growth, lower inflation, higher unemployment

Loosening of monetary policy: DMO decrease interest rates,

increasing consumer and investment economic activity,
increasing economic growth, falling unemployment, and
higher inflationary pressure
Although changes in monetary policy can be immediately
implemented, monetary policy can have a time lag of somewhere
between 6 to 18 months before the full impact of interest rate
changes are felt in the economy. For this reason, RBA might be
stimulating growth when dampening is required
o

15.5 Current stance of monetary policy

Interest rates have varied over time as monetary policy has

responded to varying economic conditions
RBA has been successful in controlling inflation averaging 2.7%,
aside from the one-off impact of the GST, which pushed inflation to
6%
There are 5 main factors that help to explain the stance of
monetary policy:
o Lower inflation objective: 2-3% of inflation goal
o Inflationary expectations: if expected low inflation, prices will
plan lower price
increases and
unions will push for
lower wage rises.
RBA will increase
interest rates to
reduce inflationary
expectations
o Labour costs:
because its one of
the most
significant
determinants of
inflation
o Economic growth
and lower
unemployment:
once RBA believes
there is low
inflation, it will
reduce interest
rates to maximise
employment.
Furthermore, level
of growth and unemployment indicate whether economy is
close to its supply constraints, where further increase in
economic growth will lead to inflation
o External factors: when global economic conditions
deteriorate, Australia experiences slower economic growth
and higher unemployment, and lower interest rates are an
important part of the policy response