Lecture 11 Monetary Policy

L11: MONETARY POLICY
Learning Objectives
1. Define money and discuss its functions.
2. Discuss the definitions of the money supply used in

Australia today.
3. Discuss the role of the Reserve Bank of Australia.
2 Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
What is money and why do we need it?
§ Money: Assets that people are generally willing to

accept in exchange for goods and services or for
payment of debts.
§ Asset: Anything of value owned by a person or

firm.
Barter and the invention of money
§ Barter is the exchange of goods or services for other

goods or services.
§ Barter requires a double coincidence of wants.
§ Commodity money: A good used as money that also
has value independent of its use as money.
§ Money makes exchange easier thereby allowing for
specialisation and higher productivity.
The functions of money
1. Medium of exchange
2. Unit of account
3. Store of value
How do we measure money today?
§ Currency: Notes and coins held by the private non-

bank sector.
§ M1: The narrowest definition of the money supply

which comprises currency plus the value of all demand
deposits with banks.
Money Demand
and
Money Supply
7-7
Money Market Diagram: Money Demand
§ The amount of cash (or money) that an individual
desires to physically hold determines their demand for
money, or Md. Md = demand for cash in your
pocket/wallet/purse.
§ Cost of holding money: The higher the nominal

interest rate, the higher the opportunity cost.
§ Thus as i ↑→Md↓. Thus the Md curve is a downward

sloping function.
7-8
The Money Demand Curve
i
M0d
Money ($million)
7-9
Money Market Diagram
§ Factors that shift Money demand curve
§ Factors that change the amount of money people want
to hold at any given nominal rate of interest will shift
the curve. For example:
1. Real income or output (Y): as incomes increase,

more money is required for a higher level of
transactions. → shift Md to the right.
2. The price level (P): the higher the price level, the
more dollars are needed to finance the same
volume of transactions → shift Md to the right.
3. Payment technology: ATMs and internet banking

→ shift Md to the left
7-10
The Money Demand Curve
i
M1d
M0d
Money ($million)
7-11
Money Market Diagram: Money Supply
§ The money supply is influenced by the RBA and consists
of notes and coins in circulation plus deposits in the
banking system (Ms = C + D).
§ The RBA targets the interest rate and thus the

money supply curve is horizontal (In the past the RBA
targets the MS, hence the money supply curve is vertical.)
§ Equilibrium interest rate occurs where money demand

and supply curves intersect.
7-12
RBA Targets The Interest Rate (i)
i
1.5% MS
M1d
M0d
100 150 Money ($million)
7-13
The RBA and Monetary Policy
7-14
The Reserve Bank of Australia (RBA)
The RBA is Australia’s central bank, and has two main responsibilities:
1. Maintaining stability of the currency, which is regarded as

maintaining low inflation via monetary policy.
2. Oversight and regulation of financial markets. (We don’t deal

with this function of the RBA)
§ Monetary policy is now conducted by directly targeting

interest rates.
7-15
Exchange Settlement Accounts (ESA)
• Accounts kept by commercial banks with the RBA
• These accounts allow the banks to settle transactions between

them e.g. a customer at Westpac receives a cheque from the
Commonwealth Bank. Westpac credits the account of their
customer & then the Commonwealth Bank credits the account of
Westpac via the exchange settlement accounts
• The interest rate (r) on these accounts is kept low by the RBA to
discourage banks parking funds in the account
• However, the banks have to keep enough cash in these accounts

to meet their obligations
Overnight Cash Market
§ Banks borrow from the overnight cash market if ESA is down
increase the interest rate in this market
§ Banks lend to the overnight cash market when ESA is up

decrease the interest rate in this market
§ The borrowings and lending are for less than 24 hrs
v The RBA intervenes to keep the cash rate at the target level
Open Market Operations (OMO)
§ Open market operations are the buying and selling of

financial assets such as short-term government bonds
in order to affect the level of reserves in the
commercial banks’ exchange settlement accounts.
7-18
Open Market Purchases (RBA Buys Bonds)
§ If r > target r then the RBA buys bonds from the banks.
§ The RBA then credits the exchange settlement accounts.
§ Exchange settlement accounts pay only low interest rates
§ The banks then loan their excess funds in the overnight cash
market (higher interest rate)
§ This acts to decrease the cash rate (r)

Open Market Sales (RBA Sells Bonds)
§ If r < target r then the RBA sells bonds to the banks.
§ The RBA then debits the exchange settlement accounts.
§ Exchange settlement accounts pay only low interest rates
§ The banks then borrow funds in the overnight cash market

(higher interest rate) to meet obligations in exchange settlement
accounts
§ This acts to increase the cash rate (r)
7-20
Setting The Cash Rate
§ The RBA not only intervenes daily to keep the interest rate at the
target level
§ The RBA can also intervene to either increase or decrease

the target cash rate
- To decrease the target cash rate the RBA buys bonds
- To increase the target cash rate the RBA sells bonds

Flow-on Effects Of Cash Rate
§ Monetary policy seeks to affect all interest rates in the

economy, not just the overnight cash rate.
§ Longer term interest rates do tend to track the cash rate quite
closely.
7-22
Recession and Expansionary
Monetary Policy
7-23
RBA targets the cash rate
§ At its monthly meeting the RBA board of governors
decides what changes, if any, shall be made to the
cash rate.
§ Financial markets follow these meetings with intense

interest because the outcome immediately influences
most interest rates and the bond, share and housing
markets.
§ Having set the cash rate, the RBA conducts open

market operations to achieve it.
7-24
Monetary policy and economic activity
The effects of monetary policy on real GDP and the price

level, cont.
§ Lower interest rates may encourage investment, increase

net exports, and may increase consumer spending. Real
GDP and the price level will rise.
The effects of monetary policy on real GDP and the price

level, cont.
§ Expansionary monetary policy: The use of monetary

policy by the RBA to decrease interest rates to increase
real GDP.
§ The RBA decreases the cash rate.
§ This decrease typically flows through to decreases in

interest rates through the entire economy.
Expansionary Monetary Policy
Real GDP
and the
The AD
price level
Reserve curve shifts
Investment, rise by
Bank Board Other to the right
consumption more than
decreases interest by more
and net they would
the cash rates fall than it
exports have
rate otherwise
increase without
would have
policy
An Expansionary Monetary Policy Transmission Process
Economy in Recession
Price level
Economy in LRAS1
Recession:
AD curve
shifts to the SRAS1
left. Expansiona
103 ry MP
A
AD curve
shifts to the
100 B right.
AD1
AD2
0 1000 1100 Real GDP (billions of

dollars)
Boom and Contractionary
Monetary Policy
7-29
Using monetary policy to fight inflation
§ Sometimes, aggregate demand may be increasing too

fast, leading to inflation, and the economy may be in
equilibrium beyond potential GDP.
§ Contractionary monetary policy is used during periods of

high or rising inflation rates.
§ The RBA uses contractionary monetary policy to slow the

rate of increase of aggregate demand to less than it
would have increased without policy.
Using monetary policy to fight inflation, cont.
§ Contractionary monetary policy: The use of monetary

policy by the RBA to increase interest rates to reduce
inflation.
§ The RBA increases the cash rate.
§ This increase typically flows through to increases in

interest rates through the entire economy.
Using monetary policy to fight inflation, cont.
§ Higher interest rates may reduce new investment,

decrease net exports, and may reduce consumer
spending. The slower growth in aggregate demand may
reduce the inflation rate.
Contractionary Monetary Policy
Real GDP
Reserve Investment, The AD and the
Bank Board Other consumption curve shifts price level
increases interest and net to the left e fall
the cash rates rise exports
rate decrease
A Contractionary Monetary Policy Transmission

Process
Contractionary Monetary policy
Price level LRAS1
Economy in
expansion:
SRAS1
Contractionary
monetary policy
causes the AD 104 B
curve to shift to
the left,
returning
economy to 100
long-run
equilibrium.
AD2(without
policy)
AD1
0 1000 1030 Real GDP (billions
of dollars)
Summary
§ Money is used as a medium of exchange, unit of account and store

of value.
§ Open market operations are used to achieve the target cash rate in
the overnight money market.
§ The money demand and money supply curves and interest rates
§ Monetary policy and the economy
Copyr7-35
ight ã

Lecture 11 Monetary Policy

Uploaded by

Copyright:

Available Formats

You might also like

Lecture 11 Monetary Policy

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Lecture 11 Monetary Policy

Uploaded by

Copyright:

Available Formats

L11: MONETARY POLICY

1. Define money and discuss its functions.

2. Discuss the definitions of the money supply used in

3. Discuss the role of the Reserve Bank of Australia.

§ Money: Assets that people are generally willing to

§ Asset: Anything of value owned by a person or

Barter and the invention of money

§ Barter is the exchange of goods or services for other

The functions of money

§ Currency: Notes and coins held by the private non-

§ M1: The narrowest definition of the money supply

§ Cost of holding money: The higher the nominal

§ Thus as i ↑→Md↓. Thus the Md curve is a downward

1. Real income or output (Y): as incomes increase,

3. Payment technology: ATMs and internet banking

§ The RBA targets the interest rate and thus the

§ Equilibrium interest rate occurs where money demand

100 150 Money ($million)

1. Maintaining stability of the currency, which is regarded as

2. Oversight and regulation of financial markets. (We don’t deal

§ Monetary policy is now conducted by directly targeting

• These accounts allow the banks to settle transactions between

• However, the banks have to keep enough cash in these accounts

§ Banks lend to the overnight cash market when ESA is up

§ The borrowings and lending are for less than 24 hrs

§ Open market operations are the buying and selling of

§ The RBA then credits the exchange settlement accounts.

§ Exchange settlement accounts pay only low interest rates

§ This acts to decrease the cash rate (r)

§ The RBA then debits the exchange settlement accounts.

§ Exchange settlement accounts pay only low interest rates

§ The banks then borrow funds in the overnight cash market

§ This acts to increase the cash rate (r)

§ The RBA can also intervene to either increase or decrease

- To increase the target cash rate the RBA sells bonds

§ Monetary policy seeks to affect all interest rates in the

§ Financial markets follow these meetings with intense

§ Having set the cash rate, the RBA conducts open

The effects of monetary policy on real GDP and the price

§ Lower interest rates may encourage investment, increase

The effects of monetary policy on real GDP and the price

§ Expansionary monetary policy: The use of monetary

§ The RBA decreases the cash rate.

§ This decrease typically flows through to decreases in

An Expansionary Monetary Policy Transmission Process

0 1000 1100 Real GDP (billions of

Using monetary policy to fight inflation

§ Sometimes, aggregate demand may be increasing too

§ Contractionary monetary policy is used during periods of

§ The RBA uses contractionary monetary policy to slow the

Using monetary policy to fight inflation, cont.

§ Contractionary monetary policy: The use of monetary

§ The RBA increases the cash rate.

§ This increase typically flows through to increases in

Using monetary policy to fight inflation, cont.

§ Higher interest rates may reduce new investment,

A Contractionary Monetary Policy Transmission

§ Money is used as a medium of exchange, unit of account and store

§ Monetary policy and the economy