Monetary Policy

Fraser I, Gionea J and Fraser S 2011, ‘Monetary Policy’, in Economics for Business, 4th edn, McGraw Hill, Sydney, pp.474-487

Chapter 23 - A soft copy of the chapter can be downloaded from vUWS - Readings and Resources folder.
Learning Objectives
Discuss the objectives of monetary policy
Explain how changes in interest rates affect different
sectors of the economy
Describe the instruments of monetary policy
Explain how the Reserve Bank of Australia uses open
market operations to influence the cash rate and
interest rates in general
Discuss the weaknesses and the strengths of monetary
policy

1
Defining Monetary Policy
Monetary policy involves policies that influence the cost and
availability of credit.

Monetary policy’s ultimate objective:

 Economic growth
 Full employment
 Relatively low inflation

Intermediate objectives
 Price of credit (interest rates)
 Availability of credit (money supply)

Tools used by the Reserve Bank are instruments of monetary policy.

2
Targets and objectives of monetary policy

Macroeconomic objectives
– Minimum unemployment
– Relatively low inflation
– Economic growth

Intermediate targets
e.g. Interest rates, Money supply

Monetary policy instruments e.g. Open Market

Operations (OMOs)
4
Objectives of Monetary Policy
The economic theory that lies behind monetary policy
is not complicated. Essentially, if the overall objective
of economic policy is to slow the rate of economic
growth, then the instruments of monetary policy can
be used to raise interest rates and thus restrict the
availability of credit.

On the other hand, if the objective is to stimulate

economic growth, interest rates are lowered and credit
becomes more readily available.

5
Interest Rates
Before looking at the detail of monetary policy, we
first consider how changes in the cost and availability
of credit affect different sectors of the economy.
Economists generally agree that changes in interest
rates are likely to affect private investment spending to
a far greater extent than consumer spending.
Remember the dual nature of interest rates: they are a
cost to the borrower and a return to the lender.

6
Effects on Household Spending
 Lower interest rates may induce some households to save less and
borrow more, thus increasing consumption spending.

 However, other households may have to increase their savings rate

to offset the lower return from lower interest rates, in order to reach
goals such as paying for children's education or retirement funding.

 Households with mortgages may take advantage of lower interest

rates to accelerate the rate at which they reduce their debt burden
by maintaining the level of repayments.

 Thus it is not clear that lower interest rates necessarily lead to

higher consumer spending.

7
Effects on Business Spending
 The impact of interest rates on business investment spending is
easier to predict because of the clear relationship between interest
rates and the investment decision.

 Factories, office buildings and capital equipment are expensive,

and the dollar cost of interest charges on funds borrowed to
finance these projects is a burden. Small changes in the interest
rate can have a significant effect on the cash flow required to fund
the repayments.

 Thus monetary policy mostly affects private investment, and

in this way it affects the level of output, employment and
income in the economy.
8
Instruments of Monetary Policy
 The instruments of monetary policy are the tools used by the Reserve Bank to
influence the price and availability of credit.

 Instruments of monetary policy included:

 Reserve asset (Liquidity) ratios, which prescribe ratios for liquidity such as the
cash to deposits ratio.

 Interest rate controls on both deposit and lending rates.

 Directives to banks on which sectors of the economy to favour, such as farmers or

exporters.

 Exchange controls, whereby approval from the Reserve Bank had to be gained
prior to funds being moved into or out of Australia.
9
Open Market Operations (OMOs)
In the period since 1980, the implementation of monetary
policy has shifted from being a process involving a complex
array of instruments to being a simple process involving only
setting the cash rate via open market operations.

Monetary Policy decisions involve setting the cash rate, which

is the rate charged on overnight loans between financial
intermediaries. The official cash rate target is the average rate of
interest paid on at call and very short-term deposits.

The Reserve Bank Board is responsible for making decisions

about changes in the cash rate target.
10
Open Market Operations (OMOs)
 The Reserve Bank uses open market operations to keep the actual
cash rate as close as possible to the target rate by managing the
supply of funds available to banks in the money market.

 Transactions between banks are settled via exchange settlement

accounts (ESA) held with the Reserve Bank. The banks are
required to maintain a positive balance Monetary policy in these
accounts at all times.

 On any day there will be a tendency for a surplus or a deficit in the

accounts. Through open market operations the Reserve Bank can
influence the interest rates banks have to pay for the funds needed
to maintain a positive balance in their ESA accounts.
11
Open Market Operations (OMOs)
Open market operations are the buying and selling of
government securities by the Reserve Bank on
secondary markets.
The objective of open market operations is to ensure
that the demand for and supply of ESA funds are in
balance at the target cash rate.
Open market operations influence both the general
level of liquidity and yields in financial markets

12
Open Market Operations (OMOs)
In general, if the Reserve Bank wishes to reduce the
availability of funds it sells securities. This tends to reduce
the availability of finance and raise the cash rate. Rises in
the cash rate will tend to raise the general level of interest
rates (Contractionary Monetary Policy)

Alternatively, to increase the availability of funds and reduce

the cash rate, the Reserve Bank purchases securities which
will tend to increase the availability of funds and lower the
cash rate. Falls in the cash rate will tend to lower the general
level of interest rates (Expansionary Monetary Policy)
13
Example 1: Contractionary Monetary Policy
(sale of securities)

Face value Market value Return Yield

% on face value 10/100

$100 $100 10% p.a 10%

Assume that government bonds are issued in the primary

market with a face value of $100. The interest rate over the
life of the bond is guaranteed at 10 per cent of the face value
per annum. This means that, over the life of the bond, the
holder will receive $10 per year, regardless of changes in the
market value of the bond.
14
Example 1: Contractionary Monetary Policy
(sale of securities)
Face value Market value Return Yield
% on face value 10/80
$100 $80 10% 12.5%

 Now assume that the RBA sells bonds with a face value of $100 for $80 (now the market value of
the security). This will lead to :

 Less money is held by the banks because it has been swapped for bonds and
banks may seek more funds on the short-term money market causing interest
rates to tend upwards.

 Yields on government bonds have risen. Any borrowers who compete with the
government for loan funds must also raise the yields they offer on their
securities. This leads to a general rise in the level of interest rates in the
economy. 15
Example 2: Expansionary Monetary Policy
(Purchase of Securities)

Face value Market value Return Yield

% on face value 10/150
$100 $150 10% 6.67%

 Assume that the RBA offers to purchase a security with a face value of
$100 for $150.This will lead to:

 More liquidity is held by the banks as they swap money for bonds and
they will try to shed these funds by lending more on the short-term
money market.

 Yields on government bonds have fallen. Borrowers who compete with the
government for loan funds can reduce the interest rates payable on their
securities.
16
Quantitative Easing
 Quantitative easing involves purchases of a wide range of securities by
the central bank with the aim of increasing the money supply (by
injecting more money) and lowering interest rates.

 Used by the United Kingdom and United States during the GFC.

 It is essentially the same as the open market operation outlined before

but involves a much wider range of securities and sellers. The process is
often described as 'printing money‘ when it involves the Treasury selling
government securities to the central bank to finance government
expenditure because in this case the government is spending more but
the private sector is not spending less. Such situations can lead to
inflation and the devaluation of the currency to stimulate demand and
the economy out of recession.
17
Weaknesses of Monetary Policy
 Monetary policy can exert powerful pressures when used to slow down the rate of
economic growth and reduce inflationary pressures. However, it is difficult to
predict how much time will elapse between the tightening of monetary policy
and the slowing of the economy.

 The effectiveness of monetary policy is also difficult to predict when it is being

used to stimulate economic activity. Some commentators describe this process as
'like pushing on a string'. That is to say, even though finance is readily available
and interest rates are low, more borrowers do not necessarily appear. In the past
two decades some interest rate changes had little effect on economic activity,
whereas at other times the effects of changes have been dramatic.

 Also, because Australian banks rely on funding from overseas to finance a

substantial part of their loan portfolio, the interest rate they charge on loans is
heavily influenced by international factors. This means that in some
circumstances their funding costs may be higher than those indicated by the
cash rate in Australia.
18
Strengths of Monetary Policy
Extremely powerful when used to pursue contractionary economic
policies. However, it is difficult to predict the time lag between
implementing the policy and when it will take effect.

The main strength of monetary policy is the speed with which it

can be changed-its flexibility. Open market operations can be
carried out on a daily basis and can influence most interest rates
within a matter of weeks.

The other attraction of monetary policy is for politicians in that its

effect is more subtle and widespread than fiscal policy. Changes in
fiscal policy usually produce identifiable winners and losers,
whereas the effects of monetary policy are more diffuse and can be
blamed on a variety of factors other than political government.
19
What determine the impact of a monetary policy
 The effectiveness of monetary policy depends on factors such as:
(a) levels of indebtedness
(b) actual and expected inflation
(c) levels of business and consumer confidence

 The attitude of banks is another factor. The effect of a looser monetary policy
may be to increase the cash reserves of the banking system, but if banks are
raising credit standards because of previous losses on risky lending, then fewer
customers will qualify for loans. This actually occurred in the aftermath of the
GFC with bank lending falling because banks were raising their credit
standards, even though interest rates were progressively lowered.

 The attitude of potential borrowers is also important. Following the 2008 GFC,
in 2009 businesses reduced their borrowings in order to restore balance sheet
strength and raised capital through issues of shares. Thus, even if banks were
willing lenders, the number of willing borrowers in 2009 and beyond was
probably smaller than in 2007 and earlier.
20
Summary of monetary policy
Easy monetary policy Tight monetary policy
Problem: Problem: inflation
unemployment and Remedy: induce a
deflation contraction in the
Remedy: induce an supply of money, and
expansion in the supply therefore spending, by
of money, and therefore increasing the interest
spending, by reducing rate
the interest rate Means: sell bonds in
Means: buy bonds in the open market
the open market

21