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Monetary Policy Monetary Policy: The policy, operated by the Reserve Bank, that affects the rate of growth of money supply, the interest rate, and the level of bank deposits, and indirectly affects the level of consumer spending. Ination targeting: the Reserve Banks adjustment of monetary policy to achieve and maintain price stability. Sterilization; Reserve Bank actions to offset the effects of intervention in the foreign exchange market. Role of the RBA; Responsible for: monetary policy stability of the nancial system overall payments system stability (money transfers among nancial institutions) the exchange rate, and Australias foreign currency reserves banking on behalf of the Australian Government the printing of Australias currency notes.

Money Base: The money base is a measure of the very liquid assets of the nancial system, and is dened as the cash holdings of the non-bank public and the banks, and deposits of banks and the non-bank sector with the Reserve Bank. Money Supply (M3); notes and coins in the hands of the non-bank public, plus bank deposits. Overseas Interest Rates; When there are signicant differences between interest rates in Australia and interest rates overseas, depositors can be tempted to shift their savings from one country to another in search of great prots. For example, when interest rates overseas are greater than in Australia, large holders of money in Australia can be attracted to move money abroad where the returns, through higher interest rates, are greater. This can lead to a shortage of funds in Australia. Relative real interest rates, therefore, are an important consideration. Effects of interest rates; Rising interest rates will have a signicant effects on the economy and the level of economic activity. rises in interest rates can cause reductions in the components of aggregate demand, which in turn leads to increased unemployment and lower rates of economic growth, For example, in Australia during the period 1988-90, rising interest rates led to signicant reductions in consumer demand. The rises in interest rates were reected in higher

prices, and potential consumers were in a position where they had to spend increasingly larger amounts of dollars on previously negotiated loans. The importance of Interest Rates; Interest rates are important for several reasons: Interest rates inuence the level of economic activity: personal loan rates inuence consumption expenditure, the rate of return on capital together with the cost of funds inuences capital investment and the rate of return on real estate (rents) affects building. Interest rates affect capital investment: by changing the return on capital relative to the return on securities. The exchange rate is inuenced by interest rates. Interest rates determine the type of use of funds Interest rate inuence the distribution of income, because low interest rates disadvantage retired persons who depend on the income they receive from their nancial assets. On the other hand, low rates are good for young families who usually have a higher level of debt - particularly if they have bought a house and mortgage. Interest rates represent the price of credit - the return paid on borrowed money. Market forces of supply and demand for money and credit inuence interest rates in a free market situation. Open Market Operations; 1. RBA monitors data during month, and assesses future conditions. 2. Board meet 1st Tuesday of each month and announce intention at 2.30 p.m. Tuesday. They can either increase, decrease, or keep the same cash rate. 3. Decision to increase I.Rs by 0.25%. RBA moves into money market (R.I.T.S) and sells commonwealth government securities (repos) 4. By Selling C.G.S, therefore the government decreases cash in the money market, and interest rates increase. 5. Exchange settlement accounts are run by institutions who wish to be involved in this system. They use these accounts to pay for the C.G.S, and under legislation they need to be topped up to the legislated level by the end of the trading day. They might need to borrow from other banks or use to their savings to pay for these. 6. The money pool in the larger money market is reduced and gradually over days/weeks the increase in increase in interest rates is transmitted through to the rest of the market - Transmission effect. Effect on monetary Policy on Domestic stability; manipulating the cash rate is an effective way of inuencing interest rates and economic activity. monetary policy is more effective at imposing a credit squeeze than at restoring condence and the path to economic recovery. monetary policy may be switched to a short-term stabilization focuses of a limited period of time. It is a exible policy: changes in the target cash rate can be implemented quickly. The Reserve Bank of Australia operates in the specialist money market daily. Effect on Demand - e.g. lowering interest rates encourages buying

less interest needs to be paid on loans encourages use of credit reduces prices Supply - e.g. Lowering interest rates cuts production costs creates condence reduces repayment costs encourages employment

By using an expansionary (loose) monetary policy stance the internal economy should be stimulated - economic growth and employment increases. By using a contractionary (tight) monetary policy stance the internal economy should be slowed - economic growth decreases, employment falls and ination is reduced. That is, this stance is appropriate to slow a booming economy e.g. 1999-2000, 1989/90. By using a neutral monetary policy stance the RBA is trying not to either stimulate or slow the level of economic activity. It will probably set a cash target around 4.5-5% to maintain a steady rate of growth with lower ination. Effect of monetary policy on external stability; Monetary Policy has a signicant, but often conicting, relationship with external stability. At the end of the 1980s high interest rates were aimed at the external problem at the time. Interest rate policy is exible, but more effective on the upswing of the trade cycle than on the downswing. Higher interest rates force spending to contract - after a while. Lower interest rates lead to more spending - but only after the restoration of business and consumer condence. High interest rates contribute to exchange rate appreciation. This makes exports less price competitive on world markets, and imports cheaper in Australian currency. High interest rates particularly in the late 1980s attracted capital inow. Higher interest rates (especially in comparison to overseas rates) will likely result in an appreciation of the $AUD. The consequences of this stance are that: exports become expensive imports become comparatively less expensive against local products. overseas investors are attracted to Australia (capital inow) repayments of past borrowings because they are easier the impact on the various components of the Current Accounting will depend on a number of conditions.

Effect of Monetary Policy on Resource Allocation; Government intervention aims to improve the efciency in the allocation of resources. Maximum consumer satisfaction is achieved by producing what consumers want. Government aims to reduce inefciencies while increasing the extent of market competition.

Some would argue that the best markets are unregulated ones - but generally, governments do tend to provide some form of regulation through legislation or economic policy controls. In the nancial market or sector of the Australian economy, the government provides elements of control or supervision to ensure nancial system stability. One of the basic aims of these activities is to protect depositors. However, the main effect of monetary policy on the allocation of resources is through its effects on investment expenditure. When a restrictive monetary policy is used to affect the levels of aggregate demand and economic activity, it does so essentially through higher interest rates so as to make money more expensive to borrow. This antiinationary stance tends to restrain growth in aggregate demand, especially growth in investment expenditure, which can lead to higher unemployment and unused productive capacity. In its efforts to restrain inationary pressure, the government can distort the allocation of resources and reduce the efciency of that allocation because some resources will not be used and employment opportunities will not be created. Rises in interest rates are intended to encourage consumers to save rather than spend. 2. Improve efciency in resource allocation. MP can be very efcient in this objective as it has considerable impact on supply. By controlling ination MP can increase producer (and consumer) condence leading to long term investment in productive assets. Low interest rates reduces production costs and with low ination help to minimize wage demands. Low interest rates promote improved competitiveness against overseas competition. MP can be used to discourage speculative investment Appropriate MP can create a balance between the levels of savings (investment) and consumption and thus make available funds for research and development. Effect of Monetary Policy on distribution of income; Inequalities in the distribution of income exist in a market economy. Inequalities are inevitable, given the presence of inherited wealth, enabling some individuals to earn higher incomes, varying wage rates and differing skills, qualications and opportunities. Monetary policy is blunt. Interest rates affect the whole economy. Substantial changes in rates affect almost all consumers and producers and their ability to borrow money. It is not possible to conne their effects to one section of the economy. Monetary policy, therefore, is unable to be applied selectively like Budgetary Policy. (weakness) High interest rates to contain inationary pressures run the risk of damaging the equity objective. 1. Improve equity in income distribution. Low interest rates encourage increased consumption increased investment leading to increase employment (incomes) and unemployment is the main cause of poverty. Low interest rates help exporters- raising incomes and employment Low interest rates reduces costs of borrowing, credit car charges - helping to keep prices down; ination generally adversely affects low income earners and holders of few real assets.

Low interest rates encourages property speculation. High interest rates assists those with investments/ real assets. High interest rates encourages overseas investment and is likely to assist importers and possibly those employed in importing industries.

High Interest Rates Groups likely to gain Savers and lenders Retirees Importers Strengths of Monetary Policy; 1. Flexible - MP can be easily adjusted e.g. 2003 changes in cash rate. 2. Transparent - changes in interest rates are generally well publicized and actions of the RBA closely monitored. 3. Subtle - changes are usually small and are seen more as ne tuning the economy. Weaknesses 1. Time lags- usually a considerable amount of time involved between the implementation and impact. 2. Blunt Instrument 3. Ineffectiveness to deal with serious economic problems. 4. Incompatibility - because of its inability to distinguish between groups the impact of e.g. higher interest rates will assist some areas but worsen others - consumer importers and exporters. Groups likely to lose Borrowings (home owners, farmers, small business owners) Investors Exporters