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Monetary Policy

VCE ECONOMICS

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Introduction

Monetary policy may be defined as actions taken by a country’s Central / Reserve Bank to influence the price and availability of credit in the economy.Monetary policy is carried out to achieve sustainable growth while keeping the rate of inflation as low as possible.

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Money

Money must be: A medium of

exchange A store of value A measure of value Capable of

extinguishing debt

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The Money Supply

Monetary school of economic thought believed that if the money supply could be strictly controlled, then the level of economic activity could be regulated and so could the level of inflation.

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It is thought that the growth in the money supply has a strong bearing on the level of economic activity and hence it is important to examine the factors which affect the growth of the money supply.

Factors affecting the money supply

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1. Credit creation process Financial intermediaries (e.g.

banks, housing loan companies) accept deposits from the public and reward them with the payment of interest.

They will then on lend the funds at a higher rate of interest. A portion of the funds will be retained in order to meet day to day requirements (known as the Reserve Requirement).

Factors affecting themoney supply

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Credit creation process (continued) When the funds return to the banking system,

the on lending procedure will occur. Hence an initial deposit results in the multiple

expansion of deposits and further loans. This generates growth in credit, deposits and

the money supply, as deposits are counted as part of the money supply.

Factors affecting themoney supply

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2. Government Budget outcome If the government operates a budget

deficit, then the source of their borrowing can influence the money supply. A budget deficit can be financed from three main sources.

These are presented on the next slide.

Factors affecting themoney supply

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Government Budget outcome (continued) Reserve Bank – will directly

increase the money supply and may impact on inflation

Public/financial markets – money supply is not affected but investment may be ‘crowded out’

Overseas sector – has no impact on money supply but will affect the exchange rate

Factors affecting themoney supply

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3. Market operations These are the primary monetary

policy instruments of the Central / Reserve Bank.

They take place in order to influence the level of short-term interest rates especially the overnight cash rate. It does so through the sale and purchase of government securities.

Factors affecting themoney supply

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4. Business cycle The level of economic

activity will have a direct effect on the demand for loanable funds.

As economic activity increases, then the demand for funds rises.

There is a positive correlation between the demand for credit and the level of economic activity.

Factors affecting themoney supply

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Level of economic activity change in demand for funds due to

business expectations stabilisation government policy

Causes of interest rate fluctuations

Public sector deficit this may cause interest rate fluctuations

due to financing the budget deficit

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Overseas economic events The movement of large volumes of funds

internationally to attract high interest rate

Causes of interest rate fluctuations

Inflation Lenders increase interest rates to maintain

real interest rates during periods of inflation

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Causes of interest rate fluctuations

Central/Reserve Bank monetary policy Changes in liquidity affect interest

rates

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Virtually all Central / Reserve Banks implement monetary policy by manipulating the level of liquidity in order to influence short term or overnight cash rates.This is usually achieved through the sale and purchase of government securities.

Operation of monetary policy

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Selling securities reduces liquidity in the market raising the cash rate.Conversely, the purchase of securities will increase liquidity in the market and reduce the cash rate.Any change in the cash rate will flow through to all interest rates in the economy.

Operation of monetary policy

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Many Central / Reserve Banks strongly believe that it is important to set forward targets for inflation.This helps to set expectations in the economy, and emphasises the importance of controlling inflation.Price stability is viewed as an essential precondition to sustain long term economic growth.

Inflation targeting

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1. Flexible – the Central / Reserve Bank meets regularly and decisions are made every day. Usually does not require parliamentary approval.

Strengths of monetary policy

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2. Political neutrality – impacts all sectors of the economy and hence cannot be politically motivated.

3. Effective during boom periods – tightening of monetary policy has swift and direct impact on aggregate demand. Affects decisions of consumers and investors.

Strengths of monetary policy

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4. Very effective under floating exchange rates – the interest rate changes affect the exchange rate which reinforces the impact, e.g. fall in interest rates will reduce capital inflow, and also reduce exchange rates, hence stimulating domestic demand even further.

Strengths of monetary policy

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1. Not effective during a recession – reducing interest rates in a recession may do little to boost investment or aggregate demand. For example, Japan’s interest rates have been close to 0% for the last decade with the economy still in recession.

Weaknesses of monetary policy

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2. Timelags – Monetary policy has several lags: Recognition lag Action lag Implementation lag Effect lag

Effect lag is the major lag associated with monetary policy – it is the time taken for monetary policy to actually affect the level of economic activity.

Weaknesses of monetary policy

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3. May be circumvented – There are many options available for credit. Monetary policy may therefore not impact on everyone.

Weaknesses of monetary policy

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The End