Lec week 10 monetary policy0

BEO1105 Economic Principles

Topic 10

Macroeconomic Policy I: Monetary Policy

Reading: Chapters 15 &16, Layton et al.

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The Monetary and Financial System (Chapter 15)

• Before we study Monetary Policy, it is important to understand about money, money supply, interest rates and how the financial system operates.

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Monetary and financial system: Key CONCEPTS

• What makes money ‘money’?• Other desirable properties of money• The demand for money• Four money-supply definitions• The equilibrium interest rate• How changing money supply affects interest

rates, prices, output and employment• A modern financial system

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WHAT MAKES MONEY ‘MONEY’?• Exchange can take place using a trading system

known as barter – direct exchange of one good for another.

• Barter requires double coincidence of wants.• The use of money simplifies and facilitates market

transactions.

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THE THREE FUNCTIONS OF MONEYMoney is

anything that serves as:

a medium of exchange

a unit of account

a store of value.

Money has been:

metals, shells, stones &

cigarettes

It needs to serves the

three functions

Credit cards are not money – by

themselves, they do not carry out

the three functions of

money.

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THE THREE FUNCTIONS OF MONEY (CONT.)

• Medium of exchange – the primary function of money: to be widely accepted in exchange for goods and services.

• Unit of account – the function of money to provide a common measurement of the relative value of goods and services.

• Store of value – the ability of money to hold value over time.

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THE DEMAND FOR MONEY• Money itself provides no return, so people

and business who hold cash or cheque account balances incur an opportunity cost (foregone interest or profits from the money held).

• There are three motives for holding money.

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MOTIVES FOR HOLDING MONEY• The transactions demand for money

– the stock of money people hold to make everyday predictable expenses like making purchases or paying bills.

• The precautionary demand for money– the stock of money people hold to pay for

unpredictable expenses like unforeseen events.

• The speculative demand for money – the stock of money people hold to take advantage of

expected future price changes in the price of stocks, bonds or other non-money financial assets

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OVERALL DEMAND FOR MONEY• This shows the overall quantity of money that people

want to hold at different interest rates, ceteris paribus.

• Other things being equal, there is an inverse relationship between the quantity of money demanded and the interest rate.

• The interest rate is the price of money.

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FOUR MONEY-SUPPLY DEFINITIONS• There are four different (arbitrary) definitions of money

supply in Australia:

• These account for how people hold their money in cash and notes, and in deposits at banks and non-bank institutions.

• The widest definition of money published by the Reserve Bank of Australia (RBA). Broad money is defined as currency plus ADI deposits from the non-AFI private sector, plus other short-term liquid AFI liabilities held by the non-AFI private sector.

Monetary Base M1

M3 Broad Money.

THE EQUILIBRIUM INTEREST RATE

• The money demand curve (MD) is a graphical representation of the inverse relationship between interest rates and money demand.

• The supply of money curve is independent of the interest rate.

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THE EQUILIBRIUM INTEREST RATE

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Bond Price $100 Term 10 yearsInterest Rate 5.00%Interest Paid $5 Dm > Sm Sell BondsSb > Db Bond Price Falls Bond Price $90 Interest Paid $5 Interest Rate 5.56%

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Actions by the Central Bank affects The Interest Rate

• Changing the cash rate is action taken by the nation’s central bank to influence:– the monetary base (money supply)– interest rates (lending and saving)– economic activity (circular flow)– price levels (inflation).

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INCREASING THE MONEY SUPPLY

• This creates a surplus of money at the prevailing interest rate.

• This is called expansionary monetary policy.• People seek to invest this money in interest-bearing

bonds, which drives their price higher and the interest rate lower.

• Thus the imbalance between money supply and demand disappears.

Increasing Money Supply

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The RBA decides on expansionary monetary policy, in which case they increase the money

supply and interest rates fall.

Bond Price $100 Term 10 yearsInterest Rate 5.00%Interest Paid $5 Dm < Sm Buy BondsSb < Db Bond Price Rise Bond Price $110 Interest Paid $5 Interest Rate 4.55%

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DECREASING THE MONEY SUPPLY

• This creates a shortage of money at the prevailing interest rate.

• This is called contractionary monetary policy.• People seek to sell interest-bearing bonds, which

drives their price lower and the interest rate higher.

• Thus the imbalance between money supply and demand disappears.

Decreasing Money Supply

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The RBA decides on contractionary monetary policy, in which case it lowers the money supply and the interest

rate rises.

How Changing Money Supply affects Prices, Output And Employment

• The monetary policy transmission mechanism shows how monetary policy is transmitted through the economy, affecting prices, output and employment.

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How Increasing Money Supply Affects Prices, Output And Employment

• With Increased money supply and lower interest rates :– consumers are more willing to spend– businesses are more willing to spend on plant,

structures and equipment.

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THE AUSTRALIAN FINANCIAL SYSTEM

• The Reserve Bank of Australia (RBA) is Australia’s central bank.

• The RBA is responsible for financial system stability, the financial payments system and banking services to the financial sector and the government.

• The RBA Board determines monetary policy in Australia.

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THE BANKING SYSTEM• Each bank conducts an exchange settlement account

(ESA) with the RBA in order to conduct its business with other banks and financial institutions, the RBA and the government.

• Exchange settlement accounts must have a positive balance at the end of each trading day to ensure settlements of accounts can be made.

• “An account held at the Reserve Bank of Australia by financial institutions to settle financial obligations arising from the clearing of payments.” RBA

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THE BANKING SYSTEM (CONT.)

• The banks must also maintain minimum liquidity requirements to meet short term requirements from depositors and creditors.

• They must also maintain capital adequacy requirements as reassurance to depositors that their funds are safe.

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THE BANKING SYSTEM AND CREATING MONEY

• Fractional Reserve Banking is a system whereby banks must keep only a percentage of their deposits on reserve to meet day to day liquidity needs.

• The rest can be loaned to borrowers. This creates new deposits which can be used for lending. This is credit creation (the monetary multiplier).

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THE MONEY MARKET• The short-term money market (STMM) allows banks,

non-bank institutions, merchant banks, insurance companies, etc. to invest or borrow for short periods, usually in treasury notes or commercial bills.

• Treasury notes - Commonwealth Government Securities with a short term to maturity, issued at a discount to their face value with the difference (or discount) representing the return on the note. They are used primarily to meet the Government's need for within-year finance. (RBA)

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Key Concepts to be Learnt in relation to Monetary Policy

• The goals of monetary policy and two views of the monetary policy transmission mechanism

• The appropriate role for monetary policy: the rules versus discretion debate

• Monetary targeting; Australia, 1976–85• Modern monetary policy implementation: the case of

Australia• Linking the RBA operation of monetary policy to the

AD–AS framework

What Is Monetary Policy?

• Australia’s central bank (Reserve Bank of Australia; RBA) has responsibility for the determination and implementation of monetary policy.

• Monetary policy: The actions taken by the Central Bank (Reserve Bank of Australia; RBA) to affect interest rates in order to keep inflation low and stable.

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THE GOALS OF MONETARY POLICY

• The Goals of Monetary policy in Australia:– Low and stable inflation rate: with inflation low

and stable, it is predicted that economic growth will be higher and unemployment lower in the long term.

– Full employment of the Labour Force– Stability of the Australian currency.– Economic prosperity and welfare for the people of

Australia.

Monetary Policy in Australia

• Monetary policy in Australia is conducted in a transparent and forward-looking manner.

• Transparency is achieved through regular public commentary by the RBA Governor, and means that the RBA is accountable for its actions.

• The forward-looking nature of monetary policy means the RBA pays close attention to leading indicators (i.e. housing approvals) to try to prevent inflation rising (rather than trying to reduce inflation after it has already risen).

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THE KEYNESIAN VIEW OF MONETARY POLICY

Changes in monetary policy affect interest rates, which affects consumer expenditure and investment demand.

This affects AD, resulting in changes to real output, employment and prices.

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THE MONETARIST’S VIEW OF MONETARY POLICY

Changes in money supply directly affect changes in AD, and therefore changes in real output,

employment and prices.

THE EQUATION OF EXCHANGE• This is an accounting identity that states that the money

supply times the velocity of money equals total spending. MV

= PQ• Where:

• M = money supply• V = velocity of circulation (the average number of times per period

a $ of the money supply is spent on final goods and services)• P = the price level• Q = quantity of output

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THE QUANTITY THEORY OF MONEY

• Classical economists believe that V and Q in are fairly constant and

• changes in the price level (inflation) are directly related to changes in the quantity of money.

• M.V = P.Q• Therefore, an increase in money supply causes

prices to rise (inflationary)

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MODERN MONETARISM• Evidence today suggests Velocity is not constant. • The economy is not always at full employment.• Thus, although Money Supply and Price level are

correlated, they do not change proportionally.• If well below full employment, and increase in M

will result in an increase in nominal GPD• If near full employment, and increase in M will

increase prices rather than GDP.

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THE ROLE FOR MONETARY POLICY: THE RULES VS. DISCRETION DEBATE

• Monetary policy has powerful effects on the macro economy.

• Keynesians would prefer the central bank to retain considerable discretion to adjust monetary policy.

• Monetarists prefer pre-announced and widely publicised rules, especially one for pre-set targets for money supply growth.

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COUNTERCYCLICAL MACROECONOMIC POLICY

• Macroeconomic policy aims to smooth fluctuations in the business cycle.

• The RBA aims to adjust monetary policy in a timely way so the impacts of the policy will be felt at the right time in the business cycle.

• This is difficult to do due to time lags.

TIME LAGS• These are delays associated with

implementing countercyclical policy:– information lags– policy determination lags– policy effectiveness lags.• The length of time associated with some of

these lags can be long and highly variable• Caution: the market is self-correcting and

intervention could be disruptive by the time policy takes effect

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Inflation Targeting Since 1996 Annual Inflation Rate, Australia, 1970-2007

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MODERN MONETARY POLICY IMPLEMENTATION IN AUSTRALIA

• The RBA (since 1996) has an official inflation target of 2–3 per cent per annum.

• The RBA adjusts the overnight cash rate, which influences all other interest rates.

• The RBA announces its cash rate target, then uses open-market operations to maintain that rate (buy and sell government securities).

• securities - A financial instrument which represents a claim over real assets or a future income stream. Such instruments are usually tradeable. Examples of securities include bonds, bills of exchange, promissory notes, certificates of deposit and shares.

Cash Rate

• The Cash Rate is the interest rate on overnight loans between financial institutions including the RBA.

• Determined by the interaction of demand for and supply of funds in the overnight funds market.

• Open Market Operations (OMOs) can also be used to change the cash rate.

• A change in the cash rate typically flows through the financial system impacting all interest rates.

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Open Market Operations

• Open market consist of the RBA buying and selling Commonwealth government securities from the private sector - usually other banks – for cash.

• RBA simply electronically debit or credit the Exchange Settlement Account (ESA) of other banks.

• ESAs are accounts held with RBA by other banks and financial institutions.

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OPEN MARKET OPERATIONS

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Changing the Cash RateShort-term interest rates, Australia, 1985-2007

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Effective DateChange in cash rate

Percentage pointsNew cash rate target

Per cent2 May 2012 -0.50 3.757 Dec 2011 -0.25 4.252 Nov 2011 -0.25 4.503 Nov 2010 +0.25 4.755 May 2010 +0.25 4.507 Apr 2010 +0.25 4.25

3 Mar 2010 +0.25 4.002 Dec 2009 +0.25 3.754 Nov 2009 +0.25 3.507 Oct 2009 +0.25 3.258 Apr 2009 -0.25 3.004 Feb 2009 -1.00 3.253 Dec 2008 -1.00 4.255 Nov 2008 -0.75 5.258 Oct 2008 -1.00 6.003 Sep 2008 -0.25 7.005 Mar 2008 +0.25 7.256 Feb 2008 +0.25 7.007 Nov 2007 +0.25 6.758 Aug 2007 +0.25 6.50

Monetary policy decisions are expressed in terms of a target for the cash rate, which is the overnight money market interest rate. A media release is issued at 2.30 pm after each Reserve Bank Board meeting, with the Board's decision taking effect the following day

Monetary Policy Transparency

• The RBA Board meets on the first Tuesday of the month (except January).

• The Board determines interest rate policy.• The decision is announced to the media and on

the Bank’s website at 2.30 p.m.• OMOs commence the morning following any

change in policy.

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• Aim: To provide an economic stimulus when the economy is in recession.

• Expansionary Monetary Policy aims to increase real GDP and to reduce the level of unemployment.

Expansionary Monetary Policy

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•The RBA uses OMOs to buy back Commonwealth

government securities (bonds).

•This will increase money supply and decrease

the cash rate

• A decrease in the cash rate will decrease other

market interest rates.

Expansionary Monetary Policy Transmission

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•A decrease in interest interest rates will increase both

investment and interest-sensitive consumption.

•The decrease in interest rates will also decrease the exchange rate value of the dollar ($ depreciates). This will increase net exports.

•Thus, decrease in interest rates will increase aggregate demand (AD), real GDP and the price level, and reduce the level of unemployment.

Expansionary Monetary Policy Transmission (Continued)

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Real GDP (billions of 2003/04 dollars)

Pri

ce le

vel

(GD

P d

efla

tor,

200

3/04

= 1

00)

95

105

125

850 950900 1,000

108

SASAD0

Increase in AD raises price leveland increasesreal GDP...

0

A

B

AD1

Using Expansionary Monetary Policy to Increase Aggregate Demand

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Full Employment

LAS

RBA Operation of Contractionary Monetary Policy

• If the RBA believes that inflation is at the top of its acceptable range and will persist:– it would react by increasing the cash rate (often in a

series of small, monthly steps). This increases interest rates in the economy.

• Aim: To slow down the economy when the inflation is higher than target and keep increasing.

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CONTRACTIONARY MONETARY POLICY

• Contractionary monetary policy causes a decrease in total spending ( aggregate demand).

• This will lead to a reduction in output (real GDP), and employment (i.e. the level of economic activity).

• The reduction in aggregate demand will also tend to reduce the rate at which prices have been rising (price level decreases).

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Contractionary Monetary Policy Transmission

RBA uses OMOs to sell securities; Money supply decreases Cash rate increases; All interest rates in the economy increase Investment and interest-sensitive consumption decrease. Increase in interest rate will increase the exchange rate value of

the dollar ($ appreciates). This leads to a reduction of net exports.

These result in decrease in real GDP and the price level, but increase the level of unemployment.

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Real GDP (billions of 2003/04 dollars)

Pri

ce le

vel

(GD

P d

efla

tor,

200

3/04

= 1

00)

95

105

125

800 900 950850 1,000

110

Decrease in AD decreases price leveland decreasesreal GDP...

0

Using Contractionary Monetary Policy to Decrease Aggregate Demand

A

B

AD0

AD1

Full Employment

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SAS

LAS

Further Reading

The RBA and the then newly elected Labor Government issued a “Statement on the Conduct of Monetary Policy” in December 2007. Find and read this document which records the relationship between the Australian Government and the RBA at:

http://www.rba.gov.au

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Summary• Goals of Monetary policy• RBA and the implementation of modern monetary

policy in Australia• Inflation targeting• Cash rate• Open market operations• Expansionary monetary policy and its effects on real

GDP and price level• Contractionary monetary policy and its effects on

real GDP and price level

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Feedback

• Write down the most difficult concepts in today’s lecture that you need further assistance with?

• What were the most important ideas discussed in today’s lecture?

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Self-review Questions

• Compare and contrast Keynesian and Monetarist views of monetary policy.

• What is monetary policy and what are the goals of modern monetary policy of Australia?

• How does the RBA conduct open market operations to decrease the cash rate? To increase the cash rate?

• Using diagrams, explain the effects of expansionary monetary policy and contractionary monetary policy.

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