Transcript AS LR Monetary Policy and Equilibrium GDP

Chapter 12
Monetary Policy
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
12-1
Learning Objectives
• Discuss the objectives of monetary policy.
• Describe the roles of the participating
institutions and the route by which
monetary policy affects the operation of the
economy.
• Examine the balance sheet of the Reserve
Bank of Australia, through which monetary
policy is largely implemented.
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Learning Objectives (cont.)
• Analyse the techniques of monetary
policy—the major instruments and
how they function.
• Discuss the cause–effect chain
through which monetary policy
functions, and evaluate its
effectiveness.
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Learning Objectives (cont.)
• Using the aggregate demand–
aggregate supply framework, examine
monetary policy in an open economy.
• Provide a restatement of employment
theory and policy.
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Objectives of Monetary
Policy
• Monetary policy
–
influencing interest rates and credit availability to stabilise
real GDP, employment and the price level
• Fundamental objectives
–
full employment
–
non-inflationary level of total output
• The Reserve Bank of Australia has
responsibility for managing monetary policy
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Cause-Effect Chain of
Monetary Policy
• Cash rate
–
interest rate charged for exchange settlement
account funds
• Other short-term interest rates
–
the cash rate sets the cost of short-term funds
for banks
–
influences the rate at which banks are willing to
lend
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Cause-Effect Chain of
Monetary Policy (cont.)
Aggregate demand
• Availability of bank credit, which
impacts on interest-sensitive spending
(and therefore output, employment
and prices), is impacted through
monetary policy
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Monetary Policy and
Aggregate Demand
• Easy money policy
–
RBA reduces the cash rate, lowering the cost
and increasing the availability of bank credit, to
expand spending
• Tight money policy
–
RBA increases the cash rate, increasing the cost
of credit, reducing the availability of credit, to
reduce spending in the economy
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Monetary Policy and
Investment
• Increases in interest rate reduce the
viability of many investments and the
quantity of investment spending falls
• Increases in interest rate make the
purchase of financial assets more
attractive
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Balance Sheet of the RBA
• Assets:
–
gold and foreign exchange
–
government securities
• Liabilities:
–
notes on issue
–
non-callable deposits
–
exchange settlement account (ESA) funds
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Changes in ESA Funds and
Monetary Policy
• Funds flow to and from government
accounts
• Banks must maintain a positive
balance in their ESAs with the RBA
–
may borrow funds from other banks, or
–
trade in either government securities or
repurchase agreements (repos)
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Yield Curve
• The yield curve is a summary of the interest
rates that apply at any given point in time
to interest-bearing securities
• Shows the link between the cash rate and
other short-term interest rates
• Changes in the cash rate change the cost of
funds for banks
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Monetary Policy Tools
• Two major tools used by the RBA to
determine the cash rate:
–
Open market operations
–
Foreign exchange swaps and intervention
in the foreign exchange market
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Open-Market Operations
• Buying and selling of Commonwealth
government securities by the RBA in
the cash or short-term money market
• The objective of OMOs is to ensure
that the demand and supply of ESA
funds are such that they are in
balance at the target cash rate
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Open-Market Operations
(cont.)
• Buying and selling of Commonwealth
government securities by the RBA affects
the cash rate
• Cash rate provides an indication of the
RBA’s monetary policy stance
Sustained increases in cash rate target level:
tightening of monetary policy
– Sustained decreases in cash rate target level:
easing of monetary policy
–
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Open-Market Operations:
Buying Securities
• Banks sell some of their securities
• RBA pays for securities by increasing banks’
exchange settlement accounts (ESAs)
–
ESAs form part of the banks’ prime assets ratio (PAR)
requirement
• Bank reserves increase
–
Causing the monetary base and the banks’ lending ability
to increase
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Open-Market Operations:
Selling Securities
• The RBA sells securities to the banks
• Banks pay for securities by decreasing
their exchange settlement accounts
(ESAs)
• Bank reserves decrease
–
Causing the monetary base and the banks’
lending ability to decrease
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The Market for Exchange Settlement
Funds and the Cash Rate
S2
Target cash rate
S1
D2
D1
ESA funds
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Foreign Exchange Swaps
• RBA may use foreign exchange swaps
to supplement or substitute for OMO
• Foreign exchange market
intervention—either selling or buying
Australian dollars
–
purchase/sale of dollars is equivalent to
purchase/sale of government securities, and has
similar impact on banks’ ESA funds
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Rediscount Rate and
Monetary Policy
• The rate at which the RBA buys or
sells short-term securities under
repurchase agreement
• Can be used as a central tool of
monetary policy
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Easy Monetary Policy
• Implemented when the economy is faced
with the prospects of substantial
unemployment or deflationary pressure
• RBA announces its intention to reduce the
cash rate
• RBA acts to bring the ESA funds market into
balance
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PPTs t/a Macroeconomics 7/e by Jackson and McIver
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S1
S2
Interest rate
Cash rate
Easy Monetary Policy (cont.)
CR1
SF1
D1
SF2
R1
R2
CR2
D1
ESA funds
3-year funds
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Tight Monetary Policy
• Enacted when the economy is facing
significant inflationary pressures
• RBA announces its intention to
increase the target cash rate
• ESA funds are brought into balance at
this new target cash rate
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PPTs t/a Macroeconomics 7/e by Jackson and McIver
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Monetary Policy and
Equilibrium GDP
Cause–Effect Chain of Monetary Policy:
• Money supply impacts interest rates
• Interest rates affect investment
• Investment is a component of AD
• Equilibrium GDP is changed
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Real rate of interest, i
Monetary Policy and Equilibrium GDP (cont.)
SF1
10
10
8
8
6
6
D1
0
0
Quantity of money demanded and supplied
ASLR
Amount of investment, i
AS
Price level
AD1
Investment
demand
P1
Real domestic output, GDP
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
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Real rate of interest, i
Monetary Policy and Equilibrium GDP (cont.)
SF1
SF2
10
10
8
8
6
6
D1
0
0
Quantity of money demanded and supplied
ASLR
P1
Amount of investment, i
AS
Price level
AD1
Investment
demand
Easy Monetary
Policy
AD3
AD2
Real domestic output, GDP
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PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
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Real rate of interest, i
Monetary Policy and Equilibrium GDP (cont.)
SF2
10
SF1
10
8
8
6
6
Price level
D1
0
0
Quantity of money demanded and supplied
ASLR
AS
Investment
demand
Amount of investment, i
Tight Monetary
Policy
P1
AD1
Real domestic output, GDP
Copyright  2004 McGraw-Hill Australia Pty Ltd
PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
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Real rate of interest, i
Monetary Policy and Equilibrium GDP (cont.)
SF2
10
SF1
10
8
8
6
6
Price level
D1
0
0
Quantity of money demanded and supplied
ASLR
AS
Investment
demand
Amount of investment, i
Tight Monetary
Policy
P1
AD1
AD2
Real domestic output, GDP
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PPTs t/a Macroeconomics 7/e by Jackson and McIver
Slides prepared by Muni Perumal, University of Canberra, Australia
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Monetary Policy and
Equilibrium GDP (cont.)
Refinements and Feedback Effects
• Policy effectiveness depends on
–
shape of the demand for money curve
–
shape of the investment demand curve
• Feedback effects
–
Reductions in GDP tend to reduce business
profits, causing business to reduce investment
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PPTs t/a Macroeconomics 7/e by Jackson and McIver
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Monetary Policy and the
Open Economy
• Net Export Effect
–
Changes in interest rate affect the value of the
exchange rate under floating exchange rate.
An increase in interest rate appreciates the
currency, resulting in lower net exports
–
A decrease in interest rate leads to currency
depreciation and a rise in net exports
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Monetary Policy and the
Open Economy (cont.)
• External shocks may adversely impact
upon the RBA’s monetary policy
objectives
–
e.g. Assume economy is in recession. RBA
attempts to stimulate economy through easy
money. At the same time, there may be
increased demand for Australian goods.
End result: Over-stimulation
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Shortcomings of Monetary
Policy
• Cyclical asymmetry
• Conflict with Treasury goals
• Cost-push inflation
• Investment insensitivity
–
Some question how sensitive investment
actually is
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Strengths of Monetary
Policy
• Flexible and speedy to implement,
relative to fiscal policy
• Politically acceptable, due to its broad
impact
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Next Chapter:
Macroeconomic Debates
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12-34