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MONETARY POLICY

MONETARY POLICY. Before we examine Monetary Policy we need to understand what is meant by the financial sector and the supply of MONEY. The Financial Sector. The financial sector consists of:

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MONETARY POLICY

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  1. MONETARY POLICY

  2. Before we examine Monetary Policy we need to understand what is meant by the financial sector and the supply of MONEY

  3. The Financial Sector • The financial sector consists of: • Banks: Financial institutions act as intermediaries between borrowers and lenders. (Includes RBA, and Australian and foreign owned banks) • Non-Bank Financial Institutions (NBFIs): Merchant banks, building societies, credit unions, finance companies, superannuation funds, Insurance and short-term money market dealers.

  4. Money • Money is any commodity that is accepted universally as a medium of exchange for goods and services. • Money has four functions: • It is a medium of exchange • Acts as a measure of value • Is used to settle debts • Is a store of value

  5. Money Supply • There are two measures of the supply of money in the economy. • M3 = notes and coins held by the non-bank public plus any current and fixed bank deposits, made by the public • Broad Money = M3 + net deposits of savings in Non-Bank financial institutions.

  6. What is Monetary Policy • Monetary policy refers to the actions of the Reserve Bank of Australia (RBA) to influence the supply and cost of credit in the economy by manipulating the cash rate in the short term money market. • Monetary policy aims to promote low inflation, full employment and maximisation of the economic prosperity and welfare of Australian citizens. • Known as a ‘swing instrument’ or counter cyclical policy to maintain a sustainable rate of economic growth.

  7. Achievement of LOW INFLATION • The primary aim of monetary policy is to achieve the goal of low inflation over the medium term. • Low Inflation – 2-3% inflation rate (CPI) over the business cycle (7 – 10 years). • This policy is referred to as inflation targeting – the RBAs adjustment of monetary policy to achieve and maintain low inflation.

  8. Inflation Targeting • Involves: • A focus on medium term low inflation • A pre-emptive of forward looking approach to likely inflation trends (12-18 month lag) • Aims of strong and sustainable eco growth • Consideration of short term factors in policy settings such as exchange rate, eco growth and o/s i-rates • Some emphasis on asset price growth, levels of household debt and credit growth.

  9. Inflation Targeting • Many of the worlds central banks use inflation targeting to conduct monetary policy. • The advantages of inflation targeting are: • Provides an anchor point for people’s inflationary expectations • Makes the conduct of monetary policy credible if target achieved over time • Provides operational basis • Enables coordination between countries to control inflation

  10. Measures of Inflation • Headline Inflation: the measure of the average price changes across the full regime or basket of goods and services (CPI). • Underlying Inflation: inflation rate which is calculated by removing volatile items from the calculation of average price changes. (exclude one off price changes that tend to be temporary e.g. bananas in 2011)

  11. Using Monetary Policy to Pursue Domestic Stability and Better Living Standards • Domestic stability is a desirable situation where the government achieves the goals of: • Low inflation • Full employment • Strong and sustainable economic growth in order to maximise living standards

  12. Using Monetary Policy to Pursue Domestic Stability and Better Living Standards • Monetary policy is usually seen as the main stabilising instrument in the short to medium term, to help lessen the harshness of inflationary booms or recessions. • Monetary policy does this by regulating the strength of AD in a countercyclical way using either an expansionary stance or a contractionary stance. • This approach tries to smooth out fluctuations in the level of AD and economic activity to avoid recessions or unsustainable booms.

  13. Cash Rate • Interest rates are central to monetary policy and are set by the RBA to regulate the level of aggregate demand • Interest rates represent the cost or price of credit (borrowing) • The cash rate is the interest rate in the short term money market or overnight money market.

  14. Monetary Policy stance • Monetary policy effects economic activity in two ways: • The level of interest rates: • Cash rate less than 4.5% is expansionary, • Cash rate between 4.5% - 5.5% neutral stance, • Cash rate greater than 5.5% contractionary. • Changes in interest rates: • rises in interest rates are referred to as a tightening of monetary policy • falls in interest rate are an easing of monetary policy

  15. Current monetary policy stance

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