Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 23-1 Chapter 23 Monetary policy ‘EASY MONEY’ ‘TIGHT MONEY’
Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 23-2 Lecture Plan Defining monetary policy Monetary policy and economic objectives Cause-effect chain: a Keynesian view Instruments of monetary policy Summary of monetary policy (easy versus tight monetary policy) Monetary policy weaknesses and strengths
Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 23-3 Defining Monetary Policy Monetary policy involves policies that influence the cost and availability of credit Monetary policy’s ultimate objective: – Economic growth; full employment; minimum inflation Intermediate objectives – Price of credit (interest rates) – Availability of credit (money supply) Tools used by the Reserve Bank: instruments of monetary policy
Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 23-4 Targets and Objectives of Monetary Policy Intermediate targets e.g. interest rates, money supply Monetary policy instruments e.g. Open market operations (OMOs) Macroeconomic objectives – Minimum unemployment – Minimum inflation – Economic growth – External stability
Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 23-5 Summary of Monetary Policy Easy monetary policy Problem: unemployment and deflation Remedy: induce an expansion in the supply of money, and therefore spending, by reducing the interest rate Means: Buy bonds in the open market Tight monetary policy Problem: inflation Remedy: induce a contraction in the supply of money, and therefore spending, by increasing the interest rate Means: Sell bonds in the open market
Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 23-6 Open Market Operations (OMOs) The buying and selling of government securities by the Reserve Bank on secondary markets Objectives: to influence the general level of liquidity and yields in financial markets Reserve Bank conducts monetary policy through changes in the cash rate (e.g. interest paid on funds borrowed overnight by banks and other financial institutions) Changes in the cash rate are achieved through the Reserve Bank’s OMOs
Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 23-7 Example of Contractionary Monetary Policy (Sale of Securities) Face value Market value Return Yield % on face value $ 100 $80 10% 12.5% ($100) The RBA sells a security with a face value of $100 for $80 (now the market value of the security)
Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 23-8 Example of Expansionary Monetary Policy (Sale of Securities) Face value Market value Return Yield % on face value $ 100 $150 10% 6.67% ($100) The RBA offers to purchase a security with a face value of $100 for $150
Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser 23-9 Weaknesses of Monetary Policy Policy-instigated changes in money supply may be partially offset by changes in the velocity of money Cost inflation. Higher interest rates impact on costs of production Political sensitivity: higher interest rates have a significant impact on housing loans and overdrafts for small business—politically sensitive areas Dependence on monetary policies of other major countries (e.g. United States, Japan, Germany)
Copyright 2005 McGraw-Hill Australia Pty Ltd PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser Strengths of Monetary Policy Extremely powerful when used to pursue contractionary economic policies Speed and flexibility (although the time lag between implementation and effects is difficult to predict) Moderates demand-pull inflation. It is regarded as being more effective in regulating booms than dealing with a recession or cost-inflation Political acceptability (works by a more subtle route than fiscal policy)