MONETARY POLICY

W HAT IS M ONETARY P OLICY Lending by the financial sector allows consumption and investment in an economy to occur without having to pay the money there and then. However, there is a cost to receiving the money for the borrower. This is called the “Interest Rate”. The cost of this money, the interest rate, determines how much more will be paid back by the borrower – the principal plus interest.

W HAT IS M ONETARY P OLICY The Interest rate in a economy is set by the Reserve Bank. This base rate is the minimum interest rate charged. Banks and other financial institutions lend money at the base rate plus a margin. 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 Interest rate.

W HAT IS M ONETARY P OLICY A low interest rate means the cost of money is cheap and this will encourage sectors of the economy to borrow to consume goods or services or to invest and thus increase aggregate demand. A high interest rate means the cost of money is expensive and this will mean those sectors of the economy that borrow or have borrowed will have to pay more interest on their loans thus reducing consumption and investment.

W HAT IS M ONETARY P OLICY 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 Interest rate (also called the cash rate) Monetary policy aims to promote low inflation, full employment and maximisation of the economic prosperity and welfare of Australian citizens.

A CHIEVEMENT OF LOW INFLATION The primary aim of monetary policy is to achieve the goal of low inflation over the medium term. Monetary policy is effective in combating inflation but less effective in other areas of the economy. 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.

I NFLATION T ARGETING 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.

I NFLATION T ARGETING 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

M EASURES OF I NFLATION 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)

U SING M ONETARY P OLICY TO P URSUE D OMESTIC S TABILITY AND B ETTER L IVING S TANDARDS 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

U SING M ONETARY P OLICY TO P URSUE D OMESTIC S TABILITY AND B ETTER L IVING S TANDARDS 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.

C URRENT MONETARY POLICY STANCE