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Monetary Policy

By zinc007 Aug 31, 2013 1166 Words
Monetary Policy involves actions by the RBA on behalf of the govt to influence the cost and availability of money and credit in the economy. It is a macro-economic policy that is pre-emptive and counter cyclical, meaning that it smoothes the effects of fluctuations in the business cycle, and influence the level of economic activity, inflation and employment. The aim of Monetary Policy is too stabilize the currency of Australia, maintaining full employment, maintaining low inflation, and minimizing fluctuations and create economic prosperity, along with increasing the overall wellbeing of Australia's population. Along with this, is keeping inflation within a target of 2-3%, MP is conducted by the RBA, without direct control from the govt. The RBA is Australia's central bank and the 'bank's' bank. The RBA is also the only organization that can print money and has some degree of control over the supply of money. The RBA controls Monetary Policy through interest rates and Domestic Mkt. operations. The cash rate at this point in time is ________, which represents the market interest rate on overnight funds. The RBA keeps control on the cash rate through its financial market operations and it functions as the policy instrument. The RBA's Domestic Market Operations (DMO) (also known as "open market operations") are used to keep the cash rate set as close as possible to that set of the board, by managing the supply of funds available to banks in the money market. More specifically, the RBA buy and sell second-hand Commonwealth Govt. Securities (CGS) in order to influence the cash rate and the general level of interest rates. If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall. Conversely, if the Reserve Bank supplies less than banks wish to hold, they will respond by trying to borrow more in the cash market to build up their holdings of exchange settlement funds; in the process, they will bid up the cash rate. This is known as influencing it's liquidity. Tight monetary policy refers to a course of action undertaken by the Federal Reserve to constrict spending in an economy that is seen to be growing too quickly, or to curb inflation when it is rising too fast. The Fed will "make money tight" by raising short-term interest rates (also known as the Fed funds, or discount rate), which increases the cost of borrowing and effectively reduces its attractiveness. Furthermore, the RBA can alter its DMO to restrict the supply of money that the banks have, or sell long-dated government bonds in order to reduce liquidity and therefore reduce lending. This dampens consumer and investment spending, resulting in a lower level of economic activity, with lower inflation and the possibility and possible higher unemployment. Loose monetary policy refers to the lowering of interest rates, that then increase overall demand, causing an increase in consumer and business spending, the increases economic activity, lowers unemployment, while often results in upward inflation pressures. Essentially, the do this by doing the opposite to what is done when tightening monetary policy. When looking at inflation, Monetary Policy is seen as best suited for fighting inflation, and maintaining an inflation rate of between 2-3% (currently at 2.4%), leaving room for external shocks (natural disasters, carbon tax etc.) There are also a number of indicators for the RBA to look at when studying the inflation rate, Including Wage growth, an increase in AD, the exchange rate, commodity prices and the inflation rate itself (headlining and underlying). Furthermore, when certain sectors such as retail, hospitality and construction are down, then that is also a red flag indicator for the RBA. Aggregate demand is the total amount of goods and services demanded in the economy at a given overall price level and in a given time period. It can also be represented by this formula: (AD) = C + I + G + (X-M) C = Consumers' expenditures on goods and services.

I = Investment spending by companies on capital goods.
G = Government expenditures on publicly provided goods and services. X = Exports of goods and services.
M = Imports of goods and services.
It can be seen through this equation that price impacts the quantity of demanded money, as higher prices require more money to buy goods. This results in a shift of the money demand curve to the right, and the interest rate has to rise to balance supply and demand. Higher interest rates (most likely tightened monetary policy), results in a decreased incentive to borrow, and, thus, discourage investment. A decrease in investments results in a drop in the quantity of goods and services demanded, contributing to lower aggregate demand. The opposite occurs during when monetary policy is loose. However there are a number of limitations on monetary policy including time lag, as The RBA must take a preemptive approach to the implementation of its monetary functions. A time lag of up to 8-10 months may exist. Monetary policy involves the influencing of interest rates, however, not all participants in an economy are immediately affected by a change in the cost of credit and it may take time for longer-term interest rates to adjust to the cash rate. The RBA must foresee future economic conditions by looking at key economic indicators, and implement the policy with a view to it acting on a predicted threat up to a year after implementation. Furthermore, Global influences such as Globalization has resulted in a dilution of the impact of internal drivers of the domestic economy, towards more uncontrollable and unpredictable offshore, external influences. Financial deregulation also leads to mobile capital flows in overseas markets. Savings and investment can now be conducted overseas, which may affect the level of investment in Australia. Finally, political constraints mean a government must put short term popularity ahead of what is economically good for the nation. Microeconomic reforms especially are unpopular at the time of their implementation due to their usual short-term negative effect on the economy. The true benefits of reform may not be seen until the next government, who usually takes the credit. There are also a number of problems resulting from monetary policy. MP is much better at contracting than expanding, as businesses can still worry about the future, and therefore, not expand, even when times are economically good. Furthermore, as there are time lags, big events such as the GFC and Euro Zone crisis can't be dealt with effectively. Political constraints, even the RBA is controlled by the govt. as the RBA looks at govt. fiscal policy and bases some assumptions of that, and when it is wrong, MP could be tight and FP could be lose etc. The banks can also be reluctant to pass on full ir cuts, but are quick to increase them, while treasury forecasts could be wrong or inaccurate.

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