ECON1102 Chapter Notes - Chapter 12: Monetary Policy, Real Interest Rate, Demand Curve

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17 May 2018

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Chapter 12: Monetary Policy

What is Monetary Policy?

Monetary Policy: The actions taken by the Reserve Bank of Australia to manage

interest rates to pursue macroeconomic objectives

• Using monetary policy to stabilise inflation rate can slow down the

economy in SR

• But a healthy economy in LR

The Goals of Monetary Policy:

1. Full employment

2. Stability of Australian currency (controlling inflation)

3. Economic prosperity and welfare

Inflation Targeting: Conducting monetary policy so as to commit the central bank to

achieving a publicly announced level of inflation

The Demand for and Supply of Money:

The Demand for Money:

• Demand curve for money is downwards sloping

• Choice between holding money or other financial assets

• Money earns no interest/very low rate

• The interest rate is the opportunity cost of holding money

• Interest rates on financial assets are low → opportunity cost of holding money

is low → quantity of money demanded will be high

Shifts in the Money Demand Curve:

• Change in real GDP → positive relationship

• Change in price level → positive relationship

• Also, financial innovation affect demand for money

How the RBA Manages the Supply of Cash:

Open Market Operations: The RBA purchasing or selling financial instruments such

as Commonwealth Government Securities and private bonds and securities, either

by outright purchase or sale, or by the use of repurchase agreements

• A way the government ‘sterilises/offsets’ the daily deficits/surpluses in liquidity

in the financial system

Cash Rate: The interest rate that financial institutions charge on loans or pay to

borrow funds in the overnight money market

Exchange Settlement Accounts: Accounts held with the RBA by banks and other

financial institutions to enable the overnight transfer of funds (cash) between

financial institutions, and between the RBA and financial institutions

Most settlements between banks and financial institutions occur during the day in

real time = real-time gross settlement (RTGS)

• Uses the RBA’s Reserve Bank Information and Transfer system → enables

bans to access their exchange settlement accounts during the day and

overnight

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Document Summary

The goals of monetary policy: full employment, stability of australian currency (controlling inflation, economic prosperity and welfare. Inflation targeting: conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. The demand for money: demand curve for money is downwards sloping, choice between holding money or other financial assets, money earns no interest/very low rate, the interest rate is the opportunity cost of holding money. Interest rates on financial assets are low opportunity cost of holding money is low quantity of money demanded will be high. Shifts in the money demand curve: change in real gdp positive relationship, change in price level positive relationship, also, financial innovation affect demand for money. How the rba manages the supply of cash: Cash rate: the interest rate that financial institutions charge on loans or pay to borrow funds in the overnight money market.

Related Questions

The central bank of the country Oakville is hosting its annual economic policy symposium with monetary policy as the theme. Several bankers and professional economists are in attendance. Dorah Baker, a professor at the University of Oakville, is of the opinion that monetary policy should target the rate of growth of the money supply. This, she claims, would increase economic stability. Jack Snyder, a delegate attending the conference, does not agree. He thinks that monetary policy is highly effective in controlling inflation and so the central bank should continue to follow inflation-targeting. In fact, Jack also believes that the central bank should bring inflation down from the current level of four percent to as close to zero as possible.

Which of the following, if true, would suggest that monetary policy may not be very effective in substantially reducing inflation from the current level of four percent?

A. Oakville's central bank has maintained the interest rate at 0.25 percent for the last two years.

B. The highest level of inflation that Oakville has ever experienced is 5.5 percent.

C. Although the current level of inflation is considered to be high, the economy has also been growing at an impressive pace.

D. The marginal propensity to save in Oakville has traditionally been low.

E. Inflation in recent years has been driven by rising costs of production.

scarletspider222

1. Suppose the bank of Canada wanted to increase the supply of money. How could it use monetary policy to achieve the goal?

2.The money demand curve is shown in a graph with an interest rate on short term assets on the vertical axis. Why use short-term interest on the vertical axis and not the rate of return on other financial assets?

3 what will happen to the money supply is Jamie withdraws $400 from her chewing account and the reserve ratio is 5%

4. Using gold as an example, what is the difference between commodity money and commodity-backed money?

5. Suppose the annual inflation rate at 7% and 3% of the labor force is unemployed. If you were on the governing council of the bank of Canada, what action would you prescribe? How would this affect the economy, the inflation rate, and the unemployment rate?

ochreguinea-pig172

In a speech in 2017, Fed Chair Janet Yellen described the long-run federal funds rate that is consistent with achieving the Fed's mandate of high employment and price stability as the "neutral rate," which she estimates to be about 3 percent. Yellen noted that: "Waiting too long to begin moving toward the neutral rate could risk a nasty surprise down the road long dash either too much inflation, financial instability, or both. In that scenario, we could be forced to raise interest rates rapidly, which in turn could push the economy into a new recession."

Source: Janet Yellen, "The Goals of Monetary Policy and How We Pursue Them," Speech at the Commonwealth Club, San Francisco, California, January 18, 2017.

Why is it potentially a problem for the Fed to "wait too long" to raise its target for the federal funds rate? Can't the Fed just wait until inflation increases and begin to slowly increase the target at that time?

A. Monetary policy works with a lag that can be up to 18 months.

B. Prices change slowly due to menu costs.

C. Legislation takes time to implement.

D. Consumers are irrational.

Why might interest rates that are too low lead to financial instability?

A. Interest rates that are too low could result in higher unemployment.

B. Rates that are too low could lead to speculative bubbles in stocks and other financial assets.

C. Low-interest rates could lead to deflation.

D. Rates that are too low could lead to a situation of hyperinflation.

Why might the Fed rapidly increasing its target for the federal funds rate push the economy into recession?

A. In this situation, increasing the target for the federal funds rate increases aggregate demand by increasing investment.

B.A rapidly increasing federal funds rate target would decrease employment by lowering wages.

C.The Fed rapidly increasing its federal funds' rate target increases unemployment by increasing net exports.

D.Increasing the target for the federal funds rate decreases GDP by reducing consumption.

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ECON1102 Chapter Notes - Chapter 12: Monetary Policy, Real Interest Rate, Demand Curve

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