Chapter 23 Monetary policy

1. Chapter 23Monetary policy ‘TIGHT MONEY’ ‘EASY MONEY’

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

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

4. Macroeconomic objectives • Minimum unemployment • Minimum inflation • Economic growth • External stability • Intermediate targets • e.g. interest rates, money supply Monetary policy instruments e.g. Open market operations (OMOs) Targets and Objectives of Monetary Policy

5. 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 Summary of Monetary Policy

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

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)

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

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)

10. 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)