Monetary Policy
VCE ECONOMICS
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Introduction
Monetary policy may be defined as
actions taken by a country’s Central /
Reserve Bank to influence the price
and availability of credit in the
economy.
Monetary policy is carried out
to achieve sustainable growth
while keeping the rate of
inflation as low as possible.
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Money
Money must be:




A medium of
exchange
A store of value
A measure of value
Capable of
extinguishing debt
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The Money Supply
Monetary school of economic thought
believed that if the money supply
could be strictly controlled, then the
level of economic activity could be
regulated and so could the level of
inflation.
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Factors affecting the
money supply
It is thought that the
growth in the money
supply has a strong
bearing on the level of
economic activity and
hence it is important to
examine the factors
which affect the
growth of the money
supply.
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Factors affecting the
money supply
1. Credit creation process


Financial intermediaries (e.g.
banks, housing loan companies)
accept deposits from the public
and reward them with the
payment of interest.
They will then on lend the funds
at a higher rate of interest. A
portion of the funds will be
retained in order to meet day to
day requirements (known as the
Reserve Requirement).
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Factors affecting the
money supply
Credit creation process (continued)
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When the funds return to the banking system,
the on lending procedure will occur.
Hence an initial deposit results in the multiple
expansion of deposits and further loans.
This generates growth in credit, deposits and
the money supply, as deposits are counted as
part of the money supply.
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Factors affecting the
money supply
2. Government Budget outcome

If the government operates a budget
deficit, then the source of their borrowing
can influence the money supply. A
budget deficit can be financed from three
main sources.
These are presented
on the next slide.
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Factors affecting the
money supply
Government Budget outcome
(continued)



Reserve Bank – will directly
increase the money supply and
may impact on inflation
Public/financial markets – money
supply is not affected but
investment may be ‘crowded out’
Overseas sector – has no impact
on money supply but will affect the
exchange rate
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Factors affecting the
money supply
3. Market operations


These are the primary monetary
policy instruments of the
Central / Reserve Bank.
They take place in order to
influence the level of short-term
interest rates especially the
overnight cash rate. It does so
through the sale and purchase
of government securities.
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Factors affecting the
money supply
4. Business cycle

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The level of economic
activity will have a direct
effect on the demand for
loanable funds.
As economic activity
increases, then the demand
for funds rises.
There is a positive
correlation between the
demand for credit and the
level of economic activity.
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Causes of interest rate
fluctuations
Level of economic activity


change in demand for funds due to
business expectations
stabilisation government policy
Public sector deficit

this may cause interest rate fluctuations
due to financing the budget deficit
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Causes of interest rate
fluctuations
Overseas economic events

The movement of large volumes of funds
internationally to attract high interest rate
Inflation

Lenders increase interest rates to maintain
real interest rates during periods of inflation
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Causes of interest rate
fluctuations
Central/Reserve Bank monetary
policy

Changes in liquidity affect interest
rates
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Operation of monetary policy
Virtually all Central /
Reserve Banks implement
monetary policy by
manipulating the level of
liquidity in order to
influence short term or
overnight cash rates.
This is usually achieved
through the sale and
purchase of government
securities.
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Operation of monetary policy
Selling securities
reduces liquidity in
the market raising the
cash rate.
Conversely, the
purchase of securities
will increase liquidity
in the market and
reduce the cash rate.
Any change in the
cash rate will flow
through to all interest
rates in the economy.
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Inflation targeting
Many Central / Reserve Banks strongly
believe that it is important to set
forward targets for inflation.
This helps to set expectations in the
economy, and emphasises the
importance of controlling inflation.
Price stability is viewed as an essential
precondition to sustain long term
economic growth.
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Strengths of monetary policy
1. Flexible – the Central /
Reserve Bank meets
regularly and decisions
are made every day.
Usually does not require
parliamentary approval.
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Strengths of monetary
policy
2. Political neutrality – impacts all
sectors of the economy and hence
cannot be politically motivated.
3. Effective during boom periods –
tightening of monetary policy has
swift and direct impact on aggregate
demand. Affects decisions of
consumers and investors.
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Strengths of monetary policy
4. Very effective under floating exchange
rates – the interest rate changes affect the
exchange rate which reinforces the impact,
e.g. fall in interest rates will reduce capital
inflow, and also reduce exchange rates,
hence stimulating domestic demand even
further.
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Weaknesses of monetary policy
1. Not effective during a recession –
reducing interest rates in a recession
may do little to boost investment or
aggregate demand. For example,
Japan’s interest rates have been close
to 0% for the last decade with the
economy still in recession.
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Weaknesses of monetary policy
2. Timelags – Monetary policy has several
lags:
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Recognition lag
Action lag
Implementation lag
Effect lag
Effect lag is the major lag associated with
monetary policy – it is the time taken for
monetary policy to actually affect the level of
economic activity.
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Weaknesses of monetary policy
3. May be circumvented –
There are many options
available for credit.
Monetary policy may
therefore not impact on
everyone.
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The End
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