Chapter 8
The Reserve Bank and
the economy
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Learning objectives
1. What is the relationship between the price of a bond and
the interest rate on a bond?
2. How does the Reserve Bank target the overnight cash
interest rate?
3. What are the effects of the Reserve Bank changing the
target for the overnight cash interest rate?
4. How does a change in the target rate for the overnight
cash interest rate affect base money?
5. Under what circumstances can the Reserve Bank affect
the real interest rate?
6. How does the Reserve Bank’s monetary policy affect the
equilibrium level of GDP in the short run?
7. What is meant by a monetary policy reaction function?
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8-2
Chapter organisation
8.1
The Reserve Bank, interest rates and monetary
policy
8.2
Can the Reserve Bank control real interest rates?
8.3
The effects of the Reserve Bank’s actions on the
economy
8.4
The Reserve Bank’s policy reaction function
8.5
Monetary policy making: Art or science?
Summary
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8-3
Bonds
• Bonds are a type of financial asset; the issuer of a
bond is, in effect, seeking to borrow money.
– Bonds are a legal promise to repay a loan, usually including
a principal amount and regular interest payments.
– On issue, the agreed interest rate is called the coupon rate
and the interest payments are called the coupon payments.
– The borrower promises to pay annual coupon payments as
well as the principal at the end of the agreed term.
– The bond’s term, the credit risk and the tax treatment all
influence the level of the coupon rate.
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Example: Bond pricing structure
• Tanya purchases a two-year bond with a principal
amount of $1000. It has a coupon rate of 5% per
annum, so she will receive coupon payments of $50
at the end of year 1 and $50 at the end of year 2,
plus her $1000 principal.
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Market price of bonds
• Bonds do not have to be kept to maturity, and can be
sold in the bond market.
• The prices paid for bonds depends on current (not
historical) market interest rates.
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Example: Bond pricing structure
• Tanya wants to sell her bond at the end of year 1
after receiving her first coupon payment. How much
can she expect to get if the prevailing interest rate is
now 6%? How about 4%?
– If current interest rates on similar securities are 6%, her bond
needs to return 6% too or no-one would buy it.
– The coupon rate and principal payout on the bond are given,
so the only thing she can alter is the bond price.
– She would price the bond so that the principal the buyer
pays will receive 6% and yet receive $1050 at maturity.
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Example: Bond pricing structure
(cont.)
• At current interest rates of 6% the principal to earn
6% over the year and be paid is:
– $1050 = Bond price x 1.06; that is a bond price of $990.57.
• If current interest rates are 4%, the principal to earn
4% over the year and be paid is:
– $1050 = Bond price x 1.04; that is a bond price of $1010.
• A general principle is that bond prices and interest
rates are inversely related.
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Interest rates, bond prices and money
market equilibrium
• Why are interest rates and bond prices inversely
related?
– If the interest rate is below the equilibrium market price for
money, the demand for money is greater than the supply.
– To increase money holdings, the public will start to sell off
their bonds.
– An increase in the supply of bonds leads to a reduction
in their price, which is equivalent to an increase in
interest rates.
– At higher interest rates, the demand for money will decline,
until equilibrium is reached where the money demand is
equal to the amount of money available at that interest rate.
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Example: The market for 90-day bills
Figure 8.1 The market for 90-day bills
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How does the Reserve Bank affect
nominal interest rates?
Figure 8.2 The effect of an increase in the cash rate on the 90-day bill market
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The demand for money
•
Households and businesses need money for
transactions.
•
Holding money pays very little or no interest compared
to other financial assets, i.e. holding money has an
opportunity cost.
•
How much money households and firms hold to cover
transactions varies widely according to their
circumstances.
–
The opportunity cost of holding money increases if the
nominal interest rate increases, therefore less money is held.
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The supply for money
• The money supply is influenced by the Reserve Bank
and consists of notes and coins in circulation plus
deposits in the banking system.
• It does not depend on interest rates, so the money
supply curve is vertical with respect to interest rates.
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The overnight cash market
Figure 8.3 The demand and supply of base money i
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The implication of a change in
monetary policy for the money supply
• The Reserve Bank conducts monetary policy by
setting the overnight cash rate to a target and
allowing all the other interest rates in the economy
to adjust.
• Assume the Reserve Bank achieved a target cash
rate and a specific target money supply:
– If demand for money increased, the demand for money
function would shift to the right.
– If the Reserve Bank left the money supply unchanged,
people would start to sell bonds to do so.
– The price of bonds would decrease, which would increase
the interest rate.
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A change in the target cash interest rate
Figure 8.4 A change in the target cash interest
rate
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Chapter organisation
8.1
The Reserve Bank, interest rates and monetary
policy
8.2
Can the Reserve Bank control real interest rates?
8.3
The effects of the Reserve Bank’s actions on the
economy
8.4
The Reserve Bank’s policy reaction function
8.5
Monetary policy making: Art or science?
Summary
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8-17
Nominal versus real interest rates
• The Reserve Bank controls the nominal interest rate
through open-market operations.
• However, many important decisions such as saving
and investing are based on the real interest rate.
• The real interest rate, r, is the nominal rate, i, minus
the inflation rate, ¶ :
r  i
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Can the Reserve Bank control the real
interest rate?
• The inflation rate changes relatively slowly in the
short run, therefore changing the nominal rate tends
to change the real rate.
• Can the Reserve Bank control the real interest rate?
– In the short run: The Reserve Bank controls real rates
through control of nominal rates.
– In the long run: The Reserve Bank has less control because
real rates are determined by the supply and demand for
saving and investment.
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8-19
Chapter organisation
8.1
The Reserve Bank, interest rates and monetary
policy
8.2
Can the Reserve Bank control real interest rates?
8.3
The effects of the Reserve Bank’s actions on the
economy
8.4
The Reserve Bank’s policy reaction function
8.5
Monetary policy making: Art or science?
Summary
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8-20
Planned consumption expenditure and
the real interest rate
•
•
The level of real interest rates in the economy
affects planned aggregate expenditure.
A rise in interest rates reduces household
consumption expenditure through:
1. encouraging households to save more as the reward for
saving increases
2. discouraging household spending that would be financed
by credit.
•
A rise in interest rates reduces investment
expenditure through:
1. increasing the cost of borrowing, reducing the profitability of
business investment in capital equipment
2. increasing the cost of mortgages for residential housing.
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Planned consumption expenditure and
the real interest rate (cont.)
•
At any given level of output, both investment and
consumption spending decline when real interest
rates increase.
•
The converse is true when real interest rates
decrease.
•
Therefore, the Reserve Bank can use changes in the
real interest rate to eliminate output gaps and
stabilise the economy.
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Example: PAE and the real interest rate
In an economy described by:
Cd = 640 + 0.8(Y – T) – 400r
Ip = 250 – 600r
G = 300
X = 20
T = T = 250
Both Cd and Ip are affected by the interest rate, r.
PAE = Cd + Ip + G + X
= [640 + 0.8(Y – 250) – 400r] + [250 – 600r] + 300 + 20
= [1010 – 1000r] + 0.8Y
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Example: PAE and the real interest rate
(cont.)
PAE = [1010 – 1000r] + 0.8Y
• The exogenous expenditure in this economy is
[1010 – 1000r] and depends on the real interest rate, r.
• If the real interest rate is 5%, the equilibrium output is
given by:
PAE = [1010 – 1000 x (0.05)] + 0.8Y
and we know that PAE = Ye, so:
Ye = 960 + 0.8Y = 4800
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The Reserve Bank fights a recession
• Suppose the potential output for this economy is
5000. Then it faces a recessionary gap which we can
calculate as:
Y* – Ye = 5000 – 4800 = 200
• If the multiplier in the economy is 5, exogenous
spending needs to increase by 200/5 = 40.
• The Reserve Bank needs to lower the real interest
rate to increase exogenous spending by 40,
therefore:
– exogenous spending = [1010 – 1000r] = 40
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The Reserve Bank fights a recession
(cont.)
• The Reserve Bank needs to lower the real interest
rate by 4 percentage points, from 5% to 1%, to
increase exogenous spending by 40, which will raise
output by 200 with a multiplier of 5.
• This would close the recessionary gap and bring the
economy to potential output.
• A reduction in interest rates made by the Reserve
Bank to close a recessionary gap is an expansionary
monetary policy, or monetary easing.
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The Reserve Bank fights a recession
(cont.)
Figure 8.5 The Reserve Bank fights a recession
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The Reserve Bank fights inflation
• One important cause of inflation is an expansionary
output gap, so the Reserve Bank will act to close it.
• Suppose in our previous economy, potential output
was at Y* = 4600.
• At a real interest rate of 5%, our short-run Ye = 4800
so there is an expansionary gap of 200.
• With a multiplier of 5, exogenous expenditure needs
to reduce by 200/5 = 40.
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The Reserve Bank fights inflation
(cont.)
• Exogenous expenditure = [1010 – 1000r] = 40.
• The Reserve Bank needs to increase real interest
rates by 4 percentage points, from 5% to 9%, to
decrease exogenous spending by 40, which will
lower output by 200 with a multiplier of 5.
• An increase in interest rates made by the Reserve
Bank to close an expansionary gap is a
contractionary monetary policy, or monetary
tightening.
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The Reserve Bank fights inflation
(cont.)
Figure 8.6 The Reserve Bank fights inflation
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Example: The Reserve Bank fights the
global financial crisis
Figure 8.8 The use of monetary policy to fight the crisis
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Chapter organisation
8.1
The Reserve Bank, interest rates and monetary
policy
8.2
Can the Reserve Bank control real interest rates?
8.3
The effects of the Reserve Bank’s actions on the
economy
8.4
The Reserve Bank’s policy reaction function
8.5
Monetary policy making: Art or science?
Summary
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8-32
Policy reaction function
• The role of the Reserve Bank:
– Recessionary gaps: Reducing the real interest rate
– Expansionary gaps: Increasing the real interest rate
• Policy reaction function is a simple mathematical
representation of how the Reserve Bank adjusts
interest rates in light of the state of the economy.
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Taylor rule
• Taylor (1993) found that a rule that linked the
output gap and the inflation rate to the real interest
rate for the US. Federal Reserve Bank under Alan
Greenspan worked well:
y – y*
rt = 0.01 + 0.5
y*
+ 0.5𝜋
• Example: If inflation is 3% and output gap is zero,
the Federal Reserve should set the real interest
rate = r = 0.01 + 0.5 x 0 + 0.5 x 0.03 = 0.025 =
2.5%, and nominal rates at 2.5% + 3% = 5.5%.
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Policy reaction function for the RBA
• This rule has not predicted the Australian situation
well.
• The RBA has committed to a target inflation rate of
2–3% since 1993, and it is likely the inflation rate has
a greater weighting than for the US.
• We will assume the RBA relies on only one factor, the
inflation rate, in setting the real interest rate. This is a
simplification, but captures a key element.
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A hypothetical policy reaction function
for the RBA
Figure 8.9 An example of a Reserve Bank policy reaction function
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How does the RBA set its reaction
function?
• In practice, the RBA takes into account a range of
statistical analysis of the economy, and human
judgement.
• However, we can get some insight from the simple
policy reaction function:
– If the long-run value of the real interest rate is 4%, the policy
reaction function implies an inflation rate of 2% at this value.
This only makes sense if the long-run target rate of inflation
is 2%.
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Aggressiveness of RBA reaction
function
• Therefore, one important determinant of the policy
reaction function is the long-run inflation target.
• Secondly, the policy reaction function shows how
aggressively the RBA intends to pursue the target.
• A very flat line means the RBA would make very
modest responses to the real interest rate when
inflation increased, as compared to a steep upward
slope when there was a large change in real interest
rates in response to higher inflation.
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Example: A shift in the policy
reaction function
Figure 8.10 A shift in the policy reaction function
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Chapter organisation
8.1
The Reserve Bank, interest rates and monetary
policy
8.2
Can the Reserve Bank control real interest rates?
8.3
The effects of the Reserve Bank’s actions on the
economy
8.4
The Reserve Bank’s policy reaction function
8.5
Monetary policy making: Art or science?
Summary
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8-40
Monetary policy making: Art or
science?
• In reality, monetary policy, like fiscal policy, is not as
easy as our analysis makes it look.
• The real world economy is much more complex,
difficult to measure and our knowledge of its workings
imperfect.
• Consequently, the RBA tends to move cautiously and
tries to avoid large changes in the interest rate, often
making changes of only 0.25% at any one time.
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8-41
Chapter organisation
8.1
The Reserve Bank, interest rates and monetary
policy
8.2
Can the Reserve Bank control real interest rates?
8.3
The effects of the Reserve Bank’s actions on the
economy
8.4
The Reserve Bank’s policy reaction function
8.5
Monetary policy making: Art or science?
Summary
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8-42
Summary
• The Reserve Bank operates monetary policy by
targeting the overnight cash interest rate.
• Open-market operations are used to keep the cash
rate at its target.
• A change in the target is brought about through
changing the interests paid on exchange settlement
accounts.
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Summary
• In the short run, the Reserve Bank can control the
real interest rate as well as the nominal interest rate.
• The Reserve Bank’s actions affect the economy
because changes in the real interest rate affect
planned spending.
• A policy reaction function describes how the action a
policy maker takes depends on the state of the
economy.
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