Chapter 23
Monetary policy
‘TIGHT MONEY’
‘EASY MONEY’
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
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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
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
23-2
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
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
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Targets and Objectives of Monetary
Policy
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)
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
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Summary of Monetary Policy
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
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
23-5
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
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
23-6
Example of Contractionary Monetary
Policy (Sale of Securities)
Face value
Market value
Return
Yield
% on face value
$100
$80
10%
($100)
12.5%
• The RBA sells a security with a face value of $100
for $80 (now the market value of the security)
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
23-7
Example of Expansionary Monetary
Policy (Sale of Securities)
Face value
Market value
Return
Yield
% on face value
$100
$150
10%
($100)
6.67%
• The RBA offers to purchase a security with a face
value of $100 for $150
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
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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)
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
23-9
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)
Copyright  2005 McGraw-Hill Australia Pty Ltd
PPT Slides t/a Economics for Business 3e by Fraser, Gionea and Fraser
23-10