The Operation Of Monetary Policy Essay Research

The Operation Of Monetary Policy Essay, Research Paper

Monetary policy refers to actions by the Reserve Bank to influence the aggregate supply and cost of credit in the economy. The main tool of monetary policy is the Reserve Bank s use of market operations to influence the cash rate or interest rate paid on highly liquid deposits in the cash market or short term money market. By influencing the cash rate, the Reserve Bank is able to indirectly affect the term structure of interest rates in the financial system, which in turn will affect the level of spending, inflation and employment in the economy. As it is set out in the Reserve Bank s mission statement, the core objective of monetary policy is to ensure stable economic growth with low inflation, that is an underlying rate of between 2 to 3% over the course of the economic cycle, and full employment.

Monetary policy is implemented by the Reserve Bank through the use of open market operations in the short-term money market. Through the buying or selling of Commonwealth government securities (for example, Treasury Notes), the Reserve Bank can influence the cash rate which is the interest rate paid on funds lent overnight in the short term money market. The cash rate is the principle instrument of monetary policy and if the Reserve Bank wishes to alter the stance of monetary policy it will act to change the cash rate.

On a daily basis, the banks hold funds in their exchange settlement accounts to cover net withdrawals of funds from their banks as cheques clear on a daily basis. These are transferred between banks as the exchange settlement process occurs. If banks are left with excess funds in these accounts, they can lend them to the authorised dealers overnight, who typically hold a portfolio of government securities, and finance their portfolio by borrowing from banks. The interest rate at which these funds clear this market each night is the overnight cash rate.

When the government seeks to embark on a contractionay monetary policy, that is one which raises the cash rate, they enter the market as a seller of Commonwealth government securities to the dealers, leaving those dealers short of funds supply. These dealers must then borrow money from the banks, bidding up the cash rate to do so. As a response to this, banks must increase their liquidity from other sources, and thus must restrict their lending or borrow from other sources, in either case raising other interest rates. The converse occurs if the government wishes to undertake an expansionary monetary stance. The Reserve Bank enters the market as a buyer of government securities, thus increasing money supply and push interest rates down.

Changes in interest rates alter financial returns and these changes impact on the economic activity and inflation in the short and long terms. Interest rate changes will also have effects on investment, savings and consumption decisions; alterations in the cash flows between borrowers and lenders; alterations in the cost of credit and effects on money flows; effects on asset prices which may alter the distribution of wealth; and effects on the exchange rate and the relative prices of domestic and foreign goods and services. However, the key relationship is between changes in cash rates and the level of aggregate demand or domestic expenditure. Changes in domestic expenditure will in turn affect output and the price level. This is how the implementation of monetary policy is used to achieve the Reserve Bank s objectives of full employment, price stability and economic growth.

The current setting of monetary policy is quite positive, despite the world economic crisis. The Australian economy is currently growing strongly with inflation continues to stay under the monetary target and unemployment rate at a respectable level of 7.4%. While domestic economic growth is strong, other than the US, the world is still in the recession phase, with Asia and Europe still suffering from weak economic growth. This is one of the reasons why we did not increase interest rates, as global interest rates have a downward bias. Therefore, on 3rd December 1998, the RBA chose to fall in line with the G7 interest rate reductions, cutting the official cask rate target by 0.25% to 4.75%, the fist adjustment since July 1997.

Unemployment is another determinant in what monetary policy stance the RBA wished to pursuit. It effects the level of unemployment through its effects on interest rates, which effects the level of investment spending and eventually the level of unemployment. The current unemployment rate is 7.4% and although it at a relatively respectable level, many economist believes that it is at the NAIRU point and further improvement is unlikely. From current statistics, job advertisements growth is slowing and trend employment has softened to 8 700 in January from around 18 000 six months ago. Therefore, there are risks that unemployment will start to rise. Therefore, it was appropriate that the government embarked an easing monetary stance by lowering its official cash rates.

Monetary policy cannot stand alone or work against other macroeconomic policies. Policy mix should be coherent and working towards the same objectives. With Mr. Costello currently preparing his second Budget (1999/2000), there will be consideration of a similar objective of maintaining stable economic growth and encour