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Exercise 2

1. Monetary policy is the action of the Reserve Bank of Australia to influence the supply of cash in the money market through domestic market operations.
   
   The principal instrument of monetary policy is the ”cash rate”. Changes in the cash rate affect the key rates for banks and financial intermediaries; for example, an increase in the cash rate increases mortgage and business loan rates.
   

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2. In Australia, the objectives of monetary policy are formally established in the Reserve Bank Act 1959. The three main objectives are to maintain:
   • inflation at the targeted rate of between 2% and 3%
   • full employment at the NAIRU (the non-accelerated inflation rate of unemployment) between 5% and 7%
   • economic growth between 3% and 4% to sustain the living standards and welfare of the people of Australia.

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3. To achieve the objectives of monetary policy the Reserve Bank may have to alter the stance of monetary policy. There are three possible stances of monetary policy.
   • A tightening of monetary stance occurs when the government raises the cash rate to slow down economic activity. The rate increases of 0.25% that occurred in May and June of 2002 were intended to keep economic growth on target and reduce inflationary pressures.
   • An easing or loosening of monetary policy stance occurs when the Reserve Bank cuts the cash rate to stimulate economic growth, increase investment and reduce unemployment
   • A neutral stance of monetary policy exists when there is no change in the cash rate. For example, there was no change in the cash rate in the latter part of 2002.

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4. In May, August and November 2006 the Reserve Bank tightened monetary policy and increased interest rates because of changes in the economic climate in Australia. Some factors that contributed to the rate rise were:
   • the global expansion contributed to high levels of commodity prrices, which continued to add to incomes and spending in Australia
   • surveys which indicated that businesses were expanding investment plans
   • domestic demand had been expanding at a relatively strong pace against a background of limited spare capacity
   • unemployment rates declined to below 5% and the participation rate increased.
   • a rise in wealth associated with increases in housing prices occurred
   • the strong rise in house prices associated with a rapid rise in household debt and the risks of households becoming over extended
   • The world economy grew strongly in 2006 and was generally expected to grow at an above-average pace.

 

5. The impact of changes in interest rate on the economy is explained using the transmission mechanism. Changes in monetary policy are usually translated quickly into adjustments in bank lending rates.The ultimate effect on employment and inflation depends on how these changes are transmitted through the financial system and the economy. There are several mechanisms through which this can occur. They are:
   • saving and investment behaviour
   • cash flow
   • money and credit
   • asset prices
   • the exchange rate.

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