St Leonard's College · Web viewMonetary policy is used by Australia’s central bank to manage the supply of money in the economy and, in turn, influence interest rates and economic

COMPAK | ECONOMICS UNIT 4

ECONOMICS UNIT 4

Monetary policy and transmission mechanismsKEN NAILON | ECONOMICS WRITER

Area of Study 1 in VCE Economics Unit 4 focuses on the role of the Australian Government’s aggregate demand policies in stabilising the business cycle in order to achieve its domestic macroeconomic goals. The use of monetary policy by the Reserve Bank of Australia is a key aggregate demand policy instrument, as it can be specifically designed to influence the inflation rate, economic growth and employment growth. A key objective of monetary policy is to maintain low inflation and hence promote non-inflationary economic growth. The following article and accompanying review questions examine the transmission mechanisms of monetary policy and their effects through interest rate changes on aggregate demand and economic activity.

INTRODUCTION

‘Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time.’

—Statement by Philip Lowe, Governor: Monetary policy decision, media release, 2 May 2017

Monetary policy is a macroeconomic policy instrument used by Australia’s central bank, the Reserve Bank of Australia (RBA), to manage the level of aggregate demand and economic activity in the Australian economy. It is a counter-cyclical policy tool as it is used to change the direction of economic cycles, such as encouraging spending during economic downturns and tightening credit during periods of inflation. Monetary policy aims to counteract cyclical variations in economic activity and thereby smooth out fluctuations in the business cycle.

vcta.asn.au | published July 2017 | © VCTA and Ken Nailon | 1


Monetary policy is a demand management policy that has the capacity, when used appropriately, to stabilise the level of economic activity through its effects on aggregate demand and the spending of consumers and producers. For example, it can be used to counteract upward pressure on prices caused by a combination of high aggregate demand and inadequate productive capacity to meet that demand. Therefore, the aim of monetary policy is to achieve a relatively stable level of economic activity (neither too high nor too low), thereby avoiding the excesses of booms or recessions.

The RBA is responsible for Australian monetary policy, which involves setting the cash rate (the interest rate on overnight loans in the money market). In other words, the cash rate is the official interest rate that the RBA uses to control the supply of money in the economy. To achieve its statutory responsibilities of maintaining price stability, full employment, economic prosperity and welfare of the Australian people, the RBA has an inflation target and aims to keep inflation, as measured by consumer price inflation (CPI), between 2 to 3 per cent, on average, over time. The RBA therefore aims to achieve low inflation as well as stable economic activity by minimising upward pressure on future prices, thereby maintaining low and stable inflationary expectations. In other words, monetary policy is both an anti-inflationary policy and a demand management policy.

The RBA uses cash rate changes to influence other interest rates in the economy. Interest rates represent the price of borrowing money and lending money, that is, the price paid by financial institutions to those who deposit excess money with them and the price paid by those who borrow money from financial institutions. Therefore, the primary focus of interest rate changes influenced by the RBA is to achieve low inflation and maintain low expectations about future price increases. A low inflation environment enables the achievement of low inflationary economic growth and therefore higher living standards. The objective of low inflation has been a priority for government economic policy for nearly three decades because of the belief that by controlling inflation it is more likely that higher levels of economic growth and employment growth can be sustained.

By adjusting the cash rate the RBA can influence the amount of liquidity in the payments clearing system. The cash rate is determined by the supply of and demand for overnight funds in the overnight money market. If supply is high and there is too much liquidity the cash rate decreases; if demand is high and there is not enough liquidity the cash rate increases. The RBA has the ability to set the cash rate at a particular level because of its control over the supply of overnight funds in the money market.

In an effort to affect expectations in the economy and to be more transparent about its cash rate decisions, the RBA has expanded its public communications program. In addition to its quarterly statements, the twice-yearly appearance of the Governor before the House of Representatives Standing Committee on Economics Finance and Public Administration, its speeches and Reserve Bank Bulletin articles, the Reserve Bank now issues:

a media release at 2.30 pm on the day of the monthly RBA Board meeting (rather than at 9.30 am the following morning as in the past) announcing whether a cash rate change has been made supported with reasons for the RBA’s monetary policy decision and commenting on the current state of the domestic economy and overseas economies and their future prospects

minutes of Board meetings around two weeks after each meeting.



OPERATION OF MONETARY POLICY

Three important features of the financial exchange and payments system are relevant to the effective operation of monetary policy. They include the payments clearing system, the money market and Exchange Settlement Accounts, and repurchase agreements, as explained below.

Payments clearing systemThe payments clearing system refers to the payment arrangements that allow consumers, businesses and other organisations to transfer funds (money) held in an account at one financial institution to another financial institution. It includes payment instruments such as cash, cheques and electronic funds transfers that customers use to make payments.

Cash payments involve withdrawals from bank accounts over the counter or from ATMs and are mainly used for amounts under $20. Non-cash payments can be made by cheque, credit card and debit card, and by using the BPAY system for the payment of bills, direct-entry credits for social security or salary transfers, and direct-entry debits for the payment of consumer bills and business expenses. The use of electronic payment cards at the retail level has grown rapidly in recent years.

The payments clearing system generally involves two or more financial institutions and/or other payments providers requiring their payments to be ‘cleared’ between them. This means the system operates for the clearing of cheques, direct-entry payments, the operation of ATMs, and debit and credit cards. For example, the clearing of a cheque drawn on one financial institution and deposited at another requires the verification that the writer of the cheque has sufficient funds in their bank account to meet the value of the cheque. The payments system also covers the exchange of government securities, foreign currency, equity shares and other debt securities. All these require payment arrangements to be in place so that debt settlement can occur. When payments are cleared between financial institutions, the accruing debts then need to be settled and this requires the exchange of funds in their Exchange Settlement Accounts, which are held with the RBA.

Monetary policy is used by Australia’s central bank to manage the supply of money in the economy and, in turn, influence interest rates and economic activity.



The money market and Exchange Settlement AccountsThe money market is a complex system of exchange between the RBA and a range of financial institutions that act as dealers in the money market. The main financial institutions involved include banks and most other authorised deposit-taking institutions, such as building societies, credit unions and superannuation funds. The system of exchange revolves around the Exchange Settlement Accounts held by these institutions. These accounts are the means by which the providers of payment services settle the debts that have accrued in the payments clearing process. They are the accounts that banks and other financial institutions must hold with the RBA to facilitate the settlement of debts between money market participants or dealers. These debts between dealers need to be settled each day. See Figure 1.

The aim is for all Exchange Settlement Accounts to have a balance that is large enough to settle any large debts that can be incurred each day. However, it is important that balances are not too large as deposits could earn higher interest elsewhere and therefore could be invested more profitably. Surplus funds can be invested in buying government securities or can be lent to other dealers in the money market who have insufficient funds at this time and whose accounts need to have a higher balance. Dealers are encouraged to lend any excess funds in their Exchange Settlement Accounts to the money market.

FIGURE 1: THE MONEY MARKET

The money market deals in short-term funds, government securities and settlement of debt between members.


EXCHANGE SETTLEMENT ACCOUNTS

Banks

Money market dealers

Surplus funds

Deficit funds

Surplus funds

Deficit funds

Loans to dealers in the money market at the cash rate

Banks borrow from the money market (if not, then from the RBA at penalty rates)

The RBA sells government securities to the money market in exchange for surplus funds

Dealers sell government securities to the RBA or to others in the money market so that funds are obtained


Any shortage in these accounts can be funded by: recalling money lent previously to other dealers; borrowing from other dealers with excess funds; selling government securities in the money market; or using the RBA’s re-discount facility and selling securities back to the RBA.

Repurchase agreements (repos)Repurchase agreements are a major means of funding transactions in domestic financial markets. A repo is an agreement between two parties where one sells a security to another with the undertaking to buy back that security at a later date for an agreed future price. The difference between the selling price and the repurchase price is the interest earned on the transaction. Repos are generally used to fund the financial position of holders of financial securities in money markets, but they also include the main approved government securities used by the RBA in their open market operations. These securities include:

Australian Government securities—Treasury notes and Treasury bonds

semi-government securities of the states and territories—promissory notes, benchmark bonds and non-benchmark bonds

other government guaranteed debt securities—these are the additional securities approved by the RBA to be eligible for debt financing in the market.

There is a convention in the Australian financial market to distinguish between those government securities that are more easily cashed (Treasury bonds and semi-government benchmark bonds) and those government securities that are less actively traded. Because of their status all these government securities are considered a lower risk alternative to other means of financing in the money market and the RBA trades in all of the above government securities.

When the RBA enters the market and is buying government securities or repos it is providing cash to the money market and it alters the money supply in the Exchange Settlement Accounts so that it can keep the cash rate at the RBA’s target rate. Repos tend to promote liquidity and stability in the securities market and they allow the RBA the opportunity to affect the supply of overnight funds and achieve its targeted cash rate.

It is in this money market and through the workings of the exchange settlement accounts that the RBA uses its open market operations to affect the cash rate and, consequently, other interest rates in the financial sector. When the cash rate is changed financial institutions tend to adjust their interest rates on loans and deposits following the lead of the RBA’s cash rate.

Treasury bonds are medium to long-term debt securities issued by the Australian Government that carry an annual fixed interest rate over the term of the bond.



OPEN MARKET OPERATIONS AND MONETARY POLICY

Open market operations refers to the buying and selling of second-hand government securities or repurchase agreements (repos) by the RBA in the overnight money market with the aim of affecting the supply of overnight funds (liquidity) in the money market and using this action to maintain its target cash rate determined each month at RBA Board meetings. If it is decided to raise or lower the target cash rate and produce a change in domestic interest rates, the RBA will buy or sell securities to achieve the desired change in the cash rate by altering the supply of overnight funds. This interest rate policy can be used to promote economic growth and employment growth, stabilise economic activity, restrain inflationary pressures and help the achievement of domestic economic stability.

Raising or lowering the cash rate influences market interest rates in the following ways:

Higher interest rates affect the cost of borrowing and the amount borrowed. This in turn indirectly reduces spending by consumers and businesses, which in turn lowers the level of economic activity. Higher interest rates are needed when economic activity is overly high, as it tends to cause inflation. Dealing with this requires an anti-inflationary or restrictive monetary policy stance. When economic activity is too high and inflation is likely to occur, the RBA can act to counter this by selling government securities or repos in the money market, causing an increase in the cash rate, which puts upward pressure on other interest rates in the financial sector. This causes restraint on borrowing, spending and economic activity and helps to reduce inflation and restore domestic economic stability.

Lower interest rates have the opposite effect and encourage growth in the level of economic activity. This occurs when economic activity is not high enough and the boost to activity caused by lower interest rates tends to promote economic growth and employment growth. This is an expansionary monetary policy stance. If economic activity is too low and unemployment is rising, the RBA acts to decrease interest rates by buying back government securities or repos from the money market. This is designed to encourage borrowing and spending and can boost economic growth and activity.

Figure 2 shows how the RBA conducts open market operations to alter the money supply and influence interest rates.

FIGURE 2: OPEN MARKET OPERATIONS

Open market operations refers to the buying and selling of second-hand government securities or repurchase agreements (repos) in the overnight money market with a view to establishing a targeted cash rate.


RBA’S DOMESTIC OPEN

MARKET OPERATIONS

Sells securities

Buys back securities

Reduces the supply of money, causing interest rates to rise

Increases the supply of money, causing interest rates to fall


In recent times, monetary policy has been used regularly in an effort to boost economic activity and promote economic growth and employment growth. In these times, unemployment has been higher than desirable at around 6 per cent and economic growth has been modest and below the long-term average rate of growth of about 3 per cent. At the same time, inflation has not been a problem. It has been low and at times has even been below the inflation target of 2 to 3 per cent.

This has allowed interest rates to be reduced in stages over time. They are now at an all-time low with the cash rate at 1.5 per cent, down from 2.5 per cent in August 2013. In times of low inflation, it is appropriate for monetary policy to be directed at boosting economic activity and promoting economic growth and employment growth, especially if they are below their trend rate.

TRANSMISSION MECHANISMS

For open market operations to work effectively and have the desired effect on aggregate demand and economic activity, the effects of interest rate changes need to be spread through the economy. This transmission process involves interest rates having an effect on a number of dynamic factors, including levels of borrowing and lending, exchange rates, inflation rates or asset prices. The changes generated will eventually have an appropriate effect on economic activity, presumably one desired by the RBA and the Australian Government.

For example, higher interest rates reduce economic activity and slow down economic growth. Inflation would respond to this change in economic activity and would also have a tendency to dampen wage growth. Changes in interest rates can also affect exchange rates, which in turn affect prices and inflation, and hence economic activity. Price or inflationary expectations would also depend on the size of past price increases and on the economy’s response to an anti-inflationary policy. These expectations are important, as it is the reaction of consumers and businesses to a change in interest rates that will determine the success of the monetary policy changes. How much will those reactions influence aggregate demand? How much extra economic growth and employment growth will they generate?

The complexity of the transmission process helps to explain why there is a time lag of 12 to 18 months between a change in the RBA’s monetary policy stance and the point at which interest rate changes start having an effect on the wider economy.

In fairly simple terms, the transmission of a change in interest rates through the economy can be described as follows. If the RBA acts, as it has done in recent times, and decides to adopt an expansionary monetary policy stance through lower interest rates, then the following process generally occurs:

1 The RBA decreases the cash rate by buying government securities in the money market.

2 Financial markets react and lower their savings and lending rates of interest following the lead of the RBA.

3 Households and businesses react to the lower interest rates and alter their spending and investing. The lower interest rates discourage savings and encourage borrowing for more consumer spending and business investment. This can then lead to an increase in important components of aggregate demand and in economic activity. These reactions would be beneficial for economic growth and employment growth.

4 Generally higher aggregate demand leads to increased demand for labour and increased demand for wage increases. The prices set by businesses will be affected by the cost of productive resources, especially wages, and the capacity of firms to meet the increased demand. If the boost to aggregate demand is high enough it could lead to some inflationary pressures, but if the boost is moderate it should encourage non-inflationary economic growth.



How then do changing interest rates translate into changes in the level of aggregate demand and economic activity? How does this transmission process work? The way it happens and the degree of change in demand and economic activity will depend first on the size of the change in interest rates.

Somewhat large changes would tend to be in response to a major economic crisis such as a recession or an inflationary boom in economic activity. It will then depend on how much effect the change has on the expectations of consumers and businesses. Will the interest rate changes cause major changes in the behaviour of consumers and businesses regarding their spending, borrowing and investing? Will they spend more and save less? Or will it only lead to some minor changes in behaviour? The effectiveness of the monetary policy changes will largely depend on the amount of change in expectations and how that is translated through the economy.

Types of transmission mechanisms (channels)The monetary policy transmission process works via a number of transmission mechanisms or channels. These are the generally recognised ways that a change in interest rates (and their effect on other factors such as exchange rates or asset prices) will affect aggregate demand and the level of economic activity.

Savings and investment channel

This channel is sometimes referred to as the cost of credit mechanism or the intertemporal substitution mechanism. This seems to be the main transmission channel as it is about the direct effects of interest rates on demand and activity in the economy. After the interest rate change, consumers and businesses have to make decisions about whether to save more or less now so they can spend more or less at a later time. Lower interest rates will provide a lower return for savings by consumers and so tend to encourage more borrowing and more spending now and in the future. Consumers can afford to borrow more and buy assets such as cars, houses, household goods and shares. This is particularly relevant in the housing market and for householders with mortgages, as lower mortgage rates mean lower repayments and hence greater disposable income available for spending.

For businesses, the interest rate is central to decisions about investment outlays and is a major factor in deciding whether to invest or not. Lower interest rates mean they may be able to borrow enough to fund new projects. Large projects with a long-term completion date may rely on expectations about interest rate changes, not only immediately but also over the long-term. Lower financing costs for a project mean that savings could be used to expand the business and employ more workers.

Overall, greater spending, higher aggregate demand and increased economic activity are generated by the flow-on effects of lower interest rates and an expansionary monetary policy.

With respect to a restrictive monetary policy, higher interest rates would make it more costly to borrow and spending might be delayed or postponed leading to the opposite effects, namely, decreases in consumer spending and business investment. This in turn means a decline in economic activity, economic growth and employment growth.



Cash flow channel

Interest rate changes affect the cash flows of consumers and businesses. Higher interest rates tend to reduce the cash flow for some consumers and businesses. Those with variable interest rate loans will need to use more of their disposable income to finance interest payments on their loans. Householders with mortgages and with less income to spend will tend to reduce their consumption spending, and therefore aggregate demand and economic activity will decline. Business incomes and cash flows are also affected as less income is available for investment spending, and aggregate demand and economic activity will therefore decline.

By contrast, a decrease in interest rates can mean an increase in cash flows, as less money is required to finance existing loans. This can lead to more disposable income being available to increase consumer and investment spending leading to an increase in aggregate demand and economic activity. However, for those with savings invested, such as retirees, lower interest rates mean lower returns on savings, causing a reduction in cash flow that might necessitate a reduction in spending because of a decline in disposable personal income.

Exchange rate movements channel

In general, exchange rates and interest rates are closely associated, as a rise in interest rates will generally lead to an increase in the Australian dollar exchange rate (an appreciation), which is most commonly measured against the US dollar. This happens because higher interest rates in Australia tend to attract capital inflow from foreign investors seeking higher returns on their investments, particularly if interest rates are lower in other economies, such as China. Chinese investors seeking higher returns might also believe there are better prospects in Australia for investments to be profitable.

Greater capital inflow increases the demand for the Australian dollar in the foreign exchange market and puts upward pressure on the currency. An appreciating dollar makes exports dearer and imports cheaper. Relatively cheaper imports help to reduce inflationary pressures in the economy, while relatively dearer exports cause export-producing industries to be less internationally competitive, which in turn can cause a decline in export sales. This will tend to produce a fall in aggregate demand and economic activity, and reduce imported inflation and other inflationary pressures.

The Australian dollar exchange rate refers to the price at which the currency can be exchanged for another currency, such as the US dollar.



Lower interest rates have the opposite effect. They contribute to a depreciation in the Australian dollar exchange rate and to adjustments in the demand for and the prices of imports (dearer) and exports (cheaper). In general, a lower exchange rate will generate an increase in aggregate demand and economic activity as more exports are sold, while the demand for some imports may decrease with some of that demand being directed towards domestic production.

(It should be noted that another element that adds to the complexity of this transmission channel is the influence the RBA can have on exchange rates through intervening in the foreign exchange market by buying or selling foreign currencies in exchange for the Australian currency, which will influence the value of the exchange rate. This foreign exchange intervention does not occur often but it can affect the demand for and supply of money, which in turn affects the exchange rate. For example, if the RBA sells foreign currencies it increases the demand for the Australian dollar in the foreign exchange market, causing the exchange rate to appreciate.

This action has similar effects on the financial system—it reduces the demand for money, thus causing a dampening effect on aggregate demand and economic activity. Some countries use exchange rate intervention as a direct means of implementing monetary policy. Australia is not one of them but we do need to be aware of the effects of any foreign exchange intervention by the RBA on the supply of money in the money market and the linking effect this would have on interest rates.)

Availability of credit channel

The availability of money and credit to borrowers is generally determined by a lender’s assessment of the risk of default or non-repayment by the borrower. Consumers and businesses borrowing funds need to be able to make ongoing interest rate payments on loans as well as repay the loan in stages over time. Lenders must assess the ability of borrowers to pay and if the risk of default is judged to be too high then the loan (credit) will not be made available.

Generally, in times of higher interest rates the risk of default is judged to increase because interest payments are higher and so lenders are more likely to reduce loan approvals. When less credit is made available by lenders, spending by consumers and businesses is reduced as is aggregate demand and economic activity. Conversely, in times of lower interest rates the opposite occurs.

Asset prices channel

Changing asset prices for private fixed capital assets, infrastructure, houses, shares, government securities, durable household goods and so on can affect decisions made about consumer and business spending. At times, it can be difficult to recognise why prices have increased or decreased, or the extent of changes in prices. For example, housing prices in Sydney and Melbourne are rising at a far greater rate than anywhere else in Australia, and while interest rates are a contributing factor, they are one of a range of contributing factors.



Decreases in interest rates tend to increase asset prices, which can lead to additional investment in housing, infrastructure, factories, warehouses, machinery, computer equipment and other capital assets. The higher demand for these assets contributes to increases in prices. When consumers realise their net worth has increased they are likely to spend more. In addition, the rise in net worth means they have more collateral to guarantee a loan and it is easier to borrow and spend more. There are also links between interest rates and property prices with higher interest rates lowering property prices. The price of government bonds and other securities and the price of shares and other equities tend to increase with an increase in interest rates.

As with the other transmission channels, changing interest rates influence spending, aggregate demand and economic activity. Higher interest rates tend to reduce demand and economic activity, while lower interest rates tend to boost demand and economic activity.

CONCLUSION

The primary focus or aim of monetary policy is the achievement of an inflation target. This requires that over a period of time (7 to 10 years), inflation should average between 2 and 3 per cent, on average. The RBA also has a duty, within the limits of its powers, to maintain full employment and the economic prosperity and welfare of the Australians by influencing economic activity. However, the inflation target is its most important priority because the RBA argues that by achieving low inflation, economic growth and full employment can be sustained. What is the logic behind this idea? Sustaining a low inflation environment means that prices are low, thereby increasing the competitiveness of Australian industry. A more competitive economy translates into increased demand for exports as well as increased demand for domestically produced items. There is also a need for imports, especially components used in the production process. The result of all this is ongoing economic growth and greater employment opportunities. In other words, the RBA really aims to achieve a sustained increase in economic growth by focusing monetary policy on an inflation target.

The RBA has effectively used the flexibility of monetary policy with considerable success since 1990 by using small step-by-step changes to interest rates with a view to managing the level of economic activity. Interest rate adjustments were made when there were signs of some instability (rising inflation or economic growth slowing down or rising too quickly). On these occasions the RBA made 0.25 percentage point changes in interest rates to restore stability. On some occasions when the instability had been judged to be more severe, the decrease was as high as 1 percentage point, as in October and December 2008 at the time of the global financial crisis. The evidence about the success of the RBA’s monetary policy is demonstrated by the achievement of mainly low inflation rates for nearly 30 years since June 1991, with few exceptions.



REVIEW QUESTIONSMULTIPLE-CHOICE QUESTIONS

Circle the response that is correct or that best answers the question.

Question 1Lower domestic interest rates are expected to:

A. increase inflation and increase economic growth.

B. decrease economic activity and decrease unemployment.

C. discourage borrowing and encourage saving.

D. increase aggregate demand and decrease economic activity.

Question 2The Reserve Bank of Australia (RBA) lowered the cash rate six times between May 2013 and August 2016. This is referred to as:

A. expansionary monetary policy aimed at increasing interest rates.

B. restrictive monetary policy aimed at decreasing interest rates.

C. expansionary monetary policy aimed at decreasing interest rates.

D. restrictive monetary policy aimed at increasing interest rates.

Question 3 Where the underlying inflation rate is higher than the RBA target rate of inflation, the RBA will:

A. increase funds in the Exchange Settlement Accounts of banks leading to increases in interest rates.

B. increase funds in the Exchange Settlement Accounts of banks leading to decreases in interest rates.

C. decrease funds in the Exchange Settlement Accounts of banks leading to decreases in interest rates.

D. decrease funds in the Exchange Settlement Accounts of banks leading to increases in interest rates.

Question 4Which of the following is usually an important consideration in the monetary policy decision-making process?

A. trends in housing and other real estate prices

B. anticipated trends in the rate of underlying inflation

C. changes in share prices on the Australian Securities Exchange

D. the level of Australia’s net foreign debt




Question 5Monetary policy must anticipate likely inflationary pressures a year and a half in the future because:

A. the RBA Board needs time to assess the state of the economy.

B. the RBA Board meets only once a month to assess cash rate changes.

C. there is a long time lag before the RBA is able to change the cash rate.

D. there is a long time lag between changing the cash rate and its effect on economic activity.

Question 6Decreasing the cash rate in the money market is likely to lead to:

A. increased interest rates and more borrowing.

B. increased interest rates and less borrowing.

C. decreased interest rates and more borrowing.

D. decreased interest rates and less borrowing.

Question 7RBA action to increase interest rates is most likely to result in:

Inflation rate Unemployment rate Economic growth rate

A. increase increase increase

B. increase decrease decrease

C. decrease increase decrease

D. decrease decrease increase

Question 8Interest rates are most likely to be lowered if:

A. unemployment is decreasing.

B. economic growth is too low.

C. the inflation rate is below the Reserve Bank’s target range.

D. aggregate demand is increasing.

Question 9In times of low and subdued economic growth and employment growth, the RBA will:

A. decrease the supply of money in the money market by purchasing government securities

B. increase the supply of money in the money market by purchasing government securities

C. decrease the supply of money in the money market by selling government securities

D. increase the supply of money in the money market by selling government securities.



Question 10High interest rates can lead to:

A. an appreciation in the value of the Australian dollar.

B increased employment growth.

C. inflationary pressures.

D. increased consumer spending.

Question 11 A restrictive monetary policy is likely to:

A. encourage capital inflow.

B. encourage borrowing.

C. increase aggregate demand.

D. discourage national savings.

Question 12Low interest rates in Australia are likely to contribute to:

A. a rise in the value of the Australian dollar.

B. decreased lending for investment and decreased economic activity.

C. an increase in economic growth and inflationary pressures.

D. greater savings and less borrowing for investment.

Question 13An example of a monetary policy measure that could be used to reduce demand inflation is:

A. a decrease in interest rates.

B. an increase in personal income tax rates.

C. an increase in productivity rates.

D. an increase in the exchange rate.

Question 14 In times of low inflation and low economic growth and employment growth, the RBA will:

A. purchase government securities in order to decrease the cash rate.

B. purchase government securities in order to increase the cash rate.

C. sell government securities in order to decrease the cash rate.

D. sell government securities in order to increase the cash rate.



Question 15Given the transmission mechanisms of monetary policy, rising interest rates are likely to lead to:

A. an appreciating exchange rate that undermines Australia’s international competitiveness, and increases the current account deficit while reducing economic growth, employment and business investment.

B. an appreciating exchange rate that assists Australia’s international competitiveness, and reductions in the current account deficit while encouraging economic growth, employment and business investment.

C. a depreciating exchange rate that undermines Australia’s international competitiveness, and increases in the current account deficit while reducing economic growth, employment and business investment.

D. a depreciating exchange rate that assists Australia’s international competitiveness, and reductions in the current account deficit while encouraging economic growth, employment and business investment.

WRITTEN RESPONSES

Typical VCE Economics Units 3–4 exam questions on monetary policy require students to know:

• the definition and meaning of monetary policy and the terms associated with it

• the role of the RBA with respect to monetary policy and the stance of monetary policy: expansionary or contractionary

• the operation of monetary policy including the role of the cash rate, open market operations and the transmission mechanisms (channels) through which changes to interest rates can affect the level of aggregate demand

• how monetary policy works to influence aggregate demand (economic activity)

• the strengths and weaknesses of monetary policy to achieve the Australian Government’s domestic macroeconomic goals of strong and sustainable economic growth, full employment and low inflation, and how these goals may affect living standards

• the focus of monetary policy from the past two years on the levels of aggregate demand and the domestic macroeconomic goals.

For examples of past VCAA exam questions, refer to Section B of the following past VCE Economics Units 3 and 4 examination papers:

2016—Questions 3d and 3e: http://www.vcaa.vic.edu.au/Documents/exams/economics/2016/2016economics-w.pdf

2015—Questions 1e, 3a, 3b and 3c: http://www.vcaa.vic.edu.au/Documents/exams/economics/2015/2015economics-w.pdf

2014—Question 3b: http://www.vcaa.vic.edu.au/Documents/exams/economics/2014/2014economics-w.pdf

2013—Question 1c: http://www.vcaa.vic.edu.au/Documents/exams/economics/2013/2013economics-w.pdf


http://www.vcaa.vic.edu.au/Documents/exams/economics/2013/2013economics-w.pdf





Question 1a. Define the following terms:

aggregate demand monetary policy restrictive monetary policy expansionary monetary policy open market operations cash rate.

b. Explain the purpose of each of the following: monetary policy inflation targeting underlying inflation repurchase agreement (repos) open market operations.

Question 2

Transmission mechanisms are the generally recognised ways that a change in interest rates (and their effect on other factors such as exchange rates or asset prices) can affect aggregate demand and the level of economic activity.

a. Explain how each of the following factors are affected by a decrease in interest rates:

the cost of borrowing to invest

the exchange rate

the price of houses and company shares.

b. Explain what effect each of them will have on the level of economic activity.

Question 3a. Outline the types of organisations that hold Exchange Settlement Accounts and how

these accounts operate.

b. Explain how open market operations and Exchange Settlement Accounts are combined to produce an expansionary monetary policy.

c. Explain the effect of higher domestic interest rates on:

business investment

employment growth and economic growth

international competitiveness

the Australian dollar exchange rate

the current account in the balance of payments.



Question 4

On 3 August 2016, the Governor of the Reserve Bank of Australia (RBA) announced a change in monetary policy: ‘… the Board decided to lower the cash rate by 25 basis points to 1.5 per cent …’.

Source: Statement by Glenn Stevens, Governor, Monetary policy decision, media release, Reserve Bank of Australia, 3 August 2016

a. Outline one economic factor that could explain why the RBA decided to lower the cash rate in August 2016.

b. Outline the monetary policy stance adopted by the RBA during 2017. Explain how it achieved this.

c. With reference to two monetary policy transmission channels (mechanisms), explain how this stance is likely to have an impact on the goals of strong and sustainable economic growth and full employment.

d. Outline one possible negative impact on the economy caused by lowering the cash rate.



ANSWERS TO MULTIPLE-CHOICE QUESTIONS

1 A

2 C

3 D

4 B

5 D

6 C

7 C

8 B

9 B

10 A

11 A

12 C

13 D

14 A

15 A

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Disclaimer: This resource has been written by the author (Ken Nailon) for use with students of VCE Economics. This does not imply that it has been endorsed by the Victorian Curriculum and Assessment Authority (VCAA). The current VCE Economics Study Design (2017–2021) can be accessed directly via the VCTA website. VCE is a registered trademark of VCAA. While every care is taken, we accept no responsibility for the accuracy of information or advice contained in Compak. Teachers are advised to


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