Question

Consider a situation in which the Reserve Bank of Australia (RBA) decides to undertake a restrictive monetary policy. Explain the process by which the RBA undertakes such a policy and how it would work to affect the level of income as well as both the demand for and supply of money. In your answer you should identify the role that the yield curve plays in the transmission of RBA decisions to the economy.

Answer 1

The Reserve Bank of Australia manages the Australian dollar by setting the interest rate in overnight money markets.

The Reserve Bank of Australia has three mandates:

1. The stability of Australia's currency
2. Maintenance of full employment in Australia
3. The economic prosperity of the people of Australia

The Reserve Bank of Australia (RBA) undertake a restrictive monetary policy

Contractionary monetary policy is when a central bank uses its monetary policy tools to fight inflation. It's how the bank slows economic growth. Inflation is a sign of an overheated economy. It's also called a restrictive monetary policy because it restricts liquidity.

The inflation target is defined as a medium-term average rather than as a rate or band of rates that must be held at all times. This approach allows a role for monetary policy in dampening the fluctuations in output over the course of the business cycle. When aggregate demand in the economy is weak, for example, inflationary pressures are likely to be diminishing and monetary policy can be eased, which will give a short-term stimulus to economic activity.

The process by which the RBA undertakes such a policy and the level of income as well as both the demand for and supply of money.

The Reserve Bank of Australia implements monetary policy by undertaking transactions in domestic money markets. The approach is referred to as ‘Open Market Operations’. Monetary policy is implemented can be explained by stepping through five aspects of the cash market: the price, quantity, demand, supply and the policy interest rate corridor

As the Reserve Bank sets a target for the cash rate, it is often referred to as the ‘instrument’ of monetary policy.The quantity traded in this market is called Exchange Settlement (ES) balances, which are used to settle interbank transactions.

The demand for and supply of money in  Monetary policy  

Banks use ES balances as a store of value and to make payments between each other. Some of these payments are on behalf of their customers and some are related to their own business. The Reserve Bank estimates the demand for ES balances each day. Demand may vary for a number of reasons, including changing financial market conditions.

The Reserve Bank manages the supply of ES balances. Supply is set so that it meets demand and the cash rate is as close as possible to its target.

A number of factors can change the supply of ES balances. For example, any payments made by the Australian Government or received into its accounts at the Reserve Bank will affect ES balances.

The Reserve Bank responds to changes in the demand and supply of ES balances to maintain the cash rate target. This is mainly achieved with open market operations.

Monetary policy focuses on the first two elements. By decreasing the amount of money in the economy, the central bank discourages private consumption. Increasing the money supply also increase the interest rate, which discourages lending and investment. The higher interest rate also promotes saving, which further discourages private consumption. The decrease in consumption and investment leads to a decrease in growth in aggregate demand.

The higher interest rates also can slow inflation. Consumption and investment are discouraged, and market actors will choose to save instead of circulating their money in the economy. Effectively, the money supply is smaller, and there is reduced upward pressure on prices since demand for consumption goods and services has dropped.

The role that the yield curve plays in the transmission of RBA decisions to the economy

The yield curve ie. structure of interest rates – shows the yield on bonds over different terms to maturity. The yield curve for government bonds is also called the ‘risk free yield curve’ because governments are not expected to fail to pay back the borrowing they have done by issuing bonds in their own currency.

The yield curve is involved in the transmission of changes in monetary policy to a broad range of interest rates in the economy. When households, firms or governments borrow from a bank or from the market by issuing a bond, their cost of borrowing will depend on the level and slope of the yield curve.

example-

Australian households that borrow using fixed-rate mortgages usually only lock in their interest rate for 2–3 years, so this part of the yield curve is important for fixed mortgage rates. Many Australian households have mortgages with variable interest rates, so the cash rate is important for them. On the other hand, firms and governments often wish to borrow for a much longer term, say 5 or 10 years, so this part of the yield curve is important for them.

Reserve Bank of Australia though, yield curve control has been a cost-effective way to stimulate the economy by capping interest rates for borrowing terms up to several years.