Question

a.Define monetary policy and describe the main goals of monetary policy in Australia.

b.Explain why a central bank would reduce interest rates. How would a cut in interest rates affect each of the components of aggregate demand? Use the AD/AS model to illustrate the effect of a cut in interest rates on the economy

Answer 1

A.

Monetary policy refers to the policy initiatives taken up by the central bank of the country (Reserve Bank of Australia in Australia) to maintain price stability, while ensuring robust growth of the economy. It also helps to make financial system to work with sufficient liquidity and maintaining people's confidence in the banking system of the country.

It is the Reserve Bank of Australia that looks after the economy as a central bank in the country of Australia. The goals of the monetary policy in Australia is to bring price stability and prosperity, full employment in the economy and maintain welfare efforts of the people of Australia so that the economy prospers with economic as well as high social values.

B.

Central bank would reduce the interest rate to encourage consumption and investment spending. It is the part of expansionary monetary policy. Reduction in interest rates, will lead to increase in aggregate demand.

When interest rate decreases, then consumption and investments increase. Government spending can also increase if government is willing to go for the deficit financing. If government spending increases, then it will be balanced by the decreased spending in private investments. Imports will increase in the short runs, as firms in short run, will not be able to cater the rise in demand in the short run. The net impact will be to increase in AD and rightward shift of the AD in Ad-AS diagram as follows: