The government of any country has many policy areas it can use to influence its economy. In this topic we focus on monetary policy and the following topic will look at fiscal policy. They are the two (2) most used, most significant policies of the Australian government in influencing the economy.
In this topic, we will consider the overall level of the supply of money in an economy; the price setting mechanism, including interest rates for use of the money; and the role banks play in monetary policy. For example, inflation can escalate when there is easy access to funds and a growing economy. As a result, inflation is often an element of the economy that the government will want to control. Fiscal policy, on the other hand, ties into the management of the economy where a government determines its budget, level of spending and rate of taxes, which inject or extract money from the economy.
In the next three (3) topics we shall cover monetary policy then fiscal policy and, after that, international economics. We will start to see the links between these topics because monetary policy and fiscal policy are most often considered to have a causal relationship and have subsequent international economic impacts.
In topics to date, we have seen in the circular flow in the economy initially as individuals, households and businesses. Then we have the additional consideration of the government. Next comes the addition of the international economic flows at a macroeconomic level.
Welcome to Topic 9: Monetary Policy. In this topic, you will learn about:
- Monetary policy and fiscal policy
- Banks and money supply
- Interest rates
- Inflation.
These relate to the Subject Learning Outcomes:
- Interpret economic models, diagrams and tables to describe the economic situations.
- Explain how government policy influences microeconomic choices and macroeconomic outcomes.
- Analyse the economy as a whole using macroeconomic models.
Welcome to your pre-seminar learning tasks for this week. Please ensure you complete these tasks prior to attending your scheduled seminar with your lecturer.
Click on each of the following headings to read more about what is required for each of your pre-seminar learning tasks.
Read Chapter 29 and Chapter 30 of the prescribed text – Mankiw, NG 2016, Principles of microeconomics, 8th edn., Cengage Learning Custom Publishing.
Read the following journal article to learn more about the macroeconomic policy environment:
Ghosh, BN 2013, ‘Macroeconomic policy environment some obiter dicta’, EUL Journal of Social Sciences, 3(2):1-21
Watch the Reserve Bank of Australia video, Introduction to monetary policy by Gian-Piero (Gigi) Lovicu.
Read the Reserve Bank of Australia explainer, What is monetary policy.
Read Chapter 15 of the online text, Principles of macroeconomics 2e, by Greenlaw, SA & Shapiro, D.
After reading and watching the previous article, chapters and videos, complete the following three (3) tasks in your reflective journal:
- Identify the effects of monetary policy in contractionary and expansionary phases on aggregate demand and the major economic indicators mentioned in the resources.
- Identify as many examples as you can observe of the monetary policy impacts on any of the various economic indicators, such as leading and lagging indicators that have been examined in previous topics (for example, unemployment, inflation, inventories, GDP or building approvals).
- Determine the current monetary policy setting (expansionary or contractionary) for the following national economies. What factors indicate this and support your views? Justify your answer with research.
- Australia
- Japan
- USA
- Singapore
- Vietnam
- New Zealand.
You can access the reflective journal by clicking on ‘Journal’ in the navigation bar for this subject.
- Read the article by Orphanides, A & Williams, JC 2010, Monetary policy mistakes and the evolution of inflation expectations, Federal Reserve Bank of New York, 1-44.
- After reading the article, conduct additional research and list four (4) different examples of adverse consequences when mistakes are made with monetary policy and inflation becomes problematic (either high, low or fluctuating).
- Record your examples and their references in your journal.
- Watch the following video on cash rate and its settings:
- Reserve Bank of Australia 2021c, Conventional monetary policy tools: The cash rate target, streaming video, YouTube.
- In your reflective journal, compose your answers to the following questions:
- What is Australia's official cash rate (based on the most recent Reserve Bank of Australia’s first Tuesday Board monthly meeting)?
- What would you expect to be the next announcement from the Reserve Bank of Australia on the official cash rate in Australia (up, down or no change to current) and why? What is the basis for your view?
- Read the Bank of Japan paper on the effects of a zero interest rate:
- Oda, N & Ueda, K 2005, ‘The effects of the bank on Japan’s zero interest rate commitment and quantitative monetary easing on the yield curve: A macro-finance approach’, Bank of Japan’s Working Paper Series, (5):1-22.
- Identify what the Bank of Japan was aiming to do to macroeconomics in the country with this policy setting?
- After analysing the paper and conducting further research, identify and record in your reflective journal, the simultaneous policy settings for monetary policy (at the time of Japan’s zero rate) in:
- Australia
- USA
- Singapore
- Vietnam
- New Zealand.
Read the following content
Monetary policy and Fiscal Policy
Monetary policy refers to actions that central banks take to pursue objectives such as price stability, maximum employment and stable economic growth. This activity is on a large scale — a macroeconomic scale (Hopper 2018). Fiscal policy is the government budget and financial policy on inflows and withdrawals nationally and internationally.
Banks and money supply
The reserve bank or central bank of a country conducts monetary policy by influencing the supply of money in the economy and influencing market interest rates. The central bank will set an official cash rate. This may be as low as 0.25 % or in some cases has been zero, such as in Japan in 1999 (Oda & Ueda 2005). The rate can be as high as 15-20 % in other instances.
Learning task 1: Discussion forum activity
Review the RBA case study on monetary policy implementation. Analyse the RBA’s decision to lower the official cash rate as detailed in the case study. Then, post your responses to the following questions in the discussion forum.
You can also navigate to the forum by clicking on “ECO100 Subject Forum” in the navigation bar for this subject.
Reserve requirements are rules set by the reserve bank, for example, the Reserve Bank of Australia (RBA) that specify the prudential requirements of all banks operating in the country. This sets out rates of cash and other asset reserves that a bank must hold, preserved as a safety measure so the banks remain stable and solvent at all times. These reserves effectively take money supply out of circulation for the flow of the economy. The higher the rate set, the more funds are taken out of circulation. This would be part of a contractionary setting for monetary policy.
Interest rates
There are many different types of interest rates. The most commonly talked about rates tend to be home loan interest rates, which have fixed rates and variable rates as options. Bond rates are also vitally important in the economy. If you were to take out a home loan or business loan today, the bank or other financial institution would advise you of the interest rate they will charge you to borrow the money. This interest rate is the rate they charge you for the use of the money over time. The bank acquires the funds at a lower rate than the rate it charges you — that is one way they make their profits.
The interest rates the bank will borrow its money at and the rate subsequently charged to you are linked to, but not identical to, the official cash rate. For example, the official cash rate may be 0.5 %. The bank may be able to borrow its money at 1.0 %, then loan the money to you and charge you a 2.0% interest rate.
Interest rates decisions are taken by the RBA's Board. The official interest rate is the cash rate. The cash rate is the rate charged on overnight loans between financial intermediaries, which is determined in the money market due to the demand for and supply of overnight funds. Rates of interest at 3 % or below are considered record low interest rates in Australia (Trading Economics 2021).
Inflation
The concept of macroeconomics being a spiral was introduced in previous topics. Inflation is the reflected impact of escalating or falling prices in the economy. As input cost rises (wages, supplies, equipment and capital) and prices will generally increase if demand increases (expanding or growing). If we remember, in microeconomics, as demand increases, prices increase.
Ceyda Oner (2021) of the International Monetary Fund (Deputy division chief in the IMF’s Finance Department) defines inflation as:
Inflation measures how expensive a set of goods and services has become over a certain period, usually a year.
Consumers’ cost of living depends on the prices of many goods and services and the share of each in the household budget. To measure the average consumer’s cost of living, government agencies conduct household surveys to identify a basket of commonly purchased items and track, over time, the cost of purchasing this basket. Housing expenses, including rent and mortgages, constitute the largest component of the consumer basket in the United States. The cost of this basket at a given time, expressed relative to a base year is the consumer price index (CPI). The percentage change in the CPI over a certain period is consumer price inflation, the most widely used measure of inflation. For example, if the base year CPI is 100 and the current CPI is 110, inflation is 10 % over the period.
It is important to understand that wages and interest rates both impact inflation. In Australia, the low wages growth over the last decade has assisted with the RBA’s objective of keeping inflation within a 2-3 % target range (Lowe 2021).
Oner (2021) went on to say:
Most economists now believe that low, stable, and — most important — predictable inflation is good for an economy.
This is consistent with the views held and objectives set by the Governor of the RBA (Lowe 2021).
Knowledge check
Complete the following two (2) tasks. Click the arrows to navigate between the tasks.
Key takeouts
Congratulations, we made it to the end of the ninth topic! Some key takeouts from Topic 9:
- Monetary policy is directly focused on the overall supply of money in an economy.
- The settings on monetary policy will influence several key economic indicators, including aggregate demand – particularly investment and consumer consumption.
- Central banks play a key role in the money supply.
- Monetary policy has a dynamic relationship with fiscal policy, and the two (2) must be understood in conjunction.
- Monetary policy and inflation are inextricably linked and are responsive to each other.
Welcome to your seminar for this topic. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking ‘Join’ to enter the class.
Click here to access your seminar.
The learning tasks are listed below. These will be completed during the seminar with your lecturer. Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
In-seminar learning tasks
The in-seminar learning tasks identified below will be completed during the scheduled seminar. Your lecturer will guide you through these tasks. Click on each of the following headings to read more about the requirements for each of your in-seminar learning tasks.
Consider the formula for growth of an economy GDP = C + I + G (M – X) and be prepared to discuss the impact of expansionary monetary policy and contractionary monetary policy on each element of the formula.
Ensure you have completed the pre-seminar learning tasks and are familiar with the formula for growth (GDP) and the economic impacts on inflation. Complete the following task in a breakout room:
Identify the possible interventions to address inflation and its impact on GDP. You should consider the knock-on effects of such interventions in other areas of the economy. Develop an overview of how to manage inflation while remaining conscious of balance and avoiding counterproductive outcomes in other areas.
Welcome to your post-seminar learning tasks for this week. Please ensure you complete this after attending your scheduled seminar with your lecturer. Your lecturer will advise you this is to be completed during your consultation session. Click on the following heading to read more about the requirements for your post-seminar learning task.
Read the following research papers on the relationship between monetary policy and inflation:
- Ayubu, VS 2013, Monetary policy and inflation dynamics: An empirical case study of Tanzanian economy, Masters Thesis, UMEA University.
- Ryan-Collins, J 2015, Is monetary financing inflationary? A case study of the Canadian economy, Levy Economics Institute.
Answer the following questions in your reflective journal:
- Describe five (5) different impacts that monetary policy has on inflation that were highlighted in these papers.
- Based on your analysis of the two research papers, why do developing countries often exhibit wide fluctuations in inflation?
- Why does the Reserve Bank of Australia have a target inflation rate of 2-3 %?
Each week you will have a consultation session, which will be facilitated by your lecturer. You can join in and work with your peers on activities relating to this subject. These session times and activities will be communicated to you by your lecturer each week. Your lecturer will start a video stream during your scheduled class time. You can access your scheduled class by clicking on ‘Live Sessions’ found within your navigation bar and locating the relevant day/class or by clicking on the following link and then clicking 'Join' to enter the class.
Click here to access your consultation session.
Should you be unable to attend, you will be able to watch the recording, which can be found via the following link or by navigating to the class through ‘Live Sessions’ via your navigation bar.
Click here to access the recording. (Please note: this will be available shortly after the live session has ended.)
- Chapter 14 of Frank, R, Bernanke, B, Antonovics, K & Heffetz, O 2019, Principles of macroeconomics, 7th edn., McGraw Hill.
- The Age 2006 ‘The real reasons why it was the 1990s recession we had to have’, The Age, 2 December.
- Chapter 15 of Schiller, BR 2012, The macro economy today, 13th edn., McGraw-Hill.
References
- Ayubu, VS 2013, Monetary policy and inflation dynamics: An empirical case study of Tanzanian economy, Masters Thesis, UMEA University.
- Greenlaw, SA & Shapiro, D 2017, Principles of macroconomics 2e, 2nd edn., OpenStax, https://openstax.org/details/books/principles-macroeconomics-2e
- Hopper, LJ 2018, Here’s the difference between fiscal policy and monetary policy, Federal Reserve Bank of St Louis, https://www.stlouisfed.org/open-vault/2018/october/difference-between-fiscal-monetary-policy
- Lowe, P 2021, Transcript of questions & answer session - Today's monetary policy decision, Reserve Bank of Australia, https://www.rba.gov.au/speeches/2021/sp-gov-2021-11-02-qanda.html
- Oda, N & Ueda, K 2005, ‘The effects of the bank on Japan’s zero interest rate commitment and quantitative monetary easing on the yield curve: A macro-finance approach’, Bank of Japan’s Working Paper Series, (5):1-22, https://www.boj.or.jp/en/research/wps_rev/wps_2005/data/wp05e06.pdf
- Oner, C 2021, Inflation: Prices on the rise International Monetary Fund, International Monetary Fund, https://www.imf.org/external/pubs/ft/fandd/basics/30-inflation.htm
- Orphanides, A & Williams, JC 2010, Monetary policy mistakes and the evolution of inflation expectations, Federal Reserve Bank of New York, 1-44, https://www.researchgate.net/publication/228222634_Monetary_Policy_Mistakes_and_the_Evolution_of_Inflation_Expectations
- Ryan-Collins, J 2015, Is monetary financing inflationary? A case study of the Canadian economy, Levy Economics Institute, https://www.levyinstitute.org/pubs/wp_848.pdf
- Reserve Bank of Australia 2021a, Introduction to monetary policy, streaming video, YouTube, https://youtu.be/5hgPpX7H_Ak
- Reserve Bank of Australia 2021b, What is monetary policy, Reserve Bank of Australia, https://www.rba.gov.au/education/resources/explainers/what-is-monetary-policy.html
- Reserve Bank of Australia 2021c, Conventional monetary policy tools: The cash rate target, streaming video, YouTube, https://www.youtube.com/watch?v=eTNUh8NW7QI
- Trading Economics 2021, Australia interest rate, Trading Economics, https://tradingeconomics.com/australia/interest-rate#:~:text=Interest%20Rate%20in%20Australia%20averaged,percent%20in%20November%20of%202020
