Quick questions on Monetary policy and the Reserve Bank of Australia (HSC Economics Topic 4)

Monetary policy is the manipulation of the cost and availability of money and credit by the Reserve Bank of Australia to achieve macroeconomic objectives.

The Reserve Bank Act 1959 sets three statutory objectives:

The cash rate is the interest rate banks charge each other for overnight loans of reserves. The RBA sets a target for the cash rate and uses open market operations to make banks transact at that target.

Monetary policy affects the real economy through four main channels:

The RBA estimates the neutral cash rate at around 3 to 3.5 percent in 2025 (RBA Statement on Monetary Policy, indicative). The current 4.35 percent rate is therefore contractionary.

The RBA's "narrow path" of bringing inflation back to target without triggering recession has been largely achieved, though the disinflation has been slower than initially expected.

1. Time lags. Decision-to-effect lag of 12 to 18 months. The RBA must forecast where inflation will be when the policy takes full effect.

Both tools work on AD, but with different strengths:

- To lower the cash rate: the RBA buys government securities from banks, paying with new reserves. Reserves expand, the cash rate falls. - To raise the cash rate: the RBA sells government securities to banks, draining reserves.

Changes in the cash rate pass through to retail interest rates (mortgages, business loans, deposit rates) within months. Higher rates: - Raise the cost of borrowing, reducing consumption (especially of durables) and investment. - Raise debt servicing costs for existing mortgage holders, reducing disposable income.

Higher rates lower asset prices: - Housing prices fall (or rise less) as mortgage capacity tightens. - Equity prices fall as future earnings are discounted at higher rates. - Lower asset prices reduce household wealth, reducing consumption through the wealth effect.

Higher cash rate attracts foreign capital, supporting the AUD: - Higher AUD reduces import prices, lowering imported inflation. - Higher AUD reduces export competitiveness, dampening AD.

RBA forward guidance and decisions shape: - Inflation expectations. Anchored expectations reduce wage-price spirals. - Business confidence. Predictable policy supports investment planning. - Household sentiment. Signal effects on spending and saving.

Decision-to-effect lag of 12 to 18 months. The RBA must forecast where inflation will be when the policy takes full effect.

Conventional rates cannot fall much below zero (negative rates damage bank profitability).