# Monetary Policy

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Monetary policy is one the involves the manipulation of money stock and interest rates in the economy by the RBA. It is generally seen as a more effective policy than fiscal policy as it is more flexible and reactive. This chapter continues from the previous chapter on money, banks and the RBA and explains how the policy is implemented and how it affects the economy to reduce output gaps.

## Contents

Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011), pp. 208-229 (Chapter 8).

## The RBA and Interest Rates

As explained in the RBA and interest rates, the RBA can control the overnight cash rate, which indirectly spills over to other interest rates in the economy. This sections explains this relationship in more detail through the exploration of the bonds market.

### Bonds

A bond is a legal obligation to repay a debt, usually through payments of the full money lent and of interest on that amount. A bond is essentially a loan with one added benefit: the holder of a bond (i.e. the one lending the money) can choose to trade the bond to others so that the borrower pays the debt to the new owner instead of the original owner (the original lender). The basic form of bonds involve the principal amount which is the original amount the bond holder pays (or lends) to someone else, and a coupon rate which is the interest rate the lender pays on the loan on a periodic basis. Bonds are often long term obligations so that they also come with a bond term, the period of time in which the loan must be paid off. For example, a bond carrying a principal amount of \$100 and a coupon rate of 5% with a bond term of three years will involve payments of \$5 for every year for the three years, plus the original \$100 loaned, equalling a total of \$115 by the end of the three years.

Bond Price x 1.06 = \$110

That is, they are willing to pay an amount where after the 6% interest rate will return that overall return of \$110. Rearranging gives:

Bond Price = \$110/1.06 = \$103.8

Essentially says that bond buyers will only buy the bond for \$103.8 rather than \$110.

Note that the original bond holder makes \$5 + \$103.8 = \$108.8 (profit of \$8.8) and the new bond holder makes \$110 (profit of \$6.2). Total profit for the bond is \$6.2 + \$8.8 = \$15, as originally planned by lender and that 6.2/103.8 = 6%, as planned by the new bond buyer.

Now if the bond interest rate was 4%, i.e. below the coupon rate, then the bond price would be:

Bond Price = \$110/1.04 = \$105.8

So that the profit for the new owner is \$4.2, which is 4% as expected.

### RBA and Bond Interest Rates

Now the question is how does the RBA affect the bond market interest rate? It doesn't directly affect it buy by changing the overnight cash rate, the RBA can take lenders from the bond market and reduce the demand for bonds. If the public wants to buy bonds, then they will only want a lot if the interest rate is high, but will demand less if the interest rate is low. On the other hand, firms are only willing to issue a lot of bonds if the interest rates are low and will supply less if the interest rate is high. Note that a low interest rate corresponds to an increase in the price of bonds, while high interest rates correspond to decreases in the price. Therefore the supply and demand curve (when comparing quantity and price rather than interest rates) is the same as the market supply and demand curve from micro (where demand is downward sloping and supply is upward sloping). Now if the RBA chooses to increase the overnight cash rate, then the effect works in two ways: both on the supply and the demand curve.

By increasing the overnight cash rate, the RBA is giving an incentive for banks to hold more money in their exchange settlement accounts rather than lend out. That means that lenders move away from the bond market and hold money with the RBA to gain interest there, shifting the demand for bonds to the left, as the public is only willing to buy the same amount of bonds at lower prices (but higher interest rates). On the other hand, firms that borrowed from the overnight cash market before, now have to pay higher interest rates and so will move away from that market and choose to issue the same amount of bonds for lower principal amounts, shifting the supply curve to the right. The overall effect is that the new equilibrium price and quantity have changed to a point where quantity of bonds is reduced and the original price is reduced. However, the interest rate paid on the bonds has increased.

While this example has been for bonds, the same effect happens in other markets where interest rates are involved. Hence if the RBA increased or decreases the cash rate, the rest of the economy's interest rates follow.

## The RBA and Money Supply

 Surprisingly, the RBA does not have to change the money supply in order to change the cash rate. The RBA essentially has control over base money which is the amount of currency in circulation plus the deposits that banks have with the RBA in their exchange settlement accounts. If we assume base money to remain constant, then if the RBA announces that the target cash rate has increased (and hence the interest the RBA pays to exchange settlement accounts and the interest it charges on loans increase as well) then banks notice that they can make more money by simply keeping money in their exchange settlement accounts and they stop borrowing. In essence, increasing the cash rate increases the demand for base money but since the supply of money (by the RBA) is constant, market forces push the demand curve closer to the supply amount, reaching equilibrium in the higher cash rate.

## Effects of Monetary Policy on the Economy

After understanding how the RBA can control the real interest rate, we turn to analyse how the RBA's actions affect the economy. The theory is quite straight forward and relies on the idea that spending in the economy (by both households and firms) is dependant on interest rates. If the RBA decreases interest rates, then spending increases while the converse results in decreased spending. By manipulating interest rates and hence spending, the RBA effectively pushes to affect PAE and hence eliminate output gaps.

What follows next is a more structured analysis that relates PAE and interest rates to give a numerical model of their relationship which is then used to explain what action is to be taken to reduce output gaps.

### PAE and Interest Rates

Recall from Savings and Investmentthat savings is an upward function of the real interest rate and that investment is related to the interest rate through the cost of capital. By this analysis it can be concluded that consumption decreases as interest rates increase (since households prefer to save money than spend it). If consumption decreases, then firms understand that people will buy less and hence decide to reduce their investment. Hence the consumption and investment functions can be rewritten as:

C = + c(Y-T) -γr
I = IP - φr

Where:

γ and φ are some multipliers of r
r = the real interest rate

By applying these into PAE along with the other predetermined functions of G, T and NX, PAE can be rewritten as:

PAE = [ + cT + IP + G + NX - (γ+φ)r] + cY

Which now gives PAE as a function of the real interest rate. The conclusion from this relationship is that as the real interest rate increases, PAE decreases. If the RBA can set interest rates then it follows that it can also affect PAE, and now we have a model that explain how the RBA can do this. If there is a negative output gap (y - y* < 0, contraction) then the RBA needs to decrease interest rates, shifting the PAE line upwards and shifting output towards the higher potential, whereas if there is a positive output gap (y - y* > 0, expansion) then the RBA should increase interest rates, lowering PAE and shifting output towards the lower potential.

## The RBA Policy Reaction Function

The above analysis suggests that the RBA will change interest rates according to the state of the economy. In general, the determinants that the RBA looks for in determining this rate are inflation and the output gap, along with some lower limit of interest. From the analysis of the interest rate it is known that it is inversely related to inflation. Hence if inflation rises, then interest rates will fall so to compensate, the RBA increases the interest rate. In addition, if the output gap becomes more positive (expansionary), then the RBA should increase interest rates. A general equation to summarise these finding is given by:

r = f + gπ + h(y-y*)/y*

Where f, g and h are some constants or multipliers.

If we assume that the RBA only looks at inflation and changes interest rates based on that, then the relationship can be simplified to

r = f + gπ