Monetary policy Essay Example | Topics and Well Written Essays - 1250 words

Monetary policy - Essay Example The RBA often determines the official cash rate after deciding on what monetary policy target it intends to attain (Reserve Bank of Australia, 2012a). Such targets may include, increasing economic growth, lowering inflation. RBA uses open market operations to affect the changes of the official cash rate, which in turn trickles down to the financial system in the country. Although RBA changes the official cash rate through open market operations, the actual cash rates are often determined by supply and demand actions among banks. Each bank is free to determine the rate by which it lends to another bank. Changing the official cash rate however, impacts all other interest rates in the market which in turn impacts the supply and demand of money in the economic system (Reserve Bank of Australia, 2012b; Lowe, 1995:1-2). The market rate of interest on the other hand is the rate that financial institutions charge its clients for borrowing money. This interest is often impacted by changes in the official cash rate, whereby increases in cash rate would imply that the banks are borrowing from other banks expensively and hence would also increase the interest rate that they charge their customers for borrowing money. A drop in the official cash rate would make it cheaper for the banks to borrow funds and hence competition among banks would reduce the market interest rate across the Australian Economy (Smales, 2011:52-55). The RBA decreases the cash rate through open market operations in order to ensure that the official cash rate that has been set is as close as possible to the actual cash rate exhibited in the market due to forces of demand and supply. Each financial institution in the country has an Exchange settlement account for which enable banks to settle payments between each and also with the RBA. Where RBA wants to reduce the cash rate, it would buy repurchase agreements (repos) or second-hand common wealth government securities (CGS) from the financial institutio ns in the economy. The RBA pays the banks using their exchange settlement accounts with the RBA which increases the amount that they have access to and can lend out (Reserve Bank of Australia, 2012b; Kuttner and Mosser, 2002: 16). This increases the supply of money in the economy, and due to competition to lend out to borrowers, the cash rate as well as the market interest rates drop. This is as demonstrated in a simple Keynesian model below: As noted in the figure, when the RBA uses the open market mechanism to purchase government securities and repos, the money supply denoted by MS, moves from the original position MS to MS1 showing a rise in money supply. Since the supply money is inelastic relative to interest rates, the MS curve is perfectly inelastic. On the other hand, the demand for money changes with changes in interest rate. Hence as money supply increases in volume due to RBA purchasing repos and CGS, interest rates fall also drop. Answer two Effect of a decrease of inter est rate on: Consumption and Investment expenditures: a fall interest rates increases investment and consumption. As noted above, a fall in interest rates is as a result in an increase in money supply. This makes it possible for businesses and consumers increase their borrowing from banks at a lower rate of interest since it is cheaper to access loans. Hence, there would be an increase in consumption and investment expenditures financed by debt as businesses are able to access funds for capital goods such as equipments, and consumers are also able