Demand At The Target Cash Rate example essay topic

Table of Contents 1 Introduction: Australian Economy 2 1.1 Real Gross Domestic Product 2 1.2 Inflation 2 1.3 Employment 3 1.4 Current Account 3 1.5 Exchange Rate 3 2 Monetary Policy 5 2.1 Objectives of Monetary Policies 6 2.2 Demand for Money 8 2.3 Supply of Money 10 2.4 Money Equilibrium 11 2.5 Effects of Money Supply (Demand) 11 2.6 Keynesians vs. Monetarists 12 3 Monetary Policy Framework 16 4 Monetary Policy Implementation 18 5 Open Market Operations 21 6 Fractional Reserves 23 References 25 1 Introduction: Australian Economy The Australian economy strengthened as 2001 progressed, in sharp contrast to the weakening seen in most of the rest of the world. Gross Domestic Product (GDP) grew by 4.2 percent through the year to the December quarter 2001. Unemployment remained low and signs of improvement were visible in the December quarter 2001, while ongoing inflation remained within the Reserve Bank of Australia's target range over 2001. (Asia-Pacific Economic Cooperation, 2002) 1.1 Real Gross Domestic Product Real GDP increased 2.6 percent in 2001 (in year average terms) following growth of 3.1 percent in 2000. The slowing in the rate of growth in the first half of 2001 reflected the abatement of transitory factors such as the Sydney Olympics stimulus and the introduction of The New Tax System (TITS). In the second half of 2001 Australia's growth rebounded strongly, despite weakness in the world economy.

Nonetheless, over 2001 Australia was one of the strongest developed economies. (Asia-Pacific Economic Cooperation, 2002) 1.2 Inflation The Australian Consumer Price Index (CPI) increased by 3.1 percent through the year to the December quarter 2001. Various one-off factors added to inflation over that period. The price of meat, seafood, fruit and vegetables increased substantially through the year. In addition, some price effects have resulted from the events of September 11, the collapse of a major Australian insurance firm (HIH) and the second largest Australian airline (Ansett). These upwards price movements were offset somewhat by a significant decline in petrol prices over the year due to a fall in global oil prices.

(Asia-Pacific Economic Cooperation, 2002) 1.3 Employment Employment grew by 1.0 percent in 2001, while the unemployment rate increased steadily over most of the year to peak at 7.0 per cent in October 2001, before declining slightly to 6.7 percent in December 2001. Wages, as measured by average weekly ordinary-time earnings for full-time working adults and average weekly earnings (all employees), rose 5.7 percent through the year to the December quarter 2001. In contrast, the wage cost index rose by 3.4 percent through the year to the December quarter 2001. (Asia-Pacific Economic Cooperation, 2002) 1.4 Current Account The current account deficit fell to A$17.7 billion or 2.6 percent of GDP in 2001, down from A$26.3 billion or 4.0 percent of GDP in 2000. Exports at current prices increased 8.5 percent in 2001, while export volumes increased 0.76 percent in 2001. Imports increased 1.3 percent at current prices in 2001, while import volumes fell 4.6 percent in 2001.

The terms of trade increased 1.6 percent in 2001, following a 5.4 percent rise in 2000. The trade balance improved by A$10.2 billion in 2001 to record a trade surplus of A$2.9 billion. (Asia-Pacific Economic Cooperation, 2002) 1.5 Exchange Rate Since 1983, Australia has had a floating exchange rate. The Reserve Bank of Australia may undertake foreign exchange market operations when the market threatens to become excessively volatile or when the exchange rate is clearly inconsistent with underlying economic fundamentals. These operations are invariably aimed at stabilizing market conditions rather than meeting exchange rate targets.

During 2001, the Australian dollar appreciated (in nominal terms) 4.9 percent against the Japanese yen. It depreciated 8.5 percent against the US dollar and 2.9 percent against the euro. The Australian dollar also fell against the currencies of Australia's other major trading partners, which contributed to a 3.1 percent fall in the trade-weighted index. The exchange rate depreciation in 2001 improved Australia's international price competitiveness, cushioning the adverse effect of the global downturn on economic activity. (Asia-Pacific Economic Cooperation, 2002) 2 Monetary Policy The Reserve Bank of Australia (RBA) is responsible for formulating and implementing monetary policy. The Board's obligations with respect to monetary policy are laid out in the Reserve Bank Act.

Section 10 (2) of the Act, which is often referred to as the Bank's 'charter', says: "It is the duty of the Reserve Bank Board, within the limits of its powers, to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank... are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to: (a) the stability of the currency of Australia; (b) the maintenance of full employment in Australia; and (c) the economic prosperity and welfare of the people of Australia". Since 1993, these objectives have found practical expression in a target for consumer price inflation, of 2-3 per cent per annum. Monetary policy aims to achieve this over the medium term and, subject to that, to encourage the strong and sustainable growth in the economy. Controlling inflation preserves the value of money.

In the long run, this is the principal way in which monetary policy can help to form a sound basis for long-term growth in the economy. Monetary policy decisions involve setting the interest rate on overnight loans in the money market. Other interest rates in the economy are influenced by this interest rate to varying degrees, so that the behavior of borrowers and lenders in the financial markets is affected by monetary policy (though not only by monetary policy). Through these channels, monetary policy affects the economy in pursuit of the goals outlined above. (web 2003) 2.1 Objectives of Monetary Policies In Australia, the objectives of monetary policy are formally established in the Reserve Bank Act (1959). This sets out three objectives: . The stability of the currency of Australia; .

Maintenance of full employment in Australia; and. The economic prosperity and welfare of the people of Australia. The first of these, the stability of the currency, is generally interpreted to mean price stability; that is, a stable value of the Australian dollar in terms of its purchasing power over goods and services. An important development in recent years is that this objective, and its relationship to the other two, has been made more explicit with the adoption of the Bank's inflation target. This has been included in the Bank's public statements for a number of years and was formally set out in the Statement on the Conduct of Monetary Policy, issued by the Treasurer and Reserve Bank Governor in August 1996 and updated in July 2003. There are a couple of important points to note about the operational meaning of the inflation target and its relation to the other objectives.

First, unlike the specifications in some other countries, Australia's inflation target is not thought of as a 'hard-edged' band within which the inflation rate is to be confined in every period. The edges of the band are not like an electric fence that triggers sudden dramatic action only when the edges are reached. Rather, the target band is an expression of the average to be achieved over a period of years. As such, there is sufficient flexibility for policy to take account of short-run developments in employment and economic growth. In other words, there is some scope for policy to play a role in stabilizing short-run business cycle fluctuations. In the longer run, as the statement sets out, the main contribution that monetary policy can make to growth and prosperity is to keep inflation low.

The second point concerns the measurement and definition of inflation. The initial formulation referred to 'underlying inflation', but following changes to the construction of the CPI in 1998 it was agreed between the Bank and the Treasurer to focus on the headline CPI. This did not entail any change in the practical operation of policy, but was designed to make the inflation objective clearer to the public. Over time, measures of underlying inflation and the CPI move closely together, though the headline CPI is more volatile (Graph 1) as it is more affected by temporary factors, such as changes in petrol prices. The medium-term focus of the inflation target provides the Bank with the flexibility to 'look through' temporary fluctuations in the CPI.

2.2 Demand for Money The demand for money refers to the desire to hold money: to keep wealth in the form of money, rather than spending it on goods and services. It is usually to distinguish three reasons why people want to hold their assets in form of money. (J. Sloman, 2000). Transaction Motive - Money is the medium of exchange required for conducting transactions and people are required to hold balances of money in cash or in sight accounts... Precautionary Motive - Individuals will hold additional money as a precaution to unforeseen circumstances...

Speculative or Assets Motive - Certain firms and individual who speculate in bonds and shares will hold idle money in expectation that the prices of bonds and shares may fall. Money when used for this purpose is a means of temporarily storing wealth. The transactions plus precautionary demand for money is termed L 1, in graph 2. 'L's tanks for liquidity preference, which is the desire to hold assets in liquid form.

Money balances held for these two purposes are called active balances. The frequency people are paid, effects L 1, the less frequent they are paid, the greater level of money balances they will hold. The rate of interest also affects L 1. At high interest rates, people will spend less and save more of their income. The effect is likely to be bigger on the precautionary demand where high interest rates may encourage people to risk tying up their money.

The elasticity of L 1 with respect to changes in the interest rates will also depend on how money is defined. A rise in the interest rates may encourage people to switch from holding cash to keeping more money in interest bearing accounts. (J. Sloman, 2000) The speculative demand for money is termed, L 2, in graph 3. Money balances held fro these purposes are called idle balances. The major determinant of L 2 is expectations of changes in the earning potential of securities and other assets. The greater the earning potential for non-money assets, the less will be the demand for money. (J. Sloman, 2000) Graph 4 shows the total demand for money balances, L, plotted against the rate of interest. The curve is known as the liquidity preferences curve.

Any factor, other than the change in interest rates, that causes the demand for money to rise will shift the L curve to the right. (J. Sloman, 2000) 2.3 Supply of Money In graph 5, the money supply is exogenous. It is assume to be determined by the government by its choice of the level and method of financing the PSB R. Keynesians assumes that higher interest rates will lead to higher levels of money supply as shown in graph 6. The reasoning is that: . Increase in supply may occur as a result of banks expanding credit in response to the demand for credit. Higher demand fro credit will drive up interest rates, making it more profitable fro banks to supply more credit... Higher interest rates may encourage depositors to switch their deposits from low interest accounts to higher interest paid accounts.

Money is less likely to be redrawn and banks may hold less liquidity and decide to increase credit, thus increasing the money supply... Foreign investors may be attracted by high interest rates thus increasing the supply. 2.4 Money Equilibrium Equilibrium in the money market will be where the demand fro money, L, is equal to the supply of money, Ms. This equilibrium will be achieved through changes in the rate of interest and exchange rate. In graph 7, equilibrium is achieved with a rate of interest, re, and quantity of money, Me. If the rate of interest were above re, people would have money balances surplus to their needs. (J. Sloman, 2000) A shift in either Ms or L, will lead to a new equilibrium quantity of money and interest rates at a new intersection of the curves.

In practice, there is no one single rate of interest. Different assets have different interest rates. Equilibrium in the money market therefore will be first where the total demand and supply of money are equal. This is achieved by adjusting the average interest rate. (J. Sloman, 2000) 2.5 Effects of Money Supply (Demand) Changes in money supply or demand will affect national income via changes in interest rates in a three-stage process.

In graph 8, a rise in money supply (Ms) will lead to a fall in interest rate, (r): This is necessary to restore equilibrium in the money market. In graph 9, the fall in r, will lead to a rise in investment and other forms of burrowing, (I). Since burrowing money will be cheaper and investments will costs less. In graph 10, the rise in investment will lead to a multiplied rise in national income (Y) and aggregate demand. (J. Sloman, 2000) Equilibrium in the money market is where the supply and demand for money is equal. It can be achieved by changes in the interest rates. The interest rates transmission mechanism works by: Rise in money supply causes money supply to exceed demand, interests will fall, and investments will increase and in turn will cause a multiplied rise in national income.

However as national income rises, the transactions demand for money will rise and preventing large fall in interest rates. (J. Sloman, 2000) 2.6 Keynesians vs. Monetarists In Australia, with floating exchange rates, for which policy is guided by domestic economic objectives, monetary policy could be described as the management of short-term interest rates by central banks in pursuit of the domestic policy objectives, usually defined in terms of inflation and economic growth. There are certainly some differences in the way the objectives are formulated, but these are more variations on a theme than fundamental differences of approach. (web 2003) Monetary policy is the subject of a lively controversy between two schools of economics, monetarist and Keynesian. Although they agree on goals, they disagree sharply on priorities, strategies, targets, and tactics. The goals of monetary policy as agreed by both monetarist and Keynesian are: First, no business cycles, instead, production-as measured by real (inflation-corrected) gross national product-would grow steadily, in step with the capacity of the economy and its labor force. Second, a stable and low rate of price inflation, preferably zero. Third, the highest rates of capacity utilization and employment that is consistent with a stable trend of prices.

Fourth, high trend growth of productivity and real GNP per worker. Monetary policies are demand-side macroeconomic policies. They work by stimulating or discouraging spending on goods and services. Economy-wide recessions and booms reflect fluctuations in aggregate demand rather than in the economy's productive capacity. Monetary policy tries to damp, perhaps even eliminate, those fluctuations.

It is not a supply-side instrument. Central banks have no handle on productivity and real economic growth. The second and third goals frequently conflict. Should policymakers give priority to price stability or to full employment? American and European monetary policies differed dramatically after the deep 1981-82 recessions.

The Fed "fine-tuned" a six-year recovery and recouped the employment and production lost in the 1979-82 downturns. Keeping a watchful eye on employment and output, and on wages and prices, the Fed stepped on the gas when the economic engine faltered and on the brakes when it threatened to overheat. During this catch-up recovery the economy grew at a faster rate than it could sustain thereafter. The Fed sought to slow its growth to a sustainable pace as full employment was restored. Expansionary monetary policy, both agree, increases aggregate spending on goods and services-by consumers, businesses, governments, and foreigners. However, will these new demands raise output and employment?

Or will they just raise prices and speed up inflation? Keynesians say the answers depend on circumstances. Full employment means that everyone (allowing for persons between jobs) who is productive enough to be worth the prevailing real wage and wants a job at that wage is employed. In these circumstances more spending just brings inflation. Frequently, however, qualified willing workers are involuntarily unemployed; there is no demand for the products they would produce.

More spending will put them to work. Competition from firms with excess capacity and from idle workers will keep extra spending from igniting inflation. (Tobin, 2003) Monetarists answer that nature's remedy for excess supply in any market is price reduction. If wages do not adjust to unemployment, either government and union regulations are keeping them artificially high or the jobless prefer leisure and / or unemployment compensation to work at prevailing wages. Either way, the problem is not remediable by monetary policy.

Injections of new spending would be futile and inflationary. (Tobin, 2003) Keynesian Monetarist Money stored as wealth. Financial institution is not a good substitute. Speculative demand for money is dominant. Speculative demand for money is insignificant.

By changing supply of money, interest rates do not change much. By reducing small supply of money, interest rates will change drastically. 3 Monetary Policy Framework The Governor and the Treasurer of Australia agreed that the appropriate target for monetary policy is to achieve an inflation rate of 2-3 per cent on average, over the cycle, a rate sufficiently low that it does not materially distort economic decisions in the community. The inflation target is thus the centerpiece of the monetary policy framework. It provides discipline for monetary policy decision-making, and serves as an anchor for private sector inflation expectations. The inflation target is defined as a medium-term average rather than as a hard-edged target band within which inflation is to be held at all times.

This formulation allows for the inevitable uncertainties that are involved in forecasting, and lags in the effects of monetary policy on the economy. Experience in Australia and elsewhere has shown that inflation is not amenable to fine-tuning within a narrow band. The inflation target is, necessarily, forward-looking, as evidenced by the operation of monetary policy since its introduction. This approach allows a role for monetary policy in dampening the fluctuations in output over the course of the business cycle. When aggregate demand in the economy is weak, for example, inflationary pressures are likely to be diminishing and monetary policy can be eased, which will give a short-term stimulus to economic activity. (web 2003) 4 Monetary Policy Implementation Bank's Domestic Markets Department has the task of maintaining conditions in the money market so as to keep the cash rate at or near an operating target decided by the Board. The cash rate is the rate charged on overnight loans between financial intermediaries.

It has a powerful influence on other interest rates and forms the base on which the structure of interest rates in the economy is built. The close relationship between the cash rate and other money market interest rates can be seen in Diagram 2. Changes in monetary policy mean a change in the operating target for the cash rate, and hence a shift in the interest rate structure prevailing in the financial system. The Reserve Bank Board's decision to change interest rates is announced in a media release, which states the new target for the cash rate, together with the reasons why the Board has taken the decision to change it. The Reserve Bank uses its domestic market operations (sometimes called "open market operations") to influence the cash rate. On the days when monetary policy is being changed, market operations are aimed at moving the cash rate to the new target level.

Between changes in policy, the focus of market operations is on keeping the cash rate close to the target, by managing the supply of funds available to banks in the money market. The cash rate is determined in the money market as a result of the interaction of demand for and supply of overnight funds. The Reserve Bank's ability to pursue successfully a target for the cash rate stems from its control over the supply of funds which banks use to settle transactions among themselves. These are called exchange settlement funds, after the accounts at the Reserve Bank in which banks hold these funds. If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will try to shed funds by lending more in the cash market, resulting in a tendency for the cash rate to fall. Conversely, if the Reserve Bank supplies less than banks wish to hold, they will respond by trying to borrow more in the cash market to build up their holdings of exchange settlement funds; in the process, they will bid up the cash rate.

The actual level of the cash rate, which results from the Reserve Bank's market operations, as well as the target rate are shown in Diagram 3. (web 2003) 5 Open Market Operations The RBA's open market operations are designed to ensure that the actual cash rate remains close to the target rate. On a day-to-day basis, deviations in the cash rate around the target are determined by the supply and demand for exchange settlement (ES) funds. These funds are held in accounts at the RBA by banks as well as a number of other institutions, and are used by these account holders to meet their settlement obligations to each other and to the RBA. The daily aggregate net settlement obligation between ESA holders and the RBA can be very large.

This is mostly because the RBA acts as banker to the Commonwealth. Expenditure by the Commonwealth results in funds flowing into ES accounts, while the payment of federal taxes has the opposite effect. Similarly, purchases of Commonwealth Government Securities (CGS) from the Government by investors reduce ES balances while redemptions of such securities increase ES balances. The daily aggregate net settlement obligation between ESA holders and the RBA also reflects transactions by the RBA's other customers (mostly other official institutions) and by the RBA itself.

The latter include the purchase of currency notes by banks from the RBA (which reduce ES balances) and transactions undertaken by the RBA with market participants (including the unwind of repurchase agreements - see below - arising from previous operations). The RBA's domestic market operations determine the aggregate supply of ES funds and are designed to ensure that supply equals demand at the target cash rate. If the supply is too high, holders of ES funds will wish to lend their excess funds in the overnight market, putting downward pressure on the cash rate. If the supply is too low, they will wish to borrow, putting upward pressure on the rate. The RBA's open market operations, together with other elements of the framework used for the implementation of monetary policy in Australia, have proved very effective when measured by the stability of the cash rate around the target. Over the 2002/03, the average absolute deviation of the cash rate from its target was less than one basis point.

Despite the broadening of the range of domestic securities in which the RBA is willing to deal, the strong growth in the RBA's balance sheet coupled with greater seasonal concentration of flows between the RBA and the private sector has meant that the RBA has had to augment its open market operations with foreign exchange swaps. Such transactions may be unwound within a very short period or rolled forward on a short-term basis. 6 Fractional Reserves Commercial banks are required to keep a proportion of their deposits as reserves. The RBA has the power to change reserve requirements on bank deposits within legislatively set bounds.

Superficially, reserves are required for safety, to meet emergency cash needs. However, safety is not the motivation for reserve requirements. Requires commercial bank reserves on deposit at the RBA, allows RBA to control the money supply and related monetary conditions by changing reserve requirements. If reserve requirements were to be reduced, the excess in commercial banks would most likely be lent out and will reduce interest rates, supply of money will also increase and level of economy can be stimulated. A curious aspect of fractional reserves system is that every dollar of excess reserves can create more the 1 dollar change in the money supply. Any interjection of reserves into the banking system has a multiple impact upon the money supply.

The RBA must factor this multiple into its calculations when implementing monetary policies. Estimating this multiple is imprecise because of the unknowns and will add to the difficulty of implementing policies. (M. Livingston, 1993)

Bibliography

1 Asia-Pacific Economic Cooperation, "Economic Report Australia", Economic Outlook, 2002, web 2 2003, web 3 Tobin, J.
The Concise Encyclopedia of Economics", The Library of Economics and Liberty, 2003, web 4 Sloman, John.
Economics", 4th Edition, Prentice Hall, 2000 5 Livingston, Miles.
Money and Capital Market", 2nd. Edition. Kolb Publishing Company, 1993.