Interest Rates In The Money Market example essay topic

Explain the operation of Monetary Policy in the Australian Economy. Outline the current settings of Monetary Policy. Explain the predicted future direction of interest rate movement in relation to inflation and economic growth. The Reserve Bank Of Australia uses Monetary Policy to influence the level of aggregate, or total, money supply of financial intermediaries. The aims of the RBA are to maintain sustainable economic growth in a low inflationary environment with full employment. The RBA enters the short-term money market via the exchange settlement accounts by buying and selling Government securities to adjust the overnight cash rate.

The Reserve Bank of Australia is a statutory authority, established by an Act of Parliament. This Act gives the Bank specific powers and obligations; it also underlines its separateness from government compared with, for example, a Department of State. The Act charges the Bank with the responsibility for developing and use monetary policy. The Reserve Bank Board's obligations with respect to monetary policy are laid out in the Act. The Act permits the Bank to use a wide range of instruments in its market operations. Among other things, it allows the Bank to take deposits, borrow and lend money, buy and sell securities, discount and rediscount bills of exchange and promissory notes, and deal in foreign exchange, gold and other precious metals.

Market operations are conducted in government securities. Transactions are mainly in the form of repurchase agreements (usually called "repos"), which involve the sale or purchase of securities with an undertaking to reverse the transaction at an agreed date in the future and at an agreed price. The RBA buys and sell bonds to influence certain problems in the economy, if in the future they buy bonds this causes the money supply to increase and there will also be an expanding of the economy. If in the future the RBA sells bonds then the econom will contract and investment will rise as well as money supply decreasing. The current stance of Monetary Policy seems in an extensive manner, quite appropriate for the current position of the Australian economy. Currently, under the uncertain conditions, Monetary Policy is being determined not only by the level of official interest rates, but also by the interest rates faced by borrowers which have gone down over the past year.

It is also being determined by the level of the exchange rate, which is helping Australia achieve greater competition in export prices, as well as the state of asset and credit markets. Currently the RBA is balancing all these different factors and Monetary Policy will remain under continued review in the venture of improving international and domestic conditions. When looking at the current settings of Monetary Policy, we are looking at the way in which the RBA is currently using the level of interest rates. Short-term interest rates are determined by the RBA's stance and control of the overnight cash-rate. These interest rates can be adjusted by the RBA's determination to enter the short-term money market as either a buyer or seller of securities through exchange settlement accounts on the short- term money market.

The RBA, inflationary expectations and market forces, influence long-term interest rates, both domestic and international. Over the past twelve months, interest rate levels have not changed drastically. They have fallen slightly. The RBA's job is to ensure price stability by targeting official interest rates at inflation.

The aim is to keep the economy on a steady path of growth, avoiding excessive peaks and troughs. It does this by using an inflation target of between 2 and 3 percent over the course of the economic cycle. Underlying inflation has averaged at 2.1 per cent over the life of the target and currently, the level is well below this at 1.6 per cent. Monetary policy aims to contribute to the achievement of sustainable growth.

Its principal contribution to this objective in the long-run is to control inflation. The instrument which monetary policy uses is the overnight interest rate in the money market - the "cash" rate. The Bank has quite close control over this interest rate through its domestic market operations. For many years, inflation in Australia was too high, which caused economic and financial efficiency, upsetting the economy's long-run growth potential, and having negative effects on equity.

In the 1990's, a climate of low inflation has been re-established. Inflation has averaged 2 1/4 per cent in the five years to 1997 and in turn average growth in real output of 3 1/2 per cent. Unemployment is currently at 7.4 per cent. The Government is aiming to reduce economic growth and maintain it above a point, which would stabilize unemployment. The overall philosophy of these policies is to create a climate that would stimulate business investment and greater export opportunities through improved international competitiveness and also policies which would maintain consumer confidence. This is being achieved through an expansionary monetary policy stance and a continuation of micro-economic reforms.

Uncertainty in the American, Asian and European economies has seen the Australian Dollar depreciate, which may make the RBA consider increasing interest rates to maintain its value. But the strength of Australian growth over the September quarter in 1998 and the fears of higher import prices (low Australian Dollar) pushing inflation towards 3.00 per cent over 1999 has led the RBA to keep policy on hold. Overall the RBA has an easing bias due to the high level of economic uncertainty but is prepared to wait for more information on the Australian economy before acting. Monetary Policy cannot stand alone or work against other macro policies; policy mix should be coherent and working towards common objectives.

With Mr. Peter Costello preparing his second budget (1999/2000), there will be a consideration of a similar objective of maintaining a stable economic growth and encouraging employment growth whilst keeping an eye on inflationary pressures. The Current Account Deficit has experienced a significant worsening due to declining exports and increasing imports with strong domestic demand. With the CAD at 6 per cent of GDP and likely to rise during 1999, it could be perceived that Australia has major external sector problems. What has elevated the problem is Australia's low inflation rate that can largely be attributed to the RBA's stance.

The government has achieved major productivity increases through labour market reforms and technical and allocative efficiency gains in its micro-economic reform program. This has been assisted by the policy of low inflation as both aim to achieve increasing international competitiveness and therefore complemented each other in a process that encourages allocative efficiency and optimization of resource usage. It is difficult to determine any future directions of interest rate movements in relation to inflation and economic growth. If the Reserve Bank decides that change in monetary policy should occur, it specifies a new target for the cash rate. If the bank decides to further tighten policy, this will reflect in a new higher target level for the cash-rate. If it decides to loosen policy, then a resulting lower target level for the cash-rate will be stated.

The cash rate is used as an operational target for Monetary Policy because it fastens all other interest rates in the money market and, through its effects on banks' costs of funds, also underpins banks' lending interest rates. So the future direction of Monetary Policy depends on the change in interest rates that in turn affect the rate of inflation. If we look towards the long-run, inflationary expectations will increase leader to higher interest rate levels, this is known as the Fischer effect. The change in interest rates by the RBA has many effects on other aspects of the Australian economy. One effect is the strength of the Australian Dollar and commodity prices (as well as demand for commodities), which reflect the level of world economic growth. It also effects peoples savings levels, and their money supply, which creates other effects on the Australian economy.

If in the future interest rates are lowered there are many effects on the economy, firstly investment and the rate of production go up, as well as small businesses, it also has a good effect on the rural sector. Another effect is that people save less seeing that they will receive less interest on their money and inflation goes up as well and seeing that people are saving less then that means that they are spending more so imports are up. Lower interest rates usually means that capital inflow is down as well as the Australian Dollar. The RBA also must be careful of putting interest rates up too high, because this has been proven to create uncertainty in particular areas and is on the whole not good for the economy.

If in the future interest rates are put up then it will cause fixed investment to fall, and also causes lower business confidence, which at the present is extremely low. It also causes housing and rural sectors to suffer and contract, as well as lower international competitiveness which causes other problems such as lower levels of production, an increased budget deficit, which is due to revenue and the cyclical component being down, and it also causes an increase in CAD, because exports are down, import prices are up and investment is down. A high interest rate will also cause unemployment to increase and the export price to rise, as well as disposable income to fall, which in turn causes consumption to fall. It cannot be exactly determined which stance the RBA will adopt in the future direction of interest rate movement, however the evidence reveals a steady growth in interest rates over the next few months in order to accommodate for a predicted decrease in economic growth towards the end of the year. Many analysts agree, however others have been left confused at the lack of our interest rates to respond to the turmoil that has been occurring in the world financial markets over the past few months.