The Transmission of Monetary PolicyDownload the complete Explainer 110KB Show
The transmission of monetary policy describes how changes made by the Reserve Bank to its monetary policy settings flow through to economic activity and inflation. This process is complex and there is a large degree of uncertainty about the timing and size of the impact on the economy. In simple terms, the transmission can be summarised in two stages.
This explainer outlines these two stages and highlights some of the main channels through which monetary policy affects the Australian economy. First StageMonetary policy in Australia is determined by the Reserve Bank Board. The primary and conventional tool for monetary policy is the target for the cash rate, but other tools have included forward guidance, price and quantity targets for the purchase of government bonds, and the provision of low-cost fixed term funding to financial institutions. The first stage of transmission is about how changes to settings for these tools influence interest rates in the economy. The cash rate is the market interest rate for overnight loans between financial institutions, and it has a strong influence over other interest rates, such as deposit and lending rates for households and businesses. The Reserve Bank's other monetary policy tools work primarily by affecting longer-term interest rates in the economy. While monetary policy acts as a benchmark for interest rates in the economy, it is not the only determinant. Other factors, such as conditions in financial markets, changes in competition, and the risk associated with different types of loans, can also impact interest rates. As a result, the spread (or difference) between the cash rate and other interest rates varies over time. Second StageThe second stage of transmission is about how changes to monetary policy influence economic activity and inflation. To highlight this, we can use a simple example of how lower interest rates for households and businesses affect aggregate demand and inflation. (Higher interest rates have the opposite effect on demand and inflation). Aggregate DemandLower interest rates increases aggregate demand by stimulating spending. But it can take a while for the supply of goods and services to respond because more workers, equipment and infrastructure may be required to produce them. Because of this, aggregate demand is initially greater than aggregate supply, putting upward pressure on prices. As businesses increase their prices more rapidly in response to higher demand, this leads to higher inflation. There is a lag between changes to monetary policy and its effect on economic activity and inflation because households and businesses take time to adjust their behaviour. Some estimates suggest that it takes between one and two years for monetary policy to have its maximum effect. However, there is a large degree of uncertainty about these estimates because the structure of the economy changes over time, and economic conditions vary. Because of this, the overall effects of monetary policy and the length of time it takes to affect the economy can vary. Inflation ExpectationsInflation expectations also matter for the transmission of monetary policy. For example, if workers expect inflation to increase, they might ask for larger wage increases to keep up with the changes in inflation. Higher wage growth would then contribute to higher inflation. By having an inflation target, the central bank can anchor inflation expectations. This should increase the confidence of households and businesses in making decisions about saving and investment because uncertainty about the economy is reduced. Channels of Monetary Policy TransmissionSaving and Investment ChannelMonetary policy influences economic activity by changing the incentives for saving and investment. This channel typically affects consumption, housing investment and business investment.
Cash-flow ChannelMonetary policy influences interest rates, which affects the decisions of households and businesses by changing the amount of cash they have available to spend on goods and services. This is an important channel for those that are liquidity constrained (for example, those who have already borrowed up to the maximum that banks will provide).
Asset Prices and Wealth ChannelAsset prices and people's wealth influence how much they can borrow and how much they spend in the economy. The asset prices and wealth channel typically affects consumption and investment.
Exchange Rate ChannelThe exchange rate can have an important influence on economic activity and inflation in a small open economy such as Australia. It is typically more important for sectors that are export oriented or exposed to competition from imported goods and services.
What does central bank do to reduce the supply of money in the economy?Central banks conduct monetary policy by adjusting the supply of money, generally through open market operations. For instance, a central bank may reduce the amount of money by selling government bonds under a “sale and repurchase” agreement, thereby taking in money from commercial banks.
What are the tools of monetary policy and how does the central bank use these tools?Central banks have four primary monetary tools for managing the money supply. These are the reserve requirement, open market operations, the discount rate, and interest on excess reserves. These tools can either help expand or contract economic growth.
What are the 3 main tools of monetary policy and explain each tools?The Fed has traditionally used three tools to conduct monetary policy: reserve requirements, the discount rate, and open market operations. In 2008, the Fed added paying interest on reserve balances held at Reserve Banks to its monetary policy toolkit.
Which tools of monetary policy can the central bank use to decrease money supply?By lowering the reserve requirements, banks are able to loan more money, which increases the overall supply of money in the economy. Conversely, by raising the banks' reserve requirements, the Fed is able to decrease the size of the money supply.
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