The Purpose of Monetary Policy
Expert reviewed • 14 August 2024 • 11 minute read
What is Monetary Policy?
Monetary policy is a macroeconomic tool used by central banks to influence a nation's economy. It involves the management of money supply and interest rates to achieve macroeconomic objectives such as controlling inflation, managing employment levels, and ensuring economic stability. In Australia, monetary policy is conducted by the Reserve Bank of Australia (RBA).
What are the RBA's Monetary Policy Objectives?
The primary purposes of monetary policy in Australia, as set out in the Reserve Bank Act 1959, are:
- Price Stability:
- One of the primary aims of monetary policy is to control inflation. High inflation can erode purchasing power, create uncertainty, and hamper economic growth.
- The Reserve Bank of Australia (RBA) has an inflation target of 2-3% to maintain price stability.
- Maintaining Full Employment:
- By influencing economic activity, monetary policy can help reduce unemployment. Lower interest rates, for instance, can stimulate borrowing and investment, leading to job creation.
- As of 2023, in Australia, full employment is estimated to be around 4.5%.
- During the COVID-19 pandemic, the RBA lowered the cash rate to a historic low of 0.1% to support employment and economic recovery.
- Economic Growth:
- Sustained economic growth is another key objective. By managing interest rates and money supply, central banks aim to create a conducive environment for businesses to invest and expand.
- Australia's use of monetary policy to support growth has included measures like the Term Funding Facility, which provided low-cost funding to banks to support lending to businesses.
What are the Instruments of Monetary Policy?
The RBA uses several instruments to implement monetary policy:
The Cash Rate Target
The cash rate is the interest rate on overnight loans between financial intermediaries (banks). It's the RBA's primary monetary policy tool. By adjusting the cash rate target, the RBA influences banks' lending and borrowing rates in the overnight exchange settlement market. These actions are passed on to consumers in the form of interest rate increases or decreases. For example, as of July 2023, the cash rate target is 4.10%. This is a significant increase from the historic low of 0.10% maintained from November 2020 to May 2022 during the COVID-19 pandemic.
Open Market Operations
Open Market Operations (OMOs) are a key monetary policy tool used by the Reserve Bank of Australia (RBA) to influence the cash rate and money supply. The RBA buys and sells securities, typically government bonds, in the open market to manage liquidity in the financial system. This process allows the RBA to adjust the amount of money circulating in the economy. For instance, during the COVID-19 pandemic, the RBA implemented a quantitative easing (QE) programme, purchasing government bonds to inject liquidity into the economy and support economic recovery.
Forward Guidance
Forward guidance is a communication tool employed by the Reserve Bank of Australia (RBA) to shape market expectations and influence economic behaviour. Through public statements and official communications, the RBA signals its future policy intentions, helping to provide clarity and stability in financial markets. For example, in 2021 RBA Governor Philip Lowe repeatedly stated that interest rates were unlikely to rise before 2024, emphasising the RBA's commitment to maintaining accommodative monetary policy. This guidance aimed to boost confidence, encourage spending and investment, and support economic recovery. However, as economic conditions evolved more rapidly than anticipated, the RBA had to adjust its stance, highlighting the challenges of providing long-term forward guidance in an uncertain economic environment.
What are the Transmission Mechanisms of Monetary Policy?
The transmission mechanism describes how changes in monetary policy affect the broader economy. In Australia, this typically occurs through several channels:
- Interest Rate Channel: When the RBA adjusts the cash rate, it directly influences other interest rates in the economy. For example, a lower cash rate typically leads to lower mortgage rates, encouraging borrowing for home purchases and reducing repayment burdens on existing loans. It also affects savings rates, potentially shifting behaviour from saving to spending.
- Exchange Rate Channel: Interest rate changes can impact the value of the Australian dollar. Lower rates may lead to a depreciation of the AUD, making exports more competitive internationally while potentially increasing the cost of imports.
- Asset Price Channel: Monetary policy decisions can influence the prices of assets like stocks and real estate. Lower interest rates often lead to higher asset prices as investors seek better returns. This increase in asset values can create a "wealth effect," potentially boosting consumer confidence and spending.
- Credit Channel: The RBA's policies affect banks' lending practices and borrowers' appetite for debt. Easier monetary policy can increase banks' willingness to lend and make borrowing more attractive, potentially stimulating economic activity through increased credit flow.
- Expectations Channel: The RBA's actions and communications shape expectations about future economic conditions. For instance, forward guidance about maintaining low rates for an extended period can influence long-term investment decisions and consumer behaviour, even before any actual rate changes occur.