Money, Prices and the Reserve Bank

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- A change in monetary policy can be achieved by the announcement of a new target cash rate by the reserve bank. The reserve bank will always:

- Pay an interest rate on funds deposited by banks in their exchange settlement accounts that is a fixed margin below the target cash rate.

- Offer to lend exchange settlement funds to banks at a rate that is a fixed margin above the target cash rate.

- Deposits in exchange settlement accounts earn a rate which is 25 basis points below the target and loans of exchange settlement funds by the reserve bank are made at a rate that is 25 basis points above the target. (e.g. target cash rate 5% - funds deposited earn 4.75% interest rate and reserve bank will lend at 5.25%).

- Base money is equal to the amount of currency in circulation plus the deposits that banks have with reserve bank in exchange settlement accounts.

- Suppose reserve bank intends to increase target cash rate form 5 to 5.5%, which corresponds to rate paid by reserve bank on funds deposited in exchange settlement account increasing from 4.75 to 5.25%. Therefore banks will hold more funds in exchange settle accounts – increase in demand for base money. Banks offer fewer loans, funds in overnight cash market decline, borrowers responds by increasing the cash interest rate will to pay to secure loans.

- High cash rate – banks more inclined to lend money in overnight cash market – low demand for base money. Low cash rate – banks less inclined to lend money – demand for base money is high.

- The supply of base money perfectly inelastic – reserve bank has ultimate control. Reserves bank announcement of higher target cash rate relates to shift the demand for base money to the right. In the SR the effect is to create excess demand for exchange settlement funds; until cash rate has had a change to adjust. Reserve bank will allow market forces in over night cash market to push the cash interest rate upwards.

Can the reserve bank control real interest rates?

- The reserve bank controls the nominal interest rate through its targeting of the overnight cash interest rate. Because inflation is slow to adjust, in the short run the reserve bank can control the real interest rate (equal to the nominal interest rate, i minus the inflation rate ), as well as the nominal interest rate. In the long run, however the real interest rate is determined by the balance of saving and investment. [pic 5]

The effects of the reserve banks actions on the economy

- The level of real interest rates prevailing in the economy affects planned aggregate expenditure. Lower interest rate – higher planned spending, higher interest rate – lower planned spending.

Planned aggregate expenditure and the real interest rate

- The real interest rate influences the behavior of both households and firms.

- For households, the effect of a higher real interest rate is to increase the reward for saving, which leads households to save more. Consuming less in order to save more, e.g. durable goods normally financed are less attractive. (An increase in the real interest rate will lower exogenous consumption, shifting the consumption function downwards.

- A higher real interest rate also discourages firms from making capital investments.

- The conclusion is that, at any given level of output, both consumption spending and planned investment spending decline when the real interest rate increase. Conversely, a fall in the real interest rate tends to stimulate consumption and investment spending by reducing financing costs.

The reserve bank fights a recession

- Suppose the economy faces a recessionary gap – a situation in which real output is below potential output and planned spending is too low. To fight a recessionary gap the reserve bank should reduce the real interest rate, stimulating consumption and investment spending. According to the theory we have developed, this increase in planned spending will cause output to rise, restoring the economy to full employment. [Implementation of this action is an example of an expansionary monetary policy].

The reserve bank fights inflation

- One important cause of inflation is an expansionary output gap – planned spending and hence actual output exceeds potential output. When this occurs, if the high demand experienced by firms is persistent they will ultimately raise their prices, spurring inflation.

- The cure for a expansionary gap is to raise the real interest rate, which reduces consumption and planned investment by raising the cost of borrowing. The resulting fall in planned spending leads in turn to a decline in output and to a reduction in inflationary pressures.

The reserve bank’s policy reaction function

- In general, a policy reaction function describes how the action a policy maker takes depends on the state of the economy. Here the policy makers action is the reserve banks choice of the real interest rate, and the state of the economy is given by factors such as the output gap or the inflation rate.

- The Taylor rule can be written as;

[pic 6]

- Vertical axis – real interest rate, horizontal axis – rate of inflation. The upward slope of the policy reaction function captures the idea that the reserve bank reacts to increases in inflation by raising the real interest rate.

- Suppose a contractionary gap of 1 per cent has opened up with all else including the rate of inflation remaining constant. Accordingly the reserve bank responds by decreasing the real interest rate. This change is represented by a downward shift of the policy reaction function, as a result of the contractionary gap, each rate of inflation is now associated with a lower real interest rate.

Chapter 9: The aggregate demand – aggregate supply model.

Inflation, spending and output: aggregate demand curve

- The aggregate demand (AD) curve shows the relationship between the short-run equilibrium output, y, and the rate of inflation, ; the name of the curve reflects the fact that short-run equilibrium output is determined by, and equals, total planned spending in the economy; increases in inflation reduce planned spending and short-run