Econ Class 16

The Transmission of Monetary Policy

The RBA changed cash rate, which influences interest rates.

The change in interest rates translates through an economy. This is what we analyse.

It is transmitted through 3 main channels:

• Consumption/Saving and Investment
  • When RBA raises cash rate, the banks (Commonwealth, ANZ, etc.) will raise interest rates, on savings and loans. They can only change interest rates for savings and loans.
  • This changes new savings/loans!!!
  • 2 Types of loans:
    • Household loans, things to buy a house/car
    • Business loans, loans for businesses for investment
  • This is why its called savings and investment channel, as loans tend to be considered for investments.
  • Increasing cash rates, mean interest rates increase. This means borrowing money costs more, and thus people are less inclined to borrow.
  • You can get fixed rates for mortgages, but have some inclusions (e.g. the interest rate for this is higher than the current variable rate)
  • There is a profit margin, i.e. even if the cash rate is 0.1%, banks will still have variable rate of 2-3%, as this is how they make money.
  • When you save, the money goes in a bank, which is loaned out at a higher rate than your savings interest rate.
  • Thus, when cash rate increases, savings increase while loaning decrease.
  • Thus, aggregate demand decreases as people tend to save their money rather than loan to buy things like houses.
• Wealth
  • How to increase wealth: buy property, or shares.
  • When cash rate is increased, interest rates are increased, and then the demand for housing is decreased as it costs more to buy a house. This leads to housing prices decreasing. Thus, the wealth of people who own houses should decrease.
  • It costs people more to buy houses. Thus, you might not buy an existing house, or build a new house. This leads to a fall in demand in housing. Thus prices fall. When prices fall, as people have their wealth in their house, their wealth also falls. Thus, as they have less wealth, they will consume less. This reduces aggregate demand.
  • In terms of shares, if consumption has fallen, that means that companies will sell less. Thus, profits will decrease, and thus the values of their shares have fallen. Thus, the wealth of people who own shares decreases, their demand decreases, and thus aggregate demand decreases.
  • Wealth is how much you own, your assets. Assets are in property and shares in companies. If the value of assets fall, so does wealth. When people have lower wealth, they cannot afford more things, and thus demand fall.
• Cash flow
  • Deals with existing debt. If you previously have a mortgage and interest rates increase, then the interest rate for the mortgage tends to increase.
  • Mortgage repayments come out of income. Thus, when mortgage rates increases, then people with fixed incomes will have less disposable income. Thus, people have to spend less.
  • This will reduce aggregate demand.

THE GOAL OF MONETARY POLICY: TO CONTROL INFLATIONARY PRESSURE!!!!! Inflation Target Rate: 2-3% Economic Growth Target Rate: 3-4% Unemployment Target Rate: 4-5%

NO NEED TO DO EXCHANGE RATE CHANNEL!!!

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