CAtholic trials help,( i may ask numerous of question) (1 Viewer)

[red802]

hey, with the monetary policy when the rba prucahse government securities, it increases liquidity of funds, causing a fall in interest, how does it cause a fall in interest?, also how does this relate to inflation

 

[Riviet]

how does it cause a fall in interest?, also how does this relate to inflation

It causes a fall in the cash rate because there is a greater supply of funds available in the short term money market [think supply and demand]. By tightening monetary policy, the cash rate is reduced, meaning businesses are discouraged from investment and aggregate demand is dampened, leading to a decrease in economic activity and should reduce inflationary pressures. Hope that helps.

 

[Always]

I'm not sure if this is 100% correct but this is how I think of it:

Think of the RBA as this place that contains a big pool of funds that banks dip from. When it sells CGS there are less funds in the pool and thus more people chasing the same amount of money, so the cash rate increases. When it buys CGS the pool of funds increases, decreasing the level competition and thus puts downward pressure on the cash rate.

Increases in the cash rate is paid for by banks, who then pass on these costs to everyone else in the form of an interest rate rise.

Interest rate rises lower business investment (because of the higher cost of borrowing) and also lowers consumption (because people now have higher loan repayments). These are both components of aggregate demand, which influences price (from the demand & supply diagram) and thus inflation.

 

[red802]

kool, also what does it mean by policy mix, is that basically a few policy together to solve a problem e.g inflation

 

[gnrlies]

hey, with the monetary policy when the rba prucahse government securities, it increases liquidity of funds, causing a fall in interest, how does it cause a fall in interest?, also how does this relate to inflation

Crikey.. You got a bit of work to do...

Ok. Heres a simple step by step guide which describes the relationship:

1 - RBA purchases securities = increased funds in the short term money market
(as the RBA is buying GOVT bonds off banks, they are injecting funds which can be used by banks in their ESA accounts)

2 - Increased liquidity within the short term money market = increase in supply of funds
(they can be thought of as the same thing)

3 - With any demand and supply condition, an increase in supply will reduce the equilibrium price. In this case the supply of short term money has increased, and thererfore the overnight cash rate (on ESA accounts) reduces.

4 - Changes in the cash rate filter through to other interest rates (this stage is too complicated for an HSC student to understand, so take it for granted)

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Because we are probably going to see a rate rise on wednesday morning, I will explain how a rate rise will help to reduce inflation. The opposite is true for a rate reduction. (to answer the second part of your question)

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5 - Increase in interest rate has a few effects. It reduces consumption as credit becomes more expensive (interest payments rise), it also encourages savings which would reduce an individuals MPC.

6 - As per the AD = C + I + G + (x - m) model, as consumption reduces, aggregate demand also reduces

7 - Where demand reduces, demand pull inflation reduces

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As an extra, and It really shouldn't be treated as an optional extra, as this point is at the heart of what inflation targetting is all about. In other words what I am about to say is very important....:

8 - Due to transparant and reliable monetary policy (through inflation targetting), individuals can be relatively confident that inflation will be between 2 and 3% over the business cycle. Therefore inflationary expectations are kept under control.

This is what forms the majority of the success of inflation targetting as it prevents things like the wage price spiral.

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So interest rates affect aggregate demand, and then help inflation through demand pull inflation and inflationary expectations.