Monetary Policy — QCE Economics — Unit 4 Flashcards & Quiz

Q1: Explain the role of the Reserve Bank of Australia (RBA) and the objectives of monetary policy.

The RBA is Australia's central bank and is responsible for monetary policy, independent of the government in setting interest rates. Under the Reserve Bank Act, monetary policy aims for price stability and full employment, thereby contributing to the economic prosperity and welfare of the Australian people. Since March 2025 decisions are made by a dedicated Monetary Policy Board, which meets eight times a year. The main instrument is the target for the cash rate — the interest rate on overnight loans between banks.

Q2: What is inflation targeting, and how are interest rate changes measured in basis points?

Inflation targeting is a framework in which the central bank sets interest rates to keep inflation within a target range over time. The RBA targets consumer price inflation of 2–3%, aiming for the midpoint of 2.5%. Raising the cash rate restrains spending when inflation is above target; lowering it supports activity when inflation is below target and unemployment is rising. Cash rate changes are expressed in basis points: 1 basis point = 0.01 percentage point, so a 0.25 percentage point move is 25 basis points.

Q3: Explain the transmission mechanism of monetary policy.

1) The RBA changes the cash rate target. 2) Banks adjust lending and deposit rates, including mortgage and business loan rates. 3) Changed borrowing costs and returns on saving alter spending: higher rates reduce consumption (C) and investment (I); lower rates encourage them. 4) The change in spending shifts aggregate demand. 5) Output, employment and inflation respond, usually with a lag of a year or more for the full effect.

Q4: What are the main channels of monetary policy transmission?

1) Interest rate (saving and investment) channel — rates change the reward for saving and the cost of borrowing for consumption and investment. 2) Cash-flow channel — rates change the repayments of borrowers and interest income of savers, altering disposable income. 3) Asset prices and wealth channel — lower rates tend to raise house and share prices, making households feel wealthier and spend more. 4) Exchange rate channel — higher rates relative to overseas attract capital, appreciating the AUD, reducing net exports and import prices. 5) Credit supply channel — rates affect the value of collateral and banks' willingness to lend.

Q5: Evaluate the effectiveness of monetary policy.

Strengths: decisions can be made at any scheduled meeting, so implementation is fast; the RBA's independence and inflation target give credibility; small, gradual changes allow fine-tuning; it affects the whole economy. Limitations: long and variable time lags before the full effect; it is a blunt instrument that cannot target particular regions or groups; it may be less effective at stimulating than restraining activity when confidence is low (‘pushing on a string’); the cash rate cannot go much below zero; and global influences such as imported inflation or world interest rates limit its control.

Q1: The RBA sets the cash rate on instructions from the Treasurer.

Answer: FALSE

The RBA is independent in setting monetary policy; its Monetary Policy Board decides the cash rate target.

Q2: The RBA targets consumer price inflation of 2–3%.

Answer: TRUE

The RBA's inflation target is 2–3%, with a focus on the 2.5% midpoint.

Q3: A cash rate increase from 3.85% to 4.10% is a 25 basis point rise.

Answer: TRUE

The rise is 0.25 percentage points, and 1 basis point = 0.01 percentage point, so it is 25 basis points.