Monetary policy is the Reserve Bank’s use of changes in interest rates to influence the level of the money supply and economic activity to achieve the basic economic objectives. This involves stability of Australia’s currency, maintenance of full employment and the economic prosperity and welfare of Australians. More importantly, the Reserve Bank of Australia’s approach to monetary policy is based on the achievement of an inflation target between 2 to 3 per cent. The main instrument of monetary policy is Market Operations (DMOs) whereby it involves actions by the Reserve Bank to buy or sell second- hand government securities (CGS) in the official money market to influence the cash rate. This, in turn, may dampen or enhance economic growth. The cash rate is the interest rate in the official money market.
In order to reduce economic activity, the RBA will increase interest rates through the use of a tightening monetary policy. This will involve the RBA selling securities in the official money market which is comprised of banks with exchange settlement funds. The RBA will offer a high yield in order to retrieve excess funds from banks, which ultimately reduces the supply of cash in the official money market. As a result, cash rate will rise, forcing banks to push this cost onto their customers through increasing interest rates to remain profitable. Consequently, changes in interest rates will affect the level of economic activity, however these impacts are unlikely to be immediate as articulated by Philip Lowe in 2010, “It takes time for changes in monetary policy to have their full effect on the economy.” Employing a tightening monetary policy to increase interest rates will be effective in discouraging consumer spending whilst enhancing the level of savings within an economy as obtaining loans become increasingly difficult. Interest rate changes can also affect the value of assets Consumers will also be more inclined to make mortgage and debt repayments rather than spend. Accordingly, aggregate demand and economic activity will decrease allowing for the achievement of government objective regarding the maintenance of economic growth between 3-4%. Evidently, the rate increases of 0.25% in May, August and November 2006 were intended to keep economic growth on target and reduce inflationary pressures.
A rise in interest rates will additionally lead to significant capital inflow through attracting foreign investment which may lead to the appreciation of the Australian dollar and a decrease in the global competitiveness of its exports. On the domestic scale, however, higher interest rates result in a decline in business investment levels as firms tend to save their income rather than purchase capital when the cost of servicing debt rises and cash flows decline. Despite lowering inflation, reduced aggregate demand will consequently contribute to a decrease in income levels and reduced employment growth, as part of the transmission