Goals of monetary policy
Role of underlying inflation
Implementing monetary policy
Tightening of MP
Loosening of MP
How other rates change
'Open mouth operations'
Exchange rate intervention
Monetary policy stance
Monetary policy neutrality
MP and economic goals
MP strengths and weaknesses
Strengths and weaknesses of monetary Policy
A strength of a policy refers to an aspect that makes it a particularly powerful tool (when compared to another policy for example). Similarly, a weakness or constraint of policy refers to an aspect that makes it less effective or powerful. Success/failure of policy refers to an evaluation of how well the policy has performed in trying to achieve its stated goals. A knowledge of strengths and weaknesses of policies will often help us to determine how successful policies have been over time.
Some strengths of monetary policy include the following:
- RBA Independence - this is an important strength that makes monetary policy superior to budgetary and microeconomic policies in terms of its ability to make policy decisions that are apolitical - that is, free from political bias. The relationship between the RBA and the government was clarified in a recent 'Statement on the Conduct of Monetary Policy' where it was highlighted that:
'The government recognises the independence of the Bank and its responsibility for monetary policy matters and respects the Bank's independence as provided by statute'
[Despite this, it is possible for the government of the day to override the RBA in the event that there is a material policy difference between the RBA and the government. In reality, this is a politically demanding process and is a course of action that is unlikely to be taken by any government.]
- Short implementation lag - Compared to budgetary and supply side policies, it takes very little time to implement a monetary policy decision once the Board decides to change policy settings. For example, once the decision was made to loosen monetary policy in May 2013, the RBA announced the decision in the afternoon and immediately entered the cash market to decrease the cash rate towards its new 2.75% target. Financial markets then automatically started to adjust other interest rates as soon as the announcement was made.
- Influence on expectations - monetary policy is particularly powerful in influencing the expectations of economic agents. In some instances, concerns expressed by the RBA Governor (without actual changes to policy settings) can have a powerful influence on the behaviour of consumers, investors, borrowers or lenders.
Some weaknesses of monetary policy include the following:
- Blunt instrument - monetary policy is unable to discriminate across the economy as any effort to restrain or stimulate AD via a change to interest rates affects all sectors equally. Unlike budgetary policy, it is unable to restrain or stimulate activity in particular sectors if it feels this is required. For example, the two speed (or patchwork) economy that existed for most of the past few years could not be managed by monetary policy. This is because an increase in interest rates to control inflationary pressures coming from the mining sector will only serve to further damage other sectors (such as manufacturing, retail and tourism) suffering under the strain inflicted by a high dollar. Similarly, monetary policy is unable to specifically re-allocate resources (e.g. to address market failures) nor improve equity by focussing on particular disadvantaged groups.
- Long impact lag - the time it takes for monetary policy actions to fully impact on the economy can be up to two years. This forces decision making to be very forward looking, relying on economic forecasts and estimates that may be incorrect or misleading. Accordingly, monetary policy can actually be pro-cyclical when it intends to be counter-cyclical. A good example of this occurred recently when the RBA tightened policy during the early part of 2008 to restrain growth, but the economy had already 'turned' and was on the downward phase of the business cycle (i.e. growth was declining). This meant that the increases in the cash rate in late 2007 and early 2008 actually contributed to Australia's economic downturn of 2008/9.
- No direct control over interest rates - The RBA only has direct control over the cash rate. The extent to which changes in the cash rate flow through to change all other rates depends on the competitive pressures existing in financial markets. This therefore changed the relationship between the cash rate and average interest rates across the economy and made it slightly more cumbersome for the RBA to implement new monetary policy settings. See the section covered earlier on how other interest rates change following a change in the target cash rate..