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Monetary policy has been getting a lot of airtime in recent months, ever since interest rates began their steady ascent. But if you’re not sure exactly what monetary policy is, don’t worry, you’re not alone. Despite being frequently used by economists and journalists, it’s a term that is not widely understood by the public.
Diana Mousina, senior economist at AMP, explains that monetary policy is “policy that influences the money supply to bring about changes in the economy”.
According to the Reserve Bank of Australia (RBA), which is in charge of setting monetary policy in Australia, “monetary policy involves setting the interest rate on overnight loans in the money market (‘the cash rate’)”.
Still confused? Perhaps the best explanation comes from Investopedia which defines monetary policy as: “a set of tools that a nation’s central bank has available to promote sustainable economic growth by controlling the overall supply of money that is available to the nation’s banks, its consumers and its businesses”.
Let’s unpack exactly what that means.
Related: Australian Inflation Rate
Where Did the Term Monetary Policy Come From?
The term ‘monetary policy’, and the idea behind it, seems to have been around since the 1870s when the buying and selling of government securities was developed by the Bank of England in order to force financial institutions to borrow money from it.
In the modern context it gained popularity in the 1960s and 1970s thanks to proponents such as renowned US economist Milton Friedman.
Mousina says it started appearing in the RBA’s briefing notes in the 1980s, when the Bank began targeting an inflation rate of between 2% to 3% during a business cycle in order to promote sustainable economic growth and employment.
How the RBA Regulates Monetary Policy
The RBA regulates monetary policy by changing the cash rate, which is the interest rate at which it, as the country’s central bank, lends money to the major banks.
The cash rate is also often described as the ‘official interest rate’, and RBA executives meet on the first Tuesday of each month (except for January) to decide whether or not they will change the cash rate.
Broadly speaking, monetary policy can be defined as either expansionary or contractionary.
Expansionary monetary policy involves decreasing the cash rate in order to expand the supply of money, which encourages higher levels of borrowing to boost consumption and investment by consumers and businesses.
By contrast, contractionary monetary policy involves increasing the cash rate in order to restrict the supply of money, so that consumers and businesses borrow less and cut consumption and investment.
If the cash rate is either increased or decreased, the major banks then have the option of passing on these changes to their customers, in the form of either lowering or increasing the interest rate it pays on savings or charges on loans.
“The major banks hold accounts with the RBA for overnight lending,” Mousina explains. “When the RBA increases or decreases the cost of the holdings that those banks have with them, those banks can pass on those changes to their customer base, either up or down, depending on whether those customers have a debt or savings with the bank. But banks don’t always necessarily pass on exactly what the RBA does, because they are influenced by their own margins.”
When the RBA increases or decreases the cost of the holdings that those banks have with them, those banks can pass on those changes to their customer base, either up or down, depending on whether those customers have a debt or savings with the bank
The RBA sets monetary policy according to its monetary policy framework, which states that “in determining monetary policy, the Bank has a duty to contribute to the stability of the currency, full employment, and the economic prosperity and welfare of the Australian people”.
Monetary Policy vs. Fiscal Policy
The fundamental difference between monetary policy and fiscal policy is that monetary policy is set by a country’s central bank whereas fiscal policy is set by a country’s government.
“Fiscal policy is undertaken by the government changing its approach to spending and taxation. When it increases spending, and it reduces taxation, it’s more stimulatory for the economy, and when it reduces spending and increases taxation, it’s trying to tighten the economy,” Mousina says.
As a consequence of it resulting from government policy, fiscal policy is subject to politics and a desire for governments to get re-elected, she adds.
“Fiscal policy is not as independent as monetary policy and it also has a very long lead time. A change that gets announced might not have an impact on the economy for 12 months, because it takes time for people to change their behaviours around taxation and the impact tends to be less dramatic than monetary policy.
“Because monetary policy is reviewed—and can be changed—monthly it doesn’t have the same lead times, especially in a country like Australia, where people take out shorter term loans and where there’s a higher share of households who are on variable interest rates, or on very short-term fixed rates.”
Frequently Asked Questions (FAQs)
What is an example of monetary policy?
An example of monetary policy in Australia is the decision made by the Reserve Bank of Australia (RBA) to adjust the official cash rate, which is the interest rate at which banks borrow money from the RBA. It has a significant impact on the interest rates that banks charge their customers for loans and the rates they offer on savings accounts.
What does monetary policy not influence in the economy?
Monetary policy primarily influences demand-side factors in an economy, such as consumption and investment. It does not directly influence supply-side factors such as productivity, technology and resources, nor does it influence fiscal policy which involves government spending and taxation, or structural issues such as labour market regulations and trade policies.
What monetary policy should be implemented to correct an inflationary economy?
To correct an inflationary economy a central bank should implement contractionary monetary policy by increasing the cash rate. This will reduce the money supply in the economy and increase bank lending interest rates to slow down spending, investment and reduce inflationary pressures.
What is monetary policy in Australia?
Monetary policy in Australia is the process by which the Reserve Bank of Australia (RBA) influences the economy through the management of interest rates and the money supply. The RBA is responsible for achieving its statutory objectives of price stability, full employment and the economic prosperity and welfare of the Australian people.