Unit 4 Economics AOS1 Monetary Policy 2020 Transmission Mechanisms

Hello. Hello everyone and welcome to our third video in our series about monetary policy. Today we're going to be talking about transmission mechanisms. So this follows on from last time when we talked about open market operations, how the RPA could have an expansionary stance or a contractionary stance to change the overall cash rate. Now we're going to be looking at when they do change the cash rate, what the on flow effects of that are and how they affect economic activity, aggregate demand, etc. So we're going to look at five different transmission mechanisms and basically it's just the flow of logic of how changing the interest rates then impacts the economy. So we're going to get straight into looking at the key knowledge. So what we're going to be looking at here is if I get out my highlighter, put it on green because I like green transmission mechanisms of monetary policy and their influence on the overall level of aggregate demand. So I'm going to look at these. VCAR loves to have a question at the end of your exam asking using one or using two transmission mechanisms explain the effects of the recent RPA decision on economic activity. And then you've got to talk about two or one of the transmission mechanisms and the flow of how they affect the economy overall. So let's get straight into it. The first one. So transmission mechanisms refer to the way a change in interest rates affect economic activity. So there are five possible channels and we're going to look at them one by one and it probably won't actually take us that long overall. So the first one is the cost of credit channel. And so with this higher cost of credit reduces willingness to borrow and provides incentive to save. So this is basically when interest rates are increased or the cash rate is increased, it gives people more of an incentive to save because if interest rates are higher, you're either going to get punished for borrowing money because you're going to have to pay back a higher rate or you are going to get more money back if you save because you're going to get interest back on whatever you save. So this leads to a consequent reduction in private consumption spending and investment spending and works to reduce aggregate demand and economic growth. So when interest rates are high, it means that credit is expensive and therefore people aren't going to borrow as much. The opposite is when we have lower interest rates, the cost of credit is cheap because we don't have to pay back as much interest and that leads to a decrease in savings and and a massive increase in consumption and investment or it's Meant to not quite at the moment. Also, higher interest rates lead to a higher rate of savings, which could also be included there. So the cost of credit channel is just all about how it affects people's willingness to borrow and their overall level of savings and spending. Now we've got the cash flow channel. So the cash flow channel looks at how it affects people's overall cash flow, which pretty logical based on that. So high interest rates negatively impact those with existing variable rate loans. Variable rate loans are loans that change the interest rate as the cash rate changes. So for example, although the cash rate is 0.25, my interest rate is somewhere about 3% on our home loan. And we have a variable rate. So if the cash rate and interest rates go up, our home loan rate would also go up and it would mean we'd have to pay more on our home loan overall because of that variable rate. So households with mortgages immediately suffer a drop in their cash flow or discretionary income when interest rates increase, because immediately, so say I think we pay something like $1,000 in interest a month. If the interest rates would go up, that interest repayment would go up and therefore our cash flow would drop because we'd have less available overall because we'd have to pay more interest. So this reduces consumption spending or private consumption spending, and therefore reduces aggregate demand. Businesses also suffer a reduction in cash flow because they've got to pay back more on their interest loans, which reduces private investment spending in aggregate demand as well. On the other side of it. So what's been happening more regularly recently is that often when interest rates are decreased, it means that we have higher cash flow. So in our case, you can see every time they've decreased the cash rate since we've had our home loan, which is about five years, that our interest repayments have gotten smaller. That's not to say we've paid less back because it benefits us to pay more back, but it means we have access to more cash if we want to, and our cash flow is therefore better off. Same for businesses. They're paying less on business loans, therefore they're more able to invest and expand and increase accurate demand. Or that is what's meant to happen. If consumers have consumer confidence and businesses have business confidence, then we have the availability of money and credit channel. So the supply of money tends to fall in times of high interest rates because less households and businesses are likely to meet lending criteria due to risk of defaulting. So in short, financial institutions are more likely to reduce the number of loan approvals when Interest rates rise, certain interest rates are higher. They're less likely to loan out as much money because they're worried that people won't be able to pay it back. And especially in Australia, we have a very high household indebtedness ratio, which means people often owe a lot more money than they have. Which means that if interest rates go up or interest rates rise, a lot of people can't actually pay the loan they have. Which creates issues for the banks. And aside from this is they make people, if people don't have enough money when they're getting a home loan, they make them pay what's called lenders mortgage insurance, which is basically you're paying the bank to have insurance if you can't pay your loan, so the bank gets all the money back. So you're paying for the bank to have insurance, which is crazy. Make sure if you ever buy a house, which hopefully you will one day, you have a decent deposit so you don't have to pay for that. So this one essentially boils down to when there is a high supply of money, banks are more willing to loan out money. And when there is a low supply of money, banks aren't willing to loan out as much money because they're afraid they won't be able to get it back. I don't recommend using this one. It's a bit harder to explain. The first two are much better to explain in an answer. But up to you. It's your vc, you can do what you want. I'm not the boss of you. There are the asset values or asset prices channel. So when there are higher interest rates, asset values are likely to fall because of a lack of demand. So when interest rates are higher, people are less likely to want to buy houses because it's going to cost them more to get a home loan. And therefore house prices should come down because there's less demand for housing. Therefore assets values fall. This should then reduce wealth, which also reduces consumption, spending and aggregate demand. On the other hand, when interest rates are low, which they currently are, it pushes house prices up or asset prices up. And that can lead to basically the rich becoming richer, the wealth goes up, which can increase their spending and aggregate demand overall. So basically when interest rates are high, asset values fall because people aren't going to invest. And when interest rates are low, asset values tend to go up because there is more demand for them because people are more willing to invest. Then lastly we have the exchange rate channel and this one, the more complicated ones, and one that comes up a bit more Often, but it's very, very important to know. So the exchange rate channel is all about how the exchange rate is impacted by changing interest rates. We've already talked about this a little bit when we looked at Area State 3 and Unit 3. But the Australian dollar is positively correlated with interest rates. So a rise in interest rates usually means a depreciation Australian dollar. Why that is is because when our interest rates are higher, especially higher compared to a lot of overseas countries, when our interest rates are higher, it means that foreign investors will invest their money in Australian financial institutions because there is a higher rate of return here. To do that, they've got to exchange their foreign currency for Australian dollars, which takes Australian dollars off the foreign exchange market and therefore makes the Australian dollar appreciate in value because of lower supply of it. The opposite is also true. And this is what's happened somewhat recently. So as our interest rates have been falling for a long, long time, we had a higher cash rate or higher interest rates compared to a lot of the rest of the world. So there's a lot of investment in Australia. As our cash rate and interest rates have been decreased, foreign investors have taken their money out of Australia. And you could see earlier this year, in March, when it occurred, the Australian dollar dropped significantly as soon as the cash rate was cut because it meant that foreign investors took their money out of Australia. So they left their foreign, their Australian dollars on the foreign exchange market and rebought their own currency or whatever currency they were going to invest in. And this can actually devalue the Australian dollar, which is good for international competitiveness because we're more able to export and we're more competitive in that way, in the original way we're talking about with the people investing in Australia. Higher interest rates leads to higher Australian dollar, which then dampens our international competitiveness and makes imports cheaper, which reduces inflationary pressure in the economy. So this is a big issue we've had for a while. The Australian dollar is often too high, which makes it hard for us to export and also means we import a lot more. We import a lot in Australia anyway. But when the Australian dollar is high, we import even more because it's a lot cheaper for us to do so, which is good if you want to lower inflation. But inflation is already pretty low. So we want the Australian dollar to be as low as possible at the moment. But that's basically how interest rates impact the exchange rate. It's all about how much foreign investment is going to occur in Australia or if foreign investors are going to leave Australia and the effect that then has on the exchange rate. All right, so these are the five transition mechanisms. You're never going to need to know all five, to be honest. That's my tip to, you know, three of them really well. I would ignore two of them completely if I was you. Just a little like, once again, you can't take action against me if that blows up in your face. But that's in my experience, that's what you need to do. So those five, pick three that you like the best, I recommend the first two and exchange rate channel because they are the ones that come up the most often. And these are basically your flow of logic when you're answering questions. When they ask to use a transmission mechanism. So often you use like the cost of credit or the cash flow mechanism or the exchange rate channel to use basically these. And when the RBA decreases or increases interest rates, this is what then happens and you get to this point. And this is the effect on economic activity and aggregate demand. Hopefully this is useful to you. If you have any questions at all, shoot me an email. I'm more than happy to help out on that. We've got one more video to come in this topic about the strengths and weaknesses of monetary policy at stimulating economic activity. Other than that, I hope you have an excellent day and I will see you next time. Goodbye.