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BUS702-The Role Tools And Functions Of The Reserve Bank

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Question

Your essay should address the following four aspects/questions:
 
1) What role does RBA play in Australia? Discuss the tools available at the disposal of RBA to carry out its functions.

2) Discuss the current economic environment (inflation and interest rates) in Australia, monetary policy employed by the central bank, and effects of those policies on financial markets including asset values and yields.
 
3) In the article, “Is the deflation bugbear heading down under?” (Fensom 2017), economist Paul Dales is quoted as saying, “an average inflation rate of around 2 per
2cent or below could mean that many economies, including Australia, are just one recession away from deflation. In other words, the next economic shock might not
 
need to be very large to push inflation below zero". Explain the connection between recession and inflation. Why is deflation so dreaded? Comment by drawing on the experiences of other countries that have experienced deflation.
 
4) In the article, “Is the deflation bugbear heading down under?” (Fensom 2017) leverage dynamics are discussed. Use this as a starting point to explain how leverage matters for the economy. 

 

Answer:

Introduction

Noteworthy, the Australian financial economy policy is formulated, regulated and implemented by the Reserve Bank of Australia (RBA) which gets its power an functions from the Reserve Bank Act(1959).The Act establishes two Boards ,the payments  systems board and the Reserve Bank Board to perform some of its major functions. The bank through the implementation of monetary policy has affected the interest rates and inflation rates in the Australian economy since its inception. Deflation is negative inflationary pressures in an economy. Unfortunately, Japan and Greece have been on the receiving end of deflation. For some economists, deflation might be a precipitate for recession and vice versa.

Undoubtedly, there is a connection between deflation and recessive periods in any economy. The monetary policy directly affects the assets and yields of the Australian enterprises due to the effects of the policies on the money supply. Monetary policies can be contractionary or expansionary which affect the asset values and yields of the Australian businesses. From an economic perspective, leverage is both desirable and undesirable in the economy. Leverage desirability stems to the fact that it might increase a firms earnings. However, leverage might instigate losses for the respective firms. Overall, leverage is a gamble that should be kept at a balance. 

 

Role and tools of RBA in Australia

Primarily, the Reserve Bank of Australia (RBA) is the central bank for the Australian economy. Fundamentally, it is mandated to formulate  the country’s monetary policy which affects the  all financial sectors in the country(Reserve bank of Australia, 2018).Additionally, the RBA is tasked with the duty of issuing Australian currency which is the Australian dollar. Also, the bank is responsible for the management of foreign exchange reserves and also responsible for maintaining a strong system of finance in the country. Fundamentally, the reserve Bank derives its powers and functions from the Reserve Bank Act of 1959.

Undoubtedly, the Act equips the bank with the powers, resources and departments which help it with the implementation of its functions. The bank through the Bank board and the payments systems board help implement it various functions

Current economic environment of Australia

Inflation

Majorly, the inflation rate in Australia has increased between the month of January and July 2018(Trading economics 2018).Predominantly, inflation refers to the instability in prices of goods and services .Specifically, the rate of consumer prices rose from 1.9 % to 2.1% during the stipulated period of time .Majorly, the rise in transportation cost is responsible for the inflationary pressures being experienced currently in the Australian economy. Currently, the Australian inflationary pressures are manageable hence the unchanged monetary policy to maintain the current inflationary conditions of in the economy. Primarily, the Bank (RBA) uses an target to control the inflationary rates in the economy.

(Trading Economics 2018)

Interest Rates

Noteworthy, the Australian cash rate stands at 1.50 % as at 7th August this year (Reserve Bank of Australia, 2018).It is worth noting that the cash rate remained unchanged as from the previous year. Primarily, the RBA is tasked with the mandate of formulating and influencing interest rates in the Australian financial economy through the cash rate. The RBA discharges this mandate through the regulation and management of the cash rate (Castelnuovo 2018). Majorly, the cash rate is formulated by the Reserve Bank Board. Through monitoring the cash rate in the Australian economy, the Bank (RBA) chose to unchanged the cash rate in the financial market economy.

(Trading Economics 2018)

Effect of RBA policy on financial markets asset values and yields.

Particularly, the monetary policy issued by the RBA directly crucially impacts on the asset prices (Alessi & Kerssenfischer 2016).Following the aftermath of the global financial crisis of 2008-09, monetary policy and measures by the RBA were effective in strengthening the Australian financial market and the economy. Monetary policy directs interest rates which influences pricing of assets and yields. Essentially, expansionary monetary policy is likely to increase the asset values. However, in the event that contractionary monetary policy is applies on asset values, the values of asset will reduce or be low.

Equally the effect of expansionary monetary policies on yields will be an increase whereas contractionary monetary policy will reduce the value of yields (Paul 2018).Basically, policy by the RBA affects the cash flow in the Australian economy. Restricted money supply will definitely affect the asset value due to the fact that the value of asset will go up. However, in the case that the monetary policy allows more cash supply in the economy, the value of asset will go down in turn affecting the investment yields for the Australian economy. 

 

Connection between recession and inflation

Inevitably, deflation might lead to recessive periods for any economy (Guerrore & Parker N.d).Majorly, recession implies stagnated economic growth rate whereas deflation is the fall in pricing for goods and services. Essentially, low pricing for goods might affect the aggregate demand and supply of goods which in turns affects the economy. Typically, fall in prices of goods and services limits the circulation and supply of money which is critical to investment and consumption of goods and services. In some instances, deflation has been the cause of recessive periods in the economy such as Japan.

Primarily recession is characterized by reduced aggregate demand for goods and services which might be due to deflation (Bordo & Filardo, 2005).Also, recession is characterized by high unemployment rates due to reduced price of labor, workers chose to stay away from employment or employer wages are low thus leaving work by some workers.

Why is deflation is feared?

Predominantly, deflation denotes the fall in pricing for goods and services. However, the impact of deflation on economic growth are majorly negative hence the fear for deflationary trends in any economy. From an economical perspective, fall in prices implies purchase delays thereby prompting further price falls thus less consumption and purchase power of goods and services. Incidentally, deflation weakens the demand for goods and services thus less revenue and less money in circulation which grows an economy. In addition, deflation negatively impacts on the interest rates (The Economist, 2015).Typically, higher interest rates encourages savings rather than investment. 

 


Additionally, deflation encourages labor market rigidity. Usually low wages for labor will discourage workers due to wage cuts. Specifically, the Japanese economy has been marred by the effects of deflation. Particularly, the Japanese economy was characterized by negative inflationary rates in the year 1998,average economic growth rate of 1 % between the year 1993-03 and a consumer inflation rate below 3 percent as at the end of the year 2003(Ito & Mishkin, 2004).The Japanese finance market experienced massive losses due to the fall in asset pricing. Also, some Japanese banks capital declined due to the deflationary pressures in the country in 1998.

Also, the Greece economy has experienced negative inflation(Eurobank ,2014).Particularly, the Greek economy experienced fall in prices for goods and services in the year 2013 .The deflation was estimated to be -2.1 % of the Greek gross domestic product. Majorly, deflation leads to high value for debts, distortion of resource allocation, reduction of financial deposits, reduced output, possible bankruptcies, and reduced income among other detrimental consequences to economic growth.

Leverages dynamics

Essentially, leverage implies the ability of businesses are able to  fund their assets through borrowing(Ingves 2015).Typically high leverage would be characterized by high debt levels as opposed to equity. Arguably, leverage can be beneficial to a business entity to a certain extent. However certain levels of leverage in the financial market can be harmful to a financial entity. According to the NAB predictions of possible increases in interest rates this year, there likelihood of slow economic growth rate might necessitate leverage for struggling firms (Fensom ,2017).With low economic growth rate due to increased interest rates, the money in circulation will be limited which could restrict the operations of businesses and affect the aggregate demand for goods and services which is key to economic growth. Due to low economic growth rate and reduced money circulation, firms might need to leverage so as to keep their operations afloat.

Importance to the economy.

According to some economic perspectives, leverage is an essential part of the business cycle due to the various benefits it affords businesses, financial or otherwise .For some businesses, leverage might be a cheaper funding option for the business as contrasted with equity (Ingves, 2013).Specifically leverage has been hailed for raising funding costs for most businesses. Basically, through obtained leverage, businesses are able to make earning on their own assets which could lead to expansion of the business, increased profits and be able to maintain the operation of the respective business (Fandom 2017). 

 


In addition, for the financial market, the returns on leveraged products might yield higher returns which is positive to the operation of the financial entity. Basically, leverage increases the investment returns if thought about and implemented properly thus leading to more revenue, expansion and investment which are crucial to the growth of the economy. Moreover, through leverage, a business might be able to retain its employees and increase production in the event that the business entity was facing hard times. Through borrowed capital, the business operations might save the business from bankruptcy (Accounting Tools 2017).

However, due to the inability to service the debt through the business assets, leverage isn’t considered a healthy option to funding .Also, leverage might lead to losses as opposed to profits as hoped thus making it a dangerous gamble for the business entity.

Conclusion

Undoubtedly, the RBA is the Australian central bank tasked with the mandate of formulating monetary measures and policies, strengthening the financial market of the Australian economy and issuance of the Australian dollar. The Role of the bank can be manifested though the implemented monetary policies which affect interest rates and inflation rates as a bid to strengthen and regulate the Australian financial market. The enabling statute grants the bank massive powers, functions and bodies to implement this mandate. The effects of monetary policy by the bank can be felt through contractionary and expansionary policies which affect the interest rates and inflation rates in the economy which directly and indirectly affect the value of assets and returns on investments.  

Essentially, Deflation which is negative inflation has led to detrimental consequences on the Japanese and Greek economy. Negative inflation leads to stagnated economic growth rates, reduced outcomes, increased value of public debts, reduced income which implies less investment, more savings and reduced investment which is critical to economy growth rate. Basically, deflation and recessive periods in an economy are related .Arguably, deflation is a cause and a consequence of recession in any economy thus the assertion that they are interconnected 

 

References

Accounting Tools.(2017).Financial leverage .Accounting tools.com.[Online].Available at https://www.accountingtools.com/articles/2017/5/14/financial-leverage[Accessed 2 Sep 2018]

Alessi, L & Kerssenfischer, M. (2016). Working Paper Series The response of asset prices to monetary policy shocks: stronger than thought. European Central Bank. [Online].Available at https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp1967.en.pdf?23d2ec9ce1c93d4315e88bb90d8531ff[Accessed 2 Sep 2018]

Bordo, M & Filardo, A. (2005).Deflation in a historical perspective. Bis working papers. [Online].Available at https://www.bis.org/publ/work186.pdf[Accessed 2 Sep 2018]

Eurobank.2014.Economy and Markets. Eurobank Research. [Online].Available at https://www.eurobank.gr/Uploads/Reports/ECONOMYMARKETS_APRIL2014%20MAY%20UPDATE.pdf[Accessed 2 Sep 2018]

Fensom, A. (2017).Is the deflation bugbear heading down under? Morning star. [Online].Available at https://www.morningstar.com.au/stocks/article/Is-the-deflation-bugbear-heading-Down-Under/8994[Accessed 2 Sep 2018]

Castelnuovo , E. (2018). RBA should be clearer about when and how interest rates will change

Online].Available at https://www.abc.net.au/news/2018-03-19/rba-future-interest-rate-policy/9562948 [Accessed 2 Sep 2018]

Guerrero F & Parker, E. (N .d). Deflation and Recession: Finding the Empirical Link. Semantics scholar. [Online].Available at https://pdfs.semanticscholar.org/ac5d/eaa8191580d28459630f0d9705bfb9409046.pdf[Accessed 2 Sep 2018]

Ingves, S. (2014).Banking on leverage.BIS.Org.[Online].Available at https://www.bis.org/speeches/sp140226.htm[Accessed 2 Sep 2018]

Ito, T & Mishkin. S.F. (2004).Two decades of Japanese Monetary Policy and the Deflation problem. The National Bureau of Economic Research. [Online].Available at https://www.nber.org/papers/w10878[Accessed 2 Sep 2018]

Paul, P. (2018). Monetary policy cycles and financial stability. FRBSF. Org .[Online].Available at https://www.frbsf.org/economic-research/files/el2018-06.pdf[Accessed 2 Sep 2018]

Reserve bank of Australia. (2018).Our role. Government of Australia. [Online].Available at https://www.bis.org/speeches/sp140226.htm[Accessed 2 Sep 2018]

The Economist. (2015).Why deflation is bad. The Economist. [Online].Available at https://www.economist.com/the-economist-explains/2015/01/07/why-deflation-is-bad[Accessed 2 Sep 2018]

Trading Economics. (2018).Australia Inflation rate. Trading economics. [Online].Available at https://tradingeconomics.com/australia/inflation-cpi[Accessed 2 Sep 2018]

Trading Economics. (2018).Australia interest rate. Trading Economics. [Online].Available at https://tradingeconomics.com/australia/interest-rate[Accessed 2 Sep 2018]

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