Monetary Policy Framework Of Reserve Bank Of Australia (RBA)

1. Explain the main objectives of monetary policy. List and describe the main functions of money and the Reserve Bank of Australia.

2. Why does the RBA take into account the global macroeconomic indicators of major economics like China, Japan, India, and USA, including the domestic macroeconomic indicators (GDP, inflation, unemployment, and exchange rate) when making a decision whether to change (increase or decrease) or keep the official cash rate unchanged? Explain.

3. the Governor of the RBA, Dr Philip Lowe, decided to leave the official cash rate unchanged at 1.50 percent. Why did the RBA keep the cash rate unchanged? Justify your answer with reasons and evidence.

4. Illustrate and explain using the money market equilibrium model and monetary transmission mechanism how an increase in the cash rate from 1.5% to 2% would help
to keep inflation within the target rate and how a further decrease from 1.5% to 1 % in the cash rate would help to stimulate the economy. In particular, discuss the effect on household consumption, business investment, government spending, GDP, inflation and housing market. Describe the circumstances in which the Board might increase and decrease the cash rate. Note: Use GDP, inflation, unemployment, fiscal deficit, and housing market data can be obtained from the Australian Bureau of Statistics and RBA websites for the last 5 years to see the trends, when answering this question.

5. Define economic growth. What are the determinants of long-run economic growth? Is the historically low interest rate of 1.50 percent (from August 2016 until the
present) sustainable to achieve long-run economic growth? Yes/No, justify your answer with reasons.

Objectives of Monetary Policy

In this paper, a case study is formulated in reference to Reserve Bank of Australia’s monetary policy statement. In the last media release of RBA, on 5^th December the board members of RBA have decided to keep the cash rate at a neutral level of 1.50 percent. RBA designs its monetary policy depending on the prevailing economic scenario. Cash rate is the instrument used by RBA to stabilize inflation and other monetary policy goals. RBA conducts a discussion board every year and then takes its decision on prevailing and future cash rate. In 2008, global economy was severely hit by financial crisis. In order to protect the economy from external shocks, RBA decides to cut the prevailing cash rate. The RBA at that time set the cash rate around 2 percent. In 2016, RBA revised the cash rate twice. First in May, when cash rate was cut to 1.75. In August, cash rate cut by 0.25 and it was set at 1.50 percent.

While deciding over cash rate, RBA considers economic condition of is economic and trade partners. Japan, India, China and USA are some countries maintaining close relation with Australia. The domestic economic performances indicators include consumption, investment, GDP, government expenditure and housing market.

Fiscal and monetary policy are two important policy tools used by government to stabilize economy. In Australia, monetary policy is considered to be more effective as compared to the monetary policy. The main goal of monetary policy is to attain a price level stability by setting a low inflation target. The major objectives of monetary policy are the following.

Stable price level: This is the first and foremost important monetary policy goal. The supply of money is controlled to attain the set inflation target. However, the inflation target is different for different countries (Kiley & Roberts, 2017). All countries sets its inflation goals to a low to moderate level. Tight monetary policy is followed to reduce inflation rate while ease monetary policy is followed to increase the price level and boost economic growth.

Money neutrality: Change in real economic variables often resulted from fluctuations in the money supply. Once the effect of money supply is neutralized then economy become more stabilized. This secures the economy from fluctuations caused from business cycle, fluctuation in price level or volatility in trade cycles.

Stable exchange rate: A related objective of monetary policy is to stabilize the exchange rate. A less volatile exchange rate helps the nation to maintain a stable trade volume. Exchange rate is related with the interest rate (Blanchard, Rogoff & Rajan, 2016). Thus, monetary authority by adjusting interest rate can influence the exchange rate under a flexible exchange rate system.

Economic Performance Indicators Considered by RBA

Economic growth: All the policies in the economy are designed to attain stable economic growth. Government by controlling money supply and inflation targets to maintain a stable growth rate of the economy.

Full Employment: Along with economic growth, policymaker also targets to achieve full employment. The economic growth attained with suitable monetary policy framework helps to attain full employment by opening new employment opportunities.

The main function of money is the use of it for transaction. In order to exchange goods or services the most convenient medium is money. Earlier that is before the advent of money people are supposed to exchange goods using barter system. However, with barter system due to lack of proper measurement units the transaction could not be undertaken properly. Money solves this problem and provide a suitable unit for capturing worth of any produced goods or service. Money is used as a store of value (Sardoni, 2015). It is possible to store money for a long horizon and thus determines purchasing power in future. The value of money though fluctuates with level of inflation but it always holds some worth. The value of any stored wealth is also measured in terms of money.

Reserve Bank of Australia is the central monetary authority. It takes all the decision related to money supply, interest rate and other money market decision in favor of Australia’s prosperity. RBA aims to maintain a stable value of Australian dollar, prints currency, maintain full employment and overall well-being (Cheung, Manning & Moore, 2014).  Achieving a stable price level is one of the primary objectives RBA. The targeted inflation rate in Australia lies between 2-3 percent. RBA also looks after all other form of financial transaction like control of foreign exchange reserve, control overseas financial transaction and control other functions of banks.

In times of taking decision regarding cash rates, RBA needs to consider economic performance of nation whose economy is related with Australian economy. Economic expansion of trade partners positively influences economic performance of Australia. During volatile economic condition of partner countries, strong domestic support is needed to overcome external shocks.

China is one nation whose economic movement affects Australia the most. There is a bilateral trade and financial relation between China and Australia. China is one of the fastest growing developing nation in world. In achieving the growth rate China needs some external support. Most of the raw material, which China demands, come from Australia. China provides an extended domestic market for goods exported from Australia. Australia has a large stock of mineral resources (Pascali, 2017). The mineral resources are exported to China to support the energy sector. In terms of service, Australia assists China in its education service. China invests in different projects of Australia. Fluctuations in such investments affects Australian economy.

Relation of RBA with Other Countries

USA is another nation influencing economic behavior of Australia. USA is regarded as the most powerful and largest economy in the globe. Australia and USA singed an effective bilateral trade agreement in 2005 to strengthen their economic relation. The two nations exchanged goods and services worth billions of dollar each year (Mascitelli & Wilson, 2018). USA makes capital investment in Australia. The firms in USA operate their plants in Australia. These create both employment opportunity and economic prosperity.

Australia has established a trade relation with India. India is the fifth largest market for Australian export. Billions of worth of goods are exchange between these two nations. Australia exports minerals, vegetables and services to India. India with its economic growth invests in different sectors of Australia (Xiang, Kuang & Li, 2017). The attractive sectors for investment include manufacturing, energy and resource sector and other services.

Another important trade partner of Australia is Japan. Japan makes adequate capital investment in Australia. The Japan Australian Economic Partnership in 2014 strengthens the relation between Australia and Japan (Piggott & Woodland, 2016). With this agreement the all the trade and investment barriers has been eliminated. Like other nation, Australia exports energy and minerals to Japan.

The evaluation of economic relation between Australia and these nations gives rationale of taking economic status of these countries in designing monetary policy framework. The trade and economic relation makes Australian economy dependent on these nations. USA suffered a financial crisis in 2008 following crisis in the housing market. The crisis spread out from USA. This time RBA had cut cash rate for monetary expansion. China is growing at a rapid rate following investment in housing market and development of infrastructure (Chacko & Davis, 2017). Government in USA has recently raised the interest rate. Japan and India also revises policies to boost their economic growth. Following changes in these economies Australian economy is affected either through altering trade volume or through changing financial investment. Therefore, RBA takes into consideration the economic performance and status of these nations in deciding interest rate. 

Cash rate sets by the RBA controls the investible funds in the economy. Based on the cash rate, the commercial banks determines the interest rate prevailing in the economy. A low cash rate means a low interest rate. This increases investment in the economy. This provides rationale for lowering the cash rate. However, the policy has an adverse impact of raising economic debt. With the aim of stimulating investment, RBA in 2011 has announced a cut in the prevailing cash rate. In the month of May in 2015, RBA has settled the interest rate at 2.0 percent. The RBA has kept the cash rate fixed for one year. Finally, after two times revision by 0.25 basis point, cash rate finally settled at 1.50 percent. The low cash rate though helps Australia to maintain a stable growth but it adversely affect the property market. The low cash rate make it easier to borrow funds easily. As a result, debt in housing market has significantly raised in the short span. However, no increase in household income is recorded (smh.com.au, 2018). Following the experience in the housing market, RBA has now decided to introduce lending constraint in the property market. However, RBA cannot increase the cash rate, as it will then affect the productive investment as well. For this, RBA has announced to keep a neutral cash rate to maintain a balance growth rate.

Cash Rate and Its Impact on Investment and Debt

Money market equilibrium is ascertained from a balancing state of money demand and money supply in the economy. The demand and supply relating to real money balances is considered as two most vital elements of money market (Bernanke et al., 2015). The model of liquidity preference presumes the supply of money in the economy is regarded as fixed.

The instances of real money balance is stated below in the illustrations; 

The liquidity preference theory takes into the consideration the converse association between demand for money and interest rate. 

Equilibrium is determined in the following manner   

The interest rate prevail in an economy is ascertained from state of equilibrium in the money market. The monetary policy performed by RBA helps in influencing the supply of money with the help of changes in rate of cash. Cash rate change helps in influencing the economic variables with the help of monetary transition mechanism.

The impact of monetary policy helps in transmitting the goods and money market with the help of varied channels. RBA during the month of August in 2016, lower the rate of cash by 0.25 points and the overall cash rate lowered from 1.75 to 1.50. together with the rate of interest, the equilibrium quantity of money also reduced (Cowen & Tabarrok, 2015). Cutting down of the cash rate, results in lowering down of the money supply. As a result of this it reflected a shift in the supply of money curve. Consequently, a new balancing state is attained on the intersection point of shifted supply curve and prevalent money demand curve.

The cash rate is adjusted by RBA to meet the targeted goals. Responding the recession of 1991, RBA undertaken an easy monetary policy which resulted a reduction in the cash rate from the period of 1990 to 1995. From the year 2008, a stable amount of cash rate of 5% is maintained by RBA. Furthermore, responding to the Global financial crisis, the cash rate of RBA has declined further (Goodwin et al., 2015). The cash rate has lowered down further with cash rate reaching around 2% and in the later stages falling to 1.75% and 1.50%. 

Gross Domestic Product (GDP) is regarded as the measurement of value of goods and services that is produced in an economy in terms of monetary terms.

The Australian economy has recorded a growth a rate of 0.6 percent. An assertion can be bought forward by stating that the growth rate has fall down from the figures reported in the earlier quarter at the growth rate of 0.9 per cent (Sunley, 2017). The positive growth rate represents a constant rise in GDP. Hence, a strong monetary policy with lower rate of cash has assisted the economy in maintaining the rate of growth.

Money Market Equilibrium

Inflation can be defined as the steady rise in price level in an economy.  

The direct impact created on the cash rate is reflected on the price level. After making an investment in cash rate, the level of price in Australia has steadied around 2 to 3 percent (Cosgrove & Olitsky, 2015). When price level raises upward, RBA increases the cash rate whereas in the times of a downturn in price level, RBA lowers the interest rate.

As evident from the above stated table movement in the rate of unemployment is in accordance with the movement of the RBA’s cash rate (Maurice & Thomas, 2015). RBA has revised the cash rate downwardly during the year 2016 and this resulted the unemployment rate to fall down significantly. Presently the cash rate is settled at 1.50 while the unemployment rate has settled to approximately 5%.

During the year 2016, the budget deficit of Australia represented 2.40 per cent of GDP. Ranging from the year 1979 to 2016 the budget deficit averaged around -0.97 percent (Argy & Nevile, 2016). The constant deficit in the budget can be considered as weaker financial position which ultimately forces Australia to remain dependent on the monetary policy.

Australia has witnessed an inflation in the housing price over the last ten years with housing price inflation standing 10 per cent during the year 2013. The increase in the housing price is in accordance with the association among the housing price and inflation (Blanchflower et al., 2014). The housing turnover rates has the demand in the market of property, financial and lawful services.

The economic growth of a nation is determined in respect of the production capacity. The economic growth is attained with the help of the slow and steady rise in income, fall in unemployment and the overall enhancement in the health of the economy (Bhattarai, 2016). The growth rate is determined in respect of the GDP that act as the original indicator of growth rate having the potential of demonstrating the growth aspects of a nation by providing an indication towards the long term growth.

The long run economic growth rate is reliant on the key components of gross domestic product along with the productivity of the nation. The amount of public expenses, the level of capital formation and investment level, rate of exchange, rate of employment are regarded as few indicators of the economic expansion. To attain the long run economic growth and standard of living productivity growth is regarded as the important indicator (Manalo et al., 2015). As evident from the situation the productive growth rate of Australia was low during the year 1980 in comparison to the productive growth in 1960. Evidently during the year 1980s, the growth rate in Australia was as lower than OECD nations. Following that the monetary and financial growth there has been a steady growth in the economy.

The cash rate has been cut down by RBA to as low as 1.50 per cent. The easing of monetary policy assists the nation in maintaining the stability under the different macroeconomic reflectors. The monetary policy assist Australia handling the growing pressure from other developed countries. Several economic and trading partners of Australia is faced with lower investment and lower export with lower inflation as well (Bhattarai, 2016). The Australian economy requires shield from the external shocks and RBA uses cash rate as a supporting tool for the economy. Australia has been successful in maintaining the steady growth rate with discretionary monetary policy. RBA sets monetary policy in anticipation to maintain the wage and employment growth for a long run economic expansion.

Conclusion: 

Conclusively the study assessed the current monetary policy of RBA. According to the recent release, the governor of RBA has announced the maintenance of neutral cash rate of 1.50 percent. The decision of monetary policy has been undertaken following the consideration of domestic and external macroeconomic indicators. The lower amount of cash rate is considered to be the detrimental factor for housing market. Therefore, the cash rate should be lower to steadily support the long run economic expansion of Australia.

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