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Importance of Domestic and Global Macroeconomic Indicators for RBA Monetary Policy

At its meeting today, the Board decided to leave the cash rate unchanged at 1.50 per cent.

The global economic expansion is continuing. A number of advanced economies are growing at an above-trend rate and unemployment rates are low. Growth in China has slowed a little, with the authorities easing policy while continuing to pay close attention to the risks in the financial sector. Globally, inflation remains low, although it has increased in some economies and further increases are expected given the tight labour markets. One uncertainty regarding the global outlook stems from the direction of international trade policy in the United States.

Financial conditions remain expansionary, although they are gradually becoming less so in some countries. There has been a broad-based appreciation of the US dollar over recent months. In Australia, money-market interest rates are higher than they were at the start of the year, although they have declined somewhat since the end of June. These higher money-market rates have not fed through into higher interest rates on retail deposits. Some lenders have increased mortgage rates by small amounts, although the average mortgage rate paid is lower than a year ago. 

The Bank's central forecast for the Australian economy remains unchanged. GDP growth is expected to average a bit above 3 per cent in 2018 and 2019. This should see some further reduction in spare capacity. Business conditions are positive and non-mining business investment is continuing to increase. Higher levels of public infrastructure investment are also supporting the economy, as is growth in resource exports. One continuing source of uncertainty is the outlook for household consumption. Household income has been growing slowly and debt levels are high. The drought has led to difficult conditions in parts of the farm sector. 

Australia's terms of trade have increased over the past couple of years due to rises in some commodity prices. While the terms of trade are expected to decline over time, they are likely to stay at a relatively high level. The Australian dollar remains within the range that it has been in over the past two years. 

The outlook for the labour market remains positive. The vacancy rate is high and other forward-looking indicators continue to point to solid growth in employment. Employment growth continues to be faster than growth in the working-age population. A further gradual decline in the unemployment rate is expected over the next couple of years to around 5 per cent. Wages growth remains low. This is likely to continue for a while yet, although the improvement in the economy should see some lift in wages growth over time. Consistent with this, the rate of wages growth appears to have troughed and there are increased reports of skills shortages in some areas. 

Main Objectives of Monetary Policy and Functions of Money and RBA

The latest inflation data were in line with the Bank's expectations. Over the past year, the CPI increased by 2.1 per cent, and in underlying terms, inflation was close to 2 per cent. The central forecast is for inflation to be higher in 2019 and 2020 than it is currently. In the interim, once-off declines in some administered prices in the September quarter are expected to result in headline inflation in 2018 being a little lower than earlier expected, at 1¾ per cent. 

Conditions in the Sydney and Melbourne housing markets have continued to ease and nationwide measures of rent inflation remain low. Housing credit growth has declined to an annual rate of 5½ per cent. This is largely due to reduced demand by investors as the dynamics of the housing market have changed. Lending standards are also tighter than they were a few years ago, partly reflecting APRA's earlier supervisory measures to help contain the build-up of risk in household balance sheets. There is competition for borrowers of high credit quality. 

The low level of interest rates is continuing to support the Australian economy. Further progress in reducing unemployment and having inflation return to target is expected, although this progress is likely to be gradual. Taking account of the available information, the Board judged that holding the stance of monetary policy unchanged at this meeting would be consistent with sustainable growth in the economy and achieving the inflation target over time. 

1: Why does the RBA takes into account the domestic (Australian) and global

(China, Japan, and USA) macroeconomic indicators (GDP growth rate, investment, household consumption, inflation, unemployment, and exchange rate) when making a decision whether to change (increase or decrease) or keep the official cash rate unchanged? Explain.

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

3: On 7-August-2018, the Governor of the RBA, Dr Philip Lowe, decided to leave the official cash rate unchanged at 1.50 percent as house prices continue to fall. Why did the RBA keep the cash rate unchanged for the last 2 years? Justify your answer with reasons and evidence. (Note: information found in detail monthly minutes of RBA) https://www.rba.gov.au/monetary-policy/rba-board-minutes/2018/

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, GDP, inflation and housing market. Describe the circumstances in which the RBA Board might increase 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 August 2018) sustainable to achieve long-run economic growth? Yes/No, justify your answer with reasons. Note: Students need to give their own views supported and justified by several references and examples. 

Conclusion: Provide an overarching conclusion to the case.

Importance of Domestic and Global Macroeconomic Indicators for RBA Monetary Policy

This report is designed for developing practical knowledge about different concepts and terminologies related to macro-economics. This report is mainly based on the case study article of RBA decision 7th August 2018. As per the analysis of this case study, the board of RBA has organized meeting of its members for 11 times in a year at the location of Martin place in Sydney. Earlier to the meeting, the members of this board were provided the data related to analysis of financial markets and economy of Australia. Example of these data includes the facts related to future inflation forecasts and the potential path of economic growth for domestic as well as the overseas concerns. Different decisions taken under monetary policy of the country are totally based on wide range of macro-economic assumptions. As per analysis of this article, a consensus was approached by the RBA staff to leave the interest rate as it is or unchanged (i.e. 1.5%). RBA takes into account different instruments for taking any decision like cash rate.

There are different objectives of this report. It will help to understand reasons, due to which RBA takes into consideration the global and domestic macroeconomic factors for taking economic decisions like ascertainment of cash rate. The report is also aimed to provide explanation of different objectives of monetary policy. Further, the report will focus on analysing reasons due to which the Governor of RBA decided to keep the official cash rate unchanged at the level of 1.50% in last 2 years. Final section of this report will define economic growth and will elaborate the determinants of long run economic growth. It will also help to know whether consistent cash rate of 1.5% can help to achieve long term economic growth or not.

Macroeconomics can be defined as the area of study that takes into account the study of various economic performance indicators like GDP, unemployment, inflation, national income, money supply etc (Kaplan & Gungor, 2017). Inflation can be defined as the level of pricing in an economy. In other words, the inflation can explained as the rate, with which the general level of pricing for different products and services is increasing in a country. The current level of inflation can significantly affect the decision of central bank like RBA in context of cash rate determination. If the inflation rate of country is high and it is adversely affect interest of overall economy, the RBA will take decision of declining the cash rate (Ali et al., 2015). Due to decline in cash rate, the demand for liquidity or cash will decline in the money market. This way, demand for money will reduce against the supply of money. This will ultimately help to control and reduce inflation rate.

Main Objectives of Monetary Policy and Functions of Money and RBA

Money Supply is also a major factor that is taken into consideration by the RBA while determining appropriate decision for changing the cash rate. It is so because the high level of money supply also affects the purchasing power of currency. If the money supply in market is high, then RBA decides to increase the cash rate for controlling supplying of money in market (Kaplan & Gungor, 2017). The example of global macro economic indicator that is taken into account for determination of cash rate is the foreign exchange rate. Large reserves of foreign exchanges are kept by the countries for achievement of stable value of their currency against foreign currency like USD.

Monetary policy can be defined as the macroeconomic policy that is designed by central bank of a country for management of money supply in the country. Main objective behind formation of monetary policy is to improve supply and demand of in economy and also to improve economic growth rate in country. There are two types of monetary policy such as expansionary monetary policy and the contractionary monetary policy (Lin & Cheng, 2016). Under expansionary monetary policy, the central bank focuses on declining interest rate in order to increase supply of money. In contrast to this, the central bank of a country like Australia decides to increase interest rate in order to control or reduce supply of money in economy.

One of the major objectives of monetary policy is to control or manage the inflation rate in country. Expansionary monetary policy can lead to increase in inflation rate. It is so because due to increased supply of money or cash in economy, the value of money in terms of purchasing power reduces. In contrast to this, contractionary monetary policy leads to decline in level of inflation rate as a result of declined flow of cash or money in the economy. Another objective of monetary policy is to reduce unemployment level in country (Smets, 2014). This is done through expansionary monetary policy. Through reduction in interest rate, the central bank tries to facilitate bank finance at lower interest rate. Due to this decision, the investments in corporate sector increases in the economy in different sectors. This ultimately leads to increase in new job opportunities in economy. This way, the unemployment problem is addressed in economy through monetary policy.

According to different economists like Robertson, Hayek and Wicksteed, the objective of monetary policy is also to achieve the neutrality of money in country. This neutrality is often required in order to achieve stability in different economic measures like inflation, and the price level. Neutrality stands for stability in the flow of money in the country (Lin & Cheng, 2016). With the achievement of monetary neutrality, the central bank of a country can ensure that no any situations of deflation or inflation, trade cycles and the economic fluctuations occur in the economy with the passage of time.

Reasons for Keeping Cash Rate Unchanged for the Last 2 Years

It is also a major objective of monetary policy to achieve exchange rate stability in economy. Under gold standard, this was the core objective of monetary policy in different countries across globe. For example, the central bank of country like Australia takes into account the corrective measures, whenever it faces any disequilibrium in the balance of payment in country (Smets, 2014). According to Gold standard, the central bank decides to purchase or sell the Gold in international market in order to control the exchange rate in economy.

RBA has decided to keep the cash rate unchanged at historical low level of 1.5%, because of favourable economic performance of the Australian economy. For example, the positive changes have been evidenced in terms of decline in unemployment level in country. For example, the current level of unemployment is recorded below 5.5% in 2018. In contrast to this, the unemployment rate was 11.2% in 1992. This means, the RBA decision to keep interest rate at low level has provided benefits in the form of improvement in unemployment rate in country. Similar to this, the positive results have been seen in terms of economic growth of country. For example, total annual GDP of Australia was 323,723 million $ in 1991 that increased to $1.26546 trillion in 2017. This result is associated with declining rate of interest in the country. In this context, the lower level of cash rate or interest rate in the interest of economic growth of Australia (RBA, 2018). The consistency in keeping the interest at lowest level of 1.5% will help the government to reduce unemployment level, enhance real GDP and to keep inflation level under control. This way, it would be helpful to support goal of long run economic growth for the Australian economy.

Money Market Equilibrium Model:

Money market can be defined as the market, where interaction takes place among different entities or institutions. In other words, the market is the marketplace, where the trading of financial instruments with short maturity and high level of liquidity takes place (Parlatore, 2016). Money market equilibrium can be defined as the situation or interest rate, in which quantity of money supplied equals to the quantity of money demanded. Following diagram is helpful to understand the money market equilibrium model and its application on Australian economy:

                                                           

Illustrating Monetary Policy Effects with Money Market Equilibrium Model

                                                                                                            (Source: UMN, 2018)

In the above chart, red line is supply curve. At the same time, blue line denotes the demand curve in money market. In this diagram, the point at which demand curve is intersecting supply curve is the situation of money market equilibrium. “r” is the rate of interest, at which this equilibrium is achieved. At the same time, “M” denotes the level of stock of money. This mechanism is quite helpful to achieve or keep the inflation rate within target level. If the RBA decides to increase cash rate from 1.5% to 2%, then its impact will be visible on the inflation rate of country. Due to increase in cash rate (or interest rate) the demand for money will decrease in the money market (UMN, 2018). This situation will lead to decline in inflation rate of Australia. This will also have a negative impact on the GDP or economic growth of country. In the same manner, there will be negative effect of increase in cash rate on the household consumption and business investments. In context of housing market, the increase in interest rate will lead to decline in the demand for properties and homes. Due to this decline in demand, the price level of property market will decline. This will indirectly lead to reduction in inflation level.

In contrast to this, if the interest rate (or cash rate in Australia) declines from 1.5% to 1%, than demand for money will increase against the supply of money. Due to higher level of demand for money as compared to level of supply of money, the inflation rate in the country will increase. At the same time, a hike will be seen in business investments and household consumption. A positive influence will be seen of all this on the GDP and economic growth of country (UMN, 2018). In context of household market, the demand for properties and homes will increase. Due to increased market demand, the hike will be seen in pricing of property market.

Monetary Transmission Mechanism:

Monetary transmission mechanism can be defined as the process through monetary policy decisions affect the economic conditions in country, price of different assets and market expectations. Following diagram is helpful to understand the money transmission mechanism process:

Determinants of Long-Run Economic Growth and Assessment of Sustainable Interest Rates

                                                   

                                                                                                   (Source: ECB, 2018)

As per the above diagram, whenever any change is introduced in the cash rate or interest rate under monetary policy, it will affect price level in long process. For example, increase in interest will affect expectations of individuals as well as corporate entities in market. It will lead to increase in money market interest rate. The impact of this increase will be seen on money credit, asset price, bank rates and the exchange rate in country. The increase in interest rate will lead to emergence of expectation of people for higher wages and higher price setting. This all will influence the price level for both import price and domestic price in country. This all will lead to increase in price development or inflation rate. Based on the application of money transmission mechanism, increase in cash rate from 1.5% to 2% will lead to decline in inflation rate and household consumption, demand for property market, and business investment (ECB, 2018). This will result into decline in the economic growth rate and GDP level of country. Similar to this, the decline in cash/ interest rate from 1.5% to 1% will lead to increase in demand for property market, business investments, and household consumption. This will affect the inflation rate in country positively (i.e. hike in inflation rate).

There are different circumstances, in which RBA should increase the cash rate. Example of these situations includes increase in the inflation rate in country, increase in situations of NPA in banking sector etc. The cash rate should also be increased by the RBA, when demand for cash in the market is increasing at very fast rate and it becomes very difficult for the banks and financial institutions to fulfil demand (Laubach & Williams, 2016). It is so because the extra ordinary demand for cash in the form of different types of loans can negatively affect the economic situations of country.

Economic growth can be defined as the increase in total market value of products and services produced in a country after adjustment of inflation effect over a period of time (Poghosyan, 2014). In other words, the economic growth is measured in terms of percentage increase in the real GDP (gross domestic product) of country. Following are different determinants of long run economic growth of a country:

Conclusion

Growth of Productivity:

In simple words, the growth of productivity can be measured by determination of ratio of economic output to inputs. Example of inputs includes services, material, energy, labour and the capital. The cost of goods gets declined with the increase in productivity in an economy. If the products and services are prices at lower rate, then it will result into increased demand of the service or products (Owen, 2017). In this context, the increase in market demand for product would lead to increase in revenue.

Demographic Changes:

The change in demographic factors also influences the economic growth of an economy in long run. Example of demographic factors includes the employment to population ratio. The economic growth of a country can be anticipated to grow with the increase in employment to population ratio (Poghosyan, 2014). Similar to this, the age factor of population of country also affects the employment status and long term economic growth.

Labour Force Participation:

There is positive correlation between economic growth of the country and total number of labour force participation. Labour force participation stands for the total number of workers available and working in the economy (Owen, 2017). It is generally seen across different countries of globe that the value of labour force participation is quite high in nations with higher value of industrialization and development.

Technological Progress:

The technological progress has a direct and positive relation with the economic growth. In other words, the country with availability of technological advancements will have higher economic growth rate as compared to countries with lack of technological support. For example, 40-50% of total GDP growth rate in United States is mainly caused due to technological progress (Poghosyan, 2014). Following diagram is helpful to understand the effect of technological progress on economic growth:

                                                           

                                                                                                   (Source: Lumen, 2018)

On the basis of above diagram, it can be analyzed that improvement in technology leads to increase in production and the production possibility frontier shifts outward. This results into increase in economic growth of country.

Government Activity:

The government activities or decisions also influence the long run economic growth of a country. The government activities are visible in different types of actions or decisions like investment decisions, monetary and the fiscal policies. If a government invests in different infrastructure projects like highway projects, new railway projects, preventive health care projects, production and education projects, the impact of such decisions is often visible on long run economic growth of country in favourable manner. The government also takes decisions like expansionary and contractionary policies. These policies also have impact on the economic growth of countries. The expansionary monetary policy has the positive impact on economic growth (Stiglitz & Rosengard, 2015). At the same time, contractionary monetary policy impacts economic growth of country in negative manner. Government takes different decisions under fiscal policy like economic regulations, government spending decisions and tax structure or tax rate. These decisions also impact the economic growth of country.

Following diagram is helpful to understand the historical changes in interest rate in Australia:

                                                       

                                                                                                              (Source: FT, 2018)

Value of foreign exchange rate against USD from 2014 to 2018 is shown in following diagram:

                                                     

                                                                                                         (FT, 2018)

Diagram showing historical inflation rate in Australia is below:

                                                       

                                                                                                        (Source: Jericho, 2018)

Following diagram is helpful to understand the historical GDP performance of economy of Australia (all amounts in billion USD):

                                                           

                                                                                                           (Source: Trading Economics, 2018)

Following diagram is helpful to understand the change in annual GDP growth rate of Australia:

                                                                 

                                                                                                        (Source: Trading Economics, 2018)

From the analysis above graphs, it can be said that the consistent the decision of RBA to keep the interest rate at historical low level of 1.5% would contribute positively towards the long run economic growth of Australia. For example, the interest rate of Australia was 17.5% in 1990 that has consistently declined to 1.5%. At the same time, the graphs are showing consistent improvement in economic growth of Australia in terms of GDP and annual GDP growth rate from 1990 to 2018. In this context, the economic growth of country can be expected to grow in coming time period (Ferrero, 2015). It is also anticipated that low level of interest rate in country will make availability of bank loan at lower interest rate. Due to this factor, the investment in corporate sector will increase. This will contribute in increase in overall output in the country. This will lead to economic growth of the country.

Conclusion

On the basis of above analysis, it can be concluded that cash rate or interest rate of Australia is at historical low level. The lower interest rate is quite effective to boost the investment in country and to overcome issue of unemployment in nation. It is analyzed from the report, that there are different determinants of long term economic growth in a country. Example of these determinants includes government activity, technological progress, labour force participation, demographic changes and the growth of productivity. The adoption of low cash rate has proved to be very beneficial for economy of Australia for achieving economic growth and overcoming the unemployment issue in country.

References

Ali, T.M., Mahmood, M.T. & Bashir, T. (2015). Impact of interest rate, inflation and money supply on exchange rate volatility in Pakistan. World Applied Sciences Journal, 33(4), 620-630.

ECB (2018) Transmission mechanism of monetary policy. Retrieved from: https://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html

Ferrero, A. (2015). House price booms, current account deficits, and low interest rates. Journal of Money, Credit and Banking, 47(S1), 261-293.

FT (2018) Australia cuts interest rates to record low 1.5%. Retrieved from: https://www.ft.com/content/60fa07c6-5878-11e6-9f70-badea1b336d4

Jericho, G. (2018) Housing affordability: Interest rates are lower than ever. So why is owning a home harder than ever?. Retrieved from: https://www.theguardian.com/business/grogonomics/2018/jun/05/interest-rates-are-lower-than-ever-so-why-is-owning-a-home-harder-than-ever

Kaplan, F. & Gungor, S. (2017). The Relationship Between Money Supply, Interest Rate and Inflation Rate: an Endogeneity-Exogeneity Approach. European Scientific Journal, ESJ, 13(1), 22-40.

Laubach, T. & Williams, J.C. (2016). Measuring the natural rate of interest redux. Business Economics, 51(2), 57-67.

Lin, W. & Cheng, Y. (2016). The Bank Credit Transmission Channel of Monetary Policy in Australia. International Journal of Financial Economics, 5(2), 61-65.

Lumen (2018) Determinants of Long-Run Growth. Retrieved from: https://courses.lumenlearning.com/boundless-economics/chapter/long-run-growth/

Owen, P.D. (2017). Evaluating ingenious instruments for fundamental determinants of long-run economic growth and development. Econometrics, 5(3), 38-50.

Parlatore, C. (2016). Fragility in money market funds: Sponsor support and regulation. Journal of Financial Economics, 121(3), 595-623.

Poghosyan, T. (2014). Long-run and short-run determinants of sovereign bond yields in advanced economies. Economic Systems, 38(1), 100-114.

RBA (2018) Minutes of the Monetary Policy Meeting of the Reserve Bank Board. Retrieved from: https://www.rba.gov.au/monetary-policy/rba-board-minutes/2018/2018-06-05.html

Smets, F. (2014). Financial stability and monetary policy: How closely interlinked?. International Journal of Central Banking, 10(2), 263-300.

Stiglitz, J.E. & Rosengard, J.K. (2015). Economics of the public sector: Fourth international student edition. USA: WW Norton & Company.

Trading Economics (2018) Australia GDP 1960-2018. Retrieved from: https://tradingeconomics.com/australia/gdp

Trading Economics (2018) Australia GDP Annual Growth Rate 1960-2018. Retrieved from: https://tradingeconomics.com/australia/gdp-growth-annual

UMN (2018) Principles of Economics. Retrieved from: https://open.lib.umn.edu/principleseconomics/chapter/25-2-demand-supply-and-equilibrium-in-the-money-market/

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