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.
1: Role of Domestic and Global Macroeconomic Indicators in Determination of Cash Rate
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.
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.
2: Main Objectives of Monetary Policy
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.
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.
3: Reasons behind Keeping Cash Rate Unchanged
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.
4: Money Market Equilibrium Model and Monetary Transmission Mechanism
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:
(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:
(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.
5: Determinants of long-run Economic Growth
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:
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.
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.
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.
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.
Justification of Historical Interest Rate of 1.5% until August 2018:
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:
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.
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.
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