ECON1020 Introductory Macroeconomics

What is monetary policy?

The role of the reserve bank of Australia is to maintain a stable economic environment within the country. The bank formulates monetary and fiscal policies aimed at maintaining stability and fostering a stable financial system. Monetary policies consist of decisions and actions that ensure that money supply in the economy match growth and price goals of the government (Parliament of Australia, 2017). The major objective of monetary policies is the maintenance of price stability by keeping inflation levels low and stable. These decisions include setting interest rates of loans in the money market so the behavior of borrowers and lenders is affected. Monetary policies are used in controlling levels of unemployment since the objective of government is to achieve full employment within the country. Successful implementation of monetary policies also enhance economic prosperity and welfare among citizens.

Tools of Monetary policy

There exist many several tools that the Australian reserve bank can use in implementing monetary policies in order to counter fluctuations in the financial market and influence levels of inflation.  These tools can be used in isolation or complimentarily with each other or even with fiscal policies. Fiscal policies influence the level of taxes and government expenditure in the country while trying to maintain a stable level of inflation. The reserve bank sets a cash rate that controls lending rates and deposit rates in the country. The inflation target is also used to hold inflation rates between 2 and 3 percent (Reserve Bank of Australia, 2018).

Open market operations is a common strategy used by the reserve bank of Australia in controlling inflation levels.  It includes purchasing and selling of government securities which have an effect of regulating money supply and loan conditions. When reserve bank purchases securities from the open market, commercial banks reserves increase hence enhancing the money available for them to lend and resultantly increasing money supply in the economy. When inflation levels are high, the reserve bank might sell risk free government securities that promise interest in future. This reduces the amount of money supply in the economy hence reducing inflation. The major methods used by the reserve bank in fulfilling open market operations are repurchase agreements (Repos), reverse repurchase agreements, term Auction Deposits, and horizontal Repos. Repos involves sale of government securities to commercial banks to reduce commercial bank deposits kept in the reserve bank. Reverse Repos occurs in the opposite direction with reserve bank purchasing securities from the commercial banks.

The reserve bank can also control reserve requirements for commercial banks. Commercial banks deposit a specified portion of their money with the reserve bank. This amount known as the cash reserve ratio is used by the reserve bank in adjusting the amount of money in circulation. Increasing the cash reserve ratio reduces money supply while reducing it increases money supply in the economy (Tim & Gianni , 2017). The deposits are kept at the reserve bank without interest. The reserve bank can also use discount window operations to control the amount of money in circulation in the economy. It being the lender at last resort offers loans to commercial banks at an interest rate greater than the reserve bank requirement. The penal rate discourages commercial banks from unnecessarily borrowing funds from the central bank instead of borrowing from the market.

Effects of Monetary Policies

The effects of monetary policies on the Australian economy are significant. Atkin & La Cava (2017) highlighted that, reduction of cash rate by the reserve bank makes interest rates to fall and thus stimulating higher spending. Firms respond to this phenomenon by increasing production which has an effect of increasing economic activity and employment. However, it is worth noting that, a strong increase in demand might push prices up and resultantly raising inflation levels. The Australian reserve bank also reported that, a reduction of the cash rate by 100 basis points raises gross domestic product. Also, the effect of changes in the cash rate might lead to a significant effect on economic activity and inflation between one to two years later.

Monetary policies have implications on the levels of unemployment in Australia. The pattern of the Australian Phillips curve had flattened in 2017 (Central Bank of Australia, 2017). The Philip curve theory states that unemployment is inversely proportional to inflation such that deflationary monetary policies increases levels of unemployment while expansionary monetary policies reduces unemployment. There was a decline in unemployment in 2017 when reserve bank implemented deflationary monetary policies. Wages were also reported to have increased during the period.

Increasing interest rates as a monetary policy in Australia might have an impact of attracting foreign-direct investment by making domestic assets more attractive compared to foreign assets. In 2015, Australian foreign-direct investment was reported to be at $735.5 billion an increase from the previous year (Department of Foreign Investment and Trade, 2016). The high foreign-direct investment majorly by American, Japanese, and United Kingdom investors was associated to the stable business environment in the country. Stability in economic environment resulted from stable inflation levels, stable political environment, and cheaper investment loans.

References

Central Bank of Australia, 2017. Labour and Monetary Policy. [Online]
Available at: https://www.rba.gov.au/speeches/2017/pdf/sp-gov-2017-07-26.pdf
[Accessed 4 October 2018].

Department of Foreign Investment and Trade, 2016. Trade and Investment at a Glance. [Online]
Available at: https://dfat.gov.au/about-us/publications/trade-investment/trade-at-a-glance/trade-investment-at-a-glance-2016/Pages/foreign-direct-investment.aspx
[Accessed 4 October 2018].

Parliament of Australia, 2017. Publications. [Online]
Available at: https://www.aph.gov.au/binaries/library/pubs/rp/1994-95/95rp33.pdf
[Accessed 4 October 2018].

Reserve Bank of Australia, 2018. Monetary Policy. [Online]
Available at: https://www.rba.gov.au/monetary-policy/
[Accessed 4 October 2018].

Tim , A. & Gianni , L. C., 2017. Publications. [Online]
Available at: https://www.rba.gov.au/publications/bulletin/2017/sep/pdf/bu-0917-1-the-transmission-of-monetary-policy-how-does-it-work.pdf
[Accessed 4 October 2018].