The Impact, Mechanics and the Effectiveness of the RBA Monetary Policy Decision
Predominantly, monetary policy is one of the main macroeconomic tools by which the government of a country tries to control the aggregate economy. Essentially, it is a policy that involves influencing the economy through changes in the level of money supply as well as the availability of credit. Often, this measure is directed towards the stimulation of the aggregate economy and achievement of full employment. In Australia, monetary policy formulation and implementation is the function of the Reserve Bank of Australia.
Meaning of Monetary Policy, Objectives and Functions of the RBA
Fundamentally, monetary policy is the deliberate action by the country’s government through its monetary authority to influence the volume of credit with the objective of accelerating economic growth, stabilization of prices, the creation of employment opportunities and regulating the movement of exchange rates and interest rates. More precisely, it pertains to all actions of the RBA that aim at influencing the supply of money within the Australian economy.
Objectives of Monetary Policy
It is important to note that monetary policy is implemented within the country in order achieve various objectives, among them full employment, price stability, economic growth, and stable exchange rate.
Full Employment. Monetary policy is formulated to steer the economy towards full employment. Mainly, this can be achieved through the implementation of selective credit measures that direct economic resources within the country to labor intensive sectors in the country (RBA, 2017). In addition, it may also be achieved through lowering interest rates which would reduce the cost of credit, and increase the level of investment. Consequently, this would result in an increase in the level of employment in the economy.
Achievement of Price Stability. Characteristically, this refers to the problem of controlling inflation in the economy. By and large, inflation reduces the value of money and increases the cost of living. It also reduces the incentive for people to save and may lead to the worsening of the country’s balance of payment. Thus, it is fundamental that the rate of inflation within the economy be controlled (RBA, 2017). Primarily, this goal may be achieved through the regulation of the money supply in the economy through conventional monetary policy tools such as discount rate, and minimum reserve requirements, among others.
Attain economic growth. Notably, this is a fundamental goal of the monetary policy that aims at increasing the level of a nation’s gross national product over time. In Australia, the RBA can attain this goal through the provision of investment funds in the form of cheaper credit. Sequentially, this would stimulate economic growth of the Australian economy.
Functions of the RBA
The RBA functions as the official monetary authority for the Australian economy. Thus, it is tasked with the responsibility of formulating, executing and overseeing the implementation of monetary policy within the country. It is also in charge of formulating the nation’s foreign exchange policy. In addition, it encourages liquidity, solvency and proper functioning of the nation’s financial system. Furthermore, the RBA is responsible for the supervision of commercial banks and non-bank institutions in the country to ensure proper implementation of the set policies in the country.
Another important role of the RBA is that it is charged with the responsibility of issuing the country’s legal tender in the form of currency notes and coins. Occasionally, it acts as a last resort lender for the government and commercial banks. It is also an official agent for the government charged with the obligation of issuing and underwriting government securities and bonds in the open market. Aside from that, it acts as a principal advisor and fiscal agent for both the government and commercial banks.
The Decision on the Cash Rate
In the March meeting, the RBA board made a resolution to preserve the cash rate at 1.5 percent. Notably, this decision was unanticipated, owing to the fact that the board always revises the rate to cater for the prevailing macroeconomic needs within the economy. It is worth noting that revising the official rate may help in controlling the level of inflation and stimulate the economy towards the desired path. Often, the board lowers the cash rate when the economy is in stagnated in order to stimulate the aggregate economy. In contrast, it raises the cash rate to reduce the level of economic activity when there is excessive growth.
Money Market Equilibrium Model
Essentially, the market operates at equilibrium when the demand and supply for money are equal. Thus, fluctuations in the cash rate would create a disturbance that would sway the market from the equilibrium point. More precisely, a decrease in the official rate would result in a drop in the rate of interest charged to commercial banks by the central bank. Sequentially, this would reduce the interest on loans charged by commercial banks to its customers. Thus, the overall cost of credit in the economy would drop. Consequently, more people would borrow from banks. In turn, this would raise the level of money supply in the country. As such, the money supply curve would shift to the right.
In Keynesian economics, the money demand is dependent on the level of income and interest rate. There is a positive link between money demand and income. In contrast, there is an inverse relationship between demand for interest rates and money. Thus, the reduction of official rate would lower interest rates in the economy, thereby causing an increase in demand for money. This would create an increase in the amount of money held by the public. In turn, this would lead to an increase in their demand for goods and services in the economy. Hence, this raises the aggregate demand, thereby leading to an increase in economic growth. In the same manner, an increased demand exerts pressure on prices in the economy, thereby pushing them upwards. Accordingly, this results in inflationary pressures within the economy.
Monetary Policy Transmission Mechanism
Fundamentally, this theory suggests that there is a significant link between changes in the official rate and inflation and economic growth in the country. The model proposes that the effects of changes in the cash rate on these two variables occur in stages. Typically, the first stage involves the making of the decision to change the cash rate. By and large, this decision then affects the market rates, assets, expectations of individuals and firms, and the exchange rates in the country. After that, the reduction in the official rate influences the market prices in the goods market, thereby causing an increase in the domestic demand. Following its impact on the exchange rate, a lower cash rate would result in an increase in external demand for goods and services. Sequentially, this causes a growth in the overall demand. Growth in total demand in the nation then leads to the development of domestic inflationary pressures, which when coupled with hikes in import prices results in inflation in the economy.
The monetary policy transmission mechanism
Unlike previous years where the RBA board adjusted the cash rate, this year it opted to keep the cash rate at the same point as the previous year. Fundamentally, this decision was influenced by various factors in the economy. At the time the decision was made, the economy was enjoying a period of price stability following a significant reduction in the rate of inflation. Thus, the 1.5 percent official rate in the economy facilitated the inflation rate to remain quite low (RBA, 2017). Besides, maintaining the official rate at this point would facilitate the actualization of forecasts which indicate the underlying inflation in the economy would remain low. Thus, to maintain the low rate of interest, the RBA opted to maintain the cash rate constant.
Apart from that, the decision was influenced by the fact that the low-interest rates in the economy had attracted non-mining business investments in the country. There was also a rise in the level of exports from the country. The labor market outlook indicates that the rate of unemployment is expected to reduce over time. What is more, the economy is projected to maintain the slow but steady rate of growth. For this reason, the current trends alongside the projected forecasts of key macroeconomic indicators in the country forced the board to maintain the cash rate at 1.5 percent.
It is crucial to note that RBAs decision to maintain the official rate at 1.5 percent was mainly influenced by the fact that the interest rate is relatively low, and would, therefore, result in low-interest rate levels in the entire economy (Lowe, 2017). Normally, low-interest rates are associated with high rates of investments. Thus, the RBA is hopeful that the rate of investments in the country will rise, thereby raising the rate of employment and stimulate economic growth in the nation.
According to the article, the RBA considered the conditions of the housing market when deciding on the cash rate. Mainly, one can attribute this to the fact that the Australian property market has been experiencing sustained increases in the price of houses in the country. Subsequently, this has led to the housing affordability problem in the country. Thus, the low cash rate is expected to reduce the cost of borrowing for both households and investors. For households, they would be able to achieve cheap loans and mortgages, thereby helping them in achieving the dream of home ownership.
Likewise, increased access to cheap credit for investors would reduce their cost of production, thereby leading to an increased supply of houses at a lower price. In turn, this would help households afford decent homes within the country. Regardless, the government has set up measures that supervise and regulate the lending to investors in this sector. Fundamentally, these macro-prudential measures aimed at strengthening lending standards to ensure that investors who obtain low-cost credit for purposes of housing development build affordable houses for the Australian people.
Limitations of Monetary Policy
The use of monetary policy has various limitations in the economy. The most basic limitation arises from the fact that most objectives of monetary policy are conflicting. For instance, the objective of price stability and full employment are conflicting. According to the Philips curve, in order to reduce unemployment, the rate of inflation must rise slightly. Thus, this makes it difficult for the RBA to achieve the objectives of monetary policy (Pettinger, 2013).
In addition, Keynes believes that monetary policy is ineffective in stimulating the economy during depression cycles. As such, any additional efforts to stimulate the economy through increasing the money supply would be trapped in the liquidity trap, therefore fail to stimulate growth in the economy as shown below.
It is noteworthy that many economists believe that monetary rules are better than interest targeting because it provides a systematic plan for the measures that would be undertaken in order to achieve the set objectives (Jahan, n.d.). In contrast inflation targeting only involves the announcement of the medium-term numerical target of inflation without a clear and precise plan that will work towards the achievement of this goal. For this reason, monetary rules are preferred.
All in all, all factors considered the Australian economy is on the right track. More precisely, it is undergoing a period of growth, which is anticipated to continue in the near future. Investments in the country are rising, and business and consumer confidence in the economy is relatively high. Additionally, the country is experiencing a period of price stability while the rate of unemployment is gradually reducing. Thus, the economy is moving towards the right direction, characterized by economic growth, stability, and full employment.
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