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ECON11026 Principles Of Economics Method

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Question:

Question 1: Explain the main objectives of monetary policy. List and describe the key functions of money and the Reserve Bank of Australia.
 
Question 2: 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.
 
Question 3: 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. 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.
 
 

Answer:

Introduction 

The paper prepares a case study on current state of Australian economy with particular focus on monetary policy decision of Reserve Bank of Australia. The monetary policy decision of RBA based on analysis of overall macroeconomic environment of Australia with special attention given on achieving stable growth and price level. After a number of adjustment in the official cash rate RBA has kept the interest rate fixed at 1.50 percent since August 2016 to December 2018. At the last meeting of RBA held on December 4, 2018 RBA has announced its decision to leave cash rate at 1.50 percent. The decision has been influenced by both domestic and global economic condition. There is continuous expansion of global economy with most of the advanced economy maintaining a relatively low unemployment rate. The ongoing trade tension has shown some signs of economic tensions. The current state of financial market in most of the advanced economies has been tightened somewhat. There is a slight decline in equality price along with a higher credit spread. As against the global economic condition, the economy of Australia is performing quite well. Currently, the economy is growing at an average rate of 3.5 percent. The slow growth resource export is expected to slow down growth in 2020. The domestic price level has remained stable along with a positive outlook for labor market. The condition of housing market also remains relatively stable. Housing market of Australia is receiving continuous support from the low interest rate.

Objective of monetary policy 

Definition: Monetary policy is defined as a macroeconomic policy that is designed by central bank of a nation.

Assumption: The monetary policy is assumed to be a demand sided policy that works through the instrument of money supply and interest rate and helps the economy to attain macroeconomic objectives such as price level stability, consumption, economic growth and liquidity.

Analysis: The main objective of monetary policy is to keep inflation rate within the stable targeted rate. Primary objectives of monetary policy are briefly discussed below.

Stability in price

One of the primary objectives of monetary policy is to maintain a stability in domestic price level. The central bank adjusts supply of money to keep the price level stable. During high inflationary pressure, the central bank takes tight monetary policy through raising interest rate (Gali, 2018). During deflation central bank takes expansionary monetary policy in terms of lowering the interest rate.

Stability in exchange rate

In addition to marinating stability in domestic price level, monetary policy also plays an important role in maintaining stability in exchange rate. Central bank uses foreign exchange reserve to maintain stability in relative price of currency. The policy of devaluation or evaluation are used to keep stability in the external sector.

Neutrality of money

Another priority of monetary policy is maintaining neutrality of money. The neutrality of money refers to the assumption that fluctuation in money supply does not affect real variables in an economy. By keeping money neutral, the economy can be protected from economic fluctuation and volatility in the price level.

Economic growth

Achieving a stable economic growth is one objective of monetary policy. Using monetary policy, a balance can be maintained between money demand and productive capacity. By boosting saving and investment, monetary policy contributes to attain steady growth in the economy (English, López-Salido & Tetlow, 2015)

Full employment

Along with stability in economic growth and price level monetary policy also works in favor of the attaining full employment in the economy.

 

Functions of money 

Definition: Economists define money as something that can be served as a medium of exchange, unit of account and store of value (Goodwin et al., 2015).

Assumption: Money is assumed to be a common denominator of all financial and economic transaction. Economist assume money to be a good basis for accounting economic activity.

Analysis:  The primary functions of money are medium of exchange, unit of account and store of value.

Medium of exchange

Money is used as a universally accepted medium of exchange. Money facilitates exchange in an economy and works as a common measure of exchange.

Unit of account

The worth of goods and services are accounted in terms of standard monetary unit.

Store of value

Money can be retained for a considerable long period for making future transaction. Money is considered as a convenient measure of storing wealth (Agénor & Montiel, 2015)

Other functions of money include measure of value, standard unit of postponed account and a common basis of credit.

Functions of Reserve Bank of Australia 

Reserve Bank of Australia is considered as the main monetary authority of the nation. The authority performs some primary and secondary functions. The list of RBA’s primary functions are as follows.

  • The main function of RBA is to issue currency in the nation
  • Maintain stability of domestic currency
  • Achieving level of full employment
  • Taking complete care of prosperity and economic well-being for citizen of Australia.

Since the formation data, RBA targets to attain a stable price level in the economy in terms of setting a medium term inflation target. The current inflation target of RBA lies between 2 to 3 percent (rba.gov.au., 2018) The objective of inflation targeting of RBA is followed by other objectives like maintenance of overall stability in the financial system, stability in foreign exchange reserve and providing financial and other assistance to the financial institution in the domestic and overseas economy.

Money market equilibrium 

Definition: The money market refers to an economic model that describes demand and supply of money in an economy. Equilibrium in the money market occurs at the point where quantity of money supplied equals to quantity of money demanded.

Assumption:  The two important notion in the market are demand and supply of real balances. Following the theory of liquidity preference theory, the supply of money in the economy is assumed to be fixed and is determined by the central bank (Uribe & Schmitt-Grohé, 2017) The supply of real money balance was given as

The theory of liquidity preference further assumes that money demand is inversely related with interest rate and hence, money demand curve slopes downward. The demand for money is given as

The equilibrium in the money market is given as

In figure 1, the vertical line shows supply of real money balance. The downward sloping curve shows demand for real money balance. Equilibrium in the money market occurs where money demand curve intersects money supply curve. Corresponding to the equilibrium, interest rate in the money market is obtained as r*. The conduct of monetary policy alters money market equilibrium and associated interest rate through altering money supply (Heijdra, 2017). The changes in money market equilibrium affects economy activity through monetary transmission mechanism.

 

Monetary Transmission mechanism 

Definition: Monetary transmission mechanism signifies the process through which monetary policy affects asset prices and general economic condition. In the context of the case study, monetary transmission mechanism signifies how changes in cash rate by RBA influences economic activity in general.

Assumption: There are four channels through which cash rate influences level of economic activity. These are as follows-

Saving and investment channel

A lower cash rate means smaller return on saving. This encourage household to spend more and increases aggregate demand. Lower cash rate also implies lower cost of borrowing. This in turn increases investment. Reverse is the case in times of increase in cash rate. Saving increase and investment declines resulting in a smaller aggregate demand.

Cash flow channel

When there is a decline in cash rate then borrowers have to give a lower repayment to their loans. This raise their spending. Lenders on the other hand suffers because of lower return for the fund they have lent (Johnson, 2017). RBA however assumes the former effect dominates and hence, lower cash rate increases aggregate demand.

Asset prices and wealth channel

Smaller cash rate means lower asset prices which in turn increase household wealth. As wealth increase, household becomes more confident resulting in an increase in aggregate demand.

Exchange rate channel

Lower interest rate means lower demand for Australian dollar leading to depreciation of currency. As currency depreciates, there is an expansion of export causing economic activity to expand.

RBA raises the cash rate when rate of inflation goes beyond the targeted rate. The objective is to lower inflation pressure. When RBA increases the cash rate from 1.5 percent to 2 percent then there is a downward pressure on aggregate demand as all the four channels of monetary transmission works against it (Mankiw, 2014). As shown in figure 2, aggregate demand contracts resulting in a decline in real GDP and price level.

In contrast, when RBA further lowers cash rate from 1.5% to 1%, aggregate demand boosts due to working of four transmission channels. This helps to stimulate economic activity along with a stable price level. This is shown in figure 3.

 

Effect of domestic and global macroeconomic indicators on cash rate decision

As the objective of monetary policy is not limited to price level stability, RBA needs to consider state of the overall economy before deciding cash rate. In times of economic expansion, a tight monetary policy is preferred by increasing the cash rate (Carlin & Soskice, 2014) During economic recession expansionary monetary policy is taken by lowering the cash rate to provide necessary stimulus to economic activity.

The average growth rate in Australia in the last five years remained around 3 percent. Economic growth lowered close to 2 percent in 2015. Growth however recovered and peaked above 3 percent in the middle of 2016. Since then growth again declined. GDP growth started to increase since the middle of 2017 and reached to an average growth close to 3 percent.

As reflected from the above figure the inflation targeting policy of RBA has helped the nation to maintain inflation rate between 2 to 3 percent.

The unemployment rate in Australia has declined continuously indicating strong condition on labor market. At present, unemployment rate in Australia in around 5 percent.

The housing price index in Australia recently dropped by 1.5 percent. Decline in housing price has been contributed from a continuous decline in housing price in Sydney, Perth, Melbourne and Darwin. House prices in Canberra has increased at a relatively softer pace. The residential property price has declined by 1.9 percent.

In response to a stable economic growth, stable price level, strong labor market condition and decline in housing price RBA has decided to keep the cash rate at the lower level at 1.5 percent (Manalo, Perera & Rees, 2015) During slower economic growth in 2015, RBA has lowered the interest rate to boost economic activity.

Global economic environment 

Not only domestic but also global economic condition influences RBA’s decision regarding cash rate. Australia has maintained a good terms of relation with China, Japan and USA. Trade and financial relation of Australia with rest of the nation has created a strong interdependence between economy of Australia and others. The export sector of Australia is highly dependent on China’s economic condition (Cuaresma, Doppelhofer & Feldkircher, 2014). The recent slow-down in China’s economy possesses a threat to Australian economy. RBA thus decides to not to change the cash rate to support Australian economy in times of global tension. The financial crisis in United State during 2008 hurt Australian economy. Since then, for maintaining economic stability RBA cut the cash rate for six times. The financial condition in most of the advanced countries have tightened somewhat. In order to escape from global tightening condition, RBA needs to support the economy through an ease monetary policy. The macroeconomic environment of other advanced countries affects Australian economy both directly and indirectly (Vasnev, Skirtun & Pauwels, 2013) Trade volume is the direct economic channel. Growth of these nations implies expansion of Australian export and boosts economic activity. Given the trade and economic relation, RBA considers economic environment of other advanced nations while deciding its monetary policy.

 

Explanation for holding cash rate unchanged at 1.50 percent 

The Reserve Bank of Australia in its final meeting in 2018 has decided to keep the cash rate unchanged at 2018. With this cash rate has remained unchanged for 28 months, the longest ever period in the history of cash rate. RBA last lowered the cash rate to 1.5 percent in August 2016 followed by its earlier cut to 1.75 percent during May. The RBA’s cash rate decision is followed from domestic and global economic condition as mentioned in the monetary policy statement. In the global economy, there is growing trade tension in the international trade. Along with this China’s economic slow-down put considerable pressure on Australian economy. The financial condition in advanced countries have tightened in the late 2018. The growth of GDP in third quarter of 2018 is lower than expected. In recent years, household income has slowed down putting downward pressure on demand. The condition of labor market remains strong with unemployment remained steady at 5 percent (news.com.au., 2018) House price in Sydney and Melbourne declined by 9.68 percent and 8.29 percent respectively. Taking into consideration the domestic and global economic condition the members of monetary authority has decided that monetary policy would continue to support Australian economy (rba.gov.au., 2018) The members of RBA have decided that keeping cash rate constant is consistent with the objective of sustainable growth and maintaining inflation target over longer period.

Economic growth and long term determinant of growth 

Economic growth refers to a process of increase in production of goods and services of a nation overtime. Gross Domestic Product of a nation is the best way of measuring economic growth. GDP takes into account aggregate output of the economy.

Economic growth over longer term depends on the key determinants of productivity and GDP. Public expenditure, capital formation or level of investment and technology are some of the determinants of long term growth. Productivity growth is one main drivers of long term growth and improved living standard.

The Reserve Bank of Australia has kept the interest rate to a recorded low level of 1.5 percent. The low cash rate is supportive for sustainable growth and inflation target in Australia (rba.gov.au., 2018). The low interest rate would help the economy to tackle pressure from tightening condition in advanced countries. The major trading partners are now suffering from a low investment, low inflation and low import demand. Under such circumstance Australian economy would need protection in terms of a low cash interest rate (Yeates, 2018).  The low cash rate thus is expected to keep wage and employment growth at the targeted level along with achieving a sustainable growth in the long run.

Conclusion

The case study evaluates recent monetary policy decision of RBA. Major objectives of monetary policy are stability in price level, stable economic growth, neutrality in money, full employment and maintaining exchange rate stability. Currently, RBA has kept cash rate fixed at 1.50 percent. The cash rate decision of RBA has been influenced by both domestic and global economic condition. Economic growth in Australia is relatively stable along with a stable price and strong condition of labor market. In the international market, major economies are facing a tight condition in their financial market, China is experiencing an economic slow-down and low export growth. Considering the domestic and international economic condition the 1.5 percent cash rate is expected to secure a sustainable growth for Australia.

 

References 

Abs.gov.au. (2018). Statistics. Retrieved from https://www.abs.gov.au/browse?opendocument&ref=topBar

Agénor, P. R., & Montiel, P. J. (2015). Development macroeconomics. Princeton University Press.

Carlin, W., & Soskice, D. W. (2014). Macroeconomics: Institutions, instability, and the financial system. Oxford University Press, USA.

Carr, A. (2014). Is Australia a middle power? A systemic impact approach. Australian Journal of International Affairs, 68(1), 70-84.

Cuaresma, J. C., Doppelhofer, G., & Feldkircher, M. (2014). The determinants of economic growth in European regions. Regional Studies, 48(1), 44-67.

English, W. B., López-Salido, J. D., & Tetlow, R. J. (2015). The Federal Reserve’s framework for monetary policy: Recent changes and new questions. IMF Economic Review, 63(1), 22-70.

Gali, J. (2015). Monetary policy, inflation, and the business cycle: an introduction to the new Keynesian framework and its applications. Princeton University Press.

Goodwin, N., Harris, J. M., Nelson, J. A., Roach, B., & Torras, M. (2015). Macroeconomics in context. Routledge.

Heijdra, B. J. (2017). Foundations of modern macroeconomics. Oxford university press.

Johnson, H. G. (2017). Macroeconomics and monetary theory. Routledge.

Manalo, J., Perera, D., & Rees, D. M. (2015). Exchange rate movements and the Australian economy. Economic Modelling, 47, 53-62.

Mankiw, N. G. (2014). Principles of macroeconomics. Cengage Learning.

news.com.au. (2018). RBA keeps cash rate on hold in December. Retrieved from https://www.news.com.au/finance/economy/interest-rates/rba-keeps-cash-rate-on-hold-for-28th-month/news-story/3dcc9433b2442644cb02cbe4d17db8aa

rba.gov.au. (2018). 4 December 2018 | Minutes of the Monetary Policy Meeting of the Board. Retrieved from https://www.rba.gov.au/monetary-policy/rba-board-minutes/2018/2018-12-04.html

rba.gov.au. (2018). Cash Rate. Retrieved from https://www.rba.gov.au/statistics/cash-rate/

rba.gov.au. (2018). Functions and Objectives | Reserve Bank of Australia Annual Report – 2014 | RBA. Retrieved from https://www.rba.gov.au/publications/annual-reports/rba/2014/functions.html

rba.gov.au. (2018). Statement by Philip Lowe, Governor: Monetary Policy Decision | Media Releases. Retrieved from https://www.rba.gov.au/media-releases/2018/mr-18-31.html

Uribe, M., & Schmitt-Grohé, S. (2017). Open economy macroeconomics. Princeton University Press.

Vasnev, A., Skirtun, M., & Pauwels, L. (2013). Forecasting monetary policy decisions in Australia: A forecast combinations approach. Journal of Forecasting, 32(2), 151-166.

Yeates, C. (2018). RBA signals faster growth, fewer jobless as rates held at record low. Retrieved from https://www.smh.com.au/business/the-economy/rba-keeps-tight-rein-on-rates-on-melbourne-cup-day-20181106-p50e99.html

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