Understanding Monetary Policy In Australia And Its Impact On The Economy

Question 1:

Describe monetary policy and its intended objectives. Discuss the functions of the Reserve Bank of Australia (RBA).

Question 2:

At the March meeting, the RBA Board decided to leave the cash rate unchanged at 1.5%. In the past, the Board had changed the cash rate. Using money market equilibrium model and the transmission mechanism, illustrate and explain how a change in cash rate might help to control inflation or stimulate the economy. Describe the circumstances in which the Board might increase and decrease the cash rate.

Question 3:

Discuss the main factors, including the current inflation rate that influenced the RBA Board’s March decision to leave the cash rate unchanged. Comment on the trends in key macroeconomic indicators mentioned in this media release. Using diagrams/graphs, support the arguments put forward by the RBA monetary policy decision.

Question 4:

The RBA Board considered the conditions of the housing market when deciding on the cash rate. Discuss the impacts of changing the cash rate on housing market participants. Why should the RBA be concerned about the rapid property price growth and investor borrowing? Comment on the supervisory measures (also known as macro-prudential measures) mentioned in the RBA media
release?

Question 5:

Discuss the limitations to conventional monetary policy and its implementation. Explain why some economists believe that monetary rules are a better policy option than discretionary inflation targeting.  

The role of Monetary Policy

It is imperative to point out that monetary policy has become an important and indispensable policy tool for decision in the contemporary world. Today, the Australian economy utilizes monetary policy to help steer the economy towards sustained economic growth. Fundamentally, the process of setting, implementing and regulating monetary policy is conducted by the country’s monetary policy. In this case, in Australia, monetary policy decisions are made by the Reserve Bank of Australia. The RBA is in charge of making all monetary policy decisions and policies in order to achieve sustainable growth along with other macroeconomic goals in the economy.  

1. Primarily, the monetary policy is a public interventionist action intended on influencing the pattern of economic activity aimed at achieving desired goals. Profoundly, it refers to all actions conducted by the government through the RBA which influences the cost, quantity, and supply of money in the country (RBA, 2017). More specifically, it works on two macroeconomic variables, which is the level of interest rate and the aggregate supply of money. In Australia, monetary policy is set and implemented in order to achieve specified economic objectives in the country, among them price stability, economic growth, full employment, and stable exchange rate (RBA, 2017).

Full employment. Imperatively, this goal pertains to raising the level of employment in the country. Mainly, this objective can be realized by encouraging the extension of credit facilities to labor intensive sectors such as mining and agriculture. Furthermore, the government can increase the rate of employment by lowering the cost of credit to encourage investments in the economy. A rise in the level of investment would result in an increase in employment opportunities in the country. Thus, this would aid in the movement towards full employment in the economy.

Price Stability. Typically, this is the problem of curbing inflation in the economy. Notably, this goal pertains to the reduction of inflation levels in the country to minimal and sustainable levels. Mainly, this goal is important because high levels of inflation have adverse effects on the economy as it raises the cost of living thereby affecting the poor in the country. It may also have a negative effect on the exports as it makes them costlier. Hence, this is a major goal of the monetary policy.

Stable exchange rate and equilibrium balance of payment. Monetary policy also aims at ensuring the stability of the country’s currency against that of other countries. Predominantly, this is because the fluctuations in capital outflows and inflows of the economy coupled with changes in the supply and demand foreign exchange in the country result in fluctuations in the balance of payments. For this reason, it has become a critical need for the RBA to ensure exchange rate stability in the foreign exchange market to avoid weakening of the balance of payments of the country.

Macroeconomic Objectives

Economic growth. Largely, this is the most fundamental goal of monetary policy. Economic growth relates to the sustained increase in the real GNP of the economy over a given period of time. Monetary policy can help in the achievement of this goal by providing investment funds through cheaper credit and mobilization of savings. In turn, an increase in investment rate in the economy would boost the economy’s aggregate demand, thereby increasing the level of economic growth in Australia.

Just like any other monetary authority, the RBA is charged with the responsibility of performing various functions within the Australian economy. Firstly, the RBA is in charge of formulating and implementing the nation’s monetary policy. Fundamentally, this function is aimed towards the achievement of economic growth and maintenance of price stability within the Australian economy. In addition to this, the RBA plays the role of ensuring solvency and liquidity in the economy through the control of money supply (Blanch, n.d.). Additionally, it is charged with the responsibility of issuing and underwriting government securities in the open market. Apart from that, it acts as a bank of the government, its adviser, and a fiscal agent.

Most importantly, the RBA serves the role of issuing the currency notes and coins that are used as fiat money within the Australian economy. It also supervises commercial banks and other non-bank financial institutions to ensure they corporate with the set monetary policy in relation to the reserve requirement, and liquidity ratios among others (Blanch, n.d.). It also functions as a last resort lender for the government and commercial banks. Besides that, it acts as a principal advisor to commercial banks and non-bank financial institutions in the country. In this regard, the RBA plays a significant role in the economy of Australia.

2. At the meeting that was held in March this year, the RBA board decided to preserve the official cash rate at 1.5 percent. This decision was unprecedented as the board often revised this rate in the past years to cater for the needs of the economy. In most cases, changing the cash rate has a significant influence on the rate of economic growth and inflation rates in the economy. Largely, this phenomenon can be explained using the market equilibrium model and the monetary policy transmission mechanism. 

In this model, a change in the official cash rate in the Australian economy would result in a variation in the supply and demand of money. The money market is at equilibrium when the demand and the supply of money are equal. Thus, when the RBA reduces the official rate, then banks can borrow from the commercial bank at a lower rate, and in turn, can lend to their customers at lower rates. Notably, this implies a reduction in the cost of credit. Therefore, the low cost of borrowing would encourage more individuals to obtain loans from the bank. Assuming that the loaned funds are redeposited in the banking system, then commercial banks are able to create more money. In turn, this increases the money supply in the economy. Thus, the money supply curve shifts to the right.

Full Employment

Imperatively, the demand for money if a function of income and interest rate. There is an inverse link between the speculative demand for money and rate of interest. Hence, at the reduced rate of interest, individuals would increase their demand. A rise in the amount of money held by individuals would result in an upsurge in their demand for consumer goods as well as assets. In turn, this would raise the aggregate demand in the economy. Consequently, this will result in an increase in the economy’s GDP, thereby influencing economic growth. Correspondingly, an increased demand would exert an upward pressure on prices, thereby creating inflationary pressures in the economy. The RBA can reduce the cash rate during economic recessions to stimulate the economy, and increase it during expansionary periods to slow the rate of economic activity in the economy.

Fundamentally, this model suggests that there is a significant relationship between fluctuations in the country’s official rate and the level of economic growth and inflation. Essentially, monetary transmission is the process through which the monetary decisions affect the economy in general, especially the price level. Predominantly, the transmission mechanism takes place on stages. The First stage involves the influence of the policy on the official interest rate, the exchange rate, expectations of individuals and firms, asset prices as well as wages in the market. In the next stage, the reduction in the cash rate influences changes in the goods market, thereby leading to an increase in aggregate demand and supply in the economy. Thus, this leads to an increase in the economic growth in the country. Afterward, it causes a rise in the price of commodities in the economy. In turn, this results in a rise in the level of inflation in the economy.

3. It is worth noting that the Board’s decision was made after a careful consideration of various factors in the Australian economy. First, the RBA considered the current macroeconomic conditions in the country and saw it fit that the economy would work best if the cash rate was maintained at 1.5 percent (RBA, 2017). Mainly, this is because the country is still adjusting after the cooling off of the mining investment boom. Additionally, the current official rate resulted in expansions in the economy by approximately 2.5 percent (RBA, 2017). The low rate of interest in the country also attracted non-mining business investments. Therefore, the RBA is hopeful that maintaining this rate would further steer the economy towards increased growth this year.

Price Stability

From the report, one can note that the country’s performance with regard to key macroeconomic indicators is healthy. More precisely, trends reveal that the rate of inflation in the country is relatively low, thereby indicating price stability in the economy. Likewise, there are improvements in the labor market conditions, thus signaling prospects for decreases in the rate of unemployment in the country. In addition, the rate of economic growth is increasing steadily. Besides that, financial institutions in the country can lend to their customers at low-interest rates, thereby reducing the cost of credit in the country. Profoundly, the RBA decision was informed by the view that a low-interest rate regime in the country would stimulate investment and eventually increase the rate of employment and economic growth in the country.

In its report, the RBA showed concern for the housing market. While prices in some regions were reducing, other areas experienced increases in the price of property. Thus, changing the cash rate would have significant impacts on the price of houses in the country. Raising the cash rate would restrict lending as the cost of capital would rise. This would mean that investors would borrow at a high cost, thereby transfer this cost to consumers in the form of higher prices. On the other hand, lowering the cash rate further would reduce the cost of borrowing. Hence property developers would be able to borrow at cheap rates. In turn, this would reduce the price of houses in the country.  

It is also worth noting that the Australian government has instigated various macro-prudential measures that aim at controlling the rate of lending to investors in the real estate sector. Profoundly, these measures contribute to the strengthening of the lending standards for investors and property developers in the country to ensure an equilibrium flow of interest-only loaning to 30 percent of total new residential mortgage financing. Accordingly, this has created strict internal limits to lending for individuals in the housing market. Predominantly, this is meant to ensure that the supply and demand for houses in the economy are kept in check.

5. It is essential to keep in mind that although monetary policy is widely accepted as a policy tool in the economy, it has various limitations. Generally, its limitations arise from the fact that most of the objectives of monetary policy are conflicting. For instance, the objective of price stability conflicts with the goal of attaining economic growth. In turn, this makes it difficult for the monetary policy to achieve its objectives effectively (Chand, n.d.). Besides that, the function of the monetary policy is largely limited by the fact that the role of monetary policy is restricted in the process of economic growth. Furthermore, the underdevelopment of the money market in Australia limits the ability of monetary policy to achieve its objectives. Many economists believe that monetary rules are better than interest targeting. Mainly, one can attribute this to the fact that monetary rules provide for a clear and concise plan that should be followed in order to attain the monetary goals (Binder & Rodrigue, 2016). On the other hand, interest targeting only specifies the target without specifying the measures that would be followed to achieve the target (Jahan, n.d.).

Conclusion

All in all, all factors considered the Australian economy is undergoing a period of slow but steady growth. The rate of inflation is relatively low, thereby projecting a period of price stability in the economy. Additionally, projections indicate that the economy is expected to experience a reduction in the level of unemployment in the future. Consumer and investors’ confidence in the economy is relatively high. Thus, the Australian economy is expected to experience a period of sustainable growth, low unemployment, and price stability in the future.  

References  

About Monetary Policy (2017). Reserve Bank of Australia.Retrieved 27 May 2017, https://www.rba.gov.au/monetary-policy/about.html.

Binder, C., & Rodrigue, A. (2016).  Monetary Rules and Targets: Finding the Best Path to Full Employment. Center on Budget and Policy Priorities. Retrieved from https://www.cbpp.org/research/full-employment/monetary-rules-and-targets-finding-the-best-path-to-full-employment.

Blanch, A. The role of the Reserve Bank of Australia. Domain. Retrieved from https://www.domain.com.au/advice/role-reserve-bank-of-australia/.

Cash Rate (2017). Reserve Bank of Australia.  Retrieved 27 May 2017, https://www.rba.gov.au/statistics/cash-rate/.

Chand, S. 7 Major Limitations of Monetary Policy in less Developed Countries. Your Article Library. Retrieved from https://www.yourarticlelibrary.com/economics/7-major-limitations-of-monetary-policy-in-less-developed-countries/11097/.

Jahan, S. Inflation Targeting: Holding the Line. International Monetary Fund. Retrieved from https://www.imf.org/external/pubs/ft/fandd/basics/target.htm.

Monetary Policy (2017). Reserve Bank of Australia.  Retrieved 27 May 2017, https://www.rba.gov.au/monetary-policy/.

The transmission mechanism of monetary policy. Bank of England.  Retrieved 27 May 2017, https://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf.