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Economic Performance And Monetary Policy

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Question:

Discuss about the Economic Performance and Monetary Policy.
 
 

Answer:

Introduction:

Open market operations (OMO) is used to influence money supply by either the RBA buying or selling securities from or to the other banks. If there is a need to raise the money supply for instance when there is a need to stimulate the economy, the government buys the securities from these banks (Amadeo, 2017). This sell raises the money available for lending by this banks and thus money supply is increased. If on the other hand there is a need to lower the money supply in an economy for instance during a period of high inflation rate, the government sells securities to these banks. In the process of buying, the banks use the money that otherwise could have been used for lending. This reduces the money supply.

The reserve ratio is a tool used in the regulation of the money supply by the RBA. It does this by either increasing or reducing this ratio depending on the direction the influence on the money supply is desired. The RBA regulates other banks and does not allow them to lend every deposit they receive but instead requires them to deposit with them a proportion of these overnight deposits (Federal Reserve Bank of San Francisco, 2017). If there is a need to raise the money supply, the RBA reduces the reserve requirement ration so as to leave with the banks more funds for lending; the goal of increasing money supply is attained. Similarly, if there is a need to lower the money supply, the RBA raises the reserve ratio so that banks won’t have much funds to led; the money supply is reduced

The cash rate is another tool used by RBA in influencing the money supply. It is the interest rate at which other banks borrows from the RBA; through this rate, the RBA is able to influence the interest rate at which banks lend to their borrowers (Layton, Robinson and Tucker, 2011). If there is a need to raise the money supply, the RBA cuts its cash rate, interest rate falls and borrowing increases since borrowing costs has fallen; money supply expands. Similarly, if there is a need to lower the money supply, the RBA raises the cash rate, interest rate increase, demand for money falls and thus money supply decreases.

 

Increase in reserve ratio by the RBA lowers the money supply from MS1 to MS2. This increases the value of money from MV1 to MV2. Since there is a reduction in money availability, the demand in the economy falls and so the price level. The cost of lending money when supply is low rises; the interest rate rises.

Government’s securities purchase by RBA through OMO increases the money supply from MS1 to MS2. This decreases the value of money from MV1 to MV2. Since there is an increase in money availability, the demand in the economy rises and so the price level. The cost of lending money when supply is high falls; the interest rate falls.

Since the economy was already at full employment level YLR, the new supply level is unsustainable and the economy will fall back to the vertical LRASo but at a further lower price P1. This is because demand will remain the same but supply will be higher.

The growth of the investment on housing has been great after the recovery from the Global financial recession. The prices of housing in Australia has gone up and many people have diverted their investment to the housing market. The collapse of this market would result in many people falling in troubling situations since most of the investor had used credit money that needs to be repaid back (Zhou, 2017). Default rates will rise since the low income to be received after the fall in housing prices won’t be sufficient to cover the initial loan obligations. He also noted that there would be a fall in the aggregate demand as households cut their consumption. According to Morgan (2016), the collapse will result in an increment in the economy’s unemployment rate. Keane (2017) noted that superannuation balances would fall and also return on investments since share market will also be impacted. However, the reduction of house prices will be good news for the consumers, currently houses are unaffordable, but will be more affordable after the collapse of this market. One of the major factor behind the rising price of housing is the availability of cheap credit that has resulted in interest rate being too low. Since the RBA couldn’t discourage excessive demand by raising interest rate since the low rate is necessary for this economy to grow, the government can increase its spending on increasing the supply of houses. Morgan (2016) also recommended that government should increase the level of foreign investors to boost the supply of houses. Keane noted that interest rate could be increased individually on investment loans.

 

References

Amadeo, K. (2017). What Is Monetary Policy? Objectives, Types and Tools 6 Ways to Legally Create Money Out of Thin Air. [Online] The Balance. Available at: https://www.thebalance.com/what-is-monetary-policy-objectives-types-and-tools-3305867 [Accessed 13 May 2017].

Federal Reserve Bank of San Francisco. (2017). What effect does a change in the reserve requirement ratio have on the money supply? [Online] Available at: https://www.frbsf.org/education/publications/doctor-econ/2001/august/reserve-requirements-ratio/ [Accessed 13 May 2017].

Keane, A. (2017). A property market slump will have a wide impact, hitting the share market and super balances. [Online] Dailytelegraph.com.au. Available at: https://www.dailytelegraph.com.au/business/economy/a-property-market-slump-will-have-a-wide-impact-hitting-the-sharemarket-and-super-balances/news-story/4e446248e5274786b92923dba2b1b6af [Accessed 13 May 2017].

Layton, P., Robinson, C., & Tucker, B. (2011). Economics for today. South Melbourne, Vic: Cengage Learning.

Morgan, E. (2016). Australia headed for recession next year, Professor Steve Keen says. [Online] ABC News. Available at: https://www.abc.net.au/news/2016-07-29/australia-headed-for-recession-next-year,-professor-keen-says/7674154 [Accessed 13 May 2017].

Rittenberg, L. and Tregarthen, T. (2017). Principles of Macro Economics. [Online] FlatWorld. Available at: https://catalog.flatworldknowledge.com/bookhub/23?e=rittenmacro-ch07_s02 [Accessed 13 May 2017].

Zhou, N. (2017). Australian housing market crash could lead to broader downturn, OECD warns. [Online] the Guardian. Available at: https://www.theguardian.com/business/2017/mar/03/australian-housing-market-crash-could-lead-to-broader-downturn-oecd-warns [Accessed 13 May 2017].

ncrease in reserve ratio by the RBA lowers the money sup
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