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Monetary Policy and Functions of RBA

Question:

Discuss About The Monetary As Financial Stability Regulation?

The study reflects that how change in cash rate impeoves the conditions of the economy of Australia. The objectives  of monetary policy and the functions of RBA is illustrated in relation to this change in cash rate. The importance of global macroeconomic indicators in making decision for change in cash rate set by RBA is also highlighted in this study. Global macroeconomic indicators in China and USA has been considered before setting the cash rate as the financial market of Australia is largely dependent in these two economies. Moreover, the reasons behind keeping the cash rate unchanged by RBA are also discussed in this paper.  The relation between cash rate and inflation is also discussed in this study. The effect on the consumption, GDP , inflation rate and housing marketing are also explained in this study.

The monetary policy refers to the discretionary action that has been taken by respective policymakers for influencing money supply, value of money  and availability of money (Cúrdia, and Woodford, 2014). The monetary policy adopted by the central bank of the respective countries helps in stabilizing as well as maintaining equilibrium in the system of the economy. The basic purpose of monetary policy differs from nation to nation , which includes:

  • Neutrality of money- Monetary change is the main reason behind fluctuations in the economy. It has been stated by Fiore and Tristani, (2013), monetary variation creates distortion as well as disturbances of nation economic system operation. Thus, stability in money helps in stopping fluctuations in the economy.
  • Exchange rate stability- Exchange rate stability plays a crucial role in trade. The policymakers tend to bring stability in exchange rate of a country in order to avoid violent fluctuations that results in speculative market activities (Kiyotaki and Moore, 2012).
  • Stability in price-Price stabilization repose confidence of the individual and promotes activities in business. It also helps in distributing income as well as wealth equally. Moreover, it depresses exports but encourages imports of the nation.
  • Full employment- The main aim of the Australian government is to achieve full employment with the help of increased investment. The accomplishment of full employment mainly involves exchange stability as well as prices. The beneficial effects of full employment includes-
  1. It is a vital instrument in providing economic as well as social welfare.
  2. It also aids in solving the business fluctuations problem.
  3. It facilitates government of the respective nation in solving acute unemployment problem.
  • Economic growth- Monetary policy helps to promote sustained economic growth through attainment of equilibrium between total demand for production capacity and money. Therefore, it means proper utilization of human as well as capital resources for ensuring increase in per capita income and national income.
  • Balance of Payment (BOP) equilibrium- Another objective of monetary policy is to attain equilibrium in BOP owing to the issue of international liquidity with respect to world trade growth at higher speed as compared to the world liquidity.

Adopting monetary policy –RBA implements monetary policy for stabilizing the economic growth of Australia. The decisions of monetary policy adopted by RBA involve setting rate of interest on overnight loans.

Promote financial stability- The RBA works in promoting stabilization of financial system that seeks in mitigating risk associated with financial disturbances. The central bank of Australian mainly works on this with agencies that include Council of Financial Regulators (CFR). They work together in order to increase the efficiency of regulation.

Managing foreign reserves - The RBA manages foreign currency reserves of Australia by operating in market of foreign exchange for meeting the needs of foreign exchange and assist with liquidity management.

Offering banking services – RBA also offers services of banking to the Australian government as well as foreign official organizations. These services include payments, collections, maintenance of current account and reporting. It offers facility to the government of Australia that has been used in managing bank account group  that  is well known as Official Public Account (OPA) group. The arrangements of banking involves provision of term deposit for investing of funds and access in limiting overdraft facility.

Global Macroeconomic Indicators and their Impact

Issuing banknotes – The main function of RBA is designing, producing and issuing the banknotes of Australia with the objective of providing confidence to the Australians in terms of banknotes. However, it provides effective mechanism in payment and helps the government in securing wealth of the nation.

Setting policy for payment system-RBA also functions in providing stability, competitiveness as well as  efficiency of payment system with the help of the Payment System Board. It has been stated by Fiore and Tristani, (2013), the responsibility of RBA has widened the banks focus on the system of providing high value payments that underpins stability in order to encompass commercial system in which volumes of transaction offers scope for gains.

It has been opined by Rios (2013), one nation’s spillovers can affect the financial markets of another nation that might occur the upcoming years.  The main reason behind this is that the prices of financial market highlights on the expectations of the market participants about the economic development in future. However, these expectations should be revised by the other nations immediately upon getting new information (Taussig, 2013). These spillover effects may be either direct or indirect.  Direct economic channel refers to exposure of trade where one export or import of one nation influences other nations. Trade has been considered as the global macroeconomic indicators that influences the economic performance of the nation. On the other hand, indirect channel by which other nations gets affected for the spillover of another economy is through global price level that measures inflation rate. In addition, change in inflation rate of one economy affects the financial markets of another economy.

Global macroeconomic indicators in some of the major economies includes GDP growth rate, rate of unemployment, inflation rate, rate of interest ,balance of trade and government debt to nations GDP. The central bank of Australia takes into account these indicators including their domestic indicators for making economic decision relating to the change in cash rate. This is because the cash rate affects the rate of interest of Australia that in turn affect the lenders as well as the borrowers, business activities and ultimately inflation rate in the economy. The cash rate refers to lower rate of interest at which other banks borrow and hence is considered as the benchmark rate in the nation. The term official cash rate (OCR) is used by Australia for the bank rate and is considered as the interest rate at which the RBA indicts on overnight loans to the commercial banks of this nation. Variation in official cash rate mainly influences the housing rate as well as other loans of this nation (Stein, 2012). As it influences economic activity level of the nation, RBA uses OCR as the main tool for influencing the inflation rate, money supply and monetary conditions to of Australia.

The Cash Rate and Inflation

As the development or growth of the large economies affect the financial market of other nations, RBA considers global macroeconomic indicators of China and USA for making decision regarding the setting of Official Cash Rate. The financial market of Australia with that of China and USA are directly linked to each other. Now, these global macroeconomic indicators of China and USA mainly include inflation rate, trade and GDP growth rate.  Therefore, these economic indicators reflect the economic development of these two nations that in turn hugely affects the commodities prices. However, the price level of Australian economy is mainly influenced by China and USA’s economic developments. For this reason, RBA changes the OCR by focusing on these global macroeconomic indicators in order to meet inflation target of Australia. Hence, this helps the Australian government in improving the economic condition of the country from the previous year.

The governor of RBA, Dr. Philip Lowe has decided to keep OCR unchanged at 1.50% in order to maintain stability in economic growth and achieving inflation target throughout this year. The economic conditions of this nation have shown improvement due to this low cash rate 1.50%. Moreover, economic growth in China has improved and is supported by rise in infrastructure spending as well as property construction with increase in debt level (Galí, 2015). Prices of the commodities have increased although the terms of trade in Australia has been predicted to decrease over the recent period. On the other hand, the federal reserve in US have increased rate of interest and there is no expectation that monetary easing will continue in this major economies. In addition, the financial markets functions effectively with low volatility.

Recent statistics reflects that inflation rate of Australia remains within the target rate, which is 2-3%. Economist predicts that inflation rate will increase gradually as the economic growth enhances. In addition, rise in tobacco and electricity are predicted to stimulate consumer price index (CPI) inflation (Fiore and Tristani, 2013) .  Therefore, implementation of this monetary policy will help the Australian government in stabilizing the inflation rate within the economy. It has been stated by Hamilton and Wu (2012), high exchange rate contributes to price pressure within the nation. The recent data on exchange rate value reflects that there has been appreciation of Australian dollar that partly reflects lower US dollar. This also weighs on the nation’s output as well as employment. The economist has forecasted appreciating exchange rate would be slower the activities of the economy as well as inflation rate. Even the housing market conditions have shown huge variation within the economy. In order to stabilize the housing market price and mitigate the risk associated with increasing housing indebtedness level, RBA has decided to keep OCR unchanged at 1.5%

Recent Developments in the Australian Economy

Official cash rate influences the interest rate in short run of the economy. Decrease in interest rate translates into huge availability of money for borrowing, which makes the consumers increase their expenditures. It has been noted that as consumers increase their spending, the economy grows at higher rate resulting in flow of demand for product with no variation in its supply.  Therefore, rise in demand for commodities that cannot meet with its supply leads to inflation. On the contrary, higher interest rate motivates the consumers to save in huge amount and borrow in fewer amounts (Sloman et al., 2013). However, the total money that is being circulated in market decreases. Moreover, the consumer face hurdles in purchasing goods owing to less money. Therefore, as demand becomes less than supply, increase in prices of goods stabilize or might decrease. This reflects that cash rate influences the rate of inflation in the economy.  Money market equilibrium model reflects that the demand for as well as supply of money in the economy. This framework illustrates that the demand and supply curve in respect of money reflects quantity demanded of money and quantity supplied for it at a particular interest rate. Furthermore, it has been stated by Eichhorn (2013), lower interest rate aids the people in borrowing more money and this results in increase in expenditure of the consumers. This causes the nation in higher growth that leads to increase in inflation rate. On the contrary, rising rate of interest results in decrease in expenditure of consumer that leads to increase in saving. This leads to decline in economic growth of the nation and thus creating lower inflation rate.

Over the last five years, it has been seen that GDP of Australia has been stable though it has slight fluctuations. On addition, the inflation rate also remained within the target rate while the unemployment reflects stable change with slightly higher than target rate. Even the housing market data highlights that the prices has been  stable owing to lower cash rate set by RBA. Over the years, the main objective of the RBA is to lower the official cash rate in order to improve the economic performance of the economy. In few circumstances, they have raise the raised or lowered the cash rate in order to meet the objectives and continue sustained growth in the nation.

The RBS tightens the cash rate that affects the GDP, household consumption, investment and growth in wage rate. AS RBA lowered the cash rate, growth in overall consumption of the economy remained moderate mainly in line with the nations income. In addition, non mining investment remained low as accounted by GDP share while high levels of debt of households showed a huge variation (Davis, 2013). It has noted that from the data released by Australian Bureau of Statistics (ABS) that growth in the dent if housing has outpaced slower growth rate in incomes of the households.  In order to improve the state of the Australian economy , the RBA announced supervisory measures that helped the government in mitigating the risk that are associated with high as well as increase in indebtedness levels. Therefore, it has been forecasted by RBA that economic growth of Australia will gradually rise to above 3 % over the next few years.

Conclusion

It has opined by Bös ( 2014), low rate of interest will help the nation in accelerating its economic growth. But of RBA sets the cash rate too low, then the economy might slow down. If the rate becomes close to zero, then the problems arises as the profit margins of the banks gets compressed. Therefore, the rate at which the banks earns huge on the loans lowers by this action taken by RBA. In addition, if the rate of interest is ultralow, then the profit margins on lonas are so small that it does not have real incentive in accepting the lending risk (Borio and Zhu , 2012). In that case, they keeps the money in safe assets that includes Treasury Bills that yield in higher loans. As a result, this suppresses the loan volumes in few cases in which the banks of this nation retains on books that includes commercial as well as industrial loans.

As rise or fall in cash rate influences consumption demand, GDP, price level, inflation and housing market, the main aim of RBA is to set the cash rate through monetary policy. The official cash rate (OCR) is kept on hold by the RBA when inflation rate lies within the target and hence the nation is growing at sustainable rate. In addition, as RBA motivates Australian in spending more money, they tries to keep the cash rate lower for increasing consumption demand. For example, if the confidence of consumer is low and the savings rate if taxpayers are higher, then business might suffer owing to lack of expenditure. As the cash rate becomes low, people try to buy homes and this improves the real estate market in Australia. Low interest rate cannot help in achieving long run growth in the economy. It may enhance nations’ growth during the recovery phase of economy but holding this rate for long will adversely affect economic growth. Though low interest rate boosts consumption as well as investment, it mainly reduces consumer spending by huge amount than investment. in addition, this benefits the housing market in small amount as low rate of mortgage fails to recover housing market.

Conclusion

From the above assignment, it can be concluded that cash rate that is being set by the RBA influences the economic growth of the nation. It mainly influences the inflation rate which in turn affects the economic growth. It has been seen from the data of ABS that RBA has maintained stability in inflation and GDP by keeping the cash rate moderate. Therefore, they have kept the cash rate within 1-2%. In order to stabilize the economy, they uses OCR as a tool for implementing monetary policy and keeping inflation rate low. Hence, it can been stated that RBA plays a crucial role in improving the conditions of the Australian economy.

References

Borio, C., & Zhu, H. (2012). Capital regulation, risk-taking and monetary policy: a missing link in the transmission mechanism?. Journal of Financial Stability, 8(4), 236-251.

Bös, D. (2014). Public enterprise economics: theory and application (Vol. 23). business.

Cúrdia, V., & Woodford, M. (2016). Credit frictions and optimal monetary policy. Journal of Monetary Economics, 84, 30-65.

Davis, J. B. (2013). The theory of the individual in economics: Identity and value. Routledge.

Eichhorn, W. (Ed.). (2013). Measurement in Economics: Theory and Applications of Economics Indices. Springer Science & Business Media.

Fiore, F. D., & Tristani, O. (2013). Optimal monetary policy in a model of the credit channel. The Economic Journal, 123(571), 906-931.

Frank, R. H., Bernanke, B. S., & LUI, H. K. (2015). Principles of economics. McGraw-Hill Asia.

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

Hamilton, J. D., & Wu, J. C. (2012). The effectiveness of alternative monetary policy tools in a zero lower bound management. Journal of Money, Credit and Banking, 44(s1), 3-46.

Kiyotaki, N., & Moore, J. (2012). Liquidity, business cycles, and monetary policy (No. w17934). National Bureau of Economic Research.

Mahadeva, L., & Sterne, G. (Eds.). (2012). Monetary policy frameworks in a global context. Routledge.

Rios, M. C., McConnell, C. R., & Brue, S. L. (2013). Economics: Principles, problems, and policies. McGraw-Hill.

Sloman, J., Norris, K., & Garrett, D. (2013). Principles of economics. Pearson Higher Education AU.

Stein, J. C. (2012). Monetary policy as financial stability regulation. The Quarterly Journal of Economics, 127(1), 57-95.

Taussig, F. W. (2013). Principles of economics (Vol. 2). Cosimo, Inc..

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