Australia's Economic Environment: Business Cycles, Monetary Policy, and the Impact of Low Interest Rates

This project delves into the current economic environment in Australia, examining the stages of the business cycle and key economic indicators. It explores the role of monetary policy in achieving macroeconomic goals, analyzing the latest monetary policy statement from the Reserve Bank of Australia (RBA) and the factors influencing its decisions. The impact of low interest rates on the housing market, business investment, and household debt is discussed, along with the limitations of the current monetary policy. Finally, the project compares monetary rules with discretionary inflation targeting, arguing for the superiority of rules-based policy.

ECON11026 Assessment 3
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Contents
Introduction:.............................................................................................................................3
The Current Economic Environment In Australia:.............................................................4
Stages Of The Business Cycle With Important Economic Indicators:...............................5
Monetary Policy And Its Mechanism:..................................................................................11
Latest Monetary Policy Statement Of Reserve Bank Of Australia (May 2018):.............14
Factors Influencing The Current Monetary Policy............................................................15
Impact Of The Current Low-Interest Rate On The Housing Market, Business
Investment, And.....................................................................................................................16
Household Debt......................................................................................................................16
Limitations Of The Current Monetary Policy Implemented By The Rba.......................18
Reasons Why Monetary Rules Are A Better Policy Option Than Discretionary Inflation
Targeting.................................................................................................................................19
Conclusion...............................................................................................................................20
References:..............................................................................................................................21
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Introduction:
The project is about the economic environment in Australia and the business cycles in
Australia along with its economic indicators. Then there is detail explanation of
macroeconomic goals. Further, the monetary policy and its objectives have been explained.
The impact of monetary policy on Aggregate Demand has been discussed. The monetary
policy of May 2018 has been evaluated along with factors influencing the decision regarding
monetary policy. The impact of low-interest rates on the housing market, business investment
and household debt has been discussed. Finally, the limitations of the monetary policy of the
RBA and the comparison between monetary policy and discretionary inflation targeting are
done.
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The current economic environment in Australia:
Australia with its highly developed mixed market economy has a GDP of AUD$1.69 trillion
in 2017. The country is the second wealthiest nation after Switzerland in term of wealth per
adult. In terms of nominal GDP, it ranked at 10th position while in Purchasing Price Parity
(PPP) terms it was 18th. Currently, the inflation rate is 1.8% annual and Gini coefficient for
2014 (0.333). The economy of the country is dominated by its service sector which
contributes about 60 % to the country’s GDP. The public debt stands at 42.3% of its GDP in
2017. The country has been part of a number of free trade agreements with ASEAN, Chile,
Canada, South Korea, China, Japan Malaysia, New Zealand, Thailand, Singapore and the
United States. It is a member of World Trade Organisation (WTO), OECD, Group of Twenty
(G20) and Asia-Pacific Economic Cooperation (APEC). The credit rating of Australia stands
at AAA, given by all the three major rating agencies that are Standard & Poor's, Moody's and
Fitch (Australia Economy: Population, GDP, Inflation, Business, Trade, FDI, Corruption,
2018).
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Stages of the business cycle with important economic indicators:
The business cycle is the economy-wide fluctuations in economic activity. In layman’s terms,
it is rise and fall in the GDP of the country. GDP growth rate of Australia is declining which
shows sluggish economy. After growth rate peaked around July 2017 it is continuously
declining. Since 2009 the economy is in expansion phase (Amadeo, 2018). Though the
economy is seeing slow economic growth and contraction in the middle none of them means
that the economy has entered the contraction phase. The economy will continue to expand.
("Business Cycle - The 6 Different Stages of a Business Cycle", 2018) The economic
indicators will paint a better picture -
Unemployment rate:
The unemployment rate is the segment of the labor force that does not have jobs, which is
expressed in percentage. It changes the economic position in the country changes. When the
economy is in improper shape then unemployment rate is likely to be high whereas if the
economy is growing then this number will decline and be lower.
Gross Domestic Product:
The GDP of a country is the sum total of the monetary value of all the finished goods and
services which are produced in the borders of a country during the specified period. There are
four major contributors to the GDP of a country it includes private final consumption
expenditure, government final consumption expenditure, private investment and net exports
that exports fewer imports. A rise in these factors will directly increase the GDP whereas
decline will reduce the GDP. This is the reason why Keynes suggested during Great
Depression to compensate for the decline in other three economic indicators the government
should increase its expenditure. A rise in GDP shows healthy economic situation whereas
decline shows unhealthy economic situation.
House Price Index:
Hose Price Index measures the changes in the hose prices of single families across a chosen
market. This helps in measuring whether the prices of houses are rising or falling to make
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decisions regarding the purchase of a house. It shows the long-term trends of the housing
markets.
Retail Sales:
Retail sales are an aggregate measure of the sales of retail goods over a specified period. This
is calculated by data sampling which is then used for the whole country. As retail sales show
the demand for goods by the people in the country, it can be used for knowing the economic
situation of the country and financial strength of its citizens. (Kent, 2014)
Unemployment rate:
Source: ABS (Diag.-1)
The unemployment rate rose once around 2008 which is due to the Global Financial Crises or
Great Recession of 2008. But the Australian economy rose back and the unemployment rate
started declining again. As per the latest financial information provided by ABS, the
unemployment rate is 5.5 % for March which is a decline of 0.1 % from the previous month
of February. Though the unemployment rate is high which shows lack of economic growth
which needs to be corrected.
GDP Growth:
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Source: ABS (Diag.-2)
GDP growth rate has been constantly declining which shows slow economic growth. The
slow economic growth is not good for any country. Australia which is facing high
unemployment rate needs higher economic growth to reduce it.
House Price Index:
Source: ABS (Diag.-3)
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Housing prices after declining are rising again. This will make purchasing houses difficult for
the people. But it also shows that people are purchasing more houses which are a sign of
development.
Retail Sales
Source: ABS (Diag.-4)
Retail sales which peaked around 2014 – 2015 started falling afterward. Since 2017 there has
been an increase in the retail sale which shows the economy of the country is improving.
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Macroeconomic Goals:
The branch of economics which is concerned with economic-wide factors such as aggregate
demand and aggregate supply etc. This includes calculation of national income, deciding the
trade policy with other countries, the balance of payments and also includes the budgetary
policy of the country.
There are three basic macroeconomic goals –
Full employment
Economic growth
Economic stability
Full employment -
Full employment is a situation when all available resources (capital, labor, entrepreneurship,
and land) are being used to produce goods and services. This is calculated by using
unemployment rate of the country. It means employing the highest amount of skilled and
unskilled labor that can be employed during a given period. The remaining unemployment is
structural, voluntary or frictional and it is not considered while calculating full employment.
Full employment helps the economy to grow at its highest pace.
Economic growth -
Economic growth or GDP growth is the growth is the value of goods and services produced
in the economy, adjusted for inflation that is at real prices. This is a rise in real GDP of the
country. The growth in the economy is caused by four major factors that are a rise in private
investment, private final consumption expenditure, government final consumption
expenditure and net exports. The rise in GDP helps in solving the problem of unemployment.
GDP growth also increases per capita GDP that is it helps all the citizens of the country to
grow. This helps in improving living conditions of the people in the country.
Economic stability -
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Economic stability is a situation when the economy of a country is free from fluctuations. In
a stable economy, there will be constant output growth and stable and low inflation. This
means that business cycles are not in operation in the country. Economic stability protects the
country from extreme fluctuations. This will help the firm to protect its labor force from
employment fluctuations and will help the country to use its economic resources in the most
optimum manner.
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Monetary policy and its mechanism:
This policy is developed by central bank and other regulatory committees that decide the size
and the rate of growth of the money supply that has direct effect over interest rates. It works
by changing the interest rates, changing the reserves for commercial banks and by buying and
selling government bonds. There are two types of monetary policy expansionary and
contraction. When the money supply has to be increased than the Reserve Bank of Australia
follows expansionary monetary policy this is done at the time of recession or deflation. When
the money supply has to reduce the Reserve Bank of Australia follows contraction monetary
policy. This policy decreases the money supply in the economy it is used at th e time of
inflation. This policy aims to correct inflation and deflation by increasing or decreasing the
money supply thereby changing the level of aggregate demand.
Objectives of Monetary policy:
One of the primary reasons for using monetary policy is to maintain the stability of price. The
stability of price is important for every country. In Australia, price stability will help in
increasing economic welfare and the growth of the economy. Monetary policy works side by
side the budgetary or fiscal policy and helps in achieving full employment and balanced
economic growth. It helps the economy of the country to grow thereby helping it to reach full
employment levels. (Bank, 2018)
Impact of monetary policy on Aggregate Demand (AD):
Monetary policy can affect AD, either by increasing it or decreasing it If there is a situation
of deflation in the country that is prices of goods and services is falling and GDP is falling
then the Reserve Bank of Australia can increase the money supply by lowering the interests
and supplying more money in the economy. As the money supply raises the income of the
countrymen starts raising this ends up increasing the demand for goods and services thereby
increasing the AD. ("Impacts of Federal Reserve Policies | Boundless Economics", 2018)
(Diag.-5) On the other hand, if the there is a situation of inflation that is prices of goods and
services are rapidly rising, then the Reserve Bank of Australia can decrease the money supply
by increasing the interest rates and reducing the supply of money in the economy. This will
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reduce the supply of money and reduce the demand for goods and services in the economy.
This will reduce the level of the AD. ("AD-AS Model", 2018) (Diag.-6)
This graph shows the use of expansionary monetary policy which shifts AD to the right
Source: lumenlearning.com (Diag.-5)
After following expansionary monetary policy, the supply of money will increase in the
economy and this will shift AD to the right.
This graph shows the use of contractionary monetary policy which shifts AD to the left
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Source: macroeconomicanalysis.com (Diag.-6)
After following contraction monetary policy, the supply of money will decrease in the
economy and this will shift AD to the left.
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Latest Monetary Policy statement of Reserve Bank of Australia (May 2018):
Phillip Lowe, Governor of RBA says that the cash rate will remain unchanged at 1.5%. He
added that the global economy has become stronger in the past year and the Chinese
economy is continuously growing. Inflation has remained low and the yield of long-term
bonds has risen over the past 6 months but is still low. The growth has slowed in the past few
months but the rate of unemployment has reduced. A stronger economy will contribute to the
rise in wages over time. Inflation has been low, with CPI and inflation running marginally
below 2 per cent. Forecast says it will rise to a bit above 2%. The Australian dollar has
depreciated recently, but on the basis of trade-weighted calculation, it remains within the
range. The low-interest rates will continue to back the Australian economy. The progress in
reducing the unemployment and maintaining inflation is expected to go smoothly. The target
for the RBA was to achieve 3 % growth rate for this and next year. ("RBA says no surprises
in policy statement", 2018). There is growth in exports of coal in March quarter and
Liquefied Natural Gas (LNG). Further, after a deliberate discussion of all these topics, it was
found that maintaining the current monetary policy would be consistent with achieving
sustainable growth in the economy and attaining the inflation target. ("Statement on
Monetary Policy – May 2018 | RBA", 2018)
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Factors influencing the current monetary policy
There are a number of factors that can influence the monetary policy of Australia. These are –
Inflation
Inflation is the increase in the price of goods and services in the economy. The higher rate of
inflation causes problems to the consumers. RBA wants to keep rate of inflation in 2 – 3 %
range. If inflation is rising, then the reserve bank has to increase its official rates to control
inflation.
Unemployment rate
The unemployment rate is the rate of people who are unemployed in the economy. It is
calculated in percentage terms. If the unemployment rate is higher in the economy, then the
RBA may decide to reduce its official rates. The reduced rates will reduce the rate of credit
and will induce investment thereby reducing the level of unemployment.
Consumer Price Index (CPI)
Consumer price index is the measure of change in prices of goods and services in consumer
basket. This contains the goods and services which are regularly used. Higher price means
rising inflation which means the RBA has to increase its interest rates to control the rising
rates.
Retail sales
It measures the change in monthly retail sales which is based on information provided by the
retailers. If the retail sales show a decline this shows consumer purchase sentiments are
declining which is a sign of decline in the economy. To counter this RBA will reduce the
interest rates in the economy. ("Interest Rates - How Are They Determined?” 2018)
The factors mentioned above affect the decision making of the RBA to change the interest
rates, other factors may also contribute to change in interest rates. One or more factors may
be responsible for the change in interest rates either working together or alone. (Kramer,
2014)
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Impact of the current low-interest rate on the housing market, business investment, and
Household debt
By lowering the interest rates the RBA will lower the cost of borrowing money and increase
spending. This will lead to a rise in the AD and economic growth. Low-interest rates have an
effect on all of these by changing their demand and costs.
Housing market
As interest rates are lower, the incentive for saving money in commercial banks will be
lower. This will encourage the people to invest in more earning sources that house. It will
reduce the borrowing costs, which will encourage people to invest this low-cost credit in
areas where high returns are available that is houses. Individuals who want to buy a house
and are not able to do it because of high mortgage payments will be able to buy houses now
because of lower interest payments. As AD is rising the asset prices will be rising which
makes houses an investment-friendly bet. All of this will increase the demand for houses.
(Pettinger, 2016)
Business investment
Low-interest rates increase business spending that is an investment or in economic terms
private investment. Usually, investment decisions are made on how easily loan is available
and at what cost. F terms of the loan are favorable or interest rates are lower, then the
investors are most likely to increase their investment. Lower interest rates increase the returns
for the investors that are available after paying interest and other expenses. This extra push is
enough for most investors to start investing in a business regarding which they were
previously skeptical. So, the decision for lowering interest rates will most likely increase the
business investment. ("The Effect of Interest Rates on Investments", 2018)
Household debt
As interest will be lower which will reduce the cost of borrowing, more and more households
will be taking these low-cost loans for making purchases. This will increase AD; at the same
time, it will increase the household debt. This was particularly seen in China where because
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of lower interest rates household debt raised by a significant amount. Even in Australia
because of lower costs of debt hose hold debt is rising. (Insel, 2017)
This graph shows the use of lower interest rates due to which AD shifts to the right
Source: lumenlearning.com
After reducing the interest rates the supply of money in the economy will increase and this
will shift AD to the right.
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Limitations of the current monetary policy implemented by the RBA
The monetary policy exercised by the central bank of a country has a number of limitations as
said by the Former Deputy Governor of RBA, Philip Lowe that the interest rate policy which
one of the most important tools has over the years lost its power. There has been an
unprecedented money creation by the central banks globally. In earlier times when interest
rates were used to increase economic activity has now very low effectiveness. This is due to
the high levels of debt that already exist in many advanced economies. So even low interest
rates failed to increase expenditure and investment. People have chosen to repay their loans
rather than increasing spending. Thus, monetary policy, though an important tool has not
been that effective for solving the economic problems. (Monetary Policy’s Limitations, 2015)
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Reasons why monetary rules are a better policy option than discretionary inflation
targeting.
The rules-based Monetary policy is when instead of discretion policy decisions are taken
based on rules. It plays an active role to prevent shocks and maintain a stable economy. Rules
provide better guidance in case of crashes and prevent errors in decision making. Inflation
targeting is a process in which instead of using the traditional approach the central bank uses
targets of inflation which it has to meet. This is done by forecasting the future inflation rate
and adopting the policy to achieve that rate in a controlled manner. The reason traditional
policy is better is because inflation targeting reduces the ability of the central bank to react to
the financial crisis, it damages the outcomes in exchange rate, employment, and other
macroeconomic variables except for inflation, can cause instability in case of supply-side
shocks and it usually is not supported by general public because of inflation targets. All of
these reasons make the rules-based monetary policy better than the discretionary inflation
targeting (Jahan, 2018).
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Conclusion
After the completion of the project, it can be concluded that economic environment of
Australia which was slowing down is most likely to start growing. The unemployment is
falling. The macroeconomic goals which were discussed are central to Reserve Bank of
Australia, and the bank with its monetary policy is trying to achieve these goals. After
studying the monetary policy and its objectives it can be said that monetary policy is equally
important tools as fiscal policy is and RBA’s monetary policy will help to achieve the
economic goals for Australia.
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References:
 AD-AS Model. (2018). Retrieved from
http://macroeconomicanalysis.com/macroeconomics-wikipedia/ad-as-model/
 Amadeo, K. (2018). Where Are We in the Current Business Cycle? Retrieved from
https://www.thebalance.com/where-are-we-in-the-current-business-cycle-3305593
 Australia Economy: Population, GDP, Inflation, Business, Trade, FDI, Corruption.
(2018). Retrieved from https://www.heritage.org/index/country/australia
 Bank, E. (2018). Objective of monetary policy. Retrieved from
https://www.ecb.europa.eu/mopo/intro/objective/html/index.en.html
 Business Cycle - The 6 Different Stages of a Business Cycle. (2018). Retrieved from
https://corporatefinanceinstitute.com/resources/knowledge/economics/business-cycle/
 Impacts of Federal Reserve Policies | Boundless Economics. (2018). Retrieved from
https://courses.lumenlearning.com/boundless-economics/chapter/impacts-of-federal-
reserve-policies/
 Insel, B. (2017). THE IMPACT OF HOUSEHOLD DEBT ON THE ECONOMY.
Retrieved from https://lib.ugent.be/fulltxt/RUG01/002/351/277/RUG01-
002351277_2017_0001_AC.pdf
 Interest Rates - How Are They Determined? (2018). Retrieved from
http://www.smartsearchfinance.com.au/interest_rates.html
 Jahan, S. (2018). Finance & Development. Retrieved from
http://www.imf.org/external/pubs/ft/fandd/basics/target.htm
 Kent, C. (2014). The Business Cycle in Australia | Speeches | RBA. Retrieved from
https://www.rba.gov.au/speeches/2014/sp-ag-131114.html
 Kramer, T. (2014). Factors affecting monetary policy in Australia, 28(2).
 Monetary Policy’s Limitations. (2015). Retrieved from
http://www.fwpa.com.au/statistics-count-newsletter/667-monetary-policy-s-
limitations.html
 Pettinger, T. (2016). Effect of lower interest rates. Retrieved from
https://www.economicshelp.org/blog/3417/interest-rates/effect-of-lower-interest-
rates/
 RBA says no surprises in policy statement. (2018). Retrieved from
https://www.sbs.com.au/news/rba-says-no-surprises-in-policy-statement
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 Statement on Monetary Policy – May 2018 | RBA. (2018). Retrieved from
https://www.rba.gov.au/publications/smp/2018/may/
 The Effect of Interest Rates on Investments. (2018). Retrieved from
https://finance.zacks.com/effect-interest-rates-investments-5809.html.
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