Deconstructing the Monetary Policy of Reserve Bank of Australia

This report analyses the current state of the Australian economy and the effects of expansionary and contractionary monetary policies. It also explains the necessity for unchanged cash rate and deconstructs the monetary policy of Reserve Bank of Australia.

Introduction 1
The State of Australian Economy: Current and Recent Past 2
The Effects of an Expansionary Monetary Policy 4
Effects of a Contractionary Monetary Policy 5
Economic Growth 6
Conclusion 6

Macro economics
Deconstructing the Monetary Policy of Reserve
Bank of Australia
The necessity for Unchanged Cash Rate
Introduction
Reserve Bank of Australia, recently, announced the cash rate (the lending rate of Reserve Bank
to the banks within the country).(Reserve Bank of Australia, 2018) (Mankiw, 2009) The decision
on cash rates in a decision based on a complex interaction of domestic and international factors,
which shall be explained in detail in this report). The current state of the Australian economy
based on reports first two quarters of 2018) seems to doing well. However, there are concerns
over the global economy which could hamper this growth period. Global economy, although
currently in expansionary mode, faces several challenges. Some of these challenges include an
impending USA-China trade war, the threat of protectionism rising strong globally leading to a
rise tariff barriers throughout the world , (Shane, 2018) growing volatility in financial markets,
both in the developed and developing world as well.(Lowe, 2018) This paper is a glance the
current economic situation of Australia , domestic and internationally as well as the possible in
order to explain the monetary policy stance of Reserve Bank of Australia to allow the cash rate to
remain the same. Further this paper discusses the economic push and pull factors that work in
favour of and against the adoption of any policy. In this scenario, the current domestic economy
is pushing the Reserve Bank to adopt higher interest rates while global uncertainty and
impending slowdown is the pull factor that may compel RBA to show restraint in raising interest
rates.
Reserve Bank and Monetary Policy
Money has four functions: (Barros, 2018) (Samuelson and Nordhaus, 2010)
● Medium of Exchange: Money is used to exchange value or goods or service, instead of
exchanging goods and services direct.
● Unit of Account or Measurement: It is used to provide a measure of abstract concept of
value. The perceived worth of any goods or service is expressed in monetary terms. For
example, the price of a book is 59 AUD which is worth the same as a weekly pass on the
Metro.
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● Store of Value: Money is a reliable and commonly accepted value. For example, if I
worked a week at Costco, I have earned a certain value of goods and services. Instead of
bartering goods and services for labour, I would accept payment in money and that would
be a store of value , which could then be exchanged for other goods and services.
● Means of Deferred Payment: Money can be used to fulfil a contract. A legitimate
currency issued by a government or Central Bank has value due to “Faith”. As a result,
instead of supplying the money’s worth of 100 dollars, I could accept the Australian
Dollar bill for 100 and place trust in the Reserve Bank Australia to provide me with the
commodities (such as gold, silver) in exchange,
The Reserve Bank, as the Central Bank of Australia, is the banker to the banks. The RBA
regulates the financial system, not just by way of issue of the legal tender of Australia but also by
setting the Monetary Policy.(Mankiw, 2009).
The Reserve Bank of Australia has an important role in the credit and monetary system of the
nation because it is:
● Lender of last resort i.e the last body in the country which can extend formal credit.
● Banker to the government as well as bank i.e it performs all the banking functions, for
banks operating within the country and the government, which would normally be
performed by an ordinary bank for an ordinary consumer.
● Foreign Exchange Reserve Custodian: It holds foreign exchange which is accrued from
exchange of Australian Dollars.
Monetary policy, in a way can be described as an effort by the Central Bank or government of a
country to use a “monetary aggregate to influence the path of nominal gross domestic product
(GDP)” The ultimate goals here are of bringing about a change in “the average rate of inflation”
and reducing the “instability of real output” (or real GDP) (Feldstein & Stock, 1993). Often this
aggregate is the “bank rate” (known as “cash rate” in Australia). Some of the other methods that
a Reserve Bank may regulate the financial system, is by purchase and sales of of Open Market
Securities, Treasury bills and other such financial instruments. (Mankiw, 2009).
The State of Australian Economy: Current and Recent Past
The Australian economy is an expansionary mode. The growth rate in 2018 is expected to remain
at 3..1 %. Australia has has nearly a decade of expansion since the global financial crisis .
Unemployment is nearly at its lowest point since Australia nearly full employment. Inflation is
steady while cash rates have remained low at a historical low in the last two decades. (Lowe,
2018)
The increase in GDP and full employment is known as “expansionary phase” and is characterised
by high consumption, high employment. The Aggregate Demand in such a case is rising
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(Reserve Bank of Australia, 2018). The effects of an increase in the Aggregate demand are
shown in the nest section.
Illustration 1: GDP of Australia since January 2012
Source: (Reserve Bank of Australia, 2017)
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Chart: The Cash Rate of Australia since 1990 Source: (Reserve Bank of Australia, 2018)
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Chart: Household Liabilities in Australia since 2012 (Quarterly) Source: (Reserve Bank of
Australia, 2018)
Chart: Inflation in Australia since 2012 (Quarterly) Source: (Reserve Bank of Australia, 2018)
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Chart: Unemployment in Australia since 2012 (Annual) Source: (OECD Data, 2018)
Australia is a globalised country and may be subject to problems due to fluctuations in the
global financial markets would tend to threaten the Global Financial uncertainty. (Reserve Bank
of Australia, 2018)
Some of the key points of concern are Financial instability in the Chinese corporate sector,
owing to large piles of perceived bad debts that have been accumulated by firms in China, A
slowdown in China may affect import demand for Australia(Lowe, 2018). Further, international
trends such as currency depreciation from China and other emerging Markets could further
impact the export earnings for Australia. (Reserve Bank of Australia, 2018)
Australians have deposits of over two trillion Dollars saved up in pension funds which might
closely invested in the global capital markets. (Willis Towers Watson, 2018) Any crises in the
global capital markets will affect the cash balances of the pension funds from Australia saved up
in these investments, thus, carrying forward the risk to Australia. A global slowdown, may
therefore, lead to a large flight of capital. This may directly affect institutional investment in
Australia as well as the exchange rate in Australia. Large flights of capital will cause the
exchange rate to appreciate further, causing instability in the Australian markets.
Assumptions
● As mentioned earlier, money supply is assumed to be inelastic
● Outflows, in the form of investment abroad are assumed to be non-existent.
As seen in Panel A, as the RBA decreases the interest rates, for example from 1.5% to 0.5 %,
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there is an rise in money supply from SA to SB . The money supply increase as it is more
profitable for investors and households to hold cash balances in hand rather than bank
deposits.
In Panel B, the effect of any decrease in interest rate on investment is depicted, since lower
interest rates are an incentive for business owners to borrow money. Investment which was
at index point of 100 and would shift to 200. This investments would, expectedly, result in
the expansion of production capacity.
As seen in Panel A, as the RBA decreases the interest rates, there is a rise in money supply from
SA to SB . As the money supply increases, the demand for investment increases. Similarly,
the demand for consumption may increase too.
Thus, Panel B represents the effects of a decrease in interest rate on the investment, since lower
interest rates are incentives for business owners to borrow money. Assuming business
Investment was at an index of 100 and has jumped up to 200. These investments would
generally, result in investments in equipment and production capacity of plant.
The rise in production capacity is represented C. There is an overall increase in the overall
production. This is known as economic expansion. An economic expansion is
characterised by higher consumer spending and lower unemployment.
If the Aggregate demand rises beyond potential output , then there shall be macroeconomic
instability. Potential output is referred to as the output that could be produced when full
employment is achieved. (Samuelson & Nordhaus, 2010)
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Illustration 2: Short Run Aggregate demand Extending Beyond Potential Output
Source: (Samuelson & Nordhaus, 2010)
The Effects of an Expansionary Monetary Policy: (Samuelson & Nordhaus, 2010)
● Effects on Consumption demand : When interest rates remain low, consumer spending
and borrowing increases due to the availability of credit.
● Effects on Net Exports: Lower Interest rates may also help lower or decrease the
exchange rate for Australian Dollar helping ensure that export goods and services from
Australia do not become more expensive in the world markets. This is particularly
important to sustain mining sector exports. If the Australian Dollar depreciates, an
increase in demand for Australian export commodities such as iron and metal ore would
be expected etc. The lower the interest rate, the greater will be the investment in
production capacity of such commodities, thereby making exports less expensive to
foreign buyers.
Thus, a lower cash rate set by RBI would lead to a increase in the overall expansion output
(taken as GDP here) as well as Aggregate demand
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Effects of a Contractionary Monetary Policy
On the other hand, an increase in cash rates, for example, from 1.5% to 2% will lead to a
contrarian effect. In that case, the money supplying the economy shall decrease as households
and business would be required. (Samuelson & Nordhaus, 2010)
The effects will be the complete opposite of diagrams in Illustration 1 and 2.
● Effects on Consumption demand : When interest rates increases, consumers are
incentivised to save and hold cash balances in a bank. Additionally, the access to cheap
credit is lowered. Hence, borrowing decreases, along with consumer spending.
For businessmen, cash balances in the bank would be slightly more profitable than
previously. The risk premium to invest in business is lower. Hence, expansion in capacity
that comes about as a result of lower interest does not happen.
● Effects on Net Exports: Higher Interest rates may also help in appreciation of currency
and leads to a higher the exchange rate for Australian Dollar. This will help ensure that
imports are cheaper. However, export goods and services from Australia will become
more expensive in the world markets. If the Australian Dollar appreciates, decrease in
demand for Australian export commodities such as iron and metal ore would be expected
etc. The higher the interest rate and exchange rate, the lower will be the investment in
production capacity of such commodities, thereby making exports more expensive to
foreign buyers.
● Two of Australia’s top trading partners are China and USA. The expected trade war
between USA and China may reduce the demand for Chinese goods (especially metal
ores in the USA. This indirectly affects Australia, as one of Australia’s key exports, iron
ore is a component of the steel products. As a result of the trade war, demand for
Australian exports may suffer. In such a situation an appreciation in the Australian Dollar
will have disastrous effects on iron ore.
● Effects on the housing sector: there should be some cooling of the housing sector as it
will be difficult to borrow money.
Thus, a higher cash rate set by RBA would reduce the Aggregate Demand as well as the
overall output. Hence, the expansion of the economy is halted. This policy may
also be preferable, as it does not lead to an increase in the overheating of Aggregate
demand. (Bullock, 2018)
In the current scenario, the Reserve Bank of Australia, while trying to the hold the expansion of
output, also, wishes to keep the Australian exports relatively inexpensive. Hence, a cash
rate that neither prefers an expansion or contraction of the economy is preferable. This
may be the reason the Reserve Bank has decided to keep the interest rate unchanged.
Economic Growth: A Perspective
Economic growth referred to the increase in the production of goods and services by a country
within a given period of time. Economic growth is often measured in the increase of nominal or
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Real GDP (Samuelson & Nordhaus, 2010). However, factors that affect economic growth in that
sense are accumulation of capital, increase in technology and sustained increase in human
capital.(Samuelson & Nordhaus, 2010) (MAnkiw , 2009).Natural capital or ecological
endowments of the country may also, be considered as factors causing long term growth.
Economic growth is achieved simply when the Aggregate demand increases. However, the one
factor that is often missing from the GDP calculations is the level of ecological costs made, in
order to achieve the desired GDP. (Maler, Arrow, & Dasgupta, 2003). Natural resources in any
economy are limited. If the GDP growth crosses the sustainable ecological supply, then there will
be fewer resources saved for the the future. In such a situation, excessive focus on short-term
interests. could lead to a sacrifice of long term interests. Thus, balance of long term and short
term interests is required.
A reduction in interest rates can directly affect the consumption demand and may lead to the
expansion of production. This could come at the cost on environmental sustainability. Similarly,
higher demand for Australian coal, metal ore, may affect environmental sustainability. There
could be “social costs” that the Reserve Bank is not accounting, within the monetary policy.
Hence, growth that may sacrifice the longer term development should be secondary while
making policies of Reserve Bank. (Maler, Arrow, & Dasgupta, 2003).
Conclusion
The Reserve Bank of Australia regulates the money market in Australia and is responsible for
setting the interest rates. There are both pros and cons to higher interest rates. However, Australia
has for long seen a period of expansion, given the rise in GDP as well as low unemployment rate.
The current domestic situation of Australia, although in the expansion in the current mode, may
become unsustainable , if the Aggregate Demand increases beyond the sustainable level of
output. Aggregate demand may increase due to increase in consumption, exports or government
spending. The sustainable level of output is determined by employment levels and Australia is
almost near full employment. It is the rapid consumption that must be tamed in Australia, even as
prices in Australia are lower Hence, an expansionary monetary policy is not the need of the hour
and not preferred. However, the Australian Dollar cannot be allowed to appreciate further as it
may affect exports in an already uncertain environment. This implies that a contractionary
monetary policy is also, not ideal. Hence, it is best that the cash rate remains unchanged.
However, one of the future consideration for monetary must be environmental sustainability as
environmental unsustainability has social costs , that would go unaccounted for , in the
Aggregate Demand and Supply model within Economics
References
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