Monetary Policy and the Australian Economy: An Analysis of the Reserve Bank's Decision

In this case study we will discuss about australian economic and below are the summaries point:- The paper is a case study on the current state of the Australian economy, with a focus on the monetary policy decision of the Reserve Bank of Australia. The RBA has kept the interest rate fixed at 1.50 percent since August 2016 to December 2018, influenced by both domestic and global economic conditions. The objective of monetary policy is to achieve stable growth and price levels, and the RBA analyzes the overall macroeconomic environment of Australia to make its decisions.

Running head: ECONOMICS
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Table of Contents
Introduction................................................................................................................................2
Objective of monetary policy.....................................................................................................2
Functions of money....................................................................................................................4
Functions of Reserve Bank of Australia....................................................................................5
Money market equilibrium.........................................................................................................5
Monetary Transmission mechanism..........................................................................................7
Effect of domestic and global macroeconomic indicators on cash rate decision.......................9
Domestic economic environment...........................................................................................9
Global economic environment.............................................................................................13
Explanation for holding cash rate unchanged at 1.50 percent.................................................13
Economic growth and long term determinant of growth.........................................................14
Conclusion................................................................................................................................15
References................................................................................................................................16
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Introduction
The paper prepares a case study on current state of Australian economy with
particular focus on monetary policy decision of Reserve Bank of Australia. The monetary
policy decision of RBA based on analysis of overall macroeconomic environment of
Australia with special attention given on achieving stable growth and price level. After a
number of adjustment in the official cash rate RBA has kept the interest rate fixed at 1.50
percent since August 2016 to December 2018. At the last meeting of RBA held on December
4, 2018 RBA has announced its decision to leave cash rate at 1.50 percent. The decision has
been influenced by both domestic and global economic condition. There is continuous
expansion of global economy with most of the advanced economy maintaining a relatively
low unemployment rate. The ongoing trade tension has shown some signs of economic
tensions. The current state of financial market in most of the advanced economies has been
tightened somewhat. There is a slight decline in equality price along with a higher credit
spread. As against the global economic condition, the economy of Australia is performing
quite well. Currently, the economy is growing at an average rate of 3.5 percent. The slow
growth resource export is expected to slow down growth in 2020. The domestic price level
has remained stable along with a positive outlook for labor market. The condition of housing
market also remains relatively stable. Housing market of Australia is receiving continuous
support from the low interest rate.
Objective of monetary policy
Definition: Monetary policy is defined as a macroeconomic policy that is designed by central
bank of a nation.
Assumption: The monetary policy is assumed to be a demand sided policy that works
through the instrument of money supply and interest rate and helps the economy to attain
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macroeconomic objectives such as price level stability, consumption, economic growth and
liquidity.
Analysis: The main objective of monetary policy is to keep inflation rate within the stable
targeted rate. Primary objectives of monetary policy are briefly discussed below.
Stability in price
One of the primary objectives of monetary policy is to maintain a stability in domestic
price level. The central bank adjusts supply of money to keep the price level stable. During
high inflationary pressure, the central bank takes tight monetary policy through raising
interest rate (Gali, 2018). During deflation central bank takes expansionary monetary policy
in terms of lowering the interest rate.
Stability in exchange rate
In addition to marinating stability in domestic price level, monetary policy also plays
an important role in maintaining stability in exchange rate. Central bank uses foreign
exchange reserve to maintain stability in relative price of currency. The policy of devaluation
or evaluation are used to keep stability in the external sector.
Neutrality of money
Another priority of monetary policy is maintaining neutrality of money. The neutrality
of money refers to the assumption that fluctuation in money supply does not affect real
variables in an economy. By keeping money neutral, the economy can be protected from
economic fluctuation and volatility in the price level.
Economic growth
Achieving a stable economic growth is one objective of monetary policy. Using
monetary policy, a balance can be maintained between money demand and productive
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capacity. By boosting saving and investment, monetary policy contributes to attain steady
growth in the economy (English, López-Salido & Tetlow, 2015)
Full employment
Along with stability in economic growth and price level monetary policy also works
in favor of the attaining full employment in the economy.
Functions of money
Definition: Economists define money as something that can be served as a medium of
exchange, unit of account and store of value (Goodwin et al., 2015).
Assumption: Money is assumed to be a common denominator of all financial and economic
transaction. Economist assume money to be a good basis for accounting economic activity.
Analysis: The primary functions of money are medium of exchange, unit of account and
store of value.
Medium of exchange
Money is used as a universally accepted medium of exchange. Money facilitates
exchange in an economy and works as a common measure of exchange.
Unit of account
The worth of goods and services are accounted in terms of standard monetary unit.
Store of value
Money can be retained for a considerable long period for making future transaction.
Money is considered as a convenient measure of storing wealth (Agénor & Montiel, 2015)
Other functions of money include measure of value, standard unit of postponed
account and a common basis of credit.
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Functions of Reserve Bank of Australia
Reserve Bank of Australia is considered as the main monetary authority of the nation.
The authority performs some primary and secondary functions. The list of RBA’s primary
functions are as follows.
 The main function of RBA is to issue currency in the nation
 Maintain stability of domestic currency
 Achieving level of full employment
 Taking complete care of prosperity and economic well-being for citizen of Australia.
Since the formation data, RBA targets to attain a stable price level in the economy in
terms of setting a medium term inflation target. The current inflation target of RBA lies
between 2 to 3 percent (rba.gov.au., 2018) The objective of inflation targeting of RBA is
followed by other objectives like maintenance of overall stability in the financial system,
stability in foreign exchange reserve and providing financial and other assistance to the
financial institution in the domestic and overseas economy.
Money market equilibrium
Definition: The money market refers to an economic model that describes demand and
supply of money in an economy. Equilibrium in the money market occurs at the point where
quantity of money supplied equals to quantity of money demanded.
Assumption: The two important notion in the market are demand and supply of real
balances. Following the theory of liquidity preference theory, the supply of money in the
economy is assumed to be fixed and is determined by the central bank (Uribe & Schmitt-
Grohé, 2017) The supply of real money balance was given as
( M
P )
S
= M
P
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The theory of liquidity preference further assumes that money demand is inversely related
with interest rate and hence, money demand curve slopes downward. The demand for money
is given as
( M
P )
D
=L(r )
The equilibrium in the money market is given as
Money supply=Money demand
¿ , ( M
P )
S
=( M
P ) D
Diagram
Figure 1: Money market equilibrium
(Source: as created by Author)
Analysis
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In figure 1, the vertical line shows supply of real money balance. The downward
sloping curve shows demand for real money balance. Equilibrium in the money market
occurs where money demand curve intersects money supply curve. Corresponding to the
equilibrium, interest rate in the money market is obtained as r*. The conduct of monetary
policy alters money market equilibrium and associated interest rate through altering money
supply (Heijdra, 2017). The changes in money market equilibrium affects economy activity
through monetary transmission mechanism.
Monetary Transmission mechanism
Definition: Monetary transmission mechanism signifies the process through which monetary
policy affects asset prices and general economic condition. In the context of the case study,
monetary transmission mechanism signifies how changes in cash rate by RBA influences
economic activity in general.
Assumption: There are four channels through which cash rate influences level of economic
activity. These are as follows-
Saving and investment channel
A lower cash rate means smaller return on saving. This encourage household to spend
more and increases aggregate demand. Lower cash rate also implies lower cost of borrowing.
This in turn increases investment. Reverse is the case in times of increase in cash rate. Saving
increase and investment declines resulting in a smaller aggregate demand.
Cash flow channel
When there is a decline in cash rate then borrowers have to give a lower repayment to
their loans. This raise their spending. Lenders on the other hand suffers because of lower
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return for the fund they have lent (Johnson, 2017). RBA however assumes the former effect
dominates and hence, lower cash rate increases aggregate demand.
Asset prices and wealth channel
Smaller cash rate means lower asset prices which in turn increase household wealth.
As wealth increase, household becomes more confident resulting in an increase in aggregate
demand.
Exchange rate channel
Lower interest rate means lower demand for Australian dollar leading to depreciation
of currency. As currency depreciates, there is an expansion of export causing economic
activity to expand.
Diagram
Figure 2: Effect of an increase in cash rate
(Source: as created by Author)
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Figure 3: Effect of a decrease in cash rate
(Source: as created by Author)
Analysis
RBA raises the cash rate when rate of inflation goes beyond the targeted rate. The
objective is to lower inflation pressure. When RBA increases the cash rate from 1.5 percent
to 2 percent then there is a downward pressure on aggregate demand as all the four channels
of monetary transmission works against it (Mankiw, 2014). As shown in figure 2, aggregate
demand contracts resulting in a decline in real GDP and price level.
In contrast, when RBA further lowers cash rate from 1.5% to 1%, aggregate demand
boosts due to working of four transmission channels. This helps to stimulate economic
activity along with a stable price level. This is shown in figure 3.
Effect of domestic and global macroeconomic indicators on cash rate decision
Domestic economic environment
As the objective of monetary policy is not limited to price level stability, RBA needs
to consider state of the overall economy before deciding cash rate. In times of economic
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expansion, a tight monetary policy is preferred by increasing the cash rate (Carlin & Soskice,
2014) During economic recession expansionary monetary policy is taken by lowering the
cash rate to provide necessary stimulus to economic activity.
Figure 4: GDP growth in Australia
(Source: Abs.gov.au., 2018)
The average growth rate in Australia in the last five years remained around 3 percent.
Economic growth lowered close to 2 percent in 2015. Growth however recovered and peaked
above 3 percent in the middle of 2016. Since then growth again declined. GDP growth started
to increase since the middle of 2017 and reached to an average growth close to 3 percent.
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Figure 5: Inflation rate in Australia
(Source: Abs.gov.au., 2018)
As reflected from the above figure the inflation targeting policy of RBA has helped
the nation to maintain inflation rate between 2 to 3 percent.
Figure 6: Unemployment in Australia
(Source: Abs.gov.au., 2018)
The unemployment rate in Australia has declined continuously indicating strong
condition on labor market. At present, unemployment rate in Australia in around 5 percent.
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Figure 7: Housing price index in Australia
(Source: Abs.gov.au., 2018)
The housing price index in Australia recently dropped by 1.5 percent. Decline in
housing price has been contributed from a continuous decline in housing price in Sydney,
Perth, Melbourne and Darwin. House prices in Canberra has increased at a relatively softer
pace. The residential property price has declined by 1.9 percent.
Figure 8: Cash rate in Australia
(Source: rba.gov.au., 2018)
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In response to a stable economic growth, stable price level, strong labor market
condition and decline in housing price RBA has decided to keep the cash rate at the lower
level at 1.5 percent (Manalo, Perera & Rees, 2015) During slower economic growth in 2015,
RBA has lowered the interest rate to boost economic activity.
Global economic environment
Not only domestic but also global economic condition influences RBA’s decision
regarding cash rate. Australia has maintained a good terms of relation with China, Japan and
USA. Trade and financial relation of Australia with rest of the nation has created a strong
interdependence between economy of Australia and others. The export sector of Australia is
highly dependent on China’s economic condition (Cuaresma, Doppelhofer & Feldkircher,
2014). The recent slow-down in China’s economy possesses a threat to Australian economy.
RBA thus decides to not to change the cash rate to support Australian economy in times of
global tension. The financial crisis in United State during 2008 hurt Australian economy.
Since then, for maintaining economic stability RBA cut the cash rate for six times. The
financial condition in most of the advanced countries have tightened somewhat. In order to
escape from global tightening condition, RBA needs to support the economy through an ease
monetary policy. The macroeconomic environment of other advanced countries affects
Australian economy both directly and indirectly (Vasnev, Skirtun & Pauwels, 2013) Trade
volume is the direct economic channel. Growth of these nations implies expansion of
Australian export and boosts economic activity. Given the trade and economic relation, RBA
considers economic environment of other advanced nations while deciding its monetary
policy.
Explanation for holding cash rate unchanged at 1.50 percent
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The Reserve Bank of Australia in its final meeting in 2018 has decided to keep the
cash rate unchanged at 2018. With this cash rate has remained unchanged for 28 months, the
longest ever period in the history of cash rate. RBA last lowered the cash rate to 1.5 percent
in August 2016 followed by its earlier cut to 1.75 percent during May. The RBA’s cash rate
decision is followed from domestic and global economic condition as mentioned in the
monetary policy statement. In the global economy, there is growing trade tension in the
international trade. Along with this China’s economic slow-down put considerable pressure
on Australian economy. The financial condition in advanced countries have tightened in the
late 2018. The growth of GDP in third quarter of 2018 is lower than expected. In recent years,
household income has slowed down putting downward pressure on demand. The condition of
labor market remains strong with unemployment remained steady at 5 percent (news.com.au.,
2018) House price in Sydney and Melbourne declined by 9.68 percent and 8.29 percent
respectively. Taking into consideration the domestic and global economic condition the
members of monetary authority has decided that monetary policy would continue to support
Australian economy (rba.gov.au., 2018) The members of RBA have decided that keeping
cash rate constant is consistent with the objective of sustainable growth and maintaining
inflation target over longer period.
Economic growth and long term determinant of growth
Economic growth refers to a process of increase in production of goods and services
of a nation overtime. Gross Domestic Product of a nation is the best way of measuring
economic growth. GDP takes into account aggregate output of the economy.
Economic growth over longer term depends on the key determinants of productivity
and GDP. Public expenditure, capital formation or level of investment and technology are
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some of the determinants of long term growth. Productivity growth is one main drivers of
long term growth and improved living standard.
The Reserve Bank of Australia has kept the interest rate to a recorded low level of 1.5
percent. The low cash rate is supportive for sustainable growth and inflation target in
Australia (rba.gov.au., 2018). The low interest rate would help the economy to tackle
pressure from tightening condition in advanced countries. The major trading partners are now
suffering from a low investment, low inflation and low import demand. Under such
circumstance Australian economy would need protection in terms of a low cash interest rate
(Yeates, 2018). The low cash rate thus is expected to keep wage and employment growth at
the targeted level along with achieving a sustainable growth in the long run.
Conclusion
The case study evaluates recent monetary policy decision of RBA. Major objectives
of monetary policy are stability in price level, stable economic growth, neutrality in money,
full employment and maintaining exchange rate stability. Currently, RBA has kept cash rate
fixed at 1.50 percent. The cash rate decision of RBA has been influenced by both domestic
and global economic condition. Economic growth in Australia is relatively stable along with
a stable price and strong condition of labor market. In the international market, major
economies are facing a tight condition in their financial market, China is experiencing an
economic slow-down and low export growth. Considering the domestic and international
economic condition the 1.5 percent cash rate is expected to secure a sustainable growth for
Australia.
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