Principles of Economics

This report discusses different concepts and terminologies related to macro-economics, based on the case study article of RBA decision 7th August 2018. It covers the role of domestic and global macroeconomic indicators in determination of cash rate, main objectives of monetary policy, reasons behind keeping cash rate unchanged, money market equilibrium model and monetary transmission mechanism, and determinants of long-run economic growth.

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Running Head: ECONOMICS
Principles of Economics

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Table of Contents
Introduction................................................................................................................................3
Question 1: Role of Domestic and Global Macroeconomic Indicators in Determination of
Cash Rate...................................................................................................................................5
Question 2: Main Objectives of Monetary Policy......................................................................5
Question 3: Reasons behind Keeping Cash Rate Unchanged....................................................7
Question 4: Money Market Equilibrium Model and Monetary Transmission Mechanism.......8
Question 5: Determinants of long-run Economic Growth.......................................................12
Conclusion................................................................................................................................19
References................................................................................................................................20

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Introduction
This report is designed for developing practical knowledge about different concepts and
terminologies related to macro-economics. This report is mainly based on the case study
article of RBA decision 7th August 2018. As per the analysis of this case study, the board of
RBA has organized meeting of its members for 11 times in a year at the location of Martin
place in Sydney. Earlier to the meeting, the members of this board were provided the data
related to analysis of financial markets and economy of Australia. Example of these data
includes the facts related to future inflation forecasts and the potential path of economic
growth for domestic as well as the overseas concerns. Different decisions taken under
monetary policy of the country are totally based on wide range of macro-economic
assumptions. As per analysis of this article, a consensus was approached by the RBA staff to
leave the interest rate as it is or unchanged (i.e. 1.5%). RBA takes into account different
instruments for taking any decision like cash rate.
There are different objectives of this report. It will help to understand reasons, due to which
RBA takes into consideration the global and domestic macroeconomic factors for taking
economic decisions like ascertainment of cash rate. The report is also aimed to provide
explanation of different objectives of monetary policy. Further, the report will focus on
analysing reasons due to which the Governor of RBA decided to keep the official cash rate
unchanged at the level of 1.50% in last 2 years. Final section of this report will define
economic growth and will elaborate the determinants of long run economic growth. It will
also help to know whether consistent cash rate of 1.5% can help to achieve long term
economic growth or not.

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Question 1: Role of Domestic and Global Macroeconomic Indicators in Determination
of Cash Rate
Macroeconomics can be defined as the area of study that takes into account the study of
various economic performance indicators like GDP, unemployment, inflation, national
income, money supply etc (Kaplan & Gungor, 2017). Inflation can be defined as the level of
pricing in an economy. In other words, the inflation can explained as the rate, with which the
general level of pricing for different products and services is increasing in a country. The
current level of inflation can significantly affect the decision of central bank like RBA in
context of cash rate determination. If the inflation rate of country is high and it is adversely
affect interest of overall economy, the RBA will take decision of declining the cash rate (Ali
et al., 2015). Due to decline in cash rate, the demand for liquidity or cash will decline in the
money market. This way, demand for money will reduce against the supply of money. This
will ultimately help to control and reduce inflation rate.
Money Supply is also a major factor that is taken into consideration by the RBA while
determining appropriate decision for changing the cash rate. It is so because the high level of
money supply also affects the purchasing power of currency. If the money supply in market is
high, then RBA decides to increase the cash rate for controlling supplying of money in
market (Kaplan & Gungor, 2017). The example of global macro economic indicator that is
taken into account for determination of cash rate is the foreign exchange rate. Large reserves
of foreign exchanges are kept by the countries for achievement of stable value of their
currency against foreign currency like USD.
Question 2: Main Objectives of Monetary Policy
Monetary policy can be defined as the macroeconomic policy that is designed by central bank
of a country for management of money supply in the country. Main objective behind
formation of monetary policy is to improve supply and demand of in economy and also to

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improve economic growth rate in country. There are two types of monetary policy such as
expansionary monetary policy and the contractionary monetary policy (Lin & Cheng, 2016).
Under expansionary monetary policy, the central bank focuses on declining interest rate in
order to increase supply of money. In contrast to this, the central bank of a country like
Australia decides to increase interest rate in order to control or reduce supply of money in
economy.
One of the major objectives of monetary policy is to control or manage the inflation rate in
country. Expansionary monetary policy can lead to increase in inflation rate. It is so because
due to increased supply of money or cash in economy, the value of money in terms of
purchasing power reduces. In contrast to this, contractionary monetary policy leads to decline
in level of inflation rate as a result of declined flow of cash or money in the economy.
Another objective of monetary policy is to reduce unemployment level in country (Smets,
2014). This is done through expansionary monetary policy. Through reduction in interest
rate, the central bank tries to facilitate bank finance at lower interest rate. Due to this
decision, the investments in corporate sector increases in the economy in different sectors.
This ultimately leads to increase in new job opportunities in economy. This way, the
unemployment problem is addressed in economy through monetary policy.
According to different economists like Robertson, Hayek and Wicksteed, the objective of
monetary policy is also to achieve the neutrality of money in country. This neutrality is often
required in order to achieve stability in different economic measures like inflation, and the
price level. Neutrality stands for stability in the flow of money in the country (Lin & Cheng,
2016). With the achievement of monetary neutrality, the central bank of a country can ensure
that no any situations of deflation or inflation, trade cycles and the economic fluctuations
occur in the economy with the passage of time.

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It is also a major objective of monetary policy to achieve exchange rate stability in economy.
Under gold standard, this was the core objective of monetary policy in different countries
across globe. For example, the central bank of country like Australia takes into account the
corrective measures, whenever it faces any disequilibrium in the balance of payment in
country (Smets, 2014). According to Gold standard, the central bank decides to purchase or
sell the Gold in international market in order to control the exchange rate in economy.
Question 3: Reasons behind Keeping Cash Rate Unchanged
RBA has decided to keep the cash rate unchanged at historical low level of 1.5%, because of
favourable economic performance of the Australian economy. For example, the positive
changes have been evidenced in terms of decline in unemployment level in country. For
example, the current level of unemployment is recorded below 5.5% in 2018. In contrast to
this, the unemployment rate was 11.2% in 1992. This means, the RBA decision to keep
interest rate at low level has provided benefits in the form of improvement in unemployment
rate in country. Similar to this, the positive results have been seen in terms of economic
growth of country. For example, total annual GDP of Australia was 323,723 million $ in
1991 that increased to $1.26546 trillion in 2017. This result is associated with declining rate
of interest in the country. In this context, the lower level of cash rate or interest rate in the
interest of economic growth of Australia (RBA, 2018). The consistency in keeping the
interest at lowest level of 1.5% will help the government to reduce unemployment level,
enhance real GDP and to keep inflation level under control. This way, it would be helpful to
support goal of long run economic growth for the Australian economy.
Question 4: Money Market Equilibrium Model and Monetary Transmission
Mechanism
Money Market Equilibrium Model:

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Money market can be defined as the market, where interaction takes place among different
entities or institutions. In other words, the market is the marketplace, where the trading of
financial instruments with short maturity and high level of liquidity takes place (Parlatore,
2016). Money market equilibrium can be defined as the situation or interest rate, in which
quantity of money supplied equals to the quantity of money demanded. Following diagram is
helpful to understand the money market equilibrium model and its application on Australian
economy:
(Source: UMN, 2018)
In the above chart, red line is supply curve. At the same time, blue line denotes the demand
curve in money market. In this diagram, the point at which demand curve is intersecting

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supply curve is the situation of money market equilibrium. “r” is the rate of interest, at which
this equilibrium is achieved. At the same time, “M” denotes the level of stock of money. This
mechanism is quite helpful to achieve or keep the inflation rate within target level. If the
RBA decides to increase cash rate from 1.5% to 2%, then its impact will be visible on the
inflation rate of country. Due to increase in cash rate (or interest rate) the demand for money
will decrease in the money market (UMN, 2018). This situation will lead to decline in
inflation rate of Australia. This will also have a negative impact on the GDP or economic
growth of country. In the same manner, there will be negative effect of increase in cash rate
on the household consumption and business investments. In context of housing market, the
increase in interest rate will lead to decline in the demand for properties and homes. Due to
this decline in demand, the price level of property market will decline. This will indirectly
lead to reduction in inflation level.
In contrast to this, if the interest rate (or cash rate in Australia) declines from 1.5% to 1%,
than demand for money will increase against the supply of money. Due to higher level of
demand for money as compared to level of supply of money, the inflation rate in the country
will increase. At the same time, a hike will be seen in business investments and household
consumption. A positive influence will be seen of all this on the GDP and economic growth
of country (UMN, 2018). In context of household market, the demand for properties and
homes will increase. Due to increased market demand, the hike will be seen in pricing of
property market.
Monetary Transmission Mechanism:
Monetary transmission mechanism can be defined as the process through monetary policy
decisions affect the economic conditions in country, price of different assets and market
expectations. Following diagram is helpful to understand the money transmission mechanism
process:

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(Source: ECB, 2018)
As per the above diagram, whenever any change is introduced in the cash rate or interest rate
under monetary policy, it will affect price level in long process. For example, increase in
interest will affect expectations of individuals as well as corporate entities in market. It will
lead to increase in money market interest rate. The impact of this increase will be seen on
money credit, asset price, bank rates and the exchange rate in country. The increase in interest
rate will lead to emergence of expectation of people for higher wages and higher price
setting. This all will influence the price level for both import price and domestic price in
country. This all will lead to increase in price development or inflation rate. Based on the
application of money transmission mechanism, increase in cash rate from 1.5% to 2% will
lead to decline in inflation rate and household consumption, demand for property market, and
business investment (ECB, 2018). This will result into decline in the economic growth rate
and GDP level of country. Similar to this, the decline in cash/ interest rate from 1.5% to 1%

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will lead to increase in demand for property market, business investments, and household
consumption. This will affect the inflation rate in country positively (i.e. hike in inflation
rate).
There are different circumstances, in which RBA should increase the cash rate. Example of
these situations includes increase in the inflation rate in country, increase in situations of
NPA in banking sector etc. The cash rate should also be increased by the RBA, when demand
for cash in the market is increasing at very fast rate and it becomes very difficult for the
banks and financial institutions to fulfil demand (Laubach & Williams, 2016). It is so because
the extra ordinary demand for cash in the form of different types of loans can negatively
affect the economic situations of country.
Question 5: Determinants of long-run Economic Growth
Economic growth can be defined as the increase in total market value of products and
services produced in a country after adjustment of inflation effect over a period of time
(Poghosyan, 2014). In other words, the economic growth is measured in terms of percentage
increase in the real GDP (gross domestic product) of country. Following are different
determinants of long run economic growth of a country:
Growth of Productivity:
In simple words, the growth of productivity can be measured by determination of ratio of
economic output to inputs. Example of inputs includes services, material, energy, labour and
the capital. The cost of goods gets declined with the increase in productivity in an economy.
If the products and services are prices at lower rate, then it will result into increased demand
of the service or products (Owen, 2017). In this context, the increase in market demand for
product would lead to increase in revenue.
Demographic Changes:

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The change in demographic factors also influences the economic growth of an economy in
long run. Example of demographic factors includes the employment to population ratio. The
economic growth of a country can be anticipated to grow with the increase in employment to
population ratio (Poghosyan, 2014). Similar to this, the age factor of population of country
also affects the employment status and long term economic growth.
Labour Force Participation:
There is positive correlation between economic growth of the country and total number of
labour force participation. Labour force participation stands for the total number of workers
available and working in the economy (Owen, 2017). It is generally seen across different
countries of globe that the value of labour force participation is quite high in nations with
higher value of industrialization and development.
Technological Progress:
The technological progress has a direct and positive relation with the economic growth. In
other words, the country with availability of technological advancements will have higher
economic growth rate as compared to countries with lack of technological support. For
example, 40-50% of total GDP growth rate in United States is mainly caused due to
technological progress (Poghosyan, 2014). Following diagram is helpful to understand the
effect of technological progress on economic growth:

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(Source: Lumen, 2018)
On the basis of above diagram, it can be analyzed that improvement in technology leads to
increase in production and the production possibility frontier shifts outward. This results into
increase in economic growth of country.
Government Activity:
The government activities or decisions also influence the long run economic growth of a
country. The government activities are visible in different types of actions or decisions like
investment decisions, monetary and the fiscal policies. If a government invests in different
infrastructure projects like highway projects, new railway projects, preventive health care
projects, production and education projects, the impact of such decisions is often visible on

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long run economic growth of country in favourable manner. The government also takes
decisions like expansionary and contractionary policies. These policies also have impact on
the economic growth of countries. The expansionary monetary policy has the positive impact
on economic growth (Stiglitz & Rosengard, 2015). At the same time, contractionary
monetary policy impacts economic growth of country in negative manner. Government takes
different decisions under fiscal policy like economic regulations, government spending
decisions and tax structure or tax rate. These decisions also impact the economic growth of
country.
Justification of Historical Interest Rate of 1.5% until August 2018:
Following diagram is helpful to understand the historical changes in interest rate in Australia:
(Source: FT, 2018)

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Value of foreign exchange rate against USD from 2014 to 2018 is shown in following
diagram:
(FT, 2018)
Diagram showing historical inflation rate in Australia is below:
(Source: Jericho, 2018)
Following diagram is helpful to understand the historical GDP performance of economy of
Australia (all amounts in billion USD):

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(Source: Trading Economics, 2018)
Following diagram is helpful to understand the change in annual GDP growth rate of
Australia:
(Source: Trading Economics, 2018)

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From the analysis above graphs, it can be said that the consistent the decision of RBA to keep
the interest rate at historical low level of 1.5% would contribute positively towards the long
run economic growth of Australia. For example, the interest rate of Australia was 17.5% in
1990 that has consistently declined to 1.5%. At the same time, the graphs are showing
consistent improvement in economic growth of Australia in terms of GDP and annual GDP
growth rate from 1990 to 2018. In this context, the economic growth of country can be
expected to grow in coming time period (Ferrero, 2015). It is also anticipated that low level
of interest rate in country will make availability of bank loan at lower interest rate. Due to
this factor, the investment in corporate sector will increase. This will contribute in increase in
overall output in the country. This will lead to economic growth of the country.

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Conclusion
On the basis of above analysis, it can be concluded that cash rate or interest rate of Australia
is at historical low level. The lower interest rate is quite effective to boost the investment in
country and to overcome issue of unemployment in nation. It is analyzed from the report, that
there are different determinants of long term economic growth in a country. Example of these
determinants includes government activity, technological progress, labour force participation,
demographic changes and the growth of productivity. The adoption of low cash rate has
proved to be very beneficial for economy of Australia for achieving economic growth and
overcoming the unemployment issue in country.

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References
Ali, T.M., Mahmood, M.T. & Bashir, T. (2015). Impact of interest rate, inflation and money
supply on exchange rate volatility in Pakistan. World Applied Sciences Journal, 33(4),
620-630.
ECB (2018) Transmission mechanism of monetary policy. Retrieved from:
https://www.ecb.europa.eu/mopo/intro/transmission/html/index.en.html
Ferrero, A. (2015). House price booms, current account deficits, and low interest
rates. Journal of Money, Credit and Banking, 47(S1), 261-293.
FT (2018) Australia cuts interest rates to record low 1.5%. Retrieved from:
https://www.ft.com/content/60fa07c6-5878-11e6-9f70-badea1b336d4
Jericho, G. (2018) Housing affordability: Interest rates are lower than ever. So why is
owning a home harder than ever?. Retrieved from:
https://www.theguardian.com/business/grogonomics/2018/jun/05/interest-rates-are-
lower-than-ever-so-why-is-owning-a-home-harder-than-ever
Kaplan, F. & Gungor, S. (2017). The Relationship Between Money Supply, Interest Rate and
Inflation Rate: an Endogeneity-Exogeneity Approach. European Scientific Journal,
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Laubach, T. & Williams, J.C. (2016). Measuring the natural rate of interest redux. Business
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Lumen (2018) Determinants of Long-Run Growth. Retrieved from:
https://courses.lumenlearning.com/boundless-economics/chapter/long-run-growth/

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Owen, P.D. (2017). Evaluating ingenious instruments for fundamental determinants of long-
run economic growth and development. Econometrics, 5(3), 38-50.
Parlatore, C. (2016). Fragility in money market funds: Sponsor support and
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Poghosyan, T. (2014). Long-run and short-run determinants of sovereign bond yields in
advanced economies. Economic Systems, 38(1), 100-114.
RBA (2018) Minutes of the Monetary Policy Meeting of the Reserve Bank Board. Retrieved
from: https://www.rba.gov.au/monetary-policy/rba-board-minutes/2018/2018-06-
05.html
Smets, F. (2014). Financial stability and monetary policy: How closely
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Stiglitz, J.E. & Rosengard, J.K. (2015). Economics of the public sector: Fourth international
student edition. USA: WW Norton & Company.
Trading Economics (2018) Australia GDP 1960-2018. Retrieved from:
https://tradingeconomics.com/australia/gdp
Trading Economics (2018) Australia GDP Annual Growth Rate 1960-2018. Retrieved from:
https://tradingeconomics.com/australia/gdp-growth-annual
UMN (2018) Principles of Economics. Retrieved from:
https://open.lib.umn.edu/principleseconomics/chapter/25-2-demand-supply-and-
equilibrium-in-the-money-market/