Principles of Economics: Monetary Policy, Money Market, and Economic Relations of Australia

Running Head: PRINCIPLES OF ECONOMICS
Principles of Economics
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PRINCIPLES OF ECONOMICS
Table of Contents
Introduction......................................................................................................................................3
Objective of Monetary Policy..........................................................................................................3
Main functions of money.................................................................................................................5
Functions of Reserve Bank of Australia..........................................................................................5
Australia’s Economic relation with China, Japan, India and USA..................................................6
Rationale behind setting cash rate at 1.50 percent...........................................................................9
Equilibrium in the money market....................................................................................................9
Monetary Transmission mechanism..............................................................................................11
Performance of economic indicators in Australia.........................................................................12
Australia’s cash rate trend.........................................................................................................12
GDP growth of Australia...........................................................................................................12
Inflation..........................................................................................................................................13
Unemployment..........................................................................................................................15
Balance of Australian government budgets...............................................................................16
Housing market condition..............................................................................................................16
Economic growth and determinants of long term growth.............................................................18
Sustainable growth for Australia...............................................................................................18
Conclusion.....................................................................................................................................19
References......................................................................................................................................20
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PRINCIPLES OF ECONOMICS
Introduction
The case study is based on Australian economy and is mostly concentrated on monetary
policy of Reserve Bank of Australia. In the last meeting held on December 5, 2017 the decision
board of RBA has decided to keep the cash rate unchanged at 1.50 percent. In every discussion
of RBA, decisions are taken on whether to adjust the cash rate or keep it fixed. Following the
outbreak of Global Financial Crisis, Australian economy needs monetary stimulus with a
considerable decline in the cash rate. This is the time when RBA had made a drastic reduction in
the prevailing cash rate. The low cash rate was designed to rescue Australian economy from the
recessionary hit of the crisis. In May 2016, the RBA has cut the cash rate by 0.25 points with
cash rate reduced to 1.75. A second round revision in the cash rate has been made since August
2016 and cash rate was in a historically low level of 1.50.
The level of cash rate is influenced from macroeconomic indicators of countries related
with Australia like China, Japan, Australia and USA. With a change in cash rate domestic
economic indicators like household consumption, business investment, government spending,
GDP, inflation and housing market. The ease monetary policy is expected to bring a stable long-
run growth of the economy in future.
Objective of Monetary Policy
Monetary policy is one important instrument to maintain a stable price level and attain
economic growth through controlling supply of money in the economy. Apart from achieving
stability in the price level, the monetary policy is designed to attain certain other objectives as
well. Of these, the primary objectives are discussed below.
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PRINCIPLES OF ECONOMICS
Price level stability: The primary objective of monetary policy is to achieve stability in the price
level. The central monetary authority controls money supply and adjust the supply to maintain
stability in the price level. When inflation increases, then central bank follows a tight monetary
policy. In contrast, when there is a decline in price level then, central bank has to take
expansionary monetary policy to boost the price level.
Exchange rate stability: It is necessary for every nation to have a stable price in its external
sector. Prices in the external sector is determined from the prevailing exchange rate. Therefore,
monetary policy is designed to maintain a stable exchange rate system. Central bank uses its
foreign exchange reserves to control the exchange rate. For stimulating export, central bank
adapts the policy of currency devaluation (Galí, 2015). In contrast, when country relies heavily
on import and need to import capital and consumer good then currency evaluation is appropriate
policy.
Neutrality of money: In an economy, fluctuations are often resulted from monetary fluctuations.
Monetary fluctuations have distortionary effects on economic activity. The neutrality of money
implies money does not affect real variables. Therefore, with neutrality in money, the economy
is free from cyclical fluctuation, trade cycles and price level volatility.
Economic Growth: The end objective of policymakers is to attain a secure growth rate for the
economy. A sustained economic growth can be achieved through suitable monetary policy
framework. Using the tool of monetary policy, a balance is maintained between productive
capacity and demand for money in the economy. Monetary policy through the tool of interest
rate stimulate saving and investment.
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PRINCIPLES OF ECONOMICS
Full employment: Another primary objective of the policymakers is to secure full employment
in the economy. Monetary policy provides support to the goal of achieving full employment.
Saving-Investment equilibrium is maintained at full employment level.
Main functions of money
The main functions of money are given as follows
Medium of exchange: This is the most important function of money. Money is used to exchange
goods and services and facilitate transactions. Prior to money, the transactions are supposed to
be made through barter system. However, difficulties arise in barter system as to make
transaction possible there needs to be double coincidence of wants between suppliers and
demander.
Unit of account: Money is a standard unit of measuring the worth of goods and services.
Store of value: Money is a commonly used measure of storing purchasing power. Money can be
held for a long period and can be used for making future payments. Moreover, people save
money with assurance that the value will be increased in future (Sardoni, 2015). As value of
money can be retained overtime, it offers a convenient means of storing wealth.
Other functions of money include use of money as a basis of credit, a measure of value
and a standard of postponed account.
Functions of Reserve Bank of Australia
The central monetary authority of Australia is Reserve Bank of Australia. Being the
central bank of the nation RBA has some primary and secondary functions. The primary
functions of RBA include
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PRINCIPLES OF ECONOMICS
 Maintaining stability of Australian dollar
 Maintaining full employment
 Taking care of well-being and prosperity of Australian citizen
 It is the responsibility of RBA to issue currency notes in the economy
RBA since its formation sets target to achieve stability in the price level by setting a medium
inflation target. The target is maintain an inflation target of 2 to 3 percent (Wilkins, Gardner &
Chapman, 2016). In addition to inflation targeting other functions of RBA are
 Maintain an overall stability in the Australian financial system
 Control foreign exchange reserves
 Provides banking service and related facilities to other banks and overseas financial
institution.
Australia’s Economic relation with China, Japan, India and USA
Australia today shares strong economic and financial relation with different nations. Of
which four economies that are closely related with Australia are China, Japan, India and USA.
China has entered in the phase of growth in 1970. Since then, Australia provides support
to China’s economy. Australia meets China’s demand of raw materials, building materials and
demand for energy for electricity and transportation. The relation between the two nations has
grown day by day. China now offers one of the largest market for Australian export (Mark,
2017). Therefore, growth of Australian export sector depend on economic scenario of Australia.
With fluctuations in economic indicators, terms of trade between the two nations are likely to be
affected. With advent of new sources of iron ore, natural gas and coal in China and in other
developed nations, Australian economy has affected. Australia provides education service to
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