Analysis of Expansionary Monetary Policy on Australian Economy: Report

This report analyzes the effects of expansionary monetary policy on the Australian economy, focusing on the impact of reduced cash rates on GDP, price levels, and wages. The analysis begins by examining the demand and supply of money, considering factors such as household savings, government purchases, and business investments. The report then explores how lower interest rates influence aggregate demand through consumption, investment, government purchases, and net exports. It further investigates the short-run effects on GDP, including impacts on business investment, housing, and consumer spending. The study also delves into the multiplier effects of low-interest rates, leading to rises in wages and price levels. It concludes by discussing the potential consequences of expansionary monetary policy, including the possibility of increased asset prices, referencing key economic theories and empirical data to support its findings. The report highlights the Reserve Bank of Australia's role in managing monetary policy and its effects on various sectors of the economy.

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Effects of Expansionary Monetary Policy on Australian Economy
Effects on GDP, Price Level and Wages
10/11/2017
ABC

Contents
1. Introduction.........................................................................................................................................4
2. The Demand and Supply of Money.....................................................................................................4
2.1 Supply of Money...............................................................................................................................4
2.2 Demand for Money............................................................................................................................4
3. The Effects of Reduction in the Federal Cash Rates in Aggregate Demand........................................6
4. The Effects of Lower Interest Rates on GDP in the Short Run............................................................6
5. Multiplier Effects Due to low Interest Rates: A Rise in Wages and Price Level........................................8
6. Conclusion.........................................................................................................................................10
References.................................................................................................................................................10
Figure 1 Interest Rate, Demand and Supply of Money................................................................................4
Figure 2 The Impact of Lower Interest Rate on Investment and GDP.........................................................6
Figure 3 Effects of an Expansionary Monetary Policy on Aggregate Supply in Long Run.........................8

Summary
The Government of Australia recently announced that the Reserve Bank would keep Cash Rates
low for the Australian economy. The following paper analyses the effects of this policy on
households, firms and the GDP of Australia

1. Introduction
Recently, the Australian Prime Minister Malcolm Turnbull announced the decision to reduce
budget deficit and lower the cash rate. Lowering cash rate is a part of the expansive monetary
policy that Australia has chosen to pursue since 2007. The idea is that lower interest rate will
encourage people to borrow money for businesses while easy access to credit will spur consumer
spending. This paper provides an analysis of the policy and examines whether it has been
successful so far?
2. The Demand and Supply of Money
2.1 Supply of Money
According to loanable funds theory, supply of money comes from household savings and
undistributed profits oif businesses. In a open economy, supply of money can also be from
foreign borrowing and earnings from foreign trade. Additionally, transfer payments by expats
can also be included in supply of money.
In reality, all savings in a economy are not invested. Businesses and household prefer to hold
cash balances, primarily for three motives, according to liquidity preference theory of interest:
Transaction motive: Transaction motive denotes the motive of firms and households to hold cash
balances in order to conduct day-t- day transactions.
Precautionary motive: Firms and businesses also prefer to hold money as precaution against dire
situations. Money for precautionary motives could be help theough various mediums like
investments in securities, bonds, insurance payments etc.
Speculative motive: Firms and households also prefer to hold money due to speculation about the
value of money in the future. If the rate of interest in the near future would be expected to be
high in the visible future, the cash balances held will be high.
2.2 Demand for Money
The demand for Money comes from three sources primarily

Households: Households demand money for consumption primarily.
Government: Government purchases can be a large source of demand for money. Apart from its
revenue sources like taxes and oublic sector, government can also borrow money by way of sale
of government bonds and treasuries.
Business: Businesses demand money for production of goods and services. (Chauhan, 2009)
Interest is the price paid for money. Hence, the demand for money tends to increase as the
government lowers the rate of interest. (Samuelson & Nordhaus, 2004)
Figure 1 Interest Rate, Demand and Supply of Money
Source: (Chauhan, 2009)

3. The Effects of Reduction in the Federal Cash Rates in Aggregate Demand
A decline in Cash rate will cause the increase of the supply of money in Australian economy. On
the other hand, the supply of money will rise if interest rates are high. However, in the short run,
the supply of money is not expected to change greatly. Hence, in analyses, the supply of money
is depicted as highly inelastic. (Samuelson & Nordhaus, 2004)
As the Reserve Bank of Australia (RBA) believes that a decreased in demand may cause the
growth rate to reduce, it attempts to stimulate Aggregate Demand (comparable to Gross
Domestic Product).
Aggregate demand in Australian Economy can be represented as : (Samuelson & Nordhaus,
2004)
AD= C+I+G+NX
C= Consumption Demand
I= Investment Demand
G= Government Purchases
N= Net Exports
4. The Effects of Lower Interest Rates on GDP in the Short Run
Effects on Business Investment and Wages: A decline in interest rates would lead business to
increase their spending on plant and build inventories. In the short run, wages may not increase
since wages tend to be sticky. (Samuelson & Nordhaus, 2004)
Effects on Housing: Additionally, lower interest rates imply lower mortgages for house owners.
Thus the savings of households could be utilized as investment by way of the housing market.
(Samuelson & Nordhaus, 2004) The Reserve Bank of Australia expects a glut in the housing
market soon, specially in cities like Melbourne, Perth Etc. (Reserve Bank of Australia 2017)
(Reserve Bank of Australia 2016) Lower Interest rates may incentivize consumers to purchase.
However, there are chances that low interest rates may lead to high asset prices. (Shiller, 2007).

Effects on Consumption: When interest rates are low consumer spending is high due to the easy
access of credit. (Samuelson & Nordhaus, 2004) Consumer spending provides a boost to
domestic businesses.
Effects on Net Exports: Lower Interest rates tend to also decrease the exchange rates which
makes it easier to export goods and services. Australia is a country with high exports of products
from mining sector, agricultural sector and services sector. (The Department of Foreign Affairs
and Trade , 2017) The depreciation in Australian Dollar may increase the demand for Australian
commodities like coal, iron ore, agricultural exports etc. (Makin, 2016) The lower the interest
rate, the greater will be the investment in production capacity of such commodities, thereby
increasing the demand for Australian commodities
Thus lower interest rates may lead to an increase in all the interest savings rate of the Aggregate
demand i.e. C, I, NX (Samuelson & Nordhaus, 2004)
Figure 2 The Impact of Lower Interest Rate on Investment and GDP

Source (Samuelson & Nordhaus, 2004). Prepared by Author
In the above Diagram,
Panel a)
SA and SB are money supply curves
DD curve is demand curve
Panel c)
SS curve = Supply schedule
As seen in Panel A, as the RBA decreases the interest rates, there is an rise in money supply
from SA to SB . The increase in money supply could be due to the fact that it is not profitable for
investors and consumers to hold cash balances in the bank any more.
In Panel B, the effects of a decrease in interest rate are shown on investment, since lower interest
rates are an incentive for business owners to borrow money. The Investment was at an index of
100 and has shifted to 200. These investments would generally, result in investments in
equipment and production capacity of plant.
5. Multiplier Effects Due to low Interest Rates: A Rise in Wages and Price
Level
As business investment begins to increases, prices in both labour and factor market would rise.
Wages and prices begin to adjust with these changes and the result is a higher demand is reflect
in higher cost of living. If there is a high level of uncertainty regarding a further increase in
wages, the increase will tend to amplify these effects further. Overall, the GDP will rise. In the
simplest multiplier model, the desired saving equals desired investment. This relationship is
depicted in the savings schedule.. This line represents the desired level of saving (measured
along the horizontal axis) as a function of the GDP on the vertical axis. Equilibrium GDP is
attained at that level where investment demand from panel b), figure 2 equals the desired saving
from SS schedule. (Samuelson & Nordhaus, 2004)
The impact of this multiplier effect are already seen in Panel c) of diagram 1.

In Panel c) of figure 2, the initial investment was level 3000. As interest rates are lowered , the
nominal GDP rises to level 3,300.
If this trend continues, the economy will continue to expand until potential output is reached.
Once potential output is reached, lower interest rates will only imply that a higher amount of
money would be chasing fewer goods leading to a rise in the general price level or inflation.
The extent of the prices and wages rise will depend on the expansion of money supply. If money
supply increases by 5 % with a decrease in 1 % interest rate, then wage level and price level
would rise at the same extent. This implies that the nominal GDP has risen by 5% However, this
does not imply that real GDP has increased to the same output. As Samuelson & Nordhaus,
(2004), “As prices and wages become more flexible in the long run, money supply changes tend
to have a larger impact on prices and smaller impact on output.”
Figure 3 Effects of an Expansionary Monetary Policy on Aggregate Supply in long Run

In the diagram above, the Aggregate Suppply is relatively flat since an increase in money supply
primarily has is effects on real output. However, the effects on real output tend to diminish as the
economy approaches its Potential GDP. As the Real GDP crosses the Potential output, supply
becomes inelastic, thereby only resulting in a general rise in price level.
6. Conclusion
It is not uncommon for governments to follow an expansionary policy, if they believe that
Aggregate Demand is going to reduce. Hence, the policy will be effective in achieving its targets.
However, a balanced approach on interest rates is needed since very low interest rates can also
lead to increase in asset prices.
References
Chauhan, S. (2009). MICROECONOMICS: Theory and Applications, Part 1. New Delhi: PHI Learning PVT.
Ltd.
Makin, T. (2016). The Effectiveness of Federal Fiscal Policy : A Review. Parkes: Commonwealth of
Australia 20.
Reserve Bank of Australia. (2017, February). Box A: The Pipeline of Residential Dwelling Work . (Reserve
Bank of Australia) Retrieved September 11, 2017, from Statement on Monetary Policy – February 2017:
http://www.rba.gov.au/publications/smp/2017/feb/box-a-the-pipeline-of-residential-dwelling-
work.html#fn3
Reserve Bank of Australia. (2016, August). Statement on Monetary Policy – August 2016 Box B: The
Housing Market . Retrieved September 11, 2017, from Reserve Bank of Australia:
https://www.rba.gov.au/publications/smp/2016/aug/box-b-the-housing-market.html#fn4
Samuelson, P., & Nordhaus, W. (2004). Economics: Seventeenth edition. New Delhi: Tata McGraw Hill.
Shiller, R. (2007). Low Interest Rates and High AssetPrices: An Interpretation in Terms of Changing
Economic Models. New Haven: The Brooking Institute.
The Department of Foreign Affairs and Trade . (2017). Composition of Trade Australia 2016. Melbourne:
The Department of Foreign Affairs and Trade , Australian Government.