Monetary Policy and Economic Relations: Australia Assignment

This report provides a comprehensive analysis of monetary policy in Australia, focusing on the Reserve Bank of Australia (RBA) and its influence on the economy. It examines the objectives of monetary policy, including price stability, full employment, and exchange rate stability. The report details the main functions of the RBA, such as maintaining currency stability and managing the financial system. It explores Australia's economic relations with China and the USA, highlighting the interdependence and trade dynamics between these nations. The report further delves into the money market equilibrium and the monetary transmission mechanism, illustrating how changes in the cash rate affect the economy. It also provides an overview of key economic indicators, including GDP, unemployment, inflation, fiscal deficit, and housing prices, over the past five years, to assess the effectiveness of monetary policy. The analysis includes graphical representations of these indicators and concludes with an assessment of the current economic scenario and the RBA's decisions regarding the cash rate.

Running head: ECONOMIC ASSIGNMENT
Economic Assignment
Name of the Student
Name of the University
Author note

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Table of Contents
Introduction................................................................................................................................2
Objectives of monetary Policy...................................................................................................2
Main functions of Reserve Bank of Australia............................................................................3
Economic relation of Australia with China and USA................................................................4
Money Market Equilibrium........................................................................................................6
Monetary Transmission mechanism..........................................................................................8
Conclusion................................................................................................................................18
References................................................................................................................................19

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Introduction
Monetary policy is one of the major policy tools for government to influence major
economic variables. In Australia, Reserve Bank of Australia designs monetary policy
framework. Apart from maintaining stability in the price level, RBA also aims at ensuring
stability in exchange rate, full employment, equilibrium in external balance account and
control other activities in financial market. Recently, governor of RBA has announced the
decision of keeping the cash rate at the exiting level o0f 1.5 percent.
The low rate is not the result of domestic economic condition. The scenario in global
market and economies of its trading partner determine the official rate in Australia. RBA
fears that a further cut in cash rate will lead to an increase in housing debt to the already
indebted housing market. There are pressures from advanced economies as well.
The paper analyzes the recent framework of monetary policy in Australia. The
performance of Australia in its GDP, unemployment, inflation, fiscal deficit and housing
market data of Australia for the last five year is considered. Cash rates of the economy
influences performance of the economy. The low and stable cash rate is expected to stabilize
Australian economy.
Objectives of monetary Policy
Monetary policy refers to the policy framework designed to maintain stability in the
price level and ensure a long term growth rate through influencing the available money
supply in the economy (Fontana & Setterfield, 2016). The main objectives of monetary
policies are as follows

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Neutrality of Money: This objective is designed because of the fact that economic
fluctuations are mostly resulted from monetary changes occur in the economy. It causes
distortion in the economic activity. Once money is neutralized, there is no cyclical
fluctuation, inflation, no deflation and no trade cycles.
Stability in the exchange rate: Maintaining a stable exchange rate is one of the primary
objectives of monetary policy. Volatile exchange rate leads to instability in the external sector
and affects the domestic economy as well. Whenever there is instability in exchange rate
leading to disequilibrium in Balance of payment then central bank stands to adjust the
exchange rate (Walsh, 2017)..
Stability in the price level: This is the main objective of monetary policy. The central bank
adjusts money supply in the economy to stabilize price level. At time of inflation it follows a
tight monetary policy while at times of deflation it follows an expansionary monetary policy.
Achieve full employment: The objective of full employment needs support from the
monetary Authority. The monetary authority aims at bringing equilibrium between savings
and investment at the level of full employment.
Economic Growth: Monetary policy supports sustained economic growth in terms of
maintaining equilibrium between money demand and production capacity of the economy. It
further creates conditions favourable for saving and investment to boost growth objective
(economicsdiscussion.net, 2017).
Main functions of Reserve Bank of Australia
Reserve Bank of Australia (RBA) is the central bank of Australia. Main functions of
RBA are as follows
Maintain stability in the currency of Australia

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Keeping the economy of Australia at full employment level
Look after the prosperity and welfare of Australian people.
Since 20 year from now, RBA has maintained it commitment towards achieving a
medium term inflation target. It aims to maintain inflation in consumer prices in between the
range of 2 to 3 percent (Pagan & Wilcox, 2015). Apart from designing monetary policy, RBA
performs other functions as well.
It promotes general balance or stability of Australian financial system.
Maintains foreign exchange reserves
Offers banking services and facilities to the government and official financial institution
overseas
Control operation of high valued payment system in Australia
The issuance of Australian bank notes is the responsibility of RBA
RBA publishes monetary policy statement on quarterly basis. Though it does not
directly set interest rate prevailing in the economy, it makes its contribution in determining
interest rate through its operation in money markets.
Economic relation of Australia with China and USA
Since the China’s growth phase starting in 1970, Australia has taken the position to
meet growing demand for building materials, manufacturing raw materials, energy demand
for transport and electricity. With this a strong interdependence between the two nations has
established. Today, China is considered as one of the largest trading partners of Australia in
terms of both export and imports (Heilmann et al., 2014). Domestic market in China provides
a large market for Australia’s good and hence, increases demand for resources. However,

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resource export from Australia to China has slowed down because of supplanting coal with
natural gas. The terms of trade of Australia is likely to be affected as the capacity of iron ore,
new coal and gas in Australia and other advanced nations has come on flow. An expected
result of this is the decline of Australian dollar. China is the largest market for Australian
education services. Many of the Australian banks and financial institution operates in China.
China shows its interest for making investment in Australian infrastructure projects.
Like China USA also shares a strong economic relationship with Australia. USA is
considered as one of the largest and strongest economy in the world. USA is an important
export market for Australian goods. The nations agreed on a bilateral trade agreement that
became effective in 2005 (Starr, 2014). The two nations traded goods billion of worth every
year and maintain a positive trade balance. Apart from trade relation there are capital flows
from both the nations. USA firms operate in Australia offering employment opportunities to
Australian people.
Cash rates are the rates at which RBA lends funds to commercial banks. It determines
the level of economic activity in the nation. In context of strong economic relation and
interdependence of Australia with that of China and USA RBA has to consider
macroeconomic indicators in these countries before revising the cash rate or keeping it
unchanged. In recent days, the economies of major countries have undergone changes. For
example, the Chinese economy has experienced a rising growth rate because of expansion in
infrastructure and housing construction. In United States, Federal government has expected to
increase the interest rate. In response to changes undergoing in these major economies, RBA
takes decision regarding the cash rates.
Currently, Australian economy has faced a rising trend in exchange rate. The cash rate
has a direct influence on commercial bank’s interest rate. When cash rate is low then loans

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are available at a low rate which encourages borrowing. When it is costlier for commercial
banks from the central bank then commercial banks as well raise the interest rate making
borrowing costly. At this time, RBA governor does not consider it to the interest of public to
encourage borrowing by further cutting federal cash rates. As a result, the cash rate holds at
1.5 percent. Governor Philip Lowe expects a lower cash rate leads to growth of domestic
borrowing at a faster pace and contributes to the medium term risk for the economy. He
reserve bank has considered a cut in the cash rate by 3.25% from November 2011 with the
objective of controlling Australian dollar and keep a hold on price level. However, this policy
failed to achieve its targeted objective (aph.gov.au, 2017). RBA has recorded in the housing
market price was soaring. The reserve bank has found that growth in price level has declined
in Sydney and hike in interest rate for targeted investors has a positive impact. In the last four
years, the household borrowing had risen by 6.5 percentage point but no growth is recorded
in household income over the period contributing to a rising debt in the economy (rba.gov.au,
2017). The RBA has given attention with high level of housing borrowing associated with
high debt.
RBA governor has pointed out that banks should increased constraints for lending to
real estate business to counter the oversupply. Considering the current economic scenario,
RBA decides to maintain a steady cash rate. It considers the current rate is in line with
sustainable growth rate. Dr. Lower is in opinion of a neutral cash rate. The current rate of 1.5
percent is around 2 percent below than the preferred rate. By this neutral cash rate, the
central bank provides it outlook for interest rate prevail in the nation.
Money Market Equilibrium
Equilibrium in the money market is defined as a state where money supply and money
demand matches at a point to determine interest rate in the economy. There are two important

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aspects to be defined here- supply of real money balances and demand of real money
balances. The supply of real money balance is denoted as M/P. Where M is the money supply
and P is the price level. The liquidity preference theory assumes the supply of real money
balance is fixed in the economy (Keynes, 2016). Therefore,
( M
P )
S
= M
P
Next component is money demand. Liquidity preference theory assumes interest rate is a
determinant of money demand. Interest rate is viewed as the opportunity cost of holding
money and hence depicts an inverse relation between demand for real balance and interest
rate.
( M
P )
D
=L(r )
Equilibrium interest rate is determined where supply of real balances matches with
demand for real balance.

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Figure 1: Money market equilibrium
(Source: as created by Author)
Monetary Transmission mechanism
Monetary transmission mechanism is the process through which monetary policy
affects different variables of the economy (McLeay, Radia & Thomas, 2014). There are
different channels with which the affects of monetary policy can be transmitted and affect
production of goods and services and price level.

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Figure 2: effect of an increase in cash rate
(Source: as created by Author)
When RBA increases the cash rate from 1.5% to 2%, then it means the cost faced by
commercial banks to borrow from the central bank has increased. The increased cost of
borrowing reduces the available liquidity (Moore, 2016). As a result the supply curve of real
money balnce shifts leftward, yielding a higher interest rate at r1. When interest rate increases
then the economy contracts and achieves the targeted inflation rate.

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Figure 3: effect of a decline in cash rate
(Source: as created by Author)
When cash reduced from 1.5% to 1% then availably supply of liquidity in the
economy increases reduces because of a reduced cost of borrowing. The money supply curve
shift rightward resulting in a lower interest rate (Joshi et al., 2013). As a result of reduced
interest rate, investment is boosted as interest rate is the cost of investment.

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Figure 4: GDP in the last five years
(Source: rba.gov.au, 2017)
As the graph suggests, gross domestic product in Australia has risen over the past five
years. When RBA reduces the cash rate, there is an increase in available money supply. This
boosted investment and hence output.
Figure 5: Unemployment in Australia
(Source: rba.gov.au, 2017)

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When GDP increases then production activity increases cr4eating new employment
opportunity. This helps to reduce Australian unemployment rate. The unemployment has
reduced 2015 onwards in response to a low cash rate.
Figure 6: Inflation rate in Australia
(Source: rba.gov.au, 2017 )
Cash rate has a direct influence on the inflation rate. Australian government increases
the cash rate in 2011 to keep a hold on inflation rate. This partly reduces the inflation
however, soaring housing prices disturbed inflation targeting mechanism
(theconversation.com, 2017).

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Figure 7: Deficit in government budget
(Source: rba.gov.au, 2017)
Australian government has faced a budget deficit on an average of 4% of GDP. The
structural changes that the economy is undergoing are the deriving factor for existence of
large budget deficit. Government has to spend a huge amount on health expenditure. Along
with health expenditure, government spends a significant amount on school education.

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Figure 8: housing prices and household debt in Australia
(Source: rba.gov.au, 2017)
Housing prices in Australia is growing at a rapid pace. To meet housing demand
people’s borrowing also increases as reflected from rising housing debt (Randolph, Pinnegar
& Tice, 2013). Lower nominal interest rate and moderate inflation rate allow people to
borrow leading to a growth of housing debt.

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Figure 9: Disposable income of household in Australia
(Source: rba.gov.au, 2017)
Another factor contributing to rising housing market debt is the lower average
disposable income. Disposable income of the household decreases over the past few decades
and income becomes even lower between 2012 and 2016.

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Figure 10: Merchandise trade volume
(Source: rba.gov.au, 2017)
In recent year, the merchandise trade volume has increased considerably. In this trend
China is an important source of global demand. Trade in other Asia pacific nations have
stabilized .
Figure 11: trend in global inflation
(Source: rba.gov.au, 2017)

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Core inflation globally remians low as comaprd to headline inflation. Rise in
producer prices resulted from a increses in oil price and other commodity prices.
Figure 12: Growth in China
(Source: rba.gov.au, 2017)
China is one of the major trading partners of Australia. Growth in tertiary sector is
greater than that of primary and secondary sector. The expansion of service sector in China
affects the growth of Australian economy as well.
An increase in cash rate increases the real interest rate. This will reduces business
investment . As the economy contract consumer demand reduces. As a result aggreate income
or GDP will rise. A direct imapct of cash rate is on the inflation rate of the economy. The
tightening monetray policy will help to achive inflation targeting of central bank (Easthope,
Stone & Cheshire, 2017). When orrowing becomes costly then spending on housing market
will decreses with a declining housing market debt. So nmuch contraction of the economy
crreates obtacles to the long term growth rate. Hence, in future reduction in the cash rate
might help to expand the economy. However, what exactly happen in the future taht depends
on the specific economic scenario and adjustment forces.

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RBA has cut vthe interst rate to a recorded low level of 1.5 percent. The economic
growth rate in Australia and associated unemployment rate is at a stable level. However, the
decision of a cut in interest rate is taken because of increasing pressure from major developed
economies (abc.net.au, 2017). Globally there is a low inflation rate, low in investment, low
growth of export. In order to proptect Australia from this cglobal phenemenon and maintain
steady productivity growth cash rate needs to be cut. The low rate encourages business
investment and ends up with long term growth in producdtivity along with employment
growth and growrth of wages. This justifies the decision of settting a low rate by RBA and
gains support.
Conclusion
The paper discusses recent monetary framework of Australia. Governor of
RBA has announced the decision to keep the official rate at a recorded low level of 1.5%.
However, before taking any decision regarding the cash rate the global scenario especially
that in its major trading partners such as China and USA has been evaluated. Australia shares
a strong international relation with both the nation. The decision of keeping the interest rate
has taken because of the fact that a further cut in the rate will impose additional burden of
housing debt. In view of current global scenario a low official rate is recommended and hopes
to ensure a steady long term growth for Australia in near future.

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