Economics Case Study: RBA Interest Rate Decision Analysis, 2018

This case study delves into the Reserve Bank of Australia's (RBA) monetary policy decisions, specifically focusing on the December 4, 2018, interest rate decision. The paper examines the objectives of monetary policy, including price stability, exchange rate stability, neutrality of money, economic growth, and full employment, and defines the functions of money. It analyzes the RBA's functions and the money market equilibrium, illustrating it with a diagram. Furthermore, the study explores the monetary transmission mechanism, detailing how changes in the cash rate affect economic activity through various channels, and includes diagrams to explain the effects of interest rate changes. The paper assesses the impact of both domestic (GDP growth, inflation, unemployment, housing prices) and global macroeconomic indicators on the RBA's cash rate decisions. The analysis includes an explanation of the decision to keep the cash rate unchanged at 1.50 percent, along with discussions on economic growth and its long-term determinants. The study utilizes data and graphs from the Australian Bureau of Statistics (ABS) and RBA websites to support its analysis, applying the DADA framework as requested in the assignment brief.

Running head: ECONOMICS
Economics
Name of the Student
Name of the University
Course ID

ECONOMICS
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
1

ECONOMICS
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
2

ECONOMICS
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
3

ECONOMICS
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.
4

ECONOMICS
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
5

ECONOMICS
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
6

ECONOMICS
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
7

ECONOMICS
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)
8

ECONOMICS
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
9

ECONOMICS
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.
10

ECONOMICS
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.
11