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.
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
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).
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
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.
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, 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 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.
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 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,
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.
Equilibrium interest rate is determined where supply of real balances matches with demand for real balance.
Figure 1: Money market equilibrium
(Source: as created by Author)
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.
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.
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.
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)
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).
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.
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.
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.
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)
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.
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.
References
Australia’s economic relationships with China – Parliament of Australia. (2017). Aph.gov.au. Retrieved 6 October 2017, from https://www.aph.gov.au/About_Parliament/Parliamentary_Departments/Parliamentary_Library/pubs/BriefingBook44p/China
Australian governments face a decade of budget deficits. (2017). The Conversation. Retrieved 6 October 2017, from https://theconversation.com/australian-governments-face-a-decade-of-budget-deficits-13616
Easthope, H., Stone, W., & Cheshire, L. (2017). The decline of ‘advantageous disadvantage’in gateway suburbs in Australia: The challenge of private housing market settlement for newly arrived migrants. Urban Studies, 0042098017700791.
Fontana, G., & Setterfield, M. (Eds.). (2016). Macroeconomic Theory and Macroeconomic Pedagogy. Springer.
Functions and Objectives of the Reserve Bank | Reserve Bank of Australia Annual Report – 2012 | RBA. (2017). Reserve Bank of Australia. Retrieved 6 October 2017, from https://www.rba.gov.au/publications/annual-reports/rba/2012/functions.html
Heilmann, S., Rudolf, M., Huotari, M., & Buckow, J. (2014). China’s shadow foreign policy: parallel structures challenge the established international order. China Monitor, 18.
Hutchens, G. (2017). Interest rates: why the Reserve Bank of Australia has been cutting away. the Guardian. Retrieved 6 October 2017, from https://www.theguardian.com/australia-news/2016/aug/03/interest-rates-why-the-reserve-bank-of-australia-has-been-cutting-away
Joshi, M., Cahill, D., Sidhu, J., & Kansal, M. (2013). Intellectual capital and financial performance: an evaluation of the Australian financial sector. Journal of Intellectual Capital, 14(2), 264-285.
Keynes, J. M. (2016). General theory of employment, interest and money. Atlantic Publishers & Dist.
Lowe[*] Governor, P. (2017). Household Debt, Housing Prices and Resilience | Speeches | RBA. Reserve Bank of Australia. Retrieved 6 October 2017, from https://www.rba.gov.au/speeches/2017/sp-gov-2017-05-04.html
McLeay, M., Radia, A., & Thomas, R. (2014). Money creation in the modern economy.
Measures of Consumer Price Inflation | RBA. (2017). Reserve Bank of Australia. Retrieved 6 October 2017, from https://www.rba.gov.au/inflation/measures-cpi.html
Moore, A. (2016). Measuring economic uncertainty and its effects. Economic Record.
Pagan, A., & Wilcox, D. (2015). External Review–Reserve Bank of Australia Economic Group Forecasts and Analysis. report to the Reserve Bank of Australia.
Randolph, B., Pinnegar, S., & Tice, A. (2013). The first home owner boost in Australia: a case study of outcomes in the Sydney housing market. Urban Policy and Research, 31(1), 55-73.
Reserve Bank warns it is ‘not in the public interest’ to cut cash rate further. (2017). ABC News. Retrieved 6 October 2017, from https://www.abc.net.au/news/2017-09-05/reserve-bank-on-high-household-debt-unchanged-cash-rate/8875654
Starr, R. M. (Ed.). (2014). General equilibrium models of monetary economies: Studies in the static foundations of monetary theory. Academic Press.
Statement by Philip Lowe, Governor: Monetary Policy Decision | Media Releases | RBA. (2017). Reserve Bank of Australia. Retrieved 6 October 2017, from https://www.rba.gov.au/media-releases/2017/mr-17-15.html
Top 6 Objectives of Monetary Policy. (2017). Economics Discussion. Retrieved 6 October 2017, from https://www.economicsdiscussion.net/money/top-6-objectives-of-monetary-policy/4684
Walsh, C. E. (2017). Monetary theory and policy. MIT press.
Essay Writing Service Features
Our Experience
No matter how complex your assignment is, we can find the right professional for your specific task. Contact Essay is an essay writing company that hires only the smartest minds to help you with your projects. Our expertise allows us to provide students with high-quality academic writing, editing & proofreading services.
Free Features
Free revision policy
$10Free bibliography & reference
$8Free title page
$8Free formatting
$8How Our Essay Writing Service Works
First, you will need to complete an order form. It's not difficult but, in case there is anything you find not to be clear, you may always call us so that we can guide you through it. On the order form, you will need to include some basic information concerning your order: subject, topic, number of pages, etc. We also encourage our clients to upload any relevant information or sources that will help.
Complete the order form
Once we have all the information and instructions that we need, we select the most suitable writer for your assignment. While everything seems to be clear, the writer, who has complete knowledge of the subject, may need clarification from you. It is at that point that you would receive a call or email from us.
Writer’s assignment
As soon as the writer has finished, it will be delivered both to the website and to your email address so that you will not miss it. If your deadline is close at hand, we will place a call to you to make sure that you receive the paper on time.
Completing the order and download