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.
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.
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.
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.
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.
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
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
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 China. In addition to trade relation, there are financial interdependence between the two nations. China makes investment in infrastructure projects in Australia.
Japan is considered as one of the major economic partners of Australia. Japan has a strong trade relation with Australia and is now become major source of capital investment. In 2014, Australia and Japan has signed agreement of Japan Australia Economic Partnership (JAEPA), which came into force on January 15, 2015. The agreement benefits both the nation. It creates new opportunities for trade and investment (Medcalf, 2014). The agreement increases economic interdependence between the two nations. Australia supplies minerals and energy to Japan. The investment in Japan is important for export industries in Australia.
A strong political and economic relation exists between Australia and India. In terms of export, India provides fifth largest export market to Australia. There is significant growth of investment between the two nations over decade. A total of $19.4 billion valued goods and services exchanged between Australia and India in terms of a two way-way trade relation. Major export of Australia to India include coal, gold, vegetables and education (Bildirici & Bakirtas, 2014). The imports to Australia include personal travel, travel except education services, pearls, refined petrol and gems. India invests in resource and energy sector and advanced manufacturing, technology and services.
Coming to USA, it is the strongest and most important economic partner of Australia. The USA and Australia entered to a bilateral trade agreement in 2005 (Baylis, Owens & Smith, 2017).Goods worth millions of dollars are exchanged between the two nations. Different firms of USA operates in Australia contributing to Australian economy.
Cash rates are the interest rate that RBA charged on funds loaned to commercial banks. As described above, Australia maintains a strong relation with USA, China, Japan and India. The financial and trade relation among the nations build a strong interdependence between Australian economy and these nations. Economic fluctuation in these countries affects Australian economy and based on their economic status RBA revises the cash rate prevailing in the nation. For example, in 2008, the financial crisis in USA affected the economy of Australia and RBA decided to cut its cash rate to a significantly low level. Recently, the developed and emerging economies are experience some changes in their economic environment. Growth of infrastructural sector and housing construction has brought economic growth for China. The Federal government in United States has announced to increases in raise its interest rate. There are both direct and indirect channels for how economic indicators of these countries affect Australian economy. The Direct economic channel implies changes in trade volume (Sherline, 2016). Development of these countries indicated from a higher growth rate, low unemployment and other positive signs raises the export earnings leading to economic growth of Australia. These factors affect capital investment and then RBA needs to adjust cash rate to stimulate domestic investment. Following economic and trade relation of Australia with other nations and effect of changes in economic indicators on Australia’s economic environment, RBA considers macroeconomic condition of these nations while taking decision on cash rates.
The cash rate determined by RBA directly influence the interest rate that commercial bank charge on investors. RBA revises cash rates several times to maintain stability in the price level. The RBA governor Philip Lowe relies on a low cash rate to boost Australian economy. RBA announced a reduction in cash rate in from November 2011 in order to control the price of Australian dollar and achieve its inflation target. During this time, the policy was unable to attain targeted policy goals. The policy then resulted in a massive rise in housing price. Again, in May 2015, RBA lowered the cash rate to 2.0 percent and kept the rate unchanged for one year. The cash rate further lowered to 1.75 percent and then to 1.50 percent. The low cash rate severely has severely affected housing market in Australia. With a low cost of borrowing, household raise the demand for housing causing a high price of housing. There is an approximate rise of household borrowing by 6.5% with no recorded increase in household income. This raise the debt level. Thus, the low cash rate has a detrimental effect on the economy though housing market (Goodfriend, 2016). As a result, RBA is now considering of implementing lending constraint in real estate market. Currently, RBA has decided to maintain a low cash rate of 1.5 percent. The low cash rate is expected to provide support to Australian economy. RBA believes that this low interest rate will help to secure a sustainable growth rate and attain inflation target.
Equilibrium in the money market is determined from balance between money demand and money supply in the economy. The supply and demand for real money balances are two important notion of money market. The theory of liquidity preferences assumes money supply in the economy is fixed (Keynes, 2016). Therefore, real money balance supply is given as
The liquidity preference theory further assumes an inverse relation between interest rate and money demand.
Equilibrium is ensured where
The interest rate in the economy is determined from money market equilibrium. The monetary policy conducted by RBA influences money supply through changes in the cash rates.
Change in cash rates influences economic variables through monetary transmission mechanism (Bernanke, Antonovics & Frank, 2015).
The effect of monetary policy is transmitted to goods market and money market through different channels.
RBA in August 2016 has reduced the cash rate by 0.25 basis point and the 1cash rate reduced from 1.75 to 1.50 and remained unchanged. Along with interest rate, the equilibrium quantity of money supply reduces. With a cut in the cash rate, there is an associated reduction in money supply. This is reflected with an inward shift of money supply curve. Accordingly, a new equilibrium is achieved at the intersection of new supply curve and existing money demand curve.
RBA adjusts cash rates several times to fulfill targeted objective. In response to recession occurred in 1991, RBA took an ease monetary policy and cash rate reduced significantly for the period 1990 to 1995. Since then until 2008, RBA has maintained a stable cash rate moving around 5%. Again, in response to GFC, RBA has reduced the cash rate further (Lane & Rosewall, 2015). The cash rate first reached to 2 percent, then declined to 1.75 percent and further to 1.50 percent.
GDP is defined as the measured value of goods and services produced in the economy in monetary terms.
The economy of Australia recorded a growth rate of 0.6 percent. The growth rate has recorded has accounted a slight declined from the previous quarter having a growth rate of 0.9 percent. The positive-growth rate implies a continuous increase in GDP. Therefore, the tight monetary growth in the form of low cash rate has helped the economy to maintain a growth rate (Bajada, 2017).
Inflation is defined as the gradual increase in general price level in the economy.
The direct effect of the cash rate is on the inflation rate. Following adjustments in the cash rate, price level in Australia has stabilized around 2 to 3 percent.in times of rising inflation rate RBA increases cash rate while in times of deflation RBA reduces the interest rate.
As shown above the movement of unemployment is in line with the movement of cash rate. RBA has made a downward revision in the cash rate in 2016 following which the unemployment rate reduces significantly (Enright & Petty, 2016). The cash rate now settled at 1.50 and unemployment settled at nearly 5%.
In 2016, the budget deficit in Australia amounts to 2.40 percent of GDP. The budget deficit averaged at -0.97 percent between 1979 and 2016. Continuous deficit in budget implies a weak fiscal position and hence Australia needs to rely on its monetary policy.
Australia has experienced a housing price inflation around 10 percent in the year 2013. The housing prices rose even faster from third quarter of the year (businessinsider.com.au, 2018). The price hike in housing market is in line with the relation exists between housing price and inflation. The housing turnover rate has increased stimulating demand in the property market, financial and legal service.
Economic growth is measured as an increase in country’s productive capacity. The economic growth is realized with a gradual increase in income, decline in unemployment and an overall improvement of health of the economy (Sloman, Norris & Garratt, 2014). The growth that is accounted in the form of GDP is the actual growth rate while potential growth rate reflects growth capacity of the economy and hence, give an indication towards long term growth.
The long term economic growth depends on key determinants of GDP and productivity. The level of public expenditure, formation of capital level of investment, exchange rate, employment rate are some determinants of economic growth. The productivity growth is one driving factor for long term growth and standard of living. The productivity growth in Australia was lower in 1980s as compared to that in 1960 (aph.gov.au, 2018). In 1980s, growth rate in Australia was lower than other OECD nation. After that, monetary and fiscal stimulus gradually improve economic growth.
Reserve Bank of Australia cut the cash to a significantly low level of 1.50 percent. The monetary policy easing helps the country to maintain stability in different macroeconomic indicators. The policy helps Australia to tackle the pressure coming from other developed nations. Major economies and trading partners of Australia are facing a low investment, low export growth and low inflation rate. The Australian economy needs protection from these external shocks and for this RBA uses the instrument of cash rate. Australia is successful in maintaining a stable growth rate for a long time and the easing monetary policy is expected to maintain wage and employment growth and secure a long term growth.
Conclusion
The paper analyzes the recent monetary policy of Reserve Bank of Australia. As per latest monetary policy statement, the RBA’s governor has announced to maintain a neutral cash rate of 1.50 percent. The monetary policy decision is undertaken after considering the domestic and external macroeconomic indicators. The economy of India, China, Japan and USA are countries sharing a good relation with Australia. The low cash rate in Australia has a detrimental effect in housing market. Because of low borrowing cost Australia is suffering with a large household debt. This is the reason why RBA would not reduce the cash rate further. However, the cash rate is low enough to support steady and long-term growth for Australia.
References
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