ECON11026 Principles of Economics | Market Currencies Management

The Impact, Mechanics, and the Effectiveness of the RBA’s Monetary Policy Decision

Monetary policy is an essential component of the modern economy. In most cases, the responsibility of monetary policy lies on the country’s monetary authority. In Australia, monetary policy decisions are made and implemented by the Reserve Bank of Australia (RBA, 2017). Characteristically, monetary policy involves setting the interest rates on short-term loans in the country’s money market. Through this interest rates, the RBA is able to control the money supply in the economy, and thereby influence the level of business activity in the aggregate economy to aid in the achievement of its macroeconomic objectives.

Monetary Policy, Intended Objectives, and Functions of RBA

By and large, monetary policy refers to deliberate action by the government through the country’s monetary policy to control the level of aggregate activity in the economy by controlling the money supply. Mainly, this is done by targeting a specific inflation rate or interest rate. Fundamentally, this is done through various monetary policy tools. Predominantly, the main objectives of monetary policy in Australia include the achievement of price stability, sustainable economic growth, maintain a low inflation level and achieve a low level of unemployment. In addition, monetary policy seeks to maintain a predictable exchange rate with other countries’ currencies and attain an equilibrium balance of payment.

Objectives of monetary policy

Economic growth. It is noteworthy that the achievement of sustainable economic growth for the Australian economy is one of the primary objectives of monetary policy in the country. Today, the RBA is tasked with the responsibility of stimulating economic growth in the country. Primarily, economic growth refers to the process in which the real GNP per capita of the country rises over a period of time. Thus, this policy can help in the achievement of this objective by offering investment resources through affordable credit and through the mobilization of savings that can be used for investment. Thus, the RBA can ensure the achievement of this objective by ensuring adequate availability of credit through lower costs of credit.

Price stability. The RBA is also responsible for maintaining low levels of inflation in the country. Normally, inflation weakens the capacity of money to perform its role as a store of value and means of deferred payment. Predominantly, the RBA maintains low levels of inflation in the country by controlling the money supply through the use of monetary policy tools such as Open Market Operations and minimum reserve requirements. It is worth noting that price, a certain rate of inflation in the country is inevitable. In this regard, the RBA has set the inflation target at about 2-3 percent (RBA, 2017).

Full employment. This is another major objective of the monetary policy of the country. Monetary policy can raise the level of employment in the country by extending and encouraging credit to labor intensive sectors in the country. In addition, it may do so by enacting policies that lower the rate of interest within the economy, thereby stimulate the level of investments in the economy. An increase in the investment rate would then increase the level of employment in the country.

Equilibrium Balance of Payment and stable exchange rate. It is important to note that the policies of the floating exchange rate and the increased openness due to globalization of the Australian economy have made the Australian dollar volatile. In addition, the continuous changes in capital outflows and inflows alongside fluctuations in the supply and demand of foreign exchange causes significant instabilities in the exchange rate of the Australian dollar. For this reason, it has become crucial that the RBA maintains foreign exchange stability for the country’s currency in order to prevent volatility as this may negatively affect the balance of payments of the economy. In this case, monetary policy may be used in such a manner that credit and resources are selectively channeled towards the export sector and away from the import sector. This way, the country’s balance of payment position would improve.

Functions of the Reserve Bank of Australia

It is worth pointing out that the RBA has an important role in the Australian economy. By and large, the RBA has the function of formulating and implementing the monetary policy of Australia. Mainly, this function is directed towards achieving and maintaining price stability within the Australian economy (Blanch, n.d.). In addition, the monetary authority also functions as an agency of the government responsible for the underwriting and issuing of government instruments such as government bonds and treasury bills. In this regard, the RBA plays a significant role in regulatory the quantity of money supply in the nation. Additionally, the RBA acts as a bank, advisor and fiscal agent of the Australian government. It has the function of issuing currency notes and coins in the Australian economy. It is also responsible for formulating and implementing the nation’s foreign exchange policy. Apart from that, the monetary authority has the role of ensuring solvency, liquidity, and proper operation of the country’s financial system.

The Cash Rate

At the March meeting, the RBA board opted to leave the cash rate at 1.5 percent (RBA, 2017). However, in the past years, the board changed the rate to cater for different economic conditions at the time. It is worth noting that changes in the cash rate have a significant influence on the level inflation and the rate of economic growth in the country. Typically, the official cash rate refers to the rate of interest at which the RBA charges commercial banks for short term loans. Through this rate, the RBA is able to adjust the terms and structure of rates of interests in the entire economy. Markedly, the country’s monetary policy decisions are articulated in terms of the cash rate. Thus, any variations in the cash rate would result in significant fluctuations in the entire economy.

According to the Keynesian school of thought, individuals hold money for three basic motives, among them transactional, speculative and precautionary demand for money. In this theory, the speculative demand for money depends on the level of interest rate in the economy. Thus, when the prevailing interest rate is high, individuals demand less money, and when the level of interest is low, people demand more money as they expect interest rates to rise. In the same view, when the cash rate reduces, the prevailing level of interest in the country also drops. In turn, this increases the demand for money in the economy. Thus, people would have more money at hand.

Subsequently, an increase in the amount of money held by individuals in the economy raises the level of consumption in the economy. More precisely, individuals have more income to purchase services and goods in the economy. Largely, this raises the demand for consumer’s commodities in the economy. An increase in aggregate demand will result in an increase in the real GDP of the economy. However, it is imperative to note that this may result in increases in the price of commodities. A continued increase in the prices of commodities would result in some level of inflation in the economy.

In the same view, the monetary policy transmission mechanism portends that there is a plausible correlation between the rate of inflation and the cash rate in the nation. More precisely, the policy works best through its effect on the level of aggregate demand. Thus, in the long run, it has an influence on the level of inflation in the economy. In this transmission mechanism, an adjustment in the cash rate is instantly passed on to other short-term money market rates. As soon as the cash rate changes, commercial banks alter their lending rates, thereby affecting the interest rate at which they charge their customers. In the same manner, the change in the cash rate would bring about changes in the long term interest rates within the economy.

Source: (Bank of England, n.d.).

Additionally, it would create changes in the market value of assets and securities such as equities and bonds. Intermittently, a reduction in the cash rate results in an increase in the price of bonds, and vice versa. Mainly, this is because there is an inverse relationship between the price of bonds and the level of interest rates, which are influenced by the prevailing cash rate. Furthermore, the cash rate also affects the exchange rate of the country’s currency such that a decrease in the cash rate results in a depreciation of the nation’s currency in the foreign exchange market, ceteris paribus. The change in the cash rate would also affect people’s expectations and confidence, thus influence their decisions in the financial market. It also affects individual’s consumption patterns and their saving rates and debts. Notably, the effects of the change in the cash rate to changes in the spending behavior are what results in the changes in the level of GDP in the country as well as inflation.

Imperatively, all the changes in the individual's behavior result in changes in the level of aggregate demand. Thus, a reduction in the cash rate results in an increase in the aggregate spending level in the economy, In this case, the total domestic spending encompasses private consumption expenditure, government consumption expenditure, and investment spending. Thus, the total domestic spending plus the net exports reflect the aggregate demand in the country (Bank of England, n.d.). Notably, this is equal to the GDP of the economy as well as increases the price level in the economy. Thus, a reduction in the cash rate brings about increases in the real GDP. Even so, it may bring about increases in the level of inflation in the country.

RBA’s Decision

Profoundly, the decision made by the RBA board was informed by various factors in the economy. It is believable that the Board considered a wide array of factors in the economy before deciding to maintain the official rate at 1.5 percent (RBA, 2017). Firstly, the Australian economy is still transitioning after the end of the mining investment boom, leading to an expansion of about 2.5 percent last year. In addition, this official rate led to a strong increase in the level of exports from the Australian economy. It has also stimulated a non-mining business investment in the country over the past one year. Thus, the RBA board saw it necessary to maintain this cash rate to maintain the level of investment and exports in the economy.

Besides that, the low-interest rates continue to support the prevailing macroeconomic conditions in the country. To begin with, the financial institutions in the country are in a good position to lend to its customers at a low rate. Thus, the cost of credit in the country is relatively low and would, therefore, encourage an increase in the rate of investment in the economy. Additionally, the low cash rate in the economy has created a depreciation of the Australian dollar, which in turn has supported the economy in its transition after the cooling of the mining boom. Furthermore, the current rates reflect prospects of improvements in the labor market. Forecasts indicate that the rate of unemployment in the economy will drop if all factors remain constant. Most importantly, the inflation rates in the country are relatively low. Thus, this implies that the economy is experiencing price stability and consumer price index is low. For this reason, taking all these factors into consideration, the RBA board opted to maintain the official rate at 1.5 percent (RBA, 2017). Indeed, this is expected to steer the economy towards sustainable growth.

Monetary Policy and the Housing Market

In the media statement, the RBA considered the conditions of the housing market when deciding on the cash rate. Changing the cash rate would have created significant changes in the housing market. Remarkably, the current cash rate has created a sufficiently low level of the interest rate at which commercial banks can lend to investors in the housing unit. In turn, investors are able to borrow funds from commercial banks at a low credit cost. A low credit cost implies that the cost of building housing units in the country also reduces. Consequently, this leads to a reduction in the price of houses in the country. Likewise, the rent charged for housing units in the country is expected to reduce.

Predominantly, the RBA is concerned about the rapid increases in the growth of property prices in Australia because it has reduced the housing affordability problem. Thus, maintaining the cash rate at a low level would work best in improving and increasing housing affordability in the country. To achieve this goal, the RBA has initiated various supervisory measures that have contributed to the strengthening of the lending standards. More precisely, these macro-prudential rules for commercial banks restrcit the flow new interest-only loaning to 30 percent of total new residential mortgage financing. Subsequently, this has created strict internal limits to lending. Thus, individuals and investors are able to borrow in a manner that does not result in excessive in demand or supply for houses.

Limitations of Conventional Monetary Policy

Despite its wide adoption and application, conventional monetary policy has various limitations in its implementation. The first limitation pertains to the fact that the role of monetary policy in the process of economic development is restricted. More precisely, the RBA has been assigned to a minor role in the process of development. In addition, the conflicting objectives of monetary policy make its implementation restrictive (Chand, n.d.). Some of the conflicting objectives include price stability and economic growth, full employment and balance of payment, and full employment and price stability. As such, the fulfillment of one objective results in the foregoing of the other objectives. Hence, this limits the overall applicability of monetary policy in the economy.

Another limitation relates to the fact that the country’s money market is underdeveloped. The country’s weak money market limits the coverage of the monetary policy, thereby reducing the effectiveness of monetary policy. Furthermore, the existence of unfavorable banking habits among the Australian people limits the functionality of monetary policy. Generally, the Australian people prefer to use cash instead of a cheque. In turn, this means that a significantly large proportion of cash continues to circulate within the economy, thereby limiting the credit creation process of commercial banks.

On the other hand, some economists believe that monetary policy rules are a better policy option than discretionary inflation targeting. Primarily, inflation targeting refers to where the RBA estimates and makes public the expected general rise in the price level in the country. Here, the monetary authority announces the target rate of inflation and then tries to steer the actual rate of inflation towards the target rate. Its limitation lies in the fact that once the target has been set, the RBA has to adjust the level of interest rates in the nation in order to attain the goal (Jahan, n.d.). Thus, it is associated with uncertainty (Binder & Rodrigue, 2016). In addition, it is rigid.  On the other hand, monetary policy rules are often simple and precise and therefore can improve predictability and reduce uncertainty about the motives of the policy makers. In addition, it facilitates accountability and reduces the possibility of political interference.

Conclusion

All in all, all factors considered monetary policy plays a significant role in the Australian economy. The Reserve Bank of Australia is in charge of setting and implementing monetary policy in the country. Recently, the RBA opted to preserve the official rate at 1.5 percent (RBA, 2017). Mainly, this decision was informed on the grounds that the low cash rate has facilitated slight increases in the economic growth of the country. In addition, the rate has ensured a low rate of inflation in the economy. What is more, there are great prospects for improvement in the level of employment in the economy as well as increases in the level of net exports in the nation. For this reason, the current cash rate is expected to steer the Australian economy towards sustainable economic growth in the medium and long term.

References

About Monetary Policy (2017). Reserve Bank of Australia.  Retrieved 27 May 2017, https://www.rba.gov.au/monetary-policy/about.html.

Binder, C., & Rodrigue, A. (2016).  Monetary Rules and Targets: Finding the Best Path to Full Employment. Center on Budget and Policy Priorities. Retrieved from https://www.cbpp.org/research/full-employment/monetary-rules-and-targets-finding-the-best-path-to-full-employment.

Blanch, A. The role of the Reserve Bank of Australia. Domain. Retrieved from https://www.domain.com.au/advice/role-reserve-bank-of-australia/.

Cash Rate (2017). Reserve Bank of Australia.  Retrieved 27 May 2017, https://www.rba.gov.au/statistics/cash-rate/.

Chand, S. 7 Major Limitations of Monetary Policy in less Developed Countries. Your Article Library. Retrieved from https://www.yourarticlelibrary.com/economics/7-major-limitations-of-monetary-policy-in-less-developed-countries/11097/.

Jahan, S. Inflation Targeting: Holding the Line. International Monetary Fund. Retrieved from https://www.imf.org/external/pubs/ft/fandd/basics/target.htm.

Monetary Policy (2017). Reserve Bank of Australia.  Retrieved 27 May 2017, https://www.rba.gov.au/monetary-policy/.

The transmission mechanism of monetary policy. Bank of England.  Retrieved 27 May 2017, https://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf