Introduction:
Monetary policy refers to the strategy undertaken by a country’s monetary authority to control money supply usually by targeting the interest rate to facilitate economic growth and stability. The Australian government charges the Reserve Bank of Australia with the responsibility of maintaining sustainable economic growth, high employment rate and steady prices. In other words, the RBA strives to achieve the goals of full employment and non-inflationary level of total output. To accomplish these objectives, the RBA closely monitors the economy and puts in places policies to either increase or decrease the amount of money circulating in the economy. Consequently, the addition or removal of money from the economy affects the availability of credit by lowering or raising the interest rates (cost of borrowing) (Bell 2004).
- What incentives does monetary policy alter and how does this affect economic activity? You need to be specific – e.g. how does monetary policy affect business investment?
During an economic boom, high demand is recorded which may lead to high prices and subsequently, inflation. To curb inflation, RBA pursues contractionary monetary policy such as increasing the cash rate and selling bonds to reduce amount of money in circulation. This increases the cost of lending and puts check on demand and inflation. The reduced amount of money in circulation raises the interest rates and banks puts more restrictions to access credit. It is a taxing affair for businesses and consumers to access credit thus investments and consumer expenditure falls, reducing inflationary pressures on the economy (Mitra 2007).
On the converse, in times of recession, RBA puts into place expansionary monetary policy by relaxing the cash rates and buying government bonds to increase the amount of money in circulation lowering the cost of borrowing and stimulating demand. Increasing amount of money in the economy reduces the interest rates and lowers credit restrictions applied by banks on loan applicants. Consumers and businesses can easily borrow money leading to higher investments and consumer expenditure that increases the aggregate demand (Beyeler 2007).
Since November 2011, the Reserve Bank of Australia has been pursuing expansionary monetary policy lowering the cash rate from 4.5% to 2.5% in December 2013. The changes in the cash rate have a direct effect on lending and deposits rates in the economy including the operations of the asset and credit markets. This in turn affects the amount of consumer expenditure and investment spending. The cash rate is reviewed in response to the inflation rate and total economic output. The RBA ensures inflation remains stable and low by ensuring the total expenditure is kept close to the total national output (Reserve Bank of Australia 2014).
The expansionary monetary policy adopted by the bank has a cause-effect chain. The low cash rates (reduction in cost of borrowing) alter the rate of lending by banks; the rate at which the banks are ready to borrow and provide loans. This eased the availability of credit and all interest-sensitive expenditure such as mortgages, business investment and consumer spending will be affected by the monetary policy. The decreased rate of credit meant that businesses could easily access credit. The cost of capital went down and capital’s rate of return increased; therefore, businesses were willing to borrow to finance their investments (Hossain 2009).
Furthermore, the low cost of capital increased the feasibility of business investments therefore the quantity of private investments grew considerably in the period between November 2011 and December 2013. Investment is a major component of the aggregate demand for goods and services in the Australian economy. Subsequently, the increased levels of business investment alter the equilibrium Gross Domestic Product. Secondly, the increased level of business investment boosted the employment rate in the economy. The high business expenditure has also a multiplier effect through the employee’s constant source of income enhanced the aggregate through increased consumer spending. In addition, the low cost of borrowing influences consumers’ borrowing and saving (Reserve Bank of Australia 2014).
At low levels of interest rates, savings is less attractive and consumers could access credit at ease therefore private consumption expenditure increased. Business reported increased sales and profitability thus business spending further increased. The change in interest rates impact on the value of the Australian dollar since RBA employs a floating exchange rate policy. The reduction in the cash rate led to low interest rates leading to the depreciation in the value of the Australian dollar and growth in net exports. Australian products would be cheaper in foreign markets and countries would demand more Australian goods and services while imports to the subcontinent become expensive. Businesses have to make more investment to meet both the increasing local and foreign demand. The expansionary monetary adopted by the RBA has had a positive impact on business investment. The cost of capital was low; the rate of return on capital was encouraging, positive net export effect and the high consumer expenditure inspired business to invest more positively impacting on the Australian economy and its GDP (Mishkin 2007).
- What reasons did the Reserve Bank give for its decision to raise interest rates in April 2010?
RBA increased the interest rates in April 2010 in response to the existing macroeconomic environment both locally and internationally. The bank argued that the general outlook of the economy especially the high level of the terms of trade and the prospective further large increase in investment necessitated the rise in interest rates. Australia had recorded its highest level of terms of trade and the expected mining boom would destabilize the economy at low levels of interest rates (Rate detective 2014). Next, the bank has a mandate to maintain the inflation levels within its target (2-3%). Lowering the interest rates would fuel demand that would drive inflation leading to economic instability. Moreover, at the time, growth in employment has been steady and the unemployment rate has remained stable at 5% since the beginning of 2011 (Reserve Bank of Australia 2014).
- What reasons did the Reserve Bank give for its decision not to change interest rates in December 2013?
The RBA retained the cash rate at 2.5% in December 2013 stating that the level of interest rate would promote sustainable growth in demand and maintain the current inflation rate that is consistent with the bank’s target. Further, by maintaining constant rates in the predictable future, the bank would create certainty in the economy. Consumer demand in the economy has been strong driven by the firm growth in housing construction. The country’s exports have grown significantly while business environment and confidence in the economy has improved. The global economy has shown remarkable resurgence with the major export markets in the United States, European Union and Japan registering inspiring growth. China’s economy has continued to grow as the monetary policymakers had predicted (Reserve Bank of Australia 2014).
The exchange rate has also declined and it will assist in attaining balanced economic growth. Nonetheless, historical comparison shows that the price of the Australian dollar is still too high and further depreciation would foster more economic growth. Credit demand by household has been quite low but it has recorded steady growth in the past few months. This demonstrates that Australia citizens are embracing the low interest rates on credit arising from RBA’s decision to maintain the cash rate at 2.5%. the inflationary pressure on the economy arising from the mining boom has also subdued thus it is more feasible to retain the cash rate at 2.5%. The rate of unemployment may increase as the economy adjusts to the decreasing mining investment but in the long term, it will stabilize (Reserve Bank of Australia 2014).
- Do you think that Australia’s monetary policies between 2006 and 2013 have been appropriate for the economic circumstances during this period? Explain why you think they were appropriate or not appropriate and give evidence to support your answer.
For the period between 2006 and 2013, the RBA has pursued both expansionary and contractionary monetary policies in response to the existing and forecasted macro-economic conditions. The bank has managed to pursue the appropriate monetary policies during the period. For example, in February 2006 the cash rate was 5.5 percent rising to 7.25% in August 2008 (contractionary monetary policy) before going down since the year 2008 to its low levels of 3% for the period between April and September 2009 (expansionary monetary policy). It began to rise again hitting 4.75% between December 2010 and October 2011. The current cash rate is the lowest at 2.5% operational since August 2013 (Reserve Bank of Australia 2014).
RBA has a responsibility to stabilize aggregate demand and employment levels and at the same time, maintain acceptable levels of inflation. The period between 2006 and 2008 was an economic boom with high levels of demand and outstanding economic growth that fueled inflationary pressure on the economy. RBA increased the cash rate to increase the cost of credit and capital thus curbing inflation. Then in September 2008, the economy started to experience the adverse effects of the global financial crisis. Economic growth started declining to less than 1% and the unemployment levels started to rise hitting 5.75% by November 2009; this was a 2 percent increase. Equity prices plummeted leading to reduction in households’ wealth by almost ten percent. The Australian dollar depreciated by 30% compared to its value in July 2008. The RBA had to intervene to stimulate demand in the economy through lower cash rates (Reserve Bank of Australia 2014).
RBA intervention led to recovery in equity prices and liquidity; consequently, demand grew to high levels that RBA had to reinstate higher cash rates to check inflation and regulate demand. The financial crisis has led to structural changes in the Australian economy, huge movements in the comparative world prices and an investment boom in the mining sector (Lowe 2013). At the height of the investment boom and high levels of the terms of trade, RBA had to increase the cash rate to contain the inflationary pressures on the economy. The investment boom is over and the general economic environment has improved considerably. The rate of borrowing is gradually recovering and the inflation rate (ranging between 2-3%) is within the target set by the bank. The bank has maintained an expansionary monetary policy at a cash rate of 2.5% and monetary experts expects the rate to remain until early 2015 (Reserve Bank of Australia 2014).
Conclusion:
The existing monetary policy in Australia has assisted in maintaining increased business investment by offering cheap credit and the multiplier effect of generating employment, net export effect and altering the GDP. There has been noted a gradual improvement in the business environment and the confidence on the economy. RBA has been changing the cash rate depending on the economic environment. During the economic boom, contractionary monetary policy were used to regulate demand and control inflation while during the recession, expansionary monetary policy was put in place. Proper economic regulation by the RBA has contributed to the general resilience of the Australian economy to the global financial crisis.
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