Monday, January 16, 2012

Monetary Policy in Australia

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Definition of the policy and how it operates

Monetary policy refers to actions taken by the Reserve Bank of Australia to affect the cost, availability and demand for money. The primary aim of monetary policy is the achievement of price stability, inflation between and per cent on average over the cycle. The RBA also has an agreement to maximise economic growth and employment growth, however the RBA argues that by achieving low inflation, growth and employment can be sustained.

The primary instrument of monetary policy is the overnight cash rate, which the RBA controls through open market operations. The RBA uses market operations to create a surplus or shortage of cash by buying and selling government securities. The cash rate is used as the basis of monetary policy because it underpins all other interest rates in the money market.

The secondary instrument of monetary policy is the RBA’s intervention in the foreign exchange market. The RBA does not set a particular exchange rate but under certain circumstances they may wish to appreciate or depreciate the exchange rate by buying or selling Australian dollars on the foreign exchange market.

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Because changes in the official interest rate affect demand and inflation only with a long lag, the Reserve continuously forecasts what it expects inflation to do over the next 1 to 18 months, and adjusts the stance of policy accordingly.

Definition of economic stability ( domestic and external)

Domestic economic stability involves the simultaneous achievement of price stability, rapid but steady economic growth of between 4-4.5% as measured by GDP and full employment of between 5 and 6%. Nevertheless, the RBA’s first priority is the achievement of price stability. Inflation, as measured by the CPI, must average -% per year during the course of the business cycle. The reason for giving this priority to the control of inflation is that price stability is seen as a precondition for achieving other aims.

External stability involves a nation being able to pay its way in its international financial dealings without worsening the current account deficit or foreign debt, or causing exchange rate instability. While external stability is not a high priority for monetary policy, RBA policies can help to achieve this aim by ensuring that inflation and economy activity are controlled.

Explain in theory how the policy can be used to manage internal stability

The general principle that needs to be understood is that short-term interest rates affect aggregate demand and activity. The RBA raises the cash rate when it is worried about inflation going above the target range and so wishes to discourage borrowing and spending. It lowers the cash rate when it is worried about weak growth and rising unemployment and so wishes to encourage borrowing and spending. In responding to cyclical patterns and inflation pressures, monetary policy has had a powerful influence on AD and economic activity. It is assumed that changes in aggregate demand and economic activity will have an effect on the level of demand inflation if the economy is operating at or near full capacity.

Having mentioned the objectives and instruments of monetary policy, there are a number of transmission mechanisms by which the policy can manage and achieve domestic economic stability

Saving and Investment

An increase in interest rates causes the cost of borrowing to finance expenditure to increase. This increases the incentive to save or delay spending and reduces net return to investment. In particular, higher interest rates encourage some households to delay the purchase of large investments such as a house or reduce the amount that they spend on a home. This will affect demand for household goods and demand for building materials. Due to the multiplier effect, employment in the housing and construction industry will also be dampened and further impacts will be felt throughout the economy resulting in decreased aggregate demand.

In the business sector, interest rates have a direct effect on the incentive to invest. When the cost of borrowing is high, the expectation of lower profitability may deter firms from undertaking new investment projects. However, there are many other factors that drive investment, particularly consumer confidence which affects demand for a firm’s products and the funds for investment from profits.

Cash Flow

The presence of higher interest rates will cause those who are heavily geared to have less available income, resulting in less consumption expenditure and a subsequent decrease in aggregate demand. The same principle applies in the business sector. Interest payments currently represent about 11% of company profits so any increase in interest rates can have a serious effect on available cash.

Money and Credit

A tightening of monetary policy makes it more difficult for borrowers to obtain loans and therefore directly limits their spending. This is because lenders continually adjust the requirements for credit approval, making it harder or easier to obtain loans depending on the level of risk that borrowers will default on loan payments. It is in this sense that aggregate demand and economic activity can be suppressed through lender action.

Asset Prices

Higher interest rates can be expected to reduce asset values because they increase the opportunity cost of holding those assets. A fall in asset prices could dampen spending by reducing wealth, and also by reducing borrowing capacity that the assets would be used as collateral for loans. The current housing boom, has allowed home owners to withdraw equity spend on luxury items like holidays and cars therefore increasing consumer spending. It has also meant an increase in investment expenditure with some owners withdrawing equity to start small businesses for example.

The exchange rate

From a monetary policy view, a depreciation of the exchange rate makes imported goods more expensive and since imported goods make up 0% of domestic spending, this will have an affect on the average price of goods. However, retailers have during times of a high Australian dollar, absorbed the import costs at the expense of profit margins.

Secondly, by making imports more expensive and exports cheaper, an exchange rate depreciation will tend to increase demand for both domestic import competing goods and for exports. Overall, an exchange rate depreciation will tend to increase inflation and economic activity, and an appreciation will tend to reduce prices and activity.

Explain in theory how the policy can be used to manage external stability

The achievement of external stability means finding ways to reduce Australia’s high CAD/GDP rations to around %, avoiding large net foreign debt to reduce income debits abroad and helping to stabilise the dollar. In this way, monetary policy can only make a modest attempt to help Australia pay its way in international financial transactions.

When AD and economic activity are increasing too rapidly in an economy operating near full capacity, external stability deteriorates. Inflation increases due to shortages of goods and services and as a result discourages savings and since money looses its purchasing power and drives up domestic interest rates because lenders seek to maintain their rate of return. This in turn makes foreign borrowing more attractive when inflation rises. Overall, these developments tend to worsen merchandise, services and income accounts in the balance of payments. The implementation of contractionary monetary policy is capable of quickly slowing AD and economic through the same transmission mechanisms shown above.

However, higher interest rates increase costs of productions for firms making it harder to supply goods and services at low prices. In turn cost inflation may occur, which may decrease international competitiveness resulting in a decrease in exports and/or an increase in imports both of which will worsen the current account deficit. Increase interest rates also discourage business investment so this may slow down future productive capacity growth, decreasing international competitiveness as well. This is one advantage of lower interest rates on external stability in that it can improve supply-side conditions and cost competitiveness of local producers in both domestic and overseas markets. This should theoretically increase net exports, lowering the CAD and strengthening the exchange rate.

. The RBA’s approach during the last 5 years illustrates this idea of controlling inflation first. For example, with inflation starting to rise during 14-5 and 15-6, monetary policy was tightened. Between mid-16 and 1, inflation was again tamed so that the RBA could turn its attention to stimulating economic growth to achieve between and reducing unemployment.

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