Question

Assume that the Board of the Reserve Bank of Australia decides to decrease the cash rate by 25 basis points to 1.25 per cent.

(a) Describe the monetary policy objectives of the Reserve Bank of Australia (2 marks)

(b) Using diagrams (market for bank reserves, loanable funds and AD/AS diagrams), explain how a decrease in cash rate might affect real GDP. (3 marks)

(c) Discuss the circumstances that would have led to a decrease in cash rate. What circumstances make the monetary policy less effective? (3 marks)

(d) Explain Australia’s inflation targeting policy to achieve macroeconomic stability and comment on its effectiveness over time. Describe two alternative monetary strategies

Please provide a detailed answer, thank you very much

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Answer #1
  1. The Reserve Bank Board has three objectives when setting monetary policy. The three objectives are:
  • The stability of the currency of Australia
  • The maintenance of full employment in Australia
  • The economic prosperity and welfare of the people of Australia.
  1. A lower cash rate stimulates household spending and housing investment, partly through increasing the wealth and cash flow of households. A lower cash rate also tends to result in a depreciation of the exchange rate, leading to higher net exports and imported inflation. When the Reserve Bank lowers the cash rate, this causes other interest rates in the economy to fall. Lower interest rates stimulate spending. Businesses respond to this by increasing how much they produce, leading to an increase in economic activity and employment. If the increase in demand is strong enough it can push up prices, and lead to higher inflation. This is explained in the chart below

PL Price level on vertical axis Real GDP on horizontal axis GDP

PL SRAS Equilibrium price level Equilibrium output AD 2 rGDP Yi

  1. The factors that cause an impact on cash rate are the following:
  • Inflation - The higher the inflation rate, the more interest rates are likely to rise. This occurs because lenders will demand higher interest rates as compensation for the decrease in purchasing power of the money they are paid in the future.
  • Government - The government has a say in how interest rates are affected. The U.S. Federal Reserve (the Fed) often makes announcements about how monetary policy will affect interest rates.
  • Types of loans - The interest rate for each different type of loan, depends on the credit risk, time, tax considerations (particularly in the U.S.) and convertibility of the particular loan.
  1. The Australian framework has not changed much over the past 25 years. The flexible nature of the framework, which was there at its inception, has proven to be resilient to the quite substantial changes in the macroeconomic environment that have taken place since. This is in contrast to some other countries that have moved from an initially rigid definition (which may well have been appropriate at their inception) toward something more flexible. The framework in Australia was adaptable from the start, which caused some issues in convincing some people of the seriousness with which the Reserve Bank was adopting an appropriate monetary framework.

Australia, like other countries, came to inflation targeting after trying a number of alternative approaches to monetary policy. These approaches had not delivered either the desired price stability nor acceptable macroeconomic outcomes. Inflation targeting was the next attempt to try and better achieve these outcomes. There was no guarantee of success. Now, after 25 years, there is considerably greater confidence that the regime can contribute to sound macroeconomic outcomes in terms of both inflation and growth. The proof of the pudding has been in the eating. There is greater confidence and understanding about the framework from the public, from the political process, from financial markets and from the policymakers themselves.

Two alternative monetary strategies would be:

  • Distribution of output and employment: One of the costs of inflation is that it leads to transfers between those who are better placed to take advantage of inflation (such as home-owners) and those who are not so well placed (for example, renters). Over time, inflationary pressures can lead to significant real resources being expended by individuals as they rearrange their affairs so as to benefit from inflation. Elimination or reduction of inflation means that these resources are more likely to be utilised more efficiently.
  • Review the upside and downside risks: In its current approach, the Reserve Bank of Australia does set an inflation target, specifically requiring that underlying inflation should achieve an average of ‘2-point-something’ over the course of the cycle. Unfortunately, the success or failure of such an approach cannot be properly evaluated until a full cycle has passed. As detailed in the first section of this paper, Australian monetary policy has not always moved monotonically towards its current state but has tended to meander through a range of policy regimes. Consistent with past performance, there is nothing to stop a substantial change to the focus of monetary policy. Accordingly, there is no strong guarantee that the current approach to monetary policy will be sustained for a long enough period to allow a proper evaluation of the Reserve Bank's success in achieving its stated objective.
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