Objectives of Monetary Policy and Functions of the RBA
The Impact, Mechanics and the Effectiveness of the RBA Monetary Policy Decision
Today, many economies rely on monetary policy decisions to steer the economy towards growth and stability. Notably, monetary policy has become an important part of economic decision making in the modern economy. Normally, the process of making, interpreting and implementing monetary policy is undertaken by the country’s central bank or monetary authority. In this regard, monetary policy is a function of the Reserve Bank of Australia which oversees the implementation of the policy in the country. Fundamentally, monetary policy works through its influence on money supply and interest rate to achieve the desired macroeconomic goals in the nation.
Objectives of Monetary Policy and Functions of the RBA
Essentially, monetary policy is a government interventionist measure undertaken through the country’s monetary authority to influence the pattern and level of aggregate activity in the economy. Primarily, it involves all the actions conducted by the central bank to influence the quantity of money supply and cost of borrowing in the economy. Often, the RBA manipulates the nation’s official cash rate, which creates a ripple effect on the rest of interest rates in the economy. In turn, this leads to the stimulation of the economy towards the achievement of specified macroeconomic objectives in the country.
Objectives
The monetary policy in Australia is formulated for the purpose of achieving a series of specified objectives. Its main objectives relate to the achievement of economic growth in the country, maintenance of price stability, attainment of full employment and maintenance of equilibrium balance of payment. Markedly, these objectives are discussed below:
Achieve economic growth. Notably, this a primary goal of the monetary policy in Australia. In this objective, the monetary policy aims at stimulating the economy towards a sustained increase in the country’s gross national product over a specified period of time. Typically, monetary policy can aid in the achievement of this goal through the reduction of the cost of credit by lowering the level of interest rates in the economy. In turn, a lower cost of credit increases investments and hence the GNP also increases, thereby leading to economic growth.
Full employment. In many economies, high level of unemployment has become a persistent social and economic problem. Thus, monetary policy aims at reducing the level of unemployment to sustainable levels. Fundamentally, this objective can be achieved by increasing the rate of investments and saving in the country, which would then lead to an increase in demand for workers, thereby resulting in a drop in the level of unemployment within the Australian economy.
Price Stability. Characteristically, this objective pertains to the controlling of the rate of inflation in the nation. Inflation refers to the continued rise in the price level in the economy over a given period of time. It is crucial for the monetary authority to control the level of inflation in the country as it often results in negative impacts on the economy. For instance, it may raise the cost of living and also lead to a reduction in next exports as goods from the country become expensive for the foreign market. Typically, price stability can be achieved through selective credit control and other monetary policy instruments.
Objectives
The balance of payment equilibrium. Equilibrium in the balance of payment is critical for the economy. Mainly, this can be achieved through the maintenance of a stable foreign exchange rate. Fluctuations in the country’s foreign exchange rate would result in fluctuations in the balance of payment. Thus, it is crucial for the RBA to maintain exchange rate stability.
Functions of the RBA
The RBA functions as the official monetary authority in Australia. For this reason, it is responsible for the formulation, implementation, and regulation of monetary policy in the country. In addition to this, the RBA has the responsibility of serving as a legal adviser to the government on matters pertaining to economic growth, price stability and foreign exchange policies. Likewise, it plays the role of ensuring and facilitating solvency and liquidity in the country’s banking system through its control and regulation of the money supply in the economy.
Additionally, it serves as the official issuer of fiat money in the country through its issuance of currency notes and coins in the nations. Furthermore, the central bank supervises banks and other non-bank financial institutions in the country and also acts as their last resort creditor. On top of that, the RBA plays the role of an agent of the government that is in charge of issuing and underwriting government bonds and securities (Blanch, n.d.). In this regard, the RBA plays a fundamental role in the Australian economy.
Cash Rate, Inflation, and Economic Growth
In the meeting that ended in March, the monetary authority preferred to maintain the official interest rate at 1.5 percent. Notably, this decision was exceptional since the board often revised the rate to suit the needs of the economy over the past years. Fundamentally, one can attribute this decision to the fact that the current official rate was relatively low already and changing it further would create fluctuations in the economy. Yet, as at now, the cash rate level is working for the best of the economy.
As such, the low-interest rate has allowed for price stability in the country over the past year. In addition, it instilled consumer and business confidence in the economy and steered the economy towards a slight increase in the level of economic growth. For this reason, the RBA board saw it fit to preserve the cash rate at 1.5 percent. It is imperative to note that if the board uses the cash rate to control inflation and stimulate the level of growth in the country. Fundamentally, the effects of the official rate on these two economic indicators can best be explained through the transmission mechanism and money market equilibrium model.
Monetary Policy Transmission Mechanism
The model suggests that monetary policy decisions have a significant effect on the price level in the economy. The transmission mechanism occurs in various stages. The first stage involves the influence of the monetary policy decision on the cash rate. In this case, if the RBA decides to lower the official rate, then the decision would lead to a reduction in the cash rate. In addition, it would influence the exchange rate, asset prices, and wages in the labor market as well as individuals’ and firms expectations. What follows is that the reduction in the official rate goes to further influence changes in the goods market. Here, it creates significant increases in the aggregate demand in the economy.
Factors Influencing RBA Board’s March Decision to Leave the Cash Rate Unchanged
Naturally, an upsurge in the aggregate demand would result in the growth of the nation’s real GDP, which in turn would enhance the level of economic growth. In the same view, an increase in the level domestic demand and external demand would bring about an increase in the total demand in the country. Consequently, this instigates a rise in the price of commodities in the economy, resulting in domestic inflation. Domestic inflation coupled with an increase in import prices following the effects of changes in the cash rate on exchange rate would lead to a general rise in the price level in the country. In turn, this leads to inflation.
Money Market Equilibrium Model
Just like the goods market, the money market is in equilibrium when the demand for money equals to its supply. Notably, changes in the cash rate in an economy results in changes in the money supply in the economy. Profoundly, a reduction in the cash rate results in a decrease in the cost of credit in the economy. In turn, this lowers the rate at which banks borrow from the RBA. Likewise, it lowers the rate at which the commercials banks can lend to its customers. Sequentially, this lowers the cost of credit in the economy, thereby encourages people to borrow from banks. Thus, in the diagram below, a reduction in the rate of interest from r1 to r2, results in an increase in money supply from s1 to s2.
Fundamentally, there is an inverse relationship between the demand for money and the level of interest in the economy. Thus, individuals would demand more money for speculative purchases. In turn, this raises the amount of money held by the public. Sequentially, this results in an increase in aggregate demand in the economy, which in turn translates to an increase in the real GDP of the economy. This implies an economic growth. On the other hand, an increase in demand for commodities in the economy would exert an upward pressure on the prices of services and goods in the economy, therefore leading to inflationary pressures.
Notably, the RBA would alter the level of cash rate in order to steer the economy towards the desired direction. More precisely, when there is stagnated growth, the RBA would reduce the cash rate to stimulate economic growth. On the other hand, when there is excessive growth, it would raise the cash rate.
Factors that Influenced the RBA Decision
The RBA board’s resolution to maintain the official rate at 1.5 percent was influenced by various factors. It considered the key economic indicators in the economy and saw that the current official rate would drive the economy towards growth, sustained price stability, foreign exchange stability and reduced unemployment. The board sought to maintain the rate in order to avoid fluctuations in the exchange rate that would negatively impact the country’s balance of payment. Besides, the economy is still transitioning after the cooling of the mining investment boom in the economy.
According to the report, current trends on the performance of the economy with regard to key economic indicators is healthy. As such, business confidence is high, and employment rates in the labor market are expected to rise in the near future. Additionally, the country is expected to enjoy a period of price stability since projections indicate a period of low inflation rates in the country. Investments in non-mining sectors are also expected to expand. All these factors combined would then steer the economy towards a period of steady and continuous growth. It is crucial to note that the RBA’s decision was mainly influenced by the fact that the low-interest rate level in the economy would stimulate the rate of investments, which in turn would create more employment opportunities and facilitate economic growth in Australia.
Impacts of Changing the Cash Rate on Housing Market Participants
In the report, the RBA raised concerns over the Australian housing market. Last year, property prices in the country rose significantly. Consequently, this created a housing affordability problem as many households in the country were unable to afford decent homes in the country, especially cities like Sydney and Melbourne. A fluctuation in the official rate would also have effects in the housing market. As such, lowering the cash rate would reduce the cost of borrowing, and therefore more households would be able to obtain mortgages and therefore afford decent homes in the country. Consequently, this would increase the demand for houses in the country. In the same way, investors and property developers would have access to cheap credit, thereby reducing the costs of the building. In turn, this would result in an increase in the supply of cheap and affordable houses in the country.
In order to achieve an equilibrium quantity and price for houses in the property market, the government has initiated various macro-prudential measures. Generally, these measures aim at strengthening the lending standards to investors in the property market to ensure that the funds borrowed are directed towards the development of affordable housing in the country. In turn, this is expected to improve the housing affordability situation in Australia.
Limitations of Monetary Policy
The first limitation of monetary policy is that most of its objectives are conflicting. Thus, the achievement of one objective would result in the foregoing of another objective. Subsequently, this has limited the effectiveness of monetary policy in Australia. Additionally, the role of the policy is limited and restricted in its influence in attaining economic growth in the economy. What is more, the Australian money market is still underdeveloped making it difficult for a monetary policy decision to be effective in the regulation of economic activity (Chand, n.d.).
Today, many economists believe that monetary rules are superior to interest targeting due to various reasons (Binder & Rodrigue, 2016). Firstly, monetary rules provide a precise and systematic scheme that shows how the set objectives would be achieved. On the other hand, interest targeting does not provide a strategy for the achievement of the goal, thereby making it vague (Jahan, n.d.).
Conclusion
Taking everything into account, the Australian economy is operating at sustainable rates. The economy is enjoying a period of price stability and steady economic growth. The level of unemployment is expected to drop. Business and consumer confidence is high. Likewise, investments are rising slowly. In turn, this projects that the Australian economy is expected to enjoy a period of healthy growth in the future.
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.
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