- 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.
- 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
- 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.
- 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.