Question

In: Economics

Assume that the Board of the Reserve Bank of Australia decides to decrease the cash rate...

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

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

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

(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

Solutions

Expert Solution

  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

  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.

Related Solutions

a. The Reserve Bank of Australia has announced a 0.25% decrease in the cash rate. What...
a. The Reserve Bank of Australia has announced a 0.25% decrease in the cash rate. What effects does this have on the economy and the financial markets? Provide examples of who might benefit from this decrease and those that do not. b.Explain the Australian dividend imputation credit system and how it applies in Australia. Include an analysis of how the receipt of franking credits will result in differing returns for Australian resident and international investors.
Consider a situation in which the Reserve Bank of Australia (RBA) decides to undertake a restrictive...
Consider a situation in which the Reserve Bank of Australia (RBA) decides to undertake a restrictive monetary policy. Explain the process by which the RBA undertakes such a policy and how it would work to affect the level of income as well as both the demand for and supply of money. In your answer you should identify the role that the yield curve plays in the transmission of RBA decisions to the economy.
Following a period in which the Reserve Bank of Australia has decreased the cash target rate...
Following a period in which the Reserve Bank of Australia has decreased the cash target rate to the level of 2.5% per annum, the Australian yield curve is now upward sloping. Explain the shape of the yield curve using the expectations theory, and the market segmentation theory, remembering to contrast the underlying assumptions of the two theories.
2. Assume that Susan deposits $3000 of cash into bank A and the reserve requirement is...
2. Assume that Susan deposits $3000 of cash into bank A and the reserve requirement is 10%. a. Complete a simple T-account for bank A showing this deposit and asume that bank A lends out its excess reserves to Bill. b. Bill uses the entire loan to buy groceries at Rouses Supermarket and Rouses deposits it in bank B. Suppose bank B lends out all its excess reserves to Maria, and her loan ends up in bank C. Fill in...
If the Reserve Bank of Australia sells bonds and securities in the open market, this is...
If the Reserve Bank of Australia sells bonds and securities in the open market, this is likely to lead to a: rise in interest rates and an appreciation of the Australian dollar. rise in interest rates and a depreciation of the Australian dollar. fall in interest rates and an appreciation of the Australian dollar. fall in interest rates and a depreciation of the Australian dollar.
Interest rates in Australia are currently at their lowest level since the Reserve Bank of Australia was established in 1959.
Interest rates in Australia are currently at their lowest level since the Reserve Bank of Australia was established in 1959. Outline the rationale for such low interest rates, and evaluate the extent to which this policy makes sense in Australia's current situation. Make sure to take into account both the dangers of keeping interest rates low for protracted periods of time, as well as the potential benefits of such an approach to monetary policy. In the light of your evaluation,...
Australia's Sticky Unemployment Rate Underscores Reserve Bank of Australia (RBA)'s Monetary Policy Challenge Australia’s jobless rate...
Australia's Sticky Unemployment Rate Underscores Reserve Bank of Australia (RBA)'s Monetary Policy Challenge Australia’s jobless rate held above 5% in May despite a surge in hiring, underscoring the Reserve Bank’s challenge to drive down unemployment and stoke inflation. RBA Governor Philip Lowe has made clear that easing monetary policy is not the ideal path to boosting hiring and investment, and has urged the government to undertake structural reforms. The government is trying to pass tax cuts that is estimated could...
Australia's Sticky Unemployment Rate Underscores Reserve Bank of Australia (RBA)'s Monetary Policy Challenge Australia’s jobless rate...
Australia's Sticky Unemployment Rate Underscores Reserve Bank of Australia (RBA)'s Monetary Policy Challenge Australia’s jobless rate held above 5% in May despite a surge in hiring, underscoring the Reserve Bank’s challenge to drive down unemployment and stoke inflation. RBA Governor Philip Lowe has made clear that easing monetary policy is not the ideal path to boosting hiring and investment, and has urged the government to undertake structural reforms. The government is trying to pass tax cuts that is estimated could...
Economists at the Reserve Bank of Australia (Australia's central bank) forecast that between 2020 and 2040...
Economists at the Reserve Bank of Australia (Australia's central bank) forecast that between 2020 and 2040 the country's nominal GDP will grow by 5% each year. They also predict that the country's debt will grow by 6% between 2020 and 2030 and then will remain unchanged between 2030 and 2040. What do these predictions imply for Australia's debt-to-GDP ratio in 2030 and 2040?
. Assume you are the chairman of the Board of Governors of the Federal Reserve. The...
. Assume you are the chairman of the Board of Governors of the Federal Reserve. The economy is in the midst of a recession. What type of monetary policy would you advocate? What tools would you use to implement said policy? Be specific in your response as to how the tools would work to accomplish your objectives.
ADVERTISEMENT
ADVERTISEMENT
ADVERTISEMENT