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Economics Assessment Task

1. Explain how open market operation determines the cash rate Open market operations (OMO) refer to the Reserve bank of Australia s (RBA) buying and selling of second hand Commonwealth government securities (CGS) to influence the cash rate. The cash rate is the interest rate which banks and other financial institutions charge each other on the short-term or overnight money market. The bank influences the cash rate by affecting the Exchange settlement accounts that banks hold where they settle payments with other banks and the RBA. By influencing the forces of supply and demand, the RBA can increase or decrease supply of fund in the short-term money market through OMP and thus target the cash rate. If the RBA buys second hand CGS from the bank, they deposit money into the banks ES accounts. Since banks now have additional, they can lend additional funds to other banks in the overnight money market. This increases the supply of funds in the overnight money market, which reduces the cash rate. Alternatively when the RBA sells CGS to the banks, they withdraw funds from the ES account, which decreases the supply of loan able funds and puts upward pressure on the overnight money market, thus increasing the cash rate. Add in overnight money market demand/supply curve. 2. Explain how monetary policy is transmitted into the economy Monetary policy involves influencing the cost and availability of money in the economy. The Reserve Bank of Australia (RBA) can implement monetary policy through changes in the cash rate, which influence the general level of interest rates in the economy, which has an impact on the level of consumer spending and business investment. By increasing the cash rate, this increases the cost of funding for banks to maintain profit margins. Banks will thus increase their level of interest rates they change to consumers and businesses. If interest rates increase it increases the cost of borrowing for consumers, which in turn also decreases consumption. Also if interest rates it is now more expensive for those who have already borrowed to pay back variable interest repayments, which decreases their amount of disposable income for other consumption. The change in the cash rate also affects business investment. An increase in the interest rate, in turn increases the cost of borrowing for businesses and as a result reduces investment As a result due to the decreases consumption and investment and decreased demand for goods and services in the economy there is a general decrease in the level of economic activity. Alternatively the RBA can implement monetary policy in order to encourage investment and consumer spending by decreasing the cash rate. The banks pass

this on to consumers and business by decreasing their interest rates, which increases the aggregate demand and increases investment and consumption, causing an increase in economic activity. 3. Explain the possibly impacts of loose monetary policy on the value of the exchange rate and on economic growth. The Reserve bank of Australia implements a loose monetary policy by decreasing the cash rate. This decrease has an indirect impact on both economic growth and the exchange rate. It causes a general decrease in the level of interest rate. Due to this those that invest in the Australian economy now get less returns from their investment. This discourages overseas investors and causes a decrease in financial inflows into Australia from overseas. This causes a fall in demand for the Australian dollar (AUD) and an increase in demand for foreign currency, which in turn leads to a decline in the exchange rate. The decreased interest rates, as a result of the RBAs loose monetary policy also encourages borrowing from both consumers and businesses. The ability to borrow money at these lower, more attractive rates stimulates investment and increases consumption of goods and services in the economy. It also lowers mortgage interest repayments for households leaving them with more disposable income, encourage consumer spending. . As a result there is an increase in aggregate demand in the economy, which leads to an increase in GDP and higher rates of economic growth. 4. Assess the limitation of monetary policy on Australia. The main limitation of monetary policy is that it has a time lag of around 6 to 18 months before the full impact of the interest rate changes are felt in the economy. This lag time can pose problems for policy makers as it forces them to conduct pre-emptive monetary policy and make decisions based on future expectations which can be difficult to predict. This is thus risky as the Reserve Bank of Australias forecasts could be incorrect and the economic circumstances could change during the relatively long lag period, making the current monetary policy incorrect. This is evident through the GFC, which no one was able to predict. In addition being a blunt instrument monetary policy can be quite limited as it is unable to differentiate between different sectors and parts of the economy and can only adopt one cash rate. This limitation is evident in Australias two-speed economy, which has made it difficult for the RBA to effectively use monetary policy, which places the RBA with a trade-off. If they wish to increase the cash rate to decrease economic growth and control inflation in the non-mining states of Australia this interest rate will also apply to those states that already have low economic growth. Thus they will undergo further unemployment and lower levels of growth and inflation. Alternatively if it wishes to increase economic growth in the non-mining states it will also increase growth in the mining parts of Australia. This can cause increase inflation significantly in these parts however which poses the RBA with a problem.

5. Outline the current stance of monetary policy and describe the impact it is having on the Australian economy. The Reserve Bank has engaged in an expansionary monetary policy from November 2011 and August 2013 cutting the cash rate 8 times from 4.75 to its current level of just 2.5 percent. Subdued economic growth, the projected peak of Australias mining investment boom in 2013, an alarming decline in global commodity prices and terms of trade and the economies difficult transition towards weaker, non-mining sources of growth have continued to slow economic growth, prompting the RBA to adopt this expansionary stance. The lower interest rates interest rates are leading to stimulation borrowing for consumption and investment and leading to stronger growth in aggregate demand. The lower interest rates relative to the rest of the world are also putting a downward pressure on the interest rate differential and putting downward pressure on the exchange rate through sales of Australian dollar in the financial markets. The resulting lower exchange rate caused by depreciation is improving our international competitiveness through higher import prices and lower export prices. On the other hand, it is also putting an upward pressure on price expectations as demand and output strengthen leading to higher prices and wages. This in the long term however can be harmful to the economy cause higher inflation. Australias weakening global outlook suggest that interest rates will continue to be low over the remainder of 2013. 6. Explain how the 2 speed economy is marking it difficult for the RBA to effectively use monetary policy. 2 speed economies are those economies whose industries experiences unevenly distributed rates of growth. This is evident within the Australian economy as a result of the resources boom, which has increased Australians terms of trade since the mid 2000s giving a rise to a surge in resource investment. This has brought high economic growth in parts of Australia related to the resources sector such as Western Australia and Queensland. In comparison however the non-mining sectors such as tourism, education and manufacturing have been quite sluggish with low economic growth. Especially due to the high Australian dollar, which as increased relative, export prices and decreased Australias national competitiveness. The 2-speed economy has made it difficult for the RBA to use monetary policy effectively as a result. Due to monetary policy being a blunt instrument it is unable to differentiate between different sectors and parts of the economy and can only adopt one cash rate. Therefore if it wants to slow down growth and inflation in mining sectors by increasing the cash rate it is only going to further slow economic growth in the non-mining parts of Australia such as NSW and VIC, leading to increased unemployment. Alternatively if it wants to decrease the cash rate to increase growth in the non-mining sectors, while this may benefit these regions by increasing consumption and investment on the other hand it will cause inflation to go out of control in the mining parts of Australia. Thus 7. Compare Keynesian and Monetarists views on the role of monetary policy.

Monetarists do not believe that the government should intervene by trying to manage the level of aggregate demand. They argue that this type of interventionist policy will be destabilizing in the long run and should therefore be avoided. A key problem with discretionary demand management policies is the time lags, which monetarists believe make fiscal policy too difficult to use to manage the economy effectively. The best thing therefore, is to aim to achieve price stability in the long run and use monetary policy to achieve this. Alternatively, Keynesians traditionally see fiscal policy as the key tool of economic management. Monetary policy should, in their view, simply be used as a backup to fiscal policy. They see the role of government as maintaining the economy at full employment. The way to do this was to manage the level of aggregate demand until the economy was at or close to full employment. If the economy was growing too fast, then fiscal policy should be essentially contractionary, and vice-versa when below full employment. Their main objection to monetary policy has been that there is a weak link between the money supply and aggregate demand, and that the money supply is difficult to control anyway. 8. Assess the role monetary policy played in reducing the impact of the GFC on Australia. The GFC had a significant impact on the Australian economy decreasing economic growth significantly by 0.6 per cent and increasing unemployment from 4 to 5.9 per cent. The RBAs response to the GFC was to significantly decrease the cash rate from 7.25 to 3 per cent in order to reduce borrowing costs for consumers and businesses, thus stimulating consumption and investment in order to restore confidence. Therefore the RBA played a very strong role in helping the economic avoid a recession by cutting the cash rate to 3 per cent and helping to stimulate consumption and invest and restore confidence. However it was not the only reason, the 42 billion fiscal stimulus package by the federal government also played a critical role and the resilience of Chinas economic growth during the GFC also ensured resilience in Australias exports of commodities and commodity prices, which also helped to support the economy. 9. Explain why the government can still be held accountable for interest rate increases. Though the government cannot directly affect interest rate increases it can influence the RBAs decision making through fiscal policy in order to increase the interest rates. The RBA keeps a close watch on the governments decision making and accordingly reacts using monetary policy. The government can cause interest rates to rise indirectly by encouraging spending and increased government expenditure. The increased spending can result in a multiplier effect, providing those unemployed to gain jobs who in turn will have more money to spend leading to a further increase in aggregate demand. As a result economic growth can increase which can lead to inflation if this growth is not kept under control. This is where the RBAs role comes in to respond to the government decision-making and increase interest rates in order to decrease consumption and investment in order to slow down inflation in the economy, keeping it in their target of 2-3 percent. Therefore though the government does

not control interest rates it can influence them and as a result be held accountable for interest rate increases.

10. Evaluate the effectiveness of inflation targeting by the RBA The RBA aims to target inflation by keeping it between 2-3% on average over the business cycle. This is an effective rate of inflation as it is sufficiently low that it does not materially distort economic decisions in the community, while providing discipline for monetary policy decision allowing it to dampening the fluctuations in output over the course of the cycle.

It is evident through the graph that before the inflation targeting of 2-3 percent was introduced that inflation was extremely out of control and quite high in fact. However since the mid 1993 it can be seen that the RBAs inflation targeting has been very effective at keeping inflation under control, while still allowing for significant economic growth.