economics assessment task

7/29/2019 Economics Assessment Task

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Economics Assessment Task

1. Explain how open market operation determines the cash rateOpen 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 thebanks 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 economyMonetary 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 encourageinvestment and consumer spending by decreasing the cash rate. The banks pass


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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 ofthe 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 alsoencourages 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 circumstancescould 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 itis 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.


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5. Outline the current stance of monetary policy and describe the impactit 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 globalcommodity 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 toeffectively use monetary policy.

2 speed economies are those economies whose industries experiences unevenlydistributed 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 Australiasnational 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 andparts 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 monetarypolicy.


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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 tomanage 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 theGFC 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 inhelping 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 interestrate 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 thegovernment 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


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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 RBAThe 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.

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