Monetary Policy in Australia - Report Example

Running Head: MONETARY POLICY IN AUSTRALIA Topic: Monetary Policy in Australia Lecturer: Presentation: Introduction The level of economic activity in a country is determined by forces of demand and supply. However, if the market is left to operate freely without intervention by the government, it may lead to economic fluctuations with uncontrollable levels of inflation. The government therefore exercises some control by inducing or discouraging investments and consumption or controlling the level of money supply in the economy. This is achieved through the use of fiscal and monetary policy instruments. Fiscal policy involves stimulating aggregate demand in the economy by controlling taxes and government spending. On the other hand, monetary policy involves the regulation of money supply in the economy for sustainable growth of real output, employment and price stability (Fuentes, 2006 p 37). This function is carried out by central banks through credit restrictions, changing reserve requirements and interest rates. In Australia, monetary policy is affected by the Reserve Bank which is the central bank by controlling the amount of exchange settlement funds held by commercial banks by setting interest rates on overnight loans commonly referred as ‘cash rate’ (Reserve Bank of Australia, 2001-2010). The paper discusses how the changes in stance of monetary policy in Australia involve changes in target cash rate. According to Hammon, Kanbur and Prasad (2009), monetary policy should be able to control the level of inflation hence ensuring price stability as well as promote economic growth and employment. In this view, many economies such as Australia embark on inflation targeting so as to attain financial stability as the main objectives of the Australian monetary policy as stipulated in the Reserve Bank Act (1959) is to attain currency stability, maintain full employment, economic prosperity and welfare of the people (Saunders, 2003). The inflation target is set at 2-3% and helps in making sound financial decisions by government and private sector. This ensures full employment is attained at all times as when aggregate demand is low, inflation is low hence monetary policy can be eased to stimulate economic activity. The Reserve Bank plays a key role in ensuring financial stability by managing liquidity, being chairman of council of financial regulators and playing a central role in regulating financial sector (Reserve Bank of Australia, 2001-2010). The reserve bank also sets the interest rates on interbank transactions on daily basis and this act as the driver of other interest rates in the money market. All transactions carried out in the financial sector are aimed at ensuring the interest rates are close to the set target cash rate. It also controls the funds available for exchange settlement so as to maintain currency stability. There is no fixed exchange rate set by the bank but is left under control of money market forces although the bank can intervene if market conditions are not favourable. The monetary policy also does not involve control of reserves as there are no reserve requirements for the commercial banks or restrictions on exchange settlement funds (Reserve Bank of Australia, 2001-2010). The Reserve Banks operates through domestic (open) market operations in ensuring the cash rate is close to the set target by controlling supply of funds available to the banks for their transactions. The domestic market operations of Australian economy involve the forces of demand and supply of overnight funds. The target cash rate is set by Reserve Bank Board on monthly basis and open market operation is to ensure the actual cash rate is close to the set target. The target is published on the bank’s website after the meeting and takes effect on the following day. The Governor also explains to the House of Representatives the decision of the board in coming up with the set cash rate target. According to the reserve Bank of Australia (2001-2010), the domestic market operations start at 9.30 am by estimation of the exchange settlement fund to flow into or out of the banking system for the day. The bank also communicates its intention to buy or sell securities depending on its expected rise or fall of exchange settlement funds. If it expects the funds to decline, it buys securities and credits the sellers hence raising the exchange settlement balances. On the other hand, if it expects the funds to increase, it sells the securities so as to reduce the settlement funds and maintain a balance between demand and supply of the funds. Bids are offered till 10.00am and successful applicants announced by 10.30 am. When the Reserve Bank offers a higher supply of exchange settlement funds than needed for daily transactions by the commercial banks, the banks lend the extra funds to banks which have demand for the funds hence lowering the interest rate on overnight funds as supply is higher than demand. On the other hand, if the Reserve Bank reduces the amount of settlement funds available to the banks, the banks will borrow from other banks and financial institutions so as to fulfil their financial obligations hence raising the interest or cash rate. The domestic market operations therefore ensure that the supply and demand are equal at target cash rate. The commercial banks demand for funds is determined by expected outflows while supply is determined by reserve bank transactions. The cash rate determined by demand and supply of settlement funds by the banks is passed on to borrowers or investors through market interest rates through deposits and lending. The interest rates affect the behaviour of households and businesses thereby affecting aggregate demand. An increase in interest rates makes savings attractive hence reduction of spending and consumption by households hence lowering aggregate demand. The investors are also discouraged to borrow by the high interest rates hence lowering investments and aggregate demand (Geoff, 2006). It also leads to appreciation of domestic currency making exports expensive and imports cheaper thereby discouraging exports and encouraging imports hence net exports and aggregate demand and output falls. Interest rates also affect the wealth of households and businesses through changes in asset prices. A reduction in interest rate makes demand for assets higher hence raising asset prices thereby increasing consumption by asset owners and in turn aggregate demand (Anderson, 2000). Monetary policy therefore has a great impact on aggregate demand in the economy through changes in interest rates which in Australia are determined by cash rate in the financial market. Changes in monetary policy in Australia involve changing the operating cash rate target which in turn determines the interest rates in the economy. It affects the commercial bank’s cost of funds thereby impacting on lending interest rates by banks (Makin, 1998). If the government wishes to loosen monetary policy, the Reserve Bank lowers the target cash rate. It then uses open market operations to influence the cash rate by controlling the supply of funds available to banks in the money market. A deflationary monetary policy raises short term rates hence lowering expectation of future inflation. When target cash rate is lowered, the aim will be to maintain a real cash rate close to the target hence the Reserve bank supplies more settlement funds to banks which prompts them to increase their lending hence low interest rates. The financial market hence trades at low interest rates thereby attracting borrowing of funds for investments and discourage savings and enhancing spending hence increase in aggregate demand, output and employment. This may prompt an increase in prices in the long-run. When the Banks wants to tighten its monetary policy, it sets a higher cash rate target and directs its operations towards achieving the target (Reserve Bank of Australia, 2001-2010). To increase real cash rate and discourage investments, the bank reduces the amount available for banks to carry out their interbank transactions. The banks in turn borrow funds to satisfy their money demand hence pushing cash rate up. This cash rate is transferred to money market rates and bond yields which prompt an increase in interest rates on lending and deposits for firms and households. This leads to reduction in consumption spending as households and firms save to earn higher returns. Investors are also discouraged from borrowing funds as they would pay higher interest hence reduction on investments and consequently aggregate demand. The Australian government has a floating exchange rate which is determined by market forces hence the interest rates affects exports and imports. High interests appreciate domestic currency making exports more expensive than imports hence reduction in exports. Output and employment decline hence reducing money supply in the economy. Monetary policy therefore in Australia is about regulating the amount of exchange settlement funds held by banks in the Reserve bank through manipulation of cash rate. The Reserve Bank Board is mandated to set target cash rate and ensure real cash rate is close to the set target in order to maintain currency stability, full employment and welfare of the people. The bank is independent, transparent and accountable in its operations. The target cash rate acts as a foundation for other interest rates in the money market which in turn impact on the aggregate demand of the Australian economy. However, there is uncertainty in the financial markets about the future of short term rates as they are set on monthly basis based on expectations of the Reserve Bank. The policy is however successful as it has managed to control stability of cash rate around the set target. The reserve bank of Australia acknowledges that in the financial year 2008/09, the cash rate did not deviate from the target. References Anderson, A. (2000). Economics 3ed. UK: Pearson Education. Fuentes, C. (2006). Regional Monetary Policy. USA: Routledge. Geoff, R. (2006) “As Macroeconomics /International Economy: Aggregate Demand”. Retrieved 4 October, 2010 from http://tutor2u.net/economics/revision-notes/as-macro-aggregate-demand.html> Makin, T. (1998) “A New Rule for Monetary Policy”. Agenda. Vol. 5, 1 p 17-24. Hammon, G., Kanbur, R & Prasad, E. (2009). Monetary Policy Frameworks for Emerging Markets. UK: Edward Elgar. Reserve Bank of Australia. (2001-2010). “Monetary Policy”. Retrieved 4 October, 2010 from http://www.rba.gov.au. Saunders, S. (2003). “The Experience of Inflation Targeting in Australia: Lessons for South Africa”. South African Journal of Economics. Vol. 71, 2 p 215-221. Read More