A1748060 Principles of Economics I 1012 | Lecturer: M. Dodd The RBA’s August 2018 Statement on Monetary Policy Outlook https://www.rba.gov.au/publications/smp/2018/aug/economic-outlook.html includes the following table. Table 5.1: Output Growth and Inflation Forecasts (a) Per cent Year-ended Jun 2018 Dec 2018 Jun 2019 Dec 2019 Jun 2020 Dec 2020 3 3¼ 3¼ 3¼ 3 3 Unemployment rate(b) 5.5 5½ 5¼ 5¼ 5¼ 5 CPI inflation 2.1 1¾ 2 2¼ 2¼ 2¼ 2 1¾ 2 2 2¼ 2¼ GDP growth Underlying inflation Year-average 2017/18 GDP growth 2018 2¾ 2018/19 3¼ 2019 3¼ 2019/20 3¼ 2020 3¼ (a) Technical assumptions include A$ at US$0.74, TWI at 64 and Brent crude oil price at US$73 per barrel; shaded regions are historical data (b) Average rate in the quarter Sources: ABS; RBA The RBA also says as part of this report that “the Board does not see a strong case to adjust the cash rate in the near term.” a) Explain what the ‘cash rate’ mentioned here is, and how the RBA can adjust it if they decide that would be appropriate. [3 marks] Cash rate is defined as the rate of interest charged by one bank to another should they borrow funds in the overnight interbank market. The cash rate is influenced by the demand and supply of money, which can be controlled by the RBA to meet the economic objectives of currency/price stability, low unemployment rate, and sustained economic growth. As shown in figure 1, the increase in the demand for money from MD to MD1 will lead to an increase in cash rate from r to r1, and vice versa. The increase in the supply of money from Ms to Ms2 will decrease the cash rate from r to r2, vice versa, as shown in figure 2. 3 A1748060 Principles of Economics I 1012 | Lecturer: M. Dodd The RBA can adjust the cash rate by controlling the supply of money, by either increasing the monetary base by buying and removing government/treasury bonds from circulation or decreasing it by selling and increasing bonds in circulation. Increasing the monetary base (supply of money) decreases cash rate as explained before and decreasing the supply of money from Ms to Ms1 increases the cash rate from r to r1, shown in figure 2. Hence, The RBA can the control cash rate by either holding more funds in their reserve to reduce liquidity or allowing more money to flow into the economy from their reserves, depending on what economic objectives and rates they wish to achieve. Figure 1: effect of demand for money on cash rate A1748060 Principles of Economics I 1012 | Lecturer: M. Dodd Figure 2: effects of changing supply of money on cash rate b) Why does changing the cash rate affect the economy more broadly? [1 mark] Changing cash rates is the implementation of monetary policy, which directly affects interest rates. Changes in the rate of interest can affect consumption and investment in the aggregate demand of the economy. For example, if the RBA wishes to increase consumption, they can implement expansionary monetary policy by increasing the monetary base, which leads to a decrease in cash and therefore interest rates. Lower interest rates make borrowing (investment) more attractive, increases the disposable income of loan payers and makes consumers less likely to save due to decreased investment return. Hence, this can increase consumption and investment, which can lead to an increase in AD/GDP (= C + I + G + NX) and inflation. On the other hand, implementing contractionary monetary policy (decreasing the monetary base) by increasing cash and interest rates would encourage savings due to more attractive returns, hence decreasing consumption. This would cause a decrease AD/GDP, incurring slower/lower rates of inflation. A1748060 Principles of Economics I 1012 | Lecturer: M. Dodd c) Explain with reference to the data in this table why you think that the RBA does not see a case to adjust the cash rate in the near term. [3 marks] As previously mentioned, adjusting the cash rate affects aggregate demand of the economy. Although the target rate for unemployment and GDP growth cannot be sighted on the table, the RBA aims to maintain an average annual inflation rate of 2 – 3 %. According to the data, both underlying and CPI inflation is wavering around 1.75 – 2% which meets the target inflation rate. Therefore, the RBA may not see a need to implement either contractionary or expansionary monetary policy in the near term as the forecasted inflation rate is within their target band. It is possible for the RBA to implement expansionary monetary policy to stimulate economic growth while in exchange increasing inflation rate, as there is still a 1% leeway for the target rate. However, due to possible speculations in the economy, changes in inflation and economic growth may take an extended period to be fully reflected in the statistics. d) Suppose that new data comes in that is different to the forecasts. Suggest one possible change in the data that might cause the RBA to want to adjust the cash rate and explain how and why they would make this change. [3 marks] As discussed above, the RBA could choose to implement expansionary monetary policy to stimulate economic growth and increase inflation if new data shows that the rate of inflation is 0.25 – 1% (well below target rate). Although lower rates of inflation reduce currency and price volatility, in this case the RBA would want to increase inflation (within the target band) to sustain economic growth and ensure that deflation does not occur. Deflation occurs when consumption and investment are postponed, which is undesirable for target GDP growth and the overall economy. An alternate scenario may be when the RBA would need to use contractionary monetary policy to limit inflation and economic growth. For instance, if forecasted inflation is higher than the target rate of 2 – 3%, contractionary monetary policy can be used to lower the rate of inflation. Assuming supply-side policies are unavailable to decrease inflation, aggregate demand would need to be reduced. Thus, the RBA could implement contractionary monetary policy; setting a cash rate that increases the interest rate, whereby they may limit the supply of liquid funds circulating in the economy. The effect of an increased interest rate discourages investment due to a higher cost of borrowing and encourages saving due to being able to receive more interest for deposited funds – decreasing AD and inflation. A1748060 Principles of Economics I 1012 | Lecturer: M. Dodd The RBA would want to decrease inflation to maintain the target rate, as high interest and inflation rates can lead to currency/exchange rate instability and unsustainable economic growth (hyperinflation or stagnation). Overall, maintaining the target inflation rate reduces uncertainty within the economy (i.e. of purchasing power and return on investments), providing the basis for sustained economic growth and reaching other economic objectives.
