chapter
Economic
management using
macroeconomic
monetary policy
6
6.1 Definition of monetary policy
Monetary policy is a macroeconomic instrument operated by the Reserve
Bank of Australia (RBA), involving the regulation of the nation’s
money and the rate at which credit flows into the economy via the
financial sector. Most importantly, monetary policy relies heavily on
changes in interest rates to alter the cost, availability and demand for
credit (borrowed money). In turn, interest rates have the capacity
to alter levels of AD, economic activity, cyclical unemployment
and demand inflation. However, as we know, interest rate
changes will also affect production costs, business profits and
the supply side of the economy. Overall, monetary policy is
regarded as a fairly flexible instrument in that it can change
direction at quite short notice without requiring the approval
of parliament.
204
Economics Down Under Book 2
THE SUPPLY OF MONEY OR
CREDIT IN THE ECONOMY
Definition of money
Money consists of items which can be used for making purchases of goods and services (a medium of exchange). Money
also fulfils other functions. For instance, it is commonly
regarded as a measure of value (a unit of accounting), it retains
its purchasing power fairly well over time (a store of value) and
it enables things to be purchased using credit (a standard of
deferred payments).
Measuring the money supply
In Australia, the money supply or volume of money is measured
by the RBA and consists of the following components:
■
■
■
■
■
The volume of coins and notes (cash or money base)
held by the non-bank public and deposits of banks with
the RBA
PLUS
The volume of both operating and fixed bank savings
deposits
EQUALS
M3 (one commonly quoted measure of the volume of
money)
PLUS
Net deposits of savings in non-bank financial institutions (NBFIs)
EQUALS
Broad money (a wide or comprehensive measure of the
money supply or volume of money).
Knowing changes in the volume of money is relevant when considering factors that affect the level of economic activity and the
setting of monetary policy.
The process of credit creation
How does money come into existence? In the case of cash, the
RBA supplies as much currency to the banks as is required to
meet the demand. However, these days, we are slowly becoming
a cashless society. Today the largest proportion of Australia’s
volume of money is deposits of different types with financial institutions. Bank deposits are mostly passbook or accounting entries.
These deposits are not backed up with piles of cash sitting idly in
bank vaults. Instead, deposits partly come about through the process of credit creation conducted by financial institutions. Assume,
for instance, that you make a deposit of money with your bank
and gain the advantage of receiving interest on your savings. The
bank enters this deposit against your account. Typically, part of
your deposit is put aside to ensure that the bank retains enough
liquidity (assets easily converted in cash) to meet normal customer withdrawals, to promote customer confidence and to avoid
embarrassment by institutions. Since 1998, the liquidity position
of all financial institutions has been monitored by the Australian
Prudential Regulation Authority (APRA) rather than the RBA.
This organisation checks that financial institutions have an effective liquidity management policy in place, as well as ensuring that
banks meet varying capital adequacy requirements that reflect
the level of ‘risk’ involved with lending.
Now, returning to the process of credit creation, the remainder
of your savings deposit is lent by the bank to some creditworthy
borrower you don’t even know. After paying interest to the bank,
this customer then uses the credit to purchase a good or service,
by means of a cheque or electronic funds transfer. The seller
receiving the money then makes a new deposit within the financial sector, causing the level of total deposits to grow (now consisting of both your deposit plus the one by the seller). Armed
again with extra funds which they are keen to lend in order to
make a profit, financial institutions may start a second round of
the credit creation process. Lending has multiplied the level of
deposits which, in turn, are included as part of our volume of
money. In addition to this, there are also other sources of credit
growth including endorsed bills of exchange.
Whatever, when the volume of credit grows quickly, this fuels
some types of household and business expenditure. AD
(especially C + I) is affected, as is the level of domestic economic activity. It is even possible that inflation may result from
too much credit or money in an economy which is already operating at its capacity. This aspect was emphasised by an economic
theory called monetarism which for this reason advocated strict
government control of the volume of money. By contrast to this
worry, it is also true that too little credit growth can strangle
activity. The deliberate regulation by the RBA of interest rates
on savings deposits and on credit (loans) is one way of ensuring
that the growth in AD and economic activity is neither too fast
nor too slow to ensure stability. This is an important stabilising
feature of monetary policy.
CHAPTER 6 Economic management using macroeconomic monetary policy
205
THE FINANCIAL SECTOR AND
CAPITAL MARKET
Nature and structure of the financial
sector
The capital market involves the borrowing (demanding) and
lending (supplying) of credit at a price or cost which is called
the rate of interest. Banks and other types of financial institutions (e.g. building societies, managed funds, superannuation
funds, credit unions, insurance companies, finance companies
and the stock exchange) play a pivotal role in this market. As
can be seen in figure 6.1, the RBA heads the financial sector
and uses its monetary policy to help avoid inflation and improve
domestic economic stability.
Deregulation of the financial system
Despite a need for supervision, over the last two decades there
has been considerable deregulation of Australia’s financial system.
Deregulation involves removing unnecessary government
restrictions and other impediments to the efficiency of the
Table 6.1
financial system. Deregulation has included the reforms listed in
table 6.1.
The Reserve Bank of Australia is:
• Banker to the government, banks and other NBFIs
• Issuer of coins and notes, custodian of overseas reserves
• Promoter of domestic stability (especially the 2–3%
price stability target) and external stability using
monetary policy
Banks of different types
• Trading/savings banks
• Merchant banks
• Domestic and
foreign banks
Other
financial institutions
• Finance and
insurance companies
• Building societies
and credit unions
• Superannuation funds
• Managed funds
Figure 6.1 The structure of Australia’s financial
sector
TRY SHORT ANSWER EXERCISE
1, p. 229
000
Landmarks in the deregulation of Australia’s financial system
1981
Campbell inquiry into the financial system recommended widespread deregulation to improve efficiency
by strengthening competition.
1983
Martin inquiry reaffirmed the need for deregulation.
1983
The fixed exchange rate system (where the RBA each day determined the appropriate rate for swapping
the Australian dollar with other currencies) was replaced with a floating exchange rate system (where
buyers and sellers of currencies in the foreign exchange market determine the Australian dollar’s value).
However, the RBA reserves the right to use a dirty float (the RBA itself becomes a buyer or seller of
Australian dollars) so as to smooth out and affect the exchange rate.
1985
During this year, there were several developments:
■ Sixteen foreign banks were granted bank licences to operate in Australia to create more competition
for the major banks in the capital market.
■ The RBA controls which set maximum interest rates on loans and overdrafts were abolished.
■ Direct liquidity ratio controls on banks were streamlined and scaled down.
1986
RBA restrictions governing maximum housing loan interest rates were partly abolished.
1987
The RBA-imposed reserve or liquidity ratio for savings banks was lowered and subsidy to savings banks
removed so as not to discriminate against other types of banks.
1989
The RBA eliminated most of the remaining distinctions between trading and savings banks and further
reduced the liquidity ratio for savings banks to bring them more into line with other banks. Liquidity
arrangements for trading banks were modified and the RBA moved towards prudential supervision and
capital adequacy requirements for banks to gradually replace direct liquidity controls. Deliberate
variations to liquidity ratios were no longer to be used by the RBA to control bank credit creation and
to influence AD and economic activity.
1990
The prime assets ratio (the PAR was part of the RBA’s regulation of bank liquidity) was further reduced
but prudential supervision and capital adequacy requirements were tightened to help maintain financial
stability and confidence.
1991
The partial privatisation of the Commonwealth Bank commenced via a share float.
206
Economics Down Under Book 2
1993
Additional licences were granted for foreign banks to operate branches in Australia. Foreign banks were
encouraged to operate and compete in Australia by the introduction of special tax concessions.
Restrictions on the interest rates that could be charged by banks on credit cards were removed.
1996
Stage two of the privatisation of the Commonwealth Bank was undertaken. Banks and building societies
found that they faced stiffer interest rate competition in home lending due to the spread of special
institutions like RAMS. Additionally, the Wallis Inquiry into our financial system’s efficiency commenced.
1997
Continued conversion of some building societies to bank status added to competition. The Wallis Report
was published, generally recommending further deregulation but also recommending modifications to
the system of control and prudential supervision of the financial sector.
1998–
1999
The system of having special or official dealers in the short-term money market was abolished and the
short-term money market further deregulated. The 3 per cent prime assets ratio (liquidity ratio for banks
designed to promote financial stability and confidence among customers) was abolished. However, the
Australian Prudential Regulation Authority (APRA) was set up to generally monitor all types of financial
institutions to ensure that they have sound policies in place for managing their liquidity and capital
adequacy (reflecting the riskiness of particular types of lending). The RBA relinquished this responsibility
which was expanded to include NBFIs. Additionally, the Australian Securities and Investment Commission
(ASIC) was set up to promote competition, offer consumer protection and the resolution of disputes,
replacing the Australian Securities Commission. Soon, the government is expected to create the Council of
Financial Regulators (CFR) to oversee financial regulation.
2000
In order to increase competition with banks, credit unions and some other NBFI were given the right to
issue cheques in their own name. The RBA and the ACCC also conducted an inquiry into credit card fees.
2001
The Basle Committee released the new capital adequacy recommendations. These reflected risk profiles
and credit ratings of borrowers, rather than prescriptive liquidity ratios.
2002
The ACCC/RBA inquiry deemed Bankcard interchange fees set by banks were excessive and secretive.
Disclosure is now required to promote greater competition and efficiency.
2004
Recommendations of Basle Committee to be phased in. APRA introduced a new system of prudential
supervision for the insurance industry.
2005–
2006
The RBA indicated it was to introduce reforms and regulations for the EFTPOS system and ATM fees and
charges.
2007
2008
6.2 The aims of monetary policy
The Reserve Bank Act of 1959 sets out the functions of the RBA
and its board:
. . . to ensure that the monetary and banking policy of
the [Reserve] Bank is directed towards the greatest
advantage of the people of Australia and that the powers
of the Bank . . . are exercised in such a manner as . . . will
best contribute to the stability of the currency of
Australia; the maintenance of full employment in
Australia; and the economic welfare and the prosperity of
the people of Australia.’
Given this charter, it seems that RBA policy could be used to
pursue any of the government’s economic objectives including
price stability, sustainable economic growth, full employment, external
stability, efficiency in resource allocation and equity in the distribution
of income and wealth. However, in practice, the main aims of RBA
policy are much narrower: it is the key instrument used to
stabilise domestic economic activity.
The pursuit of price stability
Since 1993, the RBA has used inflation targeting or ‘fight
inflation first’, as the priority guiding changes in monetary
policy. These days, inflation targeting means achieving an
inflation rate averaging between 2–3 per cent per year over the
CHAPTER 6 Economic management using macroeconomic monetary policy
207
course of the business cycle. This is the medium-term aim of
monetary policy. Hence, when inflationary expectations exist
and there are signs that inflation will exceed the upper end of
the target range, the RBA will tighten its stance (i.e. set higher
interest rates) in a counter-cyclical way, so as to depress
inflationary expectations, slow rising spending and curb economic activity.
The pursuit of sustainable economic
growth and full employment
Only when price stability has actually been achieved, will the
RBA turn its attention to other aspects of domestic (i.e.
internal) stability such as the pursuit of sustainable economic
growth and full employment. Again, achieving these two objectives often means that the RBA adopts a counter-cyclical expansionary stance to stimulate economic activity (without causing
an acceleration of inflation or an excessive rise, the CAD and
the NFD). The main reason for the RBA giving priority to the
control of inflation is that price stability is seen as a precondition for achieving these other objectives. Limiting inflation is
seen as the best way to create conditions that maximise the sustainable rate of economic growth and minimise cyclical unemployment. The reasoning behind this approach is simple. For
instance, low inflation helps to maintain consumer and business
confidence that is needed for a steady rise in spending. Low
inflation also discourages speculative activity, promotes
adequate saving and attracts resources into productive investment in new plant and equipment.
During the past ten years, the RBA’s approach illustrates the
idea of controlling inflation as the first step in reducing the
severity of the business cycle. For example, with inflation on the
rise between late 1998 and August 2000, monetary policy was
tightened to slow spending. However, by late 2000 and early
2001, inflation was back on target. The RBA was able to again
reduce interest rates and become expansionary to stimulate
economic growth and reduce unemployment. However,
between late 2001 and late 2006, monetary policy gradually
became more contractionary, signalling some concern over the
gradual rise in inflation to the upper end of the RBA’s target
range.
Other aims of monetary policy
As also seen in the RBA’s charter, other government economic
objectives may sometimes be pursued. However, these are seen
as less central aims and are usually sought, first by controlling
inflation, and then by promoting sustainable economic growth
and full employment. For instance, low inflation, sustainable
economic growth and full employment are all helpful for promoting equity in the distribution of personal income. Avoiding
severe cyclical fluctuations in economic activity (i.e. maintaining low inflation, sustainable growth and full employment)
can also create economic conditions where resources are most
likely to be allocated efficiently and productively. Moreover,
price stability and domestic stability are beneficial for external
stability by helping to limit the size of the CAD:GDP and NFD,
and by promoting conditions that help strengthen international competitiveness and the exchange rate. While monetary policy can have indirect effects on all government
objectives, it is clear that the main priority involves the pursuit
of domestic economic stability.
TRY SHORT ANSWER EXERCISE
1, pp.
2,
p. 000
229–30
6.3 Specific instruments of
monetary policy
The RBA has three specific instruments of monetary policy:
■ By far, the most frequently used and powerful policy involves
changing interest rates through market operations.
■ A less important monetary measure entails influencing the
exchange rate (through a dirty float and changes in interest
rates).
■ Additionally, persuasion about the desired direction of
lending activities of the financial sector is also used on
occasions.
208
Economics Down Under Book 2
RBA ‘market operations’ to
affect interest rates
Interest rates are central to monetary policy and are used by the
RBA to regulate the level of AD and economic activity. In
general terms, interest rates represent the cost or price of
credit. As such, they are normally determined in financial
markets by the demand for credit by borrowers (e.g. households, firms, governments), relative to the supply of credit by
How the RBA can increase interest
rates — a contractionary stance
Assume that the RBA wanted to increase interest rates. First it
would announce a rise in the cash rate target, and provide a
detailed explanation of its reasons. It would then set out to
achieve this target by selling government securities at a discounted
rate in the short-term money market. Financial institutions,
Cash rate %
keen to make a profit, would suddenly find these securities
more attractive, because when purchased at a lower price, their
yield would rise. This gives owners a better rate of return on
their investment. Organisations taking up this good offer would
transfer deposits to the RBA, in exchange for receiving government securities. This directly reduces deposits or the supply of
cash held by financial institutions in their Exchange settlement
accounts. Competition among institutions for limited funds to
top up their Exchange settlement accounts would increase the
cash rate towards the announced target (see figure 6.2). A rise
in the cash rate set by the RBA, is usually indicative of a tighter
monetary policy stance and is often used when inflation rises.
S1 (reduced supply of cash)
S2 (original supply of cash)
Increased
cash rate
E2
Original
cash rate
E1
RBA undertakes sales of
government securities,
lowering the supply of cash
in the money market and
lifting the cash rate.
D1
(demand for cash)
Q2
Q1
Quantity of cash (Q)
Figure 6.2 How the sale of government securities
in the short-term money market can increase the
cash rate (a contractionary stance)
How the RBA can lower interest rates
— an expansionary stance
Suppose that the RBA wanted to reduce interest rates and so it
announced a lower cash rate target, again giving the reasons for
its decision. To reach this target, the RBA would need to buy back
government securities from the financial institutions operating in
the short-term money market. RBA buying would cause the price
paid for securities to increase, thereby lowering their yield, so that
financial institutions would be happy to get rid of them. When
this occurs, deposits are transferred from the RBA to financial
institutions, in exchange for government securities. As shown in
figure 6.3, this increases the supply of cash or the level of deposits
held by financial institutions in their exchange settlement
accounts, leaving the market with excess funds. The consequence
of this would be a fall in the cash rate towards the desired RBA
target. Lower rates are often announced when economic activity
is weak and usually reflect an easier or looser monetary policy stance.
Cash rate %
lenders (e.g. households and businesses who place their savings
in financial institutions). However, the RBA has the capacity to
affect interest rates generally, by setting the cash rate. The cash
rate is the interest rate that applies to a specialised market called
the overnight, or short-term money market. This rate depends on
the overall supply of cash (i.e. deposits) in the overnight money
market which, in turn, is controlled by the RBA through its
market operations (to be explained shortly). These activities
affect the size of special balances held by each major financial
institution (e.g. banks, building societies, finance companies
and superannuation funds) in its Exchange settlement account with
the RBA. But how does this complex system work to affect
interest rates? First, more background information is needed.
Each major financial institution is required to keep its
Exchange settlement account with the RBA in credit (for which
it receives interest). These account balances exist mainly for the
purpose of settling transactions between institutions during the
day’s trading. These transactions are caused mainly by the movement of cheques (e.g. a customer with one bank writes out a
cheque payable to a customer at another bank). In turn, through
the Reserve Bank information and transfer system (RITS),
cheque amounts are either credited or debited electronically
against the Exchange settlement account for each institution.
This settlement process does not affect the total level of cash or
deposits in these accounts (since rises in deposits for one institution are offset by a fall in deposits belonging to another). As a
result, transactions of this type do not cause deposited funds to
become either scarcer or more plentiful, and so they do not affect
the cash rate. What can add to or reduce the overall size of cash
deposits in Exchange settlement accounts are the activities
between financial institutions and the RBA. For example, when
companies and individuals use cheques or electronic funds
transfer to pay taxes to the government, the overall level of balances in exchange settlement accounts falls. In reverse, when the
government through the RBA pays tax refund cheques into individuals’ bank accounts, overall balances in Exchange settlement
accounts grow. However, while these transactions may have some
effect on the cash rate in the short-term money market, they do
not allow the RBA to actually control or determine the cash rate.
The main determinant of the cash rate (along with other
interest rates generally) is the daily conduct of market operations
that directly affect the supply of cash in the short-term money
market. Market operations involve the RBA either buying back
or selling secondhand government securities or bonds to
members of the RITS through the short-term money market.
Here you should think of securities or bonds as simply government IOUs for particular amounts of money that earn a given
rate of interest over a period of time. Armed with this understanding, let us take a look at the three positions or stances on
interest rates that the RBA may want to adopt in its regulation of
economic activity.
S1 (original supply of cash)
S2 (increased supply of cash)
Increased
cash rate
E1
Lower
cash rate
E2
RBA undertakes buying
back of government
securities, increasing the
supply of cash in the market
and cutting the cash rate
D1
(demand for cash)
Q1
Q2
Quantity of cash (Q)
Figure 6.3 How the buying back of government
securities in the short-term money market can
decrease the cash rate (an expansionary stance)
CHAPTER 6 Economic management using macroeconomic monetary policy
209
The RBA decides to smooth out or alter
the exchange rate using a ‘dirty float’.
Using a ‘dirty float’ in the
foreign exchange market,
the RBA becomes a net
buyer (D) of A$s, or
reduces its net sales of the
A$ causing the dollar to
appreciate.
Using a ‘dirty float’ in the
foreign exchange market,
the RBA becomes a net
seller (S) of A$s, or
reduces net purchases of
the A$ causing the dollar
to depreciate.
A stronger A$ than
otherwise will tend to
increase the current
account deficit and
inflation, but slow AD,
economic activity and
employment.
A weaker A$ than
otherwise will tend to
reduce the current account
deficit, lift AD, economic
activity and export
incomes, but cause
inflation to rise.
The effect of a dirty float
involving the RBA buying
the A$ in the foreign
exchange market to help
moderate downward
instability in the
exchange rate is
illustrated below:
The effect of a dirty float
involving the RBA buying
the A$ in the foreign
exchange market to help
moderate downward
instability in the
exchange rate is
illustrated below:
RBA Buys
P2
P1
S–A$
D1– D2–
A$ A$
Q1 Q2Quantity
of A$
Exchange rate (A$)
2. The RBA wants to
decrease the
exchange rate or to
prevent a
further erratic and/or
uninformed rise in the A$.
Exchange rate (A$)
1. The RBA wants to
increase the exchange
rate or try to prevent a
further erratic and/or
uninformed fall in the A$.
S1of A$
S2–A$
RBA Sells
ER1
ER2
D–A$
Q1
Q2
Quantity
of A$
Figure 6.4 RBA intervention in the foreign
exchange market to affect the exchange rate
How the RBA can keep interest rates
steady — a neutral stance
Often, however, the RBA just wants to keep interest rates steady
since they are already at an appropriate level, given current
economic conditions. In this case, the RBA’s daily selling and
buying back operations will seek to avoid changing the overall
supply of cash in the short-term money market, so that the current cash rate remains unchanged. When the cash rate is held
steady at around 4.5 per cent to 5.5 per cent, this is considered
to be a fairly neutral stance and within the normal range for a
healthy economy. In this situation, there are no significant
events requiring corrective action by the RBA. By contrast, if the
210
Economics Down Under Book 2
cash rate is kept above or below this neutral range, there must
be inflationary or deflationary circumstances.
By being able to control the cash rate in this way, RBA policy
has the capacity, through a ripple effect, to influence other commercial interest rates (e.g. those on home mortgages, overdraft,
credit cards and savings deposits) that are generally applicable
elsewhere in the financial sector. As we shall see, changing monetary policy’s stance through variations in the cash rate target is
a very handy instrument for stabilising the level of spending and
economic activity.
A ‘DIRTY FLOAT’ BY THE RBA TO
AFFECT THE EXCHANGE RATE
In international trade, the exchange rate is the price at which the Australian dollar is swapped against other currencies. As part of the
deregulation of Australia’s financial system, 1983 saw the introduction of a floating exchange rate. In the case of a clean float, the
Australian dollar’s value is dictated by the forces of supply and
demand for our currency in the foreign exchange market. In
other words, sellers (suppliers mostly living in Australia) and
buyers (often living overseas) of our currency interact in the
market to negotiate the equilibrium price or exchange rate. At
equilibrium, the quantity bought and the quantity sold are
exactly equal, and the market is cleared of either a shortage or
glut of Australian dollars. However, as part of its monetary
policy, the RBA still retains the option of a dirty float.
A dirty float is where the RBA tries to affect the exchange rate
by becoming a net buyer or seller of the Australian dollar in the
foreign exchange market. Nowadays, it is mainly reserved for
special occasions when changes in the dollar are uninformed
and erratic, leading to great uncertainty in international transactions. These principles are illustrated in figure 6.4.
How the RBA can lift the exchange
rate
If the RBA was faced with a situation where the Australian dollar
was falling in an erratic and misinformed way, it is likely that it
would intervene in the foreign exchange market. Using a dirty
float, the RBA would increase its net purchases of our dollar (or
reducing net sales of our dollar would have a similar effect), by
using its limited foreign exchange reserves. As we know,
increased demand or buying of the dollar relative to its supply,
will tend to raise our exchange rate (cause an appreciation)
because our currency becomes relatively scarcer. Sometimes,
this may be all that is needed to smooth the dollar and arrest
the fall, especially if interest rates are also increased at the same
time. For instance, during September–October 2001, there was
heavy selling of our dollar on the foreign exchange market. This
fall reflected the perception among traders that our currency
was overvalued given the downturn in the US, Japan, Taiwan
and Singapore. To an extent, the market was correct, but the
RBA felt that the dollar’s fall to US$0.49 was a misinformed
overreaction. Without firm support from the RBA at the time,
the currency may have gone into a free-fall. There are also other
circumstances where a higher dollar may be desirable. For one
thing, a stronger dollar makes imports relatively more competitive against our exports. Keeping the dollar fairly steady also
helps to slow both cost and demand inflation. Although it seems
reassuring that the RBA can affect the exchange rate in this way,
the very limited level of overseas reserves held by the RBA
places a constraint on the amount of support that can be given
to the Australian dollar. Besides, in the end it is the market, not
the RBA, that will have the final say as to the exchange rate.
How the RBA can lower the exchange
rate
If the situation above was reversed and it was felt that the market
was misinformed, causing the Australian dollar to be too high, a
dirty float may again be warranted. This time, instead of buying
the dollar, the RBA may intervene in the foreign exchange
market by increasing its net sales of our currency (or reducing net
purchases of the dollar would have a similar effect), so as to put
downward pressure on our exchange rate. If successful, a weaker
dollar would tend to make exports and capital inflow more
attractive against imports and capital outflow. This has the
potential to increase AD and reduce our current account deficit
(CAD). However, there is the risk that a lower dollar will ignite
inflationary pressures.
CONTINUED RBA
DEREGULATION OF THE
FINANCIAL SECTOR
Between 1982 and 2007, continual deregulation of the financial
sector has been an important strategy aimed at improving the
efficiency and competitiveness of domestic interest rates (see
table 6.1, p. 206). This approach does not really come under
monetary policy as such; it is better classified as part of microeconomic policy. Even so, it has had an enormous impact on
how monetary policy is conducted. Instead of relying on direct
controls over interest rates and the exchange rate, the RBA now
relies on more subtle intervention in various markets.
RESERVE BANK OF AUSTRALIA
‘PERSUASION’ OVER FINANCIAL
SECTOR LENDING LEVELS
When the RBA makes public comment in the media, typically
businesses and those involved in the capital market listen and
respond accordingly.
In the past, there have been occasions where the RBA has
tried to influence the direction and levels of lending by financial institutions so that government economic objectives are
more effectively pursued. Sometimes there are attempts to talk
up lending and spending; other times, an effort is made to talk
down activity.
TRY SHORT ANSWER EXERCISE
1, p. 230
3,
000
6.4 Using monetary policy to
improve domestic economic
stability
Domestic economic stability means simultaneously achieving:
■ price stability (annual average CPI rise between 2–3 per cent
over the economic cycle)
■ sustainable economic growth (annual average rate of economic
growth around 4 per cent)
■ full employment (unemployment rate of between 5 and 6 per
cent of the labour force).
The RBA’s monetary policy is often seen as the main macroeconomic instrument, used in the short to medium term, to
help stabilise the general level of economic activity. It does this
mainly by regulating the strength of AD in a counter-cyclical
way, using either an expansionary or contractionary stance. This
helps to ensure that AD does not outstrip the growth in Australia’s productive capacity (AS). In doing this, the RBA is
mainly guided by its desire to ‘fight inflation first’ and keep the
annual average inflation rate to within its 2–3 per cent target
(over the duration of the economic cycle). Hence, in any particular year, it may be a little higher than 2–3 per cent, but in
others, a bit less. This medium-term aim of monetary policy is
called inflation targeting. However, once inflation is safely within
this range, the RBA may turn its attention to pursuing other
aspects of domestic stability. In fact, it will usually try to achieve
the highest sustainable rate of economic and employment
growth that is possible, without causing inflation to accelerate.
CHAPTER 6 Economic management using macroeconomic monetary policy
211
Generally, a rate of economic growth averaging around 4 per
cent with unemployment between 5 and 6 per cent should be
achievable and consistent with the objective of price stability.
So, how does the board of the RBA, when it meets every two
weeks, go about deciding whether to adopt an expansionary or
contractionary stance? Typically, it uses a checklist of important
indicators.
CHECKLIST
After weighing up often conflicting evidence, the RBA then
adopts a particular policy stance. This could be contractionary
(to slow AD, economic activity and inflation during an upturn),
expansionary (to lift AD and economic activity in a downturn),
or a neutral stance (to keep economic activity steady). These
three positions are summarised in the figure 6.5.
DESCRIPTION OF ITEMS
1. Inflation
The RBA takes a careful look at quarterly trends in the CPI, the underlying
inflation rate, costs of materials used in manufacture and wage costs.
2. National spending and
production
A close watch is kept on the growth in AD relative to the economy’s productive
capacity or AS. The RBA monitors trends in private consumption and
investment spending (as well as recent changes in consumer and business
confidence as leading indicators of future expenditure), retail trade, housing
approvals and household debt.
3. Labour market
Changes in labour market conditions are seen as important, including the
unemployment rate, employment growth, job vacancies and labour force
participation rates.
4. Budgetary policy stance
Account is taken of budgetary policy outcomes (e.g. surplus or deficit) and the
stance (e.g. expansionary or contractionary) being adopted by the Treasurer.
5. International developments
Overseas trends in inflation, economic activity, interest rates and other events
are reviewed, as well as changes in Australia’s exchange rate and CAD.
The RBA’s monetary policy stance, indicated by the monthly cash rate target (%)
RBA contractionary stance
— five rises in interest
rates from 4.75% (1999) to
6.25% (late 2000) when
economic activity and
inflation were rising
RBA contractionary stance — eight
rises in interest rates from 4.25%
(2002) to 6.25% (late 2006) when
inflation was tending to accelerate
due to strong AD when there was
increasingly little unused
productive capacity
Cash rate target (%)
8
6
4
2
0
RBA expansionary stance — five cuts in
interest rates from 7.5% (1996) to 4.75%
(late 1998) when AD and economic
activity slowed
1996
1997
1998
1999
2000
RBA expansionary stance — six cuts in
interest rates from 6.25% (2000) to 4.25%
(late 2001) when AD and economic
activity slowed
2001
2002
2003
2004
2005
2006
2007
2008
2009
Figure 6.5 Changing the RBA’s monetary policy stance to help improve domestic economic stability
STANCE OF
MONETARY POLICY
1. Contractionary or
tighter monetary
policy stance
(e.g. 1999–2000,
2002–07)
212
THE MAIN INDICATORS OF THIS
POLICY STANCE
RBA announces an increase in its cash
rate target (above the normal range) and
proceeds to push up interest rates using
its market operations involving net sales
of government securities in the short-term
money market.
Economics Down Under Book 2
AIM OF THE POLICY STANCE
The aim here is to use higher interest
rates to reduce inflation to 2–3 per cent.
This works mainly by slowing AD and
economic activity, and through other
transmission mechanisms.
STANCE OF
MONETARY POLICY
THE MAIN INDICATORS OF THIS
POLICY STANCE
AIM OF THE POLICY STANCE
2. Expansionary or
looser monetary
policy stance
(e.g. 1996–99,
2000–02)
RBA announces a reduction in its cash
rate target (below the normal range) and
proceeds to bring down interest rates by
its market operations involving net
repurchases of government securities in
the short-term money market.
The aim here is to use lower interest rates
to help lift economic activity and reduce
unemployment, without increasing the
inflation rate. Again this occurs by
boosting AD and other transmission
mechanisms.
3. Neutral (normal)
monetary policy
stance.
RBA sets its cash rate target within the
normal range of about 4.5 per cent to
5.5 per cent for a healthy economy. It
then holds interest rates steady by
appropriate market operations.
The aim here is to neither stimulate nor
slow AD and economic activity. Monetary
policy is adopting a fairly neutral role.
Source: Data compiled using various RBA Monthly Bulletins (table A.2).
Let us now investigate further how the RBA has actually
implemented its counter-cyclical stabilisation policies involving
changes in the cash rate during the past 10 years or so to 2007,
as shown in figure 6.5. The effects of these measures will also be
illustrated in figure 6.6 using the AD–AS diagram.
A contractionary monetary policy can
slow AD, economic activity and
inflation
In theory, inflation accelerates when AD grows faster than the
economy’s productive capacity or speed limit (i.e. currently an
average rate up to about 4 per cent a year). This is shown in
figure 6.6, by AD2, and GDP1–2. At this point, prices rise (i.e.
from P1 to P2) because excessive levels of expenditure cause
widespread shortages of goods and services (demand–pull
inflation). Cost inflation too can occur when there are shortages
of resources (e.g. wages costs rise when unemployment falls too
low). To help stop demand inflation (‘inflation targeting’ is the
RBA’s main priority), monetary policy needs to gradually adopt
a tighter or more contractionary stance designed to slow expenditure (i.e. from AD2 to AD1), without jeopardising economic
growth (i.e. this remains at GDP1–2) and full employment. In
tightening its stance, typically the RBA places greatest reliance
on its interest rate policy.
This was more or less the type of situation that occurred between
1999 and 2001, and again between late 2001 and early 2007. As
shown in figure 6.5, the RBA raised its cash rate target eight times
during this latter period, due to excessively strong AD contributing
to inflation in an economy close to its capacity (peaking at 6.25 per
cent in August 2000 and 6.25 per cent in November 2006). The
steps involved in lifting interest rates are as follows:
Step 1: The tightening of monetary policy will start by the RBA
announcing an increase in its cash rate target in the shortterm money market. This indicates the RBA’s new stance.
Step 2: Next, the RBA will set out to achieve this higher target
by undertaking market operations involving net sales of
government securities to financial institutions, at an
attractive lower or discounted price. This lifts the yield
(percentage return on money) on securities and makes
ownership of them more desirable.
AS
General price level
P2
Demand inflation
AD2 = excess AD that causes
P1
P0
AD0 =
weak AD and recession. This
requires an expansionary monetary
policy stance to lift spending
an inflationary boom. This is
corrected using a contractionary
monetary policy stance to slow
spending and reduce inflation.
AD1 = ideal levels of spending
as a result of successful countercyclical monetary policy
GDP0 =
GDP1 and GDP2 =
the economy is in a
the economy is at its
recession with high
productive capacity
unemployment
Real GDP/national output
Figure 6.6 Using monetary policy in a counter-cyclical way helps to reduce cyclical instability in economic
activity.
CHAPTER 6 Economic management using macroeconomic monetary policy
213
Step 3: As financial institutions transfer money to the RBA in
exchange for government securities, there is a shortage of
cash deposits in their exchange settlement accounts. They
must then compete among themselves for limited
funds, in order to maintain positive balances in their
accounts. The shortage of cash then drives up interest
rates in the overnight money market.
Step 4: A higher cash rate then spreads to other interest rates in
the financial market like a ripple effect. Rates paid on
mortgages, credit cards, business overdrafts and savings
accounts, all rise.
Step 5: The final aspect of this tighter monetary policy stance
involves what is called the transmission mechanism or the
ways higher interest rates actually work to slow inflation.
As shown in figure 6.7, there are at least three of these:
1. Higher interest rates tend to slow economic activity
(e.g. between 1999–2000 and 2002–07) by
increasing the level of saving and reducing the
level of credit-sensitive spending (i.e. C + I) that
relies heavily on borrowing. This slows AD (as seen
in figure 6.6, removes shortages of goods and services, and reduces demand inflation.
2. Higher domestic interest rates relative to those overseas, tend to cause the A$ to appreciate (e.g. between
2002 and early 2007). This happens because Australia
has become even more attractive to foreign investors
who are seeking our better rates of return. This
increases the demand for the A$ relative to its supply
in the foreign exchange market, causing an appreci-
ation of the currency. In turn, a higher A$ slows
inflation in two ways. For one thing, the cost of
imports is cheaper for households and firms. This
reduces cost inflation. Demand inflation also tends
to ease with a higher $A. This is because sales of our
exports are reduced relative to our spending on
imports.
3. Higher interest rates can work to slow inflation by
helping to reduce inflationary expectations in the community. People become confident that the RBA will
not let inflation take hold. Indeed, during both
1999–2001 and 2002–07, rising interest rates did help
to keep inflationary expectations in check, thereby
improving domestic economic stability.
Although the RBA relies mostly on higher interest rates to
control inflation, there are also two other less important instruments available. One other approach is that RBA could apply a
dirty float to try to lift the exchange rate for the A$. This would
involve the RBA buying the A$ in the foreign exchange market,
by using its reserves of other overseas currencies. The rise in the
demand for dollars relative to their supply, makes the currency
scarcer, thus lifting the price or the exchange rate. In turn, a
stronger dollar slows inflation in two ways. First, it makes exports
dearer and less attractive relative to imports. This tends to
reduce net exports and AD, ease shortages of goods and services
and slow demand inflation. Second, a stronger currency makes
imported household items cheaper and also lowers the cost of
imported materials and equipment used in production by local
firms. This, too, eases the pressure of costs on inflation.
The RBA increases interest rates
1. Higher interest rates slow inflation by affecting the decision to save or spend.
Most importantly, higher real interest rates encourage or reward greater saving and they lower
credit-sensitive household consumption and business investment spending by making borrowing more
expensive. Both C and I spending are deferred. This slows AD and economic activity, removes shortages of
goods and services, and reduces demand inflation.
2. Higher interest rates tend to slow inflation by pushing up the exchange rate.
Higher domestic rates tend to lift the exchange rate by:
– attracting overseas investment and money capital into the country which lifts the demand for the A$ in
the foreign exchange market, causing a rise in the dollar
– slowing total expenditure and hence imports, thereby reducing the supply of the A$ in the foreign
exchange market
– increasing savings and reducing dependence on overseas borrowing and debt repayments.
In turn, a stronger A$ helps to make imports cheaper, relative to exports. This not only slows AD and
demand inflation (by slowing net exports), but it also eases cost inflation pressures.
3. Higher interest rates can reduce inflationary expectations.
When people get accustomed to inflation and expect it to continue, it becomes a self-fulfilling prediction.
Individuals then take action to protect their purchasing power from the effects of rising prices. Wage earners
push for more pay, adding to cost and demand inflation. Asset buyers push up property and share prices,
fuelling further inflation. By contrast, higher interest rates depress inflationary expectations because they
affect peoples’ perceptions and signal the determination of the RBA to control inflation.
Inflation slows down
Figure 6.7 Some of the transmission mechanisms whereby a tighter monetary policy stance controls
inflation
214
Economics Down Under Book 2
An expansionary monetary policy can
lift AD, economic growth and
employment
In theory, applying a more expansionary stance for monetary
policy can counteract a downswing or recession in the business
cycle. As shown on the AD–AS diagram in figure 6.6 (p. 213) the
RBA can use lower interest rates to stimulate AD. Starting on
this diagram at AD0, GDP0 and P0, a reduction in interest rates
would tend to accelerate expenditure from AD0 to AD1, and lift
national production from GDP0 to GDP1 (without much
increase in the inflation rate). Clearly, domestic economic
stability should be improved and recession avoided.
In more detail, the main steps involved with an expansionary
approach are as follows:
Step 1: The loosening of monetary policy will start by the RBA
announcing a reduction in its cash rate target for the shortterm money market.
Step 2: The RBA will then set out to achieve this lower target by
undertaking market operations in the short-term money
market involving net repurchases or buying back of government securities from financial institutions. This action
will tend to lift the price of securities, reduce the yield and
encourage institutions to get rid of their government
securities.
Step 3: As the RBA transfers money to financial institutions (in
exchange for their government securities), there is a
surplus of cash deposits in exchange settlement accounts. The
glut of cash drives down interest rates in the overnight
money market.
Step 4: A lower cash rate spreads in a ripple effect to other
interest rates in the financial market.
Step 5: Finally, a looser monetary policy stance involving reduced
interest rates should tend to stimulate economic growth
and reduce unemployment. There are at least two
important transmission mechanisms:
1. Lower interest rates tend to boost economic
activity by accelerating AD. This happens because
lower rates discourage saving and encourage creditsensitive C and I spending (that rely on
borrowing). In turn, this tends to cause retail sales
to rise and stocks to fall. Firms should respond by
lifting production (GDP) and employing more
resources, including labour. Indeed, the RBA estimates that a real cut in the cash rate of 1 per cent,
helps to accelerate economic growth in GDP by
around 0.8 per cent.
2. As seen in 2001–02, a cut in domestic interest rates
relative to those overseas causes a fall in our
exchange rate. This is partly because there is more
capital outflow from Australia seeking better returns
elsewhere. This leads to increased sales of the A$ in
the foreign exchange market, causing the exchange
rate to depreciate. In turn, AD rises due to exports
becoming more attractive relative to imports. Again
this is helpful in stimulating economic activity during
a downturn, thereby helping to improve domestic
economic stability.
The RBA could also reinforce expansionary interest rate cuts
to correct a downturn, by using two other less important
measures. First, if it was felt that the exchange rate was too high,
theoretically, the RBA could directly weaken the currency a little
by selling off the dollar in the foreign exchange market using a
dirty float. In turn, a lower exchange rate would tend to stimulate exports relative to imports, thereby strengthening AD.
Second, the RBA may use its influence (persuasion) to
encourage more lending by the financial sector and to talk up
the economy by painting an optimistic picture. Persuasion like
this might also help recovery and improve domestic stability.
Monetary policy can sometimes
promote domestic stability by
increasing AS
While monetary policy is primarily a macroeconomic measure
designed to regulate AD and reduce the severity of the business
cycle, it can also have effects on the supply-side of the economy.
For instance, if the RBA were able to cut interest rates after it had
brought inflation under control (e.g. as in 1996–99 or 2001–02),
this would tend to reduce production costs for firms with bank
overdrafts, enhance competitiveness, and strengthen business
profitability. Firms would then be more likely to expand their
operations and be less likely to close. As a result, structural
unemployment should be lower, thanks to improved supply-side
conditions. Using the AD–AS diagram in figure 6.8, this would
result in the outward shift in productive capacity (i.e. from AS1
to AS2). Equilibrium would now occur at a higher level of GDP
(i.e. a shift from GDP1 to GDP2) and at a lower level of inflation
(i.e. P1 to P2). Domestic economic stability should be improved.
AS1 —
original supply-side
conditions
General price level
Another monetary policy strategy is that RBA could use its
influence or persuasion (e.g. during 1999–2000 and 2004–05) to
issue warnings of caution about the excessive levels of lending
by the financial sector, or high spending by households and
firms. This could help talk down economic activity and inflation,
and thus improve domestic stability.
P1
AS2 — how increased
productive capacity
and supply can result
from RBA reductions
in interest rates
Cost inflation
P2
AD1 = ideal levels
of spending
GDP1 =
original sustainable rate
of economic growth
and employment
GDP2 = increased
sustainable rate of
economic growth
Real GDP/national output
Figure 6.8 How lower interest rates could have a
beneficial supply-side effect on domestic economic
stability
CHAPTER 6 Economic management using macroeconomic monetary policy
215
Unfortunately, however, it is not always possible for the RBA
to lower interest rates in this way. Sometimes, the RBA is forced
to lift interest rates to slow demand inflation. In this situation,
the policy would contribute to higher production costs, business
closures, increase structural unemployment, and an inward shift
in the AS line (i.e. a decrease in productive capacity with a shift
from AS2 to AS1).
Other advantages of monetary policy
Apart from promoting domestic stability by regulating the level
of AD, there are also some other advantages of using monetary
policy to improve domestic economic stability.
Short implementation lags for monetary policy
Long time lags (i.e. delays in recognition, implementation and
impact of policy) are a worry for policy makers since they reduce
the effectiveness of RBA stabilisation measures. Policy may end
up being mismatched to the economic situation that it is meant
to correct. Instead of measures being counter-cyclical in their
impact on AD, they may become pro-cyclical and actually worsen
domestic instability (e.g. policy reduces AD in a recession and
increases it in a boom). However, a real advantage of using
changes in interest rates to steady economic activity is that their
implementation lag is quite short; with delays of only two weeks
between one RBA board meeting and the next. This lag is much
shorter than discretionary changes in budget tax rates or
budget outlays, for example, where implementation may take
the Treasurer a year or more. Despite this, there are still long
impact lags for changes in the cash rate.
Often monetary policy is able to complement budgetary policy
as a domestic stabiliser
Ideally, monetary and budgetary policies should both work
together as macroeconomic measures to help stabilise AD, slow
inflation, maintain a sustainable rate of economic growth and
deliver full employment. Policies are usually most effective if
they are compatible (i.e. complementary) rather conflicting. In
the 10 or so years to 2007, often monetary and budgetary policies have been supportive of each other. For instance, in
response to rising inflation and strong economic growth during
1999–2000 and again between 2002 and late 2006, both
budgetary and monetary policies were tightened simultaneously
Table 6.2
to slow the growth in AD. The RBA increased the cash rate while
the Treasurer grew the size of the budget surplus.
Monetary policy changes are often less political than discretionary fiscal measures
The RBA board and its governor are meant to be independent
and are not members of the currently elected government.
Being outside the political system, monetary policy, therefore,
has the advantage over budgetary policy of having fewer political constraints in setting the cash rate target. By contrast,
budgetary changes in tax rates and specific government outlays
made by the Treasurer (as a member of the elected party and
government) are highly politicised. This consideration can
sometimes restrict the use of fiscal measures needed for promoting better internal stability.
Monetary policy works best in slowing inflation
Monetary policy is better at slowing inflation than it is in stimulating economic growth during a recession. This is because rises
in interest rates designed to slow economic activity, are felt
directly by borrowers who are forced to find extra money to meet
interest repayments on existing loans. This makes it a very effective policy because spending on other things just has to be
reduced and new borrowing is deferred. By contrast, cuts in
interest rates that reduce repayments, do not force people to
spend more and there may be no increase in borrowing. It is also
possible that once interest rates get close to zero as in Japan
(2002–04), there is almost nothing else that monetary policy can
do to stimulate economic activity, if people choose not to spend.
HAS MONETARY POLICY
SUCCESSFULLY PROMOTED
DOMESTIC ECONOMIC
STABILITY?
It is very difficult to measure the success or otherwise of the
RBA’s monetary policy in promoting domestic economic stability (i.e. the simultaneous achievement of sustainable rate of
economic growth, price stability and full employment). This is
because there are so many local and international influences on
the economy. However, perhaps we could start our policy evaluation by looking at the statistical data contained in table 6.2.
Indicators of trends in domestic economic stability
1996–
97
1997–
98
1998–
99
1999–
2000
2000–
01
2001–
02
2002–
03
2003–
04
2004–
06
2005–
06
Economic growth
(% of GDP)
3.8
4.5
5.2
4.0
1.9
3.8
3.2
4.1
2.7
2.8
Inflation (% of CPI)
1.3
0.0
1.2
2.4
6.0
2.8
2.7
2.8
2.5
4.0
Unemployment
(% of labour force)
8.3
8.0
7.4
6.6
6.4
6.7
6.1
5.8
5.3
5.1
YEAR
2006–
07
2007–
08
Source: Data derived from ABS, 1350.0.
216
Economics Down Under Book 2
Some strengths
Some commentators would say that the figures in table 6.2 lend
support to the successful application of monetary policy in the
years to 2007. For instance, the RBA consistently and correctly
applied its measures in a counter-cyclical way that was designed
to improve domestic economic stability. For example, a contractionary stance (involving higher interest rates) was always used
to slow inflationary upswings in activity when spending was running ahead of production (e.g. as in 2002–07). This meant that
inflation was held down and averaged only 2.6 per cent per year.
Despite two inflationary spikes of 6 per cent and 4 per cent in
2000–01 and 2005–06 respectively, this figure was well within the
government’s 2–3 per cent target.
As for sustainable economic growth and full employment,
again the RBA can be proud of its achievements. Although a bit
below the 4 per cent target rate, the average 3.7 per cent rate of
economic growth has been held at the highest sustainable rate
that would not cause inflation. The observation that rates of
growth have been a bit slower than expected in the last four out
of five years was due only to the fact that the economy had little
unused productive capacity. Besides, economic growth over
these years has still been fast enough to cut unemployment to a
32-year low (down to only 4.4 per cent in April 2007), create
2 million new jobs and allow for the highest participation rate
ever achieved.
Some weaknesses
Despite monetary policy’s general success in the years leading
up to 2007, critics point to some of its weaknesses.
The problem of long impact lags for monetary policy
Although the implementation delay is quite short for changing the
cash rate target, the impact lag for monetary policy is quite long
Table 6.3
and nowadays, more variable following financial sector deregulation. For example, the RBA estimates that a 1 per cent reduction in interest rates will take nearly three years to have its full
expansionary impact and to lift GDP’s growth by 0.8 per cent.
After one year, the impact is about 40 per cent and even after
two years, the impact has only reached 80 per cent. This is also
complicated by the fact that the impact delay of a given change
in interest rates is variable. This is partly because it is affected by
the state of consumer and business confidence. For example, a
1 per cent rise in the cash rate designed to slow inflation, will
have either less effect or take longer to work when confidence is
strong, than it will when confidence is weak. In reverse, even
reductions in the cash rate to zero per cent (as in Japan between
2001 and 2005) are almost powerless to raise spending when
confidence is really low. The point here is that long impact lags
involved with changes in interest rates, may sometimes cause
counter-cyclical policy to become pro-cyclical. This would destabilise the economy.
Sometimes monetary policy is undermined by budgetary policy
On some occasions, successful monetary policy can be undermined by budgetary policy. An obvious instance of this was the
conflict that appeared to exist between these two policies during
2005 and 2007. As shown in table 6.3, budgetary policy involved
a significant cut in the size of the budget surplus from
$15.8 billion (2005–06) to $13.6 billion (revised estimate) for
2006–07 to only $10.6 billion for 2007–08 (budget estimate).
The budget also included very large discretionary cuts in
personal income tax and rises in infrastructure spending.
Strangely, this less contractionary fiscal stance came on top of
contractionary RBA rises in interest rates in March 2005 and
May 2006. The Treasurer was also blamed for two further rises
in the cash rate target announced in August and November
2006. Some commentators even suggested that political
considerations played a role in the tax cuts during this instance.
The conflict between the directions of budgetary and monetary policies
BUDGETARY POLICY STANCE 2005–07
MONETARY POLICY STANCE 2005–07
The 2005–06 budget
(announced in May
2005)
Contractionary surplus of
$15.8 billion
March 2005
Cash rate target = 5.5 per
cent
The 2006–07 and
2007–08 budgets
(announced in May
2006 and May 2007)
Less contractionary
surpluses of $13.8 billion
(2006–07) and $10.6
billion (2007–08)
(including large tax cuts
and extra G2 spending on
infrastructure)
May 2006
A more contractionary rise
in the cash rate target to
5.75 per cent
A more contractionary rise
in the cash rate target to
6 per cent
A more contractionary rise
in the cash rate target to
6.25 per cent
August 2006
November 2006
Source: Data derived from RBA Bulletin, November 2006.
CHAPTER 6 Economic management using macroeconomic monetary policy
217
There are also other aspects of conflict between budgetary
and monetary policies. For example, conflict can occur when
governments run large budget deficits to stimulate activity and
employment. Financing these deficits typically requires
increased government borrowing, often locally. With limited
savings or credit available, upward pressure could unintentionally be exerted on domestic interest rates. This crowds out private sector borrowers, thus contradicting the original
expansionary aims of budgetary policy. It also undermines the
RBA’s efforts to lower interest rates and stimulate the economy.
In reverse, contractionary surplus budgets may tend to cause
interest rates to fall or rise less quickly than otherwise (e.g. perhaps 2001–02 to 2006–07). This may result in crowding in by
borrowers and increase spending, undermining the RBA’s
monetary stance.
Conflict between objectives can create problems
In pursuing one economic objective, monetary policy can
undermine the achievement of other government goals. Take
the following situations:
■ Higher interest rates may well slow expenditure and reduce
demand inflation. However, as a supply-side factor, rises in
interest rates on business overdrafts also add to the production costs for firms. In order to cover higher costs and
protect profit margins, some businesses may be forced to
increase the price at which they sell their goods and services,
adding to cost inflation. This reduces the effectiveness of
monetary policy. Additionally, higher interest rates may discourage business investment, reduce business expansion,
undermine profitability and lead to the closure of some
firms. This slows economic growth and reduces AS. Furthermore, when firms close down or try to cut staff costs, structural unemployment rises. Clearly, higher interest rates also
have negative effects on domestic stability.
■ A decision to raise domestic interest rates relative to those
overseas in order to slow inflation, may attract a flood of
capital inflow, cause the A$ to appreciate, lead to a rise in
the CAD and NFD, and undermine the achievement of
external stability (e.g. 2002–06). In reverse, a cut in interest
218
Economics Down Under Book 2
rates to stimulate economic and employment growth, may
cause an exodus of investment funds seeking higher returns
abroad, weaken the currency’s exchange rate and add to
inflation.
Consideration of the conflict that can exist between some
government objectives, may limit the ability of the RBA to use
monetary policy to pursue domestic stability.
Monetary policy works less directly than budgetary policy
Critics note that monetary policy is less effective in overcoming
recessions. This is because cutting interest rates only works very
indirectly on the level of spending, by making interest repayments cheaper. People are not forced to spend more. Indeed,
even rates of zero per cent, as in Japan between 2002 and 2005,
hardly whipped pessimistic borrowers into a spending frenzy. At
this rate, Japanese monetary policy was powerless to do any
more to aid recovery and so reliance was placed on expansionary budgets.
Monetary policy is a blunt and imprecise instrument
Unlike budgetary and microeconomic policies that can surgically target particular sectors, industries or areas (e.g. rural
sector, textile producers) that are causing problems, monetary
policy is blunt and imprecise. For example, it treats all borrowers of credit in the same way, whether it be to finance
household consumption or for business investment in new
equipment. The failure to make this distinction makes it rather
clumsy. In addition, it is possible that only some (not all) Australian states need their expenditure restrained, at a point in
time. This was the case in 2006 and 2007 when unemployment
in the booming economies of WA and the ACT was around
3 per cent, but it was above 6 per cent in Tasmania where
economic growth was quite slow. Here we have a two-speed
Australian economy. Tasmania could probably do without the
recent rises in interest rates, but it will not get any choice
about the matter.
TRY SHORT ANSWER EXERCISE
1, pp.
4,
p. 000
230–31
6.5 Using monetary policy to
improve external stability
For Australia, external stability means paying our way in international financial transactions without this impacting adversely
on the exchange rate or on the size of the CAD and NFD.
Specifically, the objective means aiming for:
■ a relatively small CAD:GDP ratio (around 3–4 per cent)
■ a sustainable NFD where heavy interest repayments abroad
are avoided
■ helping to ensure that the dollar behaves predictably and
preferably retains its purchasing power.
Although monetary policy can affect the exchange rate, the
size of CAD:GDP ratio and even the NFD, its impact is less direct
and overall. It is not the most effective policy available to promote external stability. Budgetary and microeconomic policies
are probably more effective. Even so, we will now take a look
how RBA measures might try to operate in this area.
interest rates are also a production cost for most local firms. This
pushes up domestic costs and prices, relative to imports
coming from countries where interest rates are lower. Exports
are depressed and imports rise. In addition, higher domestic
interest rates attract foreign capital inflow and tend to push up
the A$, making our exports less attractive relative to imports.
In turn this also tends to worsen the CAD, increase the NFD
and weaken external stability. Having noted these weaknesses
throws some doubt on how effective monetary policy is in promoting external stability. This may be why budgetary or microeconomic policies seem to have been the preferred strategies
for promoting external stability during the past 10 years to
2007.
Limiting cyclical rises in AD might
reduce external instability
Perhaps the main way monetary policy can be used to promote
external stability is by using it to improve internal stability. If AD
and economic activity grow too quickly in an economy operating at its capacity (i.e. during a boom), external stability
quickly deteriorates. Typically, this is reflected in a cyclical rise in
the CAD:GDP ratio and a fall in the exchange rate. This is
because when AD grows too fast and outstrips production or AS,
there are widespread shortages of goods and services and excess
expenditure spills over onto imports. As a result, there is a
cyclical rise in the CAD and weakening of the A$. In addition,
cyclically strong spending locally means that there are fewer
goods and services available for export, again pushing up the
CAD. However, by applying a more contractionary monetary stance,
this cyclical problem, externally, may be reduced. For instance,
if the RBA increased interest rates, this would tend to reduce
spending and economic activity, in turn causing imports to grow
more slowly and releasing extra production for export. In
addition, higher interest rates help slow inflation and, in one
way, make our exports relatively more competitive against
imports. This too should help to reduce the CAD.
The RBA certainly has raised interest rates on several
occasions over the past 10 years. For instance, there were eight
consecutive rises in the cash rate target from 4.75 per cent in
late 2001, to 6.25 per cent in late 2006. This occurred at a time
when there was strong spending growth and the economy was
approaching its productive capacity. National expenditure was
tending to run ahead of the total production supplied, causing
a blowout in the CAD. Hence the use of contractionary monetary policy may have helped to promote external stability and
curb the cyclical rise in the size of the CAD.
Even so, there are real problems of using higher interest
rates (e.g. as between 2001 and early 2007) to reduce the CAD
and to lift the exchange rate. Unfortunately, higher rates have
an adverse supply-side effect on local firms and reduce Australia’s international competitiveness. The reason is that
Smooth out erratic changes in the A$
An unstable and unpredictable exchange rate means that the
cost of international transactions is hard to determine until the
last moment. This discourages export sales and may increase
the CAD. However, you may recall that in these circumstances,
the RBA may use a dirty float to help smooth out uninformed
and erratic swings in the dollar. For example, an unpredictable, unwarranted and dramatic drop in the exchange rate
could be partly steadied through intervention by the RBA
involving increased buying of our currency in the foreign
exchange market. In reverse, an upward surge that could
worsen the CAD might be moderated by RBA selling off the
currency. The RBA did just this on a number of occasions
between 1996 and 2007. For instance, between 1999 and 2000,
it was busy buying up Australian dollars in the foreign
exchange market (assisted by higher interest rates) to try to
stop the exchange rate plunging to an all time low (i.e. the
TWI fell to 49.7 points in 2000–01). In reverse, there was intervention to slow the rise in the A$ in 2004–05 through sales of
the currency by the RBA.
CHAPTER 6 Economic management using macroeconomic monetary policy
219
HAS MONETARY POLICY
SUCCESSFULLY PROMOTED
EXTERNAL STABILITY?
of Australian exports. These actions by the RBA should have
helped to improve external stability.
Given that monetary policy has been mainly used to promote
domestic stability, it would be unfair to blame it for Australia’s
external weaknesses shown in table 6.4. Besides monetary
policy, there were also many other influences affecting external
stability in the past 10 years.
Despite doing what it could, commentators have highlighted the
limitations of using contractionary monetary policy to pursue
external stability.
Some weaknesses
Some strengths
Certainly between 1996 and 2007, monetary policy did what it
could to promote external stability. After all, it helped to
achieve domestic economic stability, a situation where conditions are more favourable for achieving external stability. For
instance, contractionary rises in interest rates (e.g. 2002–late
2006) helped to limit the increase in AD. This reduced the spillover of excess spending onto imports in an economy near its
capacity. In addition, monetary policy successfully promoted
price stability (i.e. the average annual inflation rate was only
2.6 per cent), thereby helping to maintain the competitiveness
Table 6.4
Higher domestic interest rates can increase the CAD and NFD
Foremost, when the RBA raised interest rates to slow spending,
as it did between 2001 and early 2007, this had mixed effects on
external stability. As already noted, although higher rates can
reduce the cyclical rise in the CAD, they also add to external structural problems. Higher interest rates in Australia relative to those
overseas, cause foreign capital to rush in and take advantage of
relatively better returns here for foreign investors. This pushes
up the A$, makes our exports less attractive relative to imports,
and causes the CAD and NFD to become even bigger. This was
generally seen between 2001–07. In addition, increases in interest
rates for business overdrafts, drive up production costs for many
local firms. This reduces the competitiveness of our exports
against imports, further adding to Australia’s structural CAD.
Monetary policy and Australia’s external instability
1996–
97
1997–
98
1998–
99
1999–
2000
2000–
01
2001–
02
2002–
03
2003–
04
2004–
05
2005–
06
1. CAD:GDP ratio
for Australia (%)
— the
government’s
target = around
3–4 per cent)
3.3
4.1
5.7
5.1
2.7
3.1
5.1
5.5
6.2
2.5
2. CAD ($ billions)
17.6
22.8
33.6
32.6
18.1
20.7
40.2
46.8
57.4
54.4
3. TWI for the
exchange rate at
June (1970 =
100 points)
56.7
57.9
58.4
53.3
49.7
52.3
59.4
59.1
64.5
62.2
4. A$ exchange
rate with the
$US
0.75
0.61
0.66
0.60
0.51
0.56
0.67
0.69
0.76
0.74
5. Ratio of NFD to
GDP for
Australia (%)
39.5
40.7
39.1
43.7
45.3
45.3
47.1
46.6
48.3
52.2
Changes in the RBA’s
cash rate target
(interest rates at
July)
6.00
5.00
4.75
4.75
6.00
5.00
4.75
4.75
5.25
5.50
YEAR
2006–
07
2007–
08
5.75
Sources: Data derived from the ABS 1350.0, RBA Bulletin.
220
Economics Down Under Book 2
Pursuing external stability can conflict with other
economic objectives
If external stability is pursued using rises in interest rates for
example, this may conflict with the achievement of other
government economic objectives like efficiency in resource allocation. Higher interest rates discourage business investment
spending on new plant and equipment, and thus slow rises in
efficiency. In addition, increases in interest rates slow AD and
may undermine economic and employment growth. This may
even reduce equity in income distribution.
Budgetary and microeconomic policies are more effective
for external stability
Another reason why external stability is not the main aim of monetary policy is that budgetary and microeconomic policies are far
more effective and powerful. Contractionary monetary policy has
problems, as we have seen. It is too blunt and only works indirectly by slowing expenditure levels and lowering inflation to
improve our competitiveness. However, for the past decade, fiscal
measures and microeconomic reforms (including the promotion
of national savings, cuts in tax rates, labour market deregulation,
the ACCC, privatisation and corporatisation of the public sector,
and tariff cuts) have had a more powerful influence by tackling
the on-going structural problems causing the large CAD and
NFD, and the long-term depreciation of our currency.
The ability to prop up the A$ is limited
Nowadays, our exchange rate is determined by the forces of
demand and supply for the A$ in the foreign exchange market.
However, on some occasions when the exchange rate was falling
very rapidly (e.g. 1999–2001), the RBA may decide to intervene
using a dirty float to smooth out erratic or uninformed changes.
However, there are limits to the support that can be given to the
currency in the event of a serious collapse. For one thing, the
RBA has only limited reserves of foreign currency or gold that can be
used for purchasing A$. Even then, there is no guarantee that
when the buying intervention has ended that the currency will
not again decline. The market, not the RBA, makes the final
judgement as to where the dollar comes to rest.
The impact lag of interest rates may be long
In the event of excess AD causing inflation, the spillover onto
imports and a rise in the CAD, there is the problem of long time
lags between the RBA increasing interest rates, and its impact.
Higher rates can take up to 2–3 years to be effective, especially if
consumer and business confidence are strong.
TRY SHORT ANSWER EXERCISE
1, pp.
5,
p. 000
231–32
6.6 Using monetary policy to
improve efficiency in resource
allocation
A nation must use its resources efficiently in order to best satisfy
society’s wants and maximise its material living standards. An
annual rise in national productivity by 1.5 to 2 per cent is
considered a good performance. There are four main types of
efficiency that come to mind: allocative, technical, dynamic and
inter-temporal. Although there are some general things that
monetary policy can do to lift efficiency in resource allocation, it
is probably not as effective as other measures like microeconomic
reform or budgetary policy. There are three main ways that monetary policy can impact on efficiency in resource allocation.
Stabilising AD and the level of
economic activity
We know that resources are not allocated efficiently if economic
activity is either too weak (recession) or too strong (boom).
CHAPTER 6 Economic management using macroeconomic monetary policy
221
In a recession, resources are not used efficiently:
unemployment causes some resources to lie idle and be
wasted
■ there is often labour hoarding and over staffing at the start of
a downturn, so efficiency falls
■ recession undermines business confidence and investment
spending needed to buy new equipment, and to increase
worker productivity.
Alternatively, resources are also allocated inefficiently if there
is an inflationary boom:
■ Here, inflation causes resource owners to direct their inputs
into more speculative and less productive uses (e.g. shares,
property, antiques) that will maximise their returns. From the
economy’s point of view, this is less desirable than capital
resources flowing into setting up new companies and
expanding productive capacity.
■ Moreover, if high inflation pushes up interest rates, this
deters investment spending, and very low unemployment of
say less than 5 per cent, may cause some workers to slacken
off. In both cases, efficiency suffers.
The point is that optimum efficiency is more likely to occur
when there is domestic economic stability. As already noted,
counter-cyclical monetary policy has been fairly effective in promoting internal stability.
Certainly when the RBA reduces interest rates in a downturn
as occurred in 1996–99 and 2001–02, this should have helped to
increase efficiency in resource allocation.
■ Foremost, cheaper credit for businesses encourages confidence and promotes investment spending on new plant and
equipment incorporating the latest technology. This leads to
capital deepening and better worker efficiency (i.e. an
increase in GDP per hour worked).
■ Lower interest rates not only cause a rise in investment, but
also encourage household consumption spending (e.g. on
new cars, construction of houses, holidays and electrical
appliances). Together, these conditions lead to stronger AD.
In an economy where there is some unused productive
capacity, this reduces unemployment or idle resources and
increases efficiency.
By contrast there is a dilemma when the RBA decides to raise
interest rates as in 2002–07 to check inflation. If not controlled,
inflation encourages less productive, speculative investment.
Eventually, too, continued inflation erodes consumer and business confidence, perhaps leading to recession. The RBA, therefore, feels compelled to lift its cash rate target. However, the
problem of increasing interest rates to check inflation is that
they encourage saving and also reduce the level of productive
investment that is necessary to increase business efficiency.
Indeed, when interest rates are lifted, it is possible that productive investment (where returns are often smaller) will be
slowed even more than speculative investment (where returns
are often higher). This has negative effects on productivity, perhaps as seen between 1999 and 2006.
Despite this dilemma, the fact remains that the RBA has actually delivered price stability during the years, 1996–2006.
Average inflation has been kept within the 2–3 per cent target.
Because of this, firms have ultimately been able to enjoy the
lowest real overdraft interest rates in over 30 years. In turn, this
has helped to lift productive efficiency by directing more
resources into investment in new technology.
■
222
Economics Down Under Book 2
Boosting efficiency by deregulation of
the financial sector
Most economists believe that strong levels of competition in
markets help to promote efficiency in resource allocation. Firms
need to try and outdo their competitors through greater productivity. This does not usually occur when there are monopolies,
oligopolies or restrictions in the market. In the twenty-five years
to 2007, there has been ongoing financial sector deregulation.
This has included:
■ issuing more operating licences to foreign banks
■ floating the exchange rate
■ converting of some building societies into banks
■ allowing non-banks to issue cheques
■ deregulating credit card operations
■ introducing prudential supervision of financial institutions to
replace inflexible liquidity ratios
■ privatising government banks.
While this is more accurately classified as a microeconomic
reform rather than a monetary policy, it has affected the operation of the financial sector, and has sought to stimulate competition, keep interest rates for borrowers lower than otherwise
and increase the efficiency of Australia’s capital market.
The exchange rate’s effects on
efficiency
The exchange rate alters how competitive local goods and services are against those imported from overseas.
■ If the exchange rate falls, as happened between 1999–2001,
for example, it is easier for Australian producers to compete,
and there is less pressure to cut costs and boost efficiency in
order to survive. Even so, a lower A$ means that some firms
that import materials and equipment used in manufacture,
find that they have higher production costs making them less
competitive.
■ In reverse, when the exchange rate appreciates, as occurred
between 2002–07, this makes it far more difficult for local
firms to survive. They have to make even greater efforts to lift
their efficiency, although they are helped by the fact that a
higher A$ makes it cheaper for them to import inputs
(e.g. equipment) used in production.
Although the RBA no longer directly regulates the exchange
rate (i.e. we have a floating exchange rate), changes in interest
rates and its decisions to intervene in the foreign exchange
market through a dirty float, also affect the pressures on firms
to improve their productivity.
HAS MONETARY POLICY
SUCCESSFULLY PROMOTED
EFFICIENCY IN RESOURCE
ALLOCATION?
The trends in how efficiently Australia uses its resources shown
in table 6.5 are affected by hundreds of local and international
factors, not just monetary policy. It is simply not possible to
accurately link cause and effect. Besides, of all government policies, RBA strategies are probably the most indirect and least
important.
Table 6.5
Trends in Australian productivity
PHASE AND YEAR
Annual average change in labour
productivity by cycle —
Australia
Annual change in multifactor
productivity by cycle —
Australia
1985–89
PHASE 1
1989–94
PHASE 2
1994–99
PHASE 3
1999–2004
PHASE 4
0.8
2.2
3.2
2.2
0.7
0.9
2.1
1.0
2004–??
PHASE 5
Sources: Data derived from B Dolman, L Rahman and J Rahman, ‘Understanding productivity trends', pp. 40–41, calculated from
ABS national accounts and from Groningen Growth and Development Centre and the conference board, January 2006.
Some strengths
Some weaknesses
Looking at the data, it is clear that there are cyclical phases in
Australian productivity. After record efficiency levels in phase 3
between 1994 and 1999, there was a significant slowdown during
phase 4 to 2004. Even so, the conduct of monetary policy is
unlikely to be the main cause of this trend because, generally, the
RBA has created near record domestic economic stability (i.e.
price stability, sustainable economic growth and full employment) where conditions were very favourable for efficiency in
resource allocation. It reduced interest rates to stimulate economic growth and cut unemployment or idle resources, when
there was unused productive capacity and no risk of inflation.
The RBA only increased interest rates when its hand was forced
by rising prices (e.g. 1999–2000, 2002–06). Despite this, however,
interest rates were still far lower than in the previous 30-odd
years. For instance, in the past 10 years, the average business
overdraft rate was only 8.6 per cent, against about double this
rate in the late 1980s. Recently, this encouraged higher levels of
investment in new equipment and technology. In addition, the
on-going deregulation of the financial sector helped to spur on
competition and greater allocative efficiency in the use of Australia’s money capital. There is little else that monetary policy
could have been expected to do in this regard.
Although the RBA has generally done what it can to improve
efficiency in resource allocation, monetary policy has weaknesses.
Higher interest rates can control inflation but may discourage
investment
When inflation approaches 3 per cent a year or more, the RBA
is forced to lift interest rates. It did this eight times in the
period, 2002–07. Unfortunately, higher interest rates discourage
investment spending, which is essential for lifting technical
efficiency. In turn, this may also lead to higher unemployment
and idle resources, and it adds to the production costs of some
firms (who have borrowed credit from the bank in order to produce).
Limited efficiency from deregulation
The continued deregulation of the financial sector in the years
to 2007, probably lifted efficiency in allocating Australia’s
capital resources and meant lower interest rates than otherwise.
This helped to promote higher levels of investment. However,
critics claim that only limited efficiency benefits have been actually passed on to consumers of financial services. In supporting
these claims, mention is made of the extraordinarily high profit
margins and returns in the banking sector, along with greedily
high bank fees and charges by some international standards.
Monetary policy works only indirectly to increase efficiency
Unlike microeconomic policy that very directly cuts costs and
encourages efficiency, monetary policy operates in less direct
ways. It works mainly by creating a better domestic economic
stability where resources are more likely to be used efficiently.
Monetary policy is a blunt and imprecise instrument
Budgetary and microeconomic policies can accurately target
specific areas where efficiency is weak. For example, there could
be reduced tariffs for the car industry, special assistance to sugar
producers or lower rates of company tax. However, RBA
measures are not surgically precise and cannot single out
particular problems for attention. Cuts in interest rates, for
instance, do not just stimulate investment in new equipment,
but they also direct more resources into speculative areas and
into consumer goods, housing and services, not all of which are
as beneficial for efficiency.
TRY SHORT ANSWER EXERCISE
1, p. 232
6,
000
CHAPTER 6 Economic management using macroeconomic monetary policy
223
6.7 Using monetary policy to
improve equity in personal income
distribution
The government’s objective of an equitable income distribution
means that everyone has access to basic goods and services
needed to maintain reasonable living standards. Monetary
policy is not nearly as useful in promoting equity as say
budgetary policy. It can only work indirectly by keeping both
unemployment and inflation at low levels. In other words, when
domestic economic stability is well achieved, conditions are
most favourable for achieving an equitable distribution of
income. So how might the RBA’s measures actually work?
HOW MONETARY POLICY MIGHT
REGULATE AD TO KEEP
INFLATION AND
UNEMPLOYMENT DOWN
Equity is unlikely to exist when there is rapid inflation or high
unemployment.
Keeping inflation low
High inflation rates averaging above 2–3 per cent, reduce equity
for several reasons. For one thing, the prices of basic goods and
services (the cost of living) often rise faster than the incomes of
ordinary families. Their real purchasing power is reduced. For
the poor, food, rental accommodation, home ownership, cars,
transport, electrical goods, education, health care, entertainment, access to the law and childcare, for example, often become
less affordable and accessible, so their living standards fall. By
contrast, some individuals, like speculators in shares and property, find that their incomes rise faster than inflation generally,
so that their purchasing power is increased. Inflation arbitrarily
lowers equity for some individuals, but improves it for others. Fortunately, the RBA’s monetary policy involving higher interest
rates (via increased net sales of government securities in the
short-term money market) has successfully controlled inflation
by slowing excess AD and easing shortages of goods and services.
Indeed, inflation targeting has meant that Australia’s average
annual inflation rate has been only 2.6 per cent for the period,
1996 to 2006. This should help to promote equity.
Keeping economic activity up and unemployment low
You may recall that there are many reasons why both cyclical and
structural unemployment undermine equity and people’s access
to basic goods and services. Unemployment causes families to
suffer from the awful effects of a sudden drop in disposable
income and purchasing power. As individuals move from average
weekly earnings of around $1050 or from the minimum weekly
wage of around $512 (for early 2007), on to inadequate welfare
benefits for the unemployed of perhaps $200–250 a week for a
single, access to basic goods and services is dramatically reduced,
and increased poverty is likely to occur. The wealth of the
unemployed also tends to shrink because assets like property, pos-
224
Economics Down Under Book 2
sessions, savings and shares are sold to pay bills, leading to greater
inequality. However, by cutting interest rates and adopting a more
expansionary stance that stimulates spending, monetary policy
can help reduce cyclical unemployment and improve equity.
With lower interest rates, households and firms increase their
borrowing and spending. In turn, this lifts national production,
employment and incomes. Moreover, on the supply-side,
reducing interest rates tends to ease cost pressures, improve
profitability, encourage business expansion and results in the
fewer closures of firms. This helps to lower structural unemployment, again promoting equity. Overall, it should be noted that
the RBA’s policies have recently helped to get unemployment
down to its lowest level in around 32 years (i.e. only 4.4 per cent
in April 2007). Again, by promoting domestic stability, monetary
policy has helped to promote greater equity.
By keeping inflation and unemployment down, the RBA is
helping to increase the real purchasing power of market incomes
received by the poor. By contrast, government redistribution
measures in the budget (e.g. progressive taxes, welfare benefits)
alter the final distribution of income.
HAS MONETARY POLICY
SUCCESSFULLY PROMOTED
EQUITY IN INCOME
DISTRIBUTION?
For the past 10 years to early 2007, it is hard to prove the precise
causal connection between monetary policy and any change in
the distribution of Australia’s personal income. This is because
there are lots of other important domestic and international
variables that have also had an impact.
Some strengths
Certainly it would appear that monetary policy has helped to
create general economic conditions domestically, that are very
favourable to an equitable income distribution. As noted, the RBA
has applied interest rates in a counter-cyclical way, successfully
regulating AD and economic activity. In the past 10 or so years
to early 2007, booms and recessions have been avoided. Monetary
policy has helped to maintained strong economic growth, low
unemployment (this is at a 32-year low) and rising incomes, while
at the same time delivering low inflation (average of 2.6 per cent).
Although it is undeniable that inequality in personal incomes has
increased as shown in figure 6.9, this does not necessarily mean
that equity has decreased. In fact it is likely that the poor have
never been so rich or as able to afford as many basic goods and
services, as at present. However, by contrast, it would be hard to
imagine that equity would be as strong if there were high inflation
rates averaging over 8 per cent (as it did in the 1980s) or if unemployment was at 11 per cent (as it was in 1992–93).
disposable household income —
1996–97 to 2002–03
Australia’s changing level of equivalised mean
disposable income ($) per week by quintile —
1996–97 to 2002–03
Gini coefficient of equivalised household
disposable income
Linear (Gini coefficient of equivalised
household disposable income)
1996–97 — Mean level of equivalised
disposable income ($ per week)
0.315
0.31
2006–07
2005–06
2004–05
2003–04
2002–03
2001–02
Quintile 5
0.28
Quintile 4
0
Quintile 3
0.285
Quintile 2
200
2000–01
0.29
1999–2000
400
0.295
1998–99
600
0.3
1997–98
800
0.305
1996–97
Gini coefficient
1000
Quintile 1
Mean weekly income ($)
by quintile
2002–03 — Mean level of equivalised
disposable income ($ per week)
Figure 6.9 Trends in Australian income distribution
Source: Data derived from ABS, 6523.0 (2003–04).
Some weaknesses
Although acknowledging the general contribution of monetary
policy to improving equity between 1996 and 2007, economists
recognise its weaknesses.
Monetary policy is less effective than budgetary policy
Monetary policy is certainly not the most efficient or precise
means of redistributing final incomes equitably. RBA measures
can help to create general economic conditions (i.e. low
inflation and unemployment) where equity is likely to be maximised, and the poor can better afford to access basic goods and
services. However, budgetary measures are far more powerful in
reducing the Gini coefficient. Here we think of the effects of
direct progressive taxes that are used to help pay for direct welfare support and indirect benefits for the poor (e.g. free or
cheap health, education). Budgetary measures can also better
target specific groups of individuals who are in need of help.
Monetary policy failed to control asset speculation
Between the late 1990s and early 2007, there was a remarkable
growth in share and property prices. This enabled many among
the richer quintiles, to increase their share of household wealth
and make considerable capital gains. The rise in asset prices was
driven by cheap credit, confidence and strong economic
growth, in part, the by-products of successful monetary policy.
However, for ordinary families, the affordability of home ownership has been reduced by house prices rising faster than their
incomes. Indeed, research released in 2006 shows that average
mortgage repayments as a percentage of household income, are
now higher than when interest rates were double back in the
latter 1980s. This is because the size of the mortgage is now
much bigger due to inflated house prices. This has tended to
diminish equity and deprive lower income families of home
ownership.
Financial sector deregulation has done little for the poor
Critics of deregulation draw attention to the dramatic rise in
bank fees and charges, especially on small accounts held
typically by the poor. In addition, these people have little
bargaining power when trying to negotiate low-interest loans.
On the other side, one cannot help but notice the unusually
high profits made by banks in the 1990s and 2000s. In general,
the main beneficiaries of these profits are shareholders who are
mostly drawn from middle and upper income groups. Moreover,
deregulation and stiffer competition has caused banks to cut
staff, adding to structural unemployment and hence inequity.
TRY SHORT ANSWER EXERCISE
1, p. 232
7,
000
CHAPTER 6 Economic management using macroeconomic monetary policy
225
6.8
School Assessed
Coursework
There are two SACs to be completed for VCE Economics Unit 4,
one for each of the two outcomes. SAC 1 is about macroeconomic policy and SAC 2 covers microeconomic policy.
Assuming that you have completed chapters 5 and 6 about
budgetary and monetary policy (i.e. macroeconomic policy),
you are now in a position to tackle SAC 1. With this in mind,
your teacher must eventually select one of the following assessment tasks:
■ an essay
■ a written report
■ problem-solving exercises.
■ a test with multiple-choice and short-answer questions
■ an evaluation of print and/or electronic media.
This SAC will be marked out of 50. Teachers are also urged to
check the latest VCAA’s Assessment guide to ensure that all assessment requirements are met fully.
To help prepare you for the end-of-the-year examination and
to provide some guidance for SAC 1, several sample tasks have
been included in this section of your text. For instance, chapter
6 (about monetary policy) contains:
■ multiple-choice test items
■ short-answer test questions
■ an essay question
■ some possible questions relevant for completing a written
report.
Finally, this section of your text also contains a wide range of
other learning activities (e.g. web quests, debates, concept maps,
quiz, etc.), to help make learning more effective, interesting
and relevant.
MULTIPLE-CHOICE test questions
school assessment tasks and learning activities
Instructions: You may like to complete the following revision
questions. Using the multiple-choice answer grid below, select
the letter (A, B, C, D) that represents the most appropriate
answer for each question by marking this with a tick (✓).
Question 1
Monetary policy relates to:
A macroeconomic measures introduced by the Treasury
B macroeconomic measures of the RBA
C measures that mostly affect the flows of credit between borrowers and lenders
D both (B) and (C).
Question 2
Higher domestic interest rates will tend to:
A accelerate demand inflation
B raise the production costs of some businesses and the cost of
living for many households
C discourage overseas borrowing and weaken the exchange
rate for the Australian dollar
D increase employment.
Question 3
Despite some RBA efforts to support the currency, there was a
20 per cent depreciation of the Australian dollar against the US
dollar between December 2000 and March 2001.
Answer grid
QUESTION
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
A
B
C
D
QUESTION
A
B
C
D
226
Economics Down Under Book 2
B The RBA increases its net repurchases of government
securities in the short-term money market as part of its
market operations.
C There should be discouragement of lending by the financial
sector.
D The RBA buys the A$ in the foreign exchange market.
Question 4
Which combination of monetary strategies is most expansionary?
A The RBA increases sales of government securities in the
short-term money market and increases sales of the Australian dollar in the foreign exchange market.
B The RBA dramatically increases its buying back of government securities in the short-term money market and tries to
persuade the financial sector to increase lending.
C The RBA cuts its net sales of government securities in the
short-term money market and increases its support of the
Australian dollar in the foreign exchange market.
D There were attempts by the RBA to discourage lending by
the financial sector.
Question 9
In 2002–06, the RBA sought to achieve a higher official cash
rate target. During this time, it increased official interest rate
target on eight separate occasions because:
A demand inflation was low
B the unemployment rate was rising
C economic activity was slowing
D significant unused productive capacity did not exist in the
economy.
Question 5
Nowadays, public confidence in and the security of household
savings which are deposited in the financial sector are partly
protected by:
A RBA variations in liquidity ratios
B the Australian Prudential Regulation Authority (APRA)
which monitors capital adequacy and the management of
liquidity
C both (A) and (B)
D neither (A) nor (B).
Question 6
Measures involving the financial sector which can have a beneficial supply-side effect on cost inflation may include:
A a dirty float to support or drive up the Australian dollar
B the extension of competition in and continued deregulation
of the financial sector
C neither (A) nor (B)
D both (A) and (B).
Question 7
Faced with high and rising cyclical unemployment and no threat
of inflation, the RBA would most likely:
A undertake operations in the short-term money market
designed to achieve a lower cash rate target
B increase support for the Australian dollar involving buying
our dollar in the foreign exchange market
C talk down financial sector lending
D try all of the above measures.
Question 8
In itself, which one of the following measures would not be
appropriate for the Australian economy experiencing 5 per cent
economic growth and 8 per cent inflation?
A The RBA increases its net sales of government securities in
the short-term money market as part of its market operations.
Question 10
In 2004–05, the RBA was involved with intervention in the
foreign exchange market involving net sales of Australian
dollars. Externally, this would tend to:
A increase the CAD
B improve the terms of trade
C help exporters
D force local firms to become even more efficient and cut costs
in order to compete internationally.
Question 11
Which of the following would be a constraint on the effectiveness
and introduction of a contractionary monetary stance in promoting domestic economic stability during a period of rapidly
rising economic activity?
A The existence of very strong consumer and business confidence
B A forthcoming election which is tipped to be very closely
contested
C Already high levels of structural unemployment
D All of the above
Question 12
Which of the following is unlikely to be a constraint on the effectiveness of an expansionary monetary policy during a recession?
A Monetary policy is usually regarded as being less direct in its
impact on household spending than budgetary measures
such as tax cuts, increased welfare outlays or public works.
B Monetary policy may be weakened by crowding out in a
recession typically caused by budget deficits financed by
domestic borrowing.
C Monetary policy is subject to the same financial constraints
in boosting AD as large budget deficits.
D Monetary policy is subject to time lags in recognition, implementation and impact.
Question 13
When the RBA sets out to achieve a higher cash rate target in
the short-term money market, this might have an adverse
impact on the efficiency in resource allocation due to the fact
that higher interest rates:
CHAPTER 6 Economic management using macroeconomic monetary policy
227
school assessment tasks and learning activities
This depreciation would tend to:
A make Australian exports cheaper in the US relative to the
price of imports in Australia
B decrease the burden of repaying interest on the foreign debt
C cause a rise in the unemployment rate in the export sector
D slow the rate of domestic economic activity.
A worsen demand inflation pressures
B cause the wasteful unemployment of labour and capital
resources to decrease
C Australian firms will become more cost competitive abroad
D have an adverse supply-side impact and discourage investment in new plant and equipment incorporating the latest
technology.
Question 14
Concerning monetary policy, which statement is generally false?
A Financial sector deregulation may raise efficiency in
resource allocation by promoting greater competition.
B Contractionary monetary policy may lead to idle resources,
causing greater income inequity through reduced access to
basic goods and services.
C The failure of the RBA to effectively control inflation (e.g. in
the 1980s) could cause an arbitrary redistribution of income
away from buyers and sellers of assets in favour of exporters.
D The RBA is required by government to deliver an annual
average inflation rate of around 2–3 per cent (as measured
by the CPI) over the economic cycle.
school assessment tasks and learning activities
Question 15
Concerning the RBA’s monetary policy stance between 1996–97
and 2006, which of the following is correct?
A Policy was relatively contractionary between 1996 and 1998.
B Policy was relatively expansionary between late 1999 and
mid 2000.
C Policy was relatively contractionary between 2002–06.
D Overall, policy gave a lower priority to the control of
inflation over the achievement of full employment.
Question 16
Monetary policy is usually regarded as being most effective in
directly helping to achieve:
A improved equity in the distribution of income
B strengthening efficiency in the allocation of resources
C price stability and then perhaps fuller employment
D external stability.
Question 17
The main reason for the RBA conducting a dirty float is usually:
A smoothing out unwanted and uninformed changes in the
Australian dollar
B to achieve a particular target level for the exchange rate
C to curb spending on imports
D to encourage exports.
Question 18
If the RBA takes action to increase domestic interest rates, this
will not tend to cause:
A structural unemployment
B cost inflation
C demand inflation
D increased overseas borrowing and reduced price competitiveness of our exports.
228
Economics Down Under Book 2
Question 19
Regarding monetary policy’s general application, which statement is incorrect?
A A tighter monetary policy during periods of rapid demand
inflation may in some ways increase equity in the distribution of income.
B A tighter monetary policy can slow household and business
spending on imports, thereby helping in some ways to
reduce the CAD.
C In the long term, using monetary policy to improve price
stability provides an economic climate where there is better
business confidence, increased productive investment and
greater competitiveness to enhance the sales of locally
produced goods and services.
D When the RBA undertakes market operations designed to
increase domestic interest rates, the exchange rate for the
Australian dollar usually tends to depreciate.
Question 20
Which of the following reforms involving regulation of the
financial sector has not occurred since 1990?
A The fixed exchange rate for the Australian dollar was
replaced with a floating exchange rate.
B The PAR for liquidity was abolished.
C There was some extension of banking licences to increase
competition.
D The Australian Prudential Regulation Authority was set up
and supervision was extended to cover both banks and other
major financial institutions.
Question 21
Given the following information, what combination of monetary
policies (Nos 1–IV) may be most effective in promoting better
domestic and external stability?
ECONOMIC INDICATOR
ANNUAL %
CAD:GDP ratio (%)
4
CPI (%)
9
GDP growth (%)
6
Unemployment (%)
3
II(I) Increased RBA net sales of government securities in the
short-term money market
I(II) Increased RBA net repurchases of government securities
in the foreign exchange market
(III) Increased purchases of Australian dollars by the RBA in
the foreign exchange market
(IV) Persuasion by the RBA to encourage financial sector
lending
A Answers (I) and (III)
B Answers (II) and (IV)
C Answers (II), (III) and (IV)
D None of the above.
B the conflict with equity in income distribution
C a generally adverse political reaction
D the decline in the RBA’s holdings of overseas reserves of
currencies.
Question 23
If the RBA sold Australian dollars in the foreign exchange
market to affect the exchange rate, this would be likely to cause:
A increased exports
B increased imports
C increased Australian investment abroad
D all of the above.
Question 24
If the RBA’s policy fails to keep Australia’s inflation rate below
that of our major overseas competitors, the likely result could be:
A a worsening CAD and a depreciating exchange rate
B a rising NFD and a reduced credit rating
C both A and B above
D neither A nor B above.
Question 25
The measure of the volume of money called broad money refers
to:
A coins and notes in the hands of the non-bank public
B the value of all bank deposits and cash
C the measure, M3
D the value of all cash in the hands of the non-bank public,
bank deposits and net deposits held in non-bank financial
institutions.
Question 26
The most severe constraint which operates when the RBA cuts
interest rates to stimulate domestic economic activity is:
A a likely weakening of the exchange rate and a rise in
inflation
Question 27
Which of the following is false, following a rise in interest rates?
A The A$ will tend to appreciate.
B Efficiency may fall due to reduced investment.
C Cost inflation will fall.
D Unemployment will tend to rise.
Question 28
Competition between banks and other financial institutions
during the mid to late 1990s and early 2000s saw:
A generally reduced profit margins on each dollar of bank
lending than in some periods
B lower interest rates and a lending war on home loans
C increased trading hours by some financial institutions to
improve customer service
D all of the above.
Question 29
Following market operations by the RBA, increased interest
rates are most likely to:
A increase domestic savings but reduce investment spending
B increase consumption and unemployment
C reduce the inflow of foreign investment recorded initially as
a credit on the financial account of the balance of payments
D cause all of the above.
Question 30
If economic growth was at 2 per cent and the inflation rate was
rising by 1.2 per cent, the RBA would probably:
A tighten its monetary policy stance
B loosen its monetary policy stance
C not change its monetary policy stance
D start by tightening its policy stance before easing it.
SHORT-ANSWER test questions
Instructions: Your teacher may direct you to complete a selection
of the following questions. These questions should be useful
preparation for the end-of-year examination.
Question 2
A Read the following extract taken from a RBA Statement on
monetary policy in November 2001:
Question 1
A Define monetary policy. (2 marks)
B Briefly outline the economic role played by Australia’s financial institutions. (2 marks)
C Explain what is meant by financial deregulation and identify its
main aim. (2 marks)
D List and briefly describe two important changes associated
with financial deregulation in Australia. (2 marks)
E Identify and outline one constraint that has limited the effectiveness of financial sector deregulation. (2 marks)
‘. . . as always, the Bank continues to assess the available
information and will adjust as necessary, the stance of
policy in pursuit of sustainable economic growth, consistent
with the inflation target.’
Source: RBA Bulletin, p. 4, November 2001.
Referring to this statement by the RBA:
(a) Explain the meaning of the term policy stance. (2 marks)
(b) What is the RBA’s current operational objective for its
monetary policy? (2 marks)
CHAPTER 6 Economic management using macroeconomic monetary policy
229
school assessment tasks and learning activities
Question 22
A budget surplus is likely to help:
A reduce interest rates
B cause the Australian dollar to depreciate
C reduce unemployment
D ‘crowding out’ of private sector borrowing.
B Read the following media release about monetary policy
from the RBA in August 2006.
C Assume that the RBA decided to increase its cash rate target.
Clearly explain the process used by the RBA to push up
interest rates. Illustrate this approach using a labeled
demand–supply diagram representing the short-term money
market showing the ‘before’ and ‘after’ situations. (3 marks)
D How is the exchange rate determined for the A$? (2 marks)
E Under what domestic economic circumstances might the
RBA undertake a dirty float involving the selling of the A$ in
the foreign exchange market? Show the ‘before’ and ‘after’
effect of this policy in the foreign exchange market.
(3 marks)
F What is the RBA’s policy of persuasion? How might it be used?
(2 marks)
Question 4
A Examine figure 6.10 showing recent rises in the RBA’s cash
rate target. Describe what has happened to the cash rate
target over these years. (2 marks)
B The RBA uses a checklist approach to help determine its policy
stance. List and briefly explain three important factors on this
checklist, that the RBA may have taken into account before
making its decision to lift the cash rate target between
2002–07. (4 marks)
C Assume that the RBA decided to raise its cash rate target
because of its concerns about rising inflation.
(a) Explain how the RBA would achieve a higher cash rate
target.
(b) Explain how the achievement of a higher cash rate
target would help to slow inflation, referring to the
transmission mechanism.
(c) Explain one disadvantage of the RBA’s decision to
increase interest rates.
D Referring to the previous question, discuss the main economic advantage and the main disadvantage of the RBA’s
decision to raise its cash rate target during these years.
(3 marks)
E Identify and explain an alternative to monetary policy that
could be used to reduce the inflation rate.
F Explain how a rise in interest rates by the RBA would tend to
affect any three of the following. (1 + 1 + 1 = 3 marks)
(a) the level of business investment spending
(b) residential building approvals
(c) cost inflation
(d) imports of consumer goods and services
(e) the level of cyclical and structural unemployment.
Referring to this statement by the RBA:
(a) What specific demand-side factors at this time (extra
research needed here using the RBA website) were
causing domestic and international spending to rise so
strongly? (4 marks)
(b) Explain how these domestic and international factors
were contributing to inflationary pressures in an
economy where there was little spare productive
capacity. (2 marks)
(c) How would the rise in the cash rate target by 0.25 per
cent to 6 per cent, help to slow inflationary pressures
coming from domestic and international sources?
(4 marks)
(d) Outline two constraints or weaknesses of increasing the
cash rate target in this way. (4 marks)
(e) In determining the stance of monetary policy, outline
the main reason why priority is given to fighting inflation.
(2 marks)
Question 3
A What are interest rates? Outline the general factors that affect
the level of interest rates in Australia. (2 marks)
B Explain the meaning of the cash rate target. (2 marks)
8
6
4
2002
2003
Figure 6.10 RBA official cash rate target
Source: Data derived from RBA Bulletin.
230
Economics Down Under Book 2
2004
2005
July
August
September
October
November
December
January
February
March
April
May
June
July
August
September
October
November
December
January
February
March
April
May
June
July
August
September
October
November
December
January
February
March
April
May
June
July
August
September
October
November
December
January
February
March
April
May
June
July
0
August
September
October
November
December
January
February
March
April
May
June
2
January
February
March
April
May
June
Cash rate target (%)
school assessment tasks and learning activities
Following a decision taken by the Board (of the RBA) at its
meeting yesterday, the Bank will be operating in the money
market this morning to increase the cash rate by 25 basis
points to 6 per cent. The decision reflects the Board’s
assessment that economic activity remains strong and that
inflation pressures have increased. Growth of the Australian
economy is taking place against the background of strong
international conditions. Despite regional differences, most
indicators suggest that demand and output in Australia have
strengthened over recent months . . . The growth of demand,
against the backdrop of an economy operating with limited
productive spare capacity, has contributed to increased
inflationary pressures this year, and businesses report that
labour market conditions are tight . . . Given these
circumstances, the Board judged that an increase in the cash
rate was warranted in order to contain inflation in the
medium term.
Source: RBA media release No. 2006–05, 2 August, 2006.
2006
2007
Statistical data relating to Australian domestic conditions
1999– 2000– 2001– 2002– 2003– 2004– 2005– 2006– 2007–
2000
01
02
03
04
05
06
07
08
YEAR
RBA cash rate target at 1 July
each year (%)
4.75
6.00
5.0
4.75
4.75
5.25
5.5
Inflation rate (annual CPI %)
2.40
6.00
2.80
2.70
2.80
2.50
4.00
Unemployment rate (% labour
force)
6.60
6.40
6.70
6.10
5.80
5.30
5.10
5.75
Sources: Data derived from ABS 1350.0, RBA Bulletin.
Question 5
A Examine table 6.7 before answering the questions that
follow.
What relationship appears to exist between the cash rate
target and the exchange rate for the A$? Explain your reasoning
Table 6.7
and quote supportive examples drawn from the table above.
(4 marks)
B Examine figure 6.11 showing trends in the TWI before
answering the questions that follow.
70
65
60
55
50
2007–08
2006–07
2005–06
2004–05
2003–04
2002–03
2001–02
2000–01
1999–2000
1998–99
40
1997–98
45
1996–97
TWI index for the A$
G Select one of the following events and explain why this would
cause the RBA to tighten its monetary policy stance, and one
that would cause the RBA to loosen its stance. (2 + 2 = 4
marks)
(a) a fall in Australia’s unemployment rate to 4.6 per cent
(b) large tax cuts and rises in budget outlays as in 2006
(c) higher inflation rates and official interest rates overseas
(d) a fall in the value of GDP and a rise in unemployment
to 6.1 per cent
(e) rising prices for oil, fruit and vegetables
(f) a property and share market boom
(g) a very large depreciation of the A$.
H Examine table 6.6, before answering the questions that
follow.
Quoting supportive statistical data from table 6.6, answer
the following questions.
(a) What is the apparent relationship between the inflation
rate and the cash rate target? (2 marks)
(b) What is the apparent relationship between the unemployment rate and the cash rate target? (2 marks)
I Imagine that Australia was faced with both strong international rates of economic growth on the one hand, and
very weak domestic spending on the other. Explain how
these developments might influence the RBA’s monetary
policy stance or settings. (6 marks)
Figure 6.11 Trade weighted index (TWI)
Source: Data derived from RBA Bulletin.
(a) What is a floating exchange rate? (2 marks)
(b) Giving reasons, how would the generally higher
exchange rate for the A$ (e.g. in recent years to 2005),
tend to affect each of the following? (2 + 2 = 4 marks)
(i) the size of the CAD
(ii) the level of our NFD.
Statistical data relating to Australia’s economy
YEAR
RBA cash rate target at 1 July each year (%)
Exchange rate for the A$ at July each year
(TWI, 1970 = 100)
2002–
03
2003–
04
2004–
05
4.75
4.75
5.25
50.9
58.3
60.2
2005–
06
5.5
64.3
2006–
07
2007–
08
5.75
63.9
Source: Data derived from RBA Bulletin.
CHAPTER 6 Economic management using macroeconomic monetary policy
231
school assessment tasks and learning activities
Table 6.6
(c) Suggest two likely reasons for the general rise in the
TWI since 2000–01. (2 marks)
(d) Suggest one likely reason for the depreciation of the A$
between 1998–99 and 2000–01. (2 marks)
(e) What is meant by the RBA’s policy of smoothing the A$?
Suggest one constraint that would weaken the RBA’s
attempts to artificially push up the exchange rate.
(4 marks)
C Explain how higher interest rates might on the one hand
improve the CAD, but on the other hand, worsen it.
(4 marks)
D Suggest and outline one alternative government policy
(other than interest rates) that is more effective at reducing
the size of Australia’s CAD. (4 marks)
Question 6
A What is an efficient allocation of resources? How might the
recent rise in interest rates by the RBA (e.g. 2002–06), affect
efficiency in Australia’s allocation of resources? (4 marks)
B Why might a reduction in interest rates by the RBA, help to
increase efficiency in resource allocation? (2 marks)
C Identify and explain one important constraint of using monetary policy to improve efficiency in resource allocation.
Suggest a more effective type of policy. (2 marks)
D What is the likely effect of a stronger A$ on Australia’s
efficiency in resource allocation? (2 marks)
Question 7
A ‘Individuals are affected differently by government policy’. Explain
how the distribution of income would be affected by each of the
following decisions by the RBA:
(a) rises in the cash rate target by the RBA (e.g. 2006)
designed to lower inflation (2 marks)
(b) the decision by the RBA to allow the A$ to appreciate
(e.g. generally between 2001–2007) (2 marks)
(c) a reduction in interest rates by the RBA. (2 marks)
B Explain how the RBA’s pursuit of domestic economic stability also helps to promote equity in income distribution.
(6 marks)
C Monetary policy in general and interest rates in particular, is
not the most effective policy to improve equity. Outline a
more effective policy. (6 marks)
school assessment tasks and learning activities
AN essay
As noted already, SAC 1 for Unit 4 could require students to
complete an essay about the nature and operation of a government macroeconomic policy. Having just completed chapter 6,
you are now in a position, if directed by your teacher, to write an
essay about how monetary policy can be used to manage the
economy. A research essay about monetary policy may be structured as follows:
■ provide a clear definition of monetary policy
■ define domestic economic stability and then discuss how monetary policy can help achieve this objective, illustrating this by
reference to recent monetary policy
■ define what is meant by external stability and then discuss one
important strength and one important weakness of recent
monetary policy in helping to achieve this objective
■ define efficiency in resource allocation and then discuss one
important strength and one important weakness of recent
monetary policy in helping to achieve this objective
■
define equity in the distribution of income and then discuss
one important strength and one important weakness of
recent monetary policy in helping to achieve this objective.
Students should be encouraged to use tables and graphs, and
quote recent supportive evidence including that from recent
RBA Monthly bulletins and Annual reports (see RBA’s website), the
publications of major private banks, the media and other
sources.
OR
■
■
■
■
Define internal and external stability for the Australian
economy.
Explain what is meant by macroeconomic policy.
During the last three years, how has macroeconomic policy
been used to try and promote domestic stability in the Australian economy?
What effect would recent changes in macroeconomic policy
have on external stability and the size of the CAD?
A WRITTEN report
As noted already, SAC 1 for Unit 4 could require students to
complete a structured report about the nature and operation of
a government macroeconomic policy. Having just completed
chapter 6, you are now in a position, if directed by your teacher,
to write a report about how monetary policy can be used to
manage the economy. The report could perhaps be structured
along the lines of one of the following.
Using monetary policy to promote internal and external stability
1. Clearly define what is meant by internal and external stability for Australia.
2. In theoretical terms, explain how monetary policy can be used
to pursue domestic (internal) stability in an economy. How
232
Economics Down Under Book 2
does the achievement of domestic (internal) stability help the
achievement of external stability?
3. Explain clearly how the RBA changed its monetary policy
stance between 2002 and late 2006 to help improve domestic
economic stability in Australia. Illustrate your answer by
including and referring to tables and graphs of (e.g. official
interest rates), diagrams, quotes from the RBA Bulletin’s
‘Statement on Monetary Policy’ and newspaper reports,
etc.).
4. Briefly explain what is meant by Australia’s objective of
external stability. How might the decision to lift official
interest rates several times in 2006 be expected to affect the
achievement of external stability?
OR
Using monetary policy to promote efficiency in resource
allocation
1. Clearly define what is meant by an efficient allocation of
resources, noting how this is measured.
2. Identify in general theoretical terms, how monetary policy
may help increase efficiency in the allocation of Australia’s
resources.
3. Identify and explain the important means whereby monetary
policy tended to increase efficiency in Australia’s resource
allocation between 1996 and 2007.
4. Identify and explain two important constraints that may have
limited the effectiveness of monetary policy in promoting
greater efficiency in the allocation of Australia’s resources
between 2002 and early 2007. Illustrate your answer by reference to actual examples of monetary policy.
OR
Using monetary policy to promote greater equity in personal
income distribution
1. Clearly define what is meant by an equitable distribution of
income for Australia.
2. Indirectly, monetary policy helps to create a more equitable
distribution of personal income in Australia. By referring to
actual details of recent monetary policies, explain theoretically how this can occur.
3. Between 2002 and early 2007, the RBA increased the cash rate
target eight times. Explain clearly how these rises in interest
rates would be likely to affect the distribution of income from
the point of view of the following groups of individuals in Australia:
■ the unemployed
■ self-funded retirees
■ businesses and exporters
■ ordinary families
■ asset speculators.
4. Compare the likely effectiveness of monetary policy with
budgetary policy for promoting a more equitable distribution
of income in Australia.
OTHER learning activities
Have you tried the following learning activities in your class
recently?
■
1. Web Quest
Visit the website for this book and click on the weblinks for
this chapter (see Weblinks page 310). Use the Internet for
researching some of the following:
■ The reasons for the latest changes in the cash rate target by
the RBA.
■ Statements by the Governor of the RBA.
■ Changes in exchange rates.
■ The RBA’s Annual report on trends in the Australian economy.
■ Media reports about the RBA’s recent changes in monetary
policy.
■ Want to be Governor of the RBA for the day and see the
effects of changes in central bank interest rates? Try the interactive game or set up a competition where the aim is to maximise economic stability in a virtual economy.
As always, teachers are strongly advised to check all website
addresses listed in this text for suitability, appropriateness of
content, operation and accuracy, before asking students to
conduct research.
2. Class debate
Select one of the following topics:
■ ‘That the main economic priority of the RBA should be full
employment not price stability.’
■ ‘That monetary policy should leave the promotion of equity
in the distribution of income to budgetary policy.’
■ ‘That deregulation has made the piggy banks even fatter and
ordinary households thinner.’
3. Data show
■ Ask students to prepare a PowerPoint presentation about how
the RBA can change domestic interest rates OR the exchange
rate for the A$. These can then be used for making a class
presentation.
Get students to prepare a set of PowerPoint slides about the
nature and origin of money. Use these for a class presentation.
4. Newspaper reports
Photocopy or go onto the Internet to source a newspaper report
about a recent change in monetary policy. Students could summarise the report, make a checklist of indicators affecting the
decision, possibly identify bias in the report, or expand on what
has been said in the article.
5. Graphs as wall charts
On a regular basis, students could be asked to prepare and then
update wall charts showing trends in monetary variables
including:
■ M3 or broad money measures of the volume of money
■ the exchange rate for the A$ reflected in the TWI, US$ or
Indonesian rupee
■ official and other interest rates.
6. Role play
Set up a mock board meeting for the RBA. Work out subcommittees where board members (students) have to research, beforehand, trends in the key checklist indicators for monetary policy
during the past 12 months. In the actual meeting, each student
or group should present a 2–3 minute report about their particular indicator, followed by general discussion by all board
members of the case for and against a change in the cash rate
target. The indicators include:
■ trends in CPI inflation
■ indicators of changes in AD spending, confidence, retail sales
and quarterly GDP
■ trends in wage growth, RULCs and other production costs
CHAPTER 6 Economic management using macroeconomic monetary policy
233
school assessment tasks and learning activities
5. Identify and clearly explain two important constraints of monetary policy involving higher interest rates in 2006.
■
■
unemployment and other labour market indicators
changes in overseas economic activity, the exchange rate and
other international events
■ recent changes in the stance of budgetary policy.
Finally, individual students should work out a Statement of Monetary Policy (giving reasons for the board’s decision) for release
to the media.
Source: The basic idea for this role-play came from
Economics, VCE Study design.
school assessment tasks and learning activities
7. Crosswords
Construct a crossword using terminology and knowledge about
recent monetary policy and how it may help to promote
234
Economics Down Under Book 2
internal stability, external stability, efficiency in resource allocation and equity in personal income distribution. Use the
Internet for software that makes this task easy.
8. Team quiz
Divide the class into teams. Within a team, members can consult
each other when it is their turn to answer questions about monetary policy that the teacher (or students) has previously
written. The winning team may be awarded a prize. A variation
of this is the Economics Wheel of Fortune, using numbered questions and token prizes.
summary
Summary
chapter 6
What is monetary policy?
Using monetary policy to promote external stability
Monetary policy relates to measures of the RBA involving the
regulation of the nation’s money and the rate at which credit
flows between the financial sector and the rest of the economy.
The main instrument of monetary policy is changes in the cash
rate target implemented using market operations, but the RBA
also has the capacity to influence/smooth out the exchange rate
using a dirty float and to use persuasion to affect the general
level and direction of lending by the financial sector. Monetary
policy is normally classified as a macroeconomic policy since it is
mainly aimed at regulating AD.
Theoretically, monetary policy can help improve external stability in
several ways. Most importantly, a more contractionary stance
(i.e. higher interest rates) during a cyclical upswing in economic
activity can help avoid a blow-out in the CAD by slowing excessive expenditure and controlling domestic inflation. There is
also the added bonus (once inflation is controlled), that cuts in
domestic interest rates make overseas borrowing relatively less
attractive helping to slow the NFD and CAD. Recent policy has
generally been applied in this way. However, its effectiveness has
been limited by external constraints and the existence of conflicts between the various government objectives. Higher domestic interest rates push up the A$. While this slows inflation, it
increases the CAD by making imports relatively cheaper and
exports dearer. For some firms, higher interest rates add to production costs and make exports less competitive.
Aims/priorities of monetary policy
In recent times, the main aim of monetary policy is inflation targeting or the pursuit of price stability (CPI target of 2–3 per
cent a year). However, once this goal is achieved, other aims
including economic growth, full employment and external stability can become a focus for RBA policy.
Using monetary policy to promote domestic stability
Theoretically, monetary policy can help increase domestic economic
stability if it is applied as a counter-cyclical measure designed to
steady the increase in AD. Hence, the monetary policy stance is
usually tightened to slow AD when inflation approaches or starts
to exceed the inflation target (e.g. eight rises in the cash rate
target between 2002 and early 2007), but then it is often eased
to stimulate AD when inflation falls below the target and growth
and employment slow excessively (e.g. six cuts in official interest
rates during 2000–01). In this way, commentators note that
there have generally been improved levels of domestic economic stability (with good growth, fairly stable prices and fuller
employment) recently between 1996–97 and early 2007. Using
monetary policy in these ways depends on transmission mechanism. These have to do with the way a higher or lower cash rate
target/interest rate affects the economy. For example, a rise in
the cash rate target by the RBA will slow inflation by increasing
saving, reducing C and I spending, AD, shortages of goods and
services and general prices. Higher interest rates also reduce
inflation by pushing up the exchange rate and depressing
inflationary expectations. However, monetary policy faces constraints including time lags in impact, indirectness, bluntness/
imprecision, overseas events, the psychological outlook and the
conflict between government objectives.
Using monetary policy to promote efficiency
Theoretically, monetary policy can help improve efficiency in resource
allocation. First, it can help regulate AD in an attempt to limit
inflation and unemployment, so that these problems do not
result in inefficiency. Second, when it is possible to reduce
interest rates because inflation and expectations have been subdued, the cost to business of purchasing new and more efficient
plant and equipment, involving better technology, is made more
attractive, encouraging stronger productivity. Again in recent
years between 1992–93 and 2007, monetary policy generally has
done these things. While not really a monetary policy, financial
deregulation has also been an important efficiency development
involving the financial sector. Unfortunately, there are constraints on monetary policy’s effectiveness including the conflict
between some objectives, time lags and external events.
Using monetary policy to promote equity
Theoretically, there are only indirect ways whereby monetary policy
can promote equity. Most importantly, the counter-cyclical application of monetary policy can help curb inflation and unemployment, both of which are really detrimental to equity in the
distribution of income and wealth. In recent years, monetary
policy has done this fairly well. However, monetary policy suffers
from constraints including long impact time lags, external events
and its inability to redistribute income in a specific way relative
to the precision and directness of budgetary policy.
CHAPTER 6 Economic management using macroeconomic monetary policy
235
CONCEPT MAP 6 Economic management using
macroeconomic monetary policy
Monetary policy
Reserve Bank of Australia (RBA) measures that mainly affect the demand and supply of credit
1. Aims of monetary policy:
Recent measures largely emphasise the following objectives
— Domestic economic stability (especially price stability, inflation targeting and then, economic growth
and full employment) by using interest rate variations to regulate the growth in AD and economic
activity
— Indirectly, other aims including equity in income distribution, efficiency and external stability are
promoted by improving domestic economic stability.
2. Instruments/aspects of monetary policy:
— RBA (open) market operations (i.e. the buying and selling of government securities in the short-term
money market) are used by the RBA to alter interest rates (i.e. to alter the cost of credit used to finance
spending)
— Intervention in the foreign exchange market via a dirty float (RBA buying and selling A$) to smooth
the exchange rate for the A$
— Persuasion involving talking up/talking down spending levels.
3. Using monetary policy to promote internal/domestic economic stability:
— The key aim of RBA monetary policy is the pursuit of price stability, and only then, sustainable
economic growth and full employment. Policy is applied in a counter-cyclical way to regulate AD
— The RBA raises interest rates (by net sales of government securities) to slow excess AD (by
encouraging savings, and by discouraging borrowing and spending by making credit cheaper) and thus
reduce shortages and ease demand inflation. Note transmission mechanisms.
— The RBA lowers interest rates (by net buying back of government securities) to boost deficient AD (by
encouraging borrowing and spending using cheaper credit), and thus soften the downswing/recession.
Note transmission mechanisms.
4. Using the monetary policy to promote external stability:
— RBA policy could increase interest rates to slow AD during a cyclical upswing/boom, thus reducing
spending on imports and making exports more competitive. This would perhaps reduce the cyclical CAD.
— The RBA can use a dirty float to smooth out erratic and uninformed changes in the A$/exchange
rate, promoting more international trade.
5. Using monetary policy to promote efficiency in resource allocation:
— Monetary policy is less effective than some policies to lift efficiency
— Inflation results in the misallocation of resources into speculative areas, reduced labour efficiency and
lower investment while unemployment results in wasted capacity and lower investment
— Counter-cyclical monetary policies can minimise both inflation (by increases in interest rates) and
unemployment (by reducing interest rates) by creating favourable internal economic conditions (e.g.
strong economic growth, low inflation and low unemployment) that promote greater efficiency.
6. Using the budget to promote a more equitable distribution of personal income:
— Monetary policy is not as effective as budgetary policy in promoting an equitable distribution
of income
— However, counter-cyclical monetary policy can lower unemployment and inflation that worsen
inequality in personal incomes and or reduce the purchasing power of family incomes
— Lower interest rates can lower unemployment, while higher interest rates can lower inflation.
Both these outcomes can improve the purchasing power of those on lower incomes.
236
Economics Down Under Book 2