The Operation Of Monetary Policy Essay Research

The Operation Of Monetary Policy Essay, Research Paper Monetary policy refers to actions by the Reserve Bank to influence the aggregate supply and cost of credit in the economy. The main tool of monetary policy is the Reserve Bank s use of market operations to influence the cash rate or interest rate paid on highly liquid deposits in the cash market or short term money market.

The Operation Of Monetary Policy Essay, Research Paper

Monetary policy refers to actions by the Reserve Bank to influence the aggregate supply and cost of credit in the economy. The main tool of monetary policy is the Reserve Bank s use of market operations to influence the cash rate or interest rate paid on highly liquid deposits in the cash market or short term money market. By influencing the cash rate, the Reserve Bank is able to indirectly affect the term structure of interest rates in the financial system, which in turn will affect the level of spending, inflation and employment in the economy. As it is set out in the Reserve Bank s mission statement, the core objective of monetary policy is to ensure stable economic growth with low inflation, that is an underlying rate of between 2 to 3% over the course of the economic cycle, and full employment.

Monetary policy is implemented by the Reserve Bank through the use of open market operations in the short-term money market. Through the buying or selling of Commonwealth government securities (for example, Treasury Notes), the Reserve Bank can influence the cash rate which is the interest rate paid on funds lent overnight in the short term money market. The cash rate is the principle instrument of monetary policy and if the Reserve Bank wishes to alter the stance of monetary policy it will act to change the cash rate.

On a daily basis, the banks hold funds in their exchange settlement accounts to cover net withdrawals of funds from their banks as cheques clear on a daily basis. These are transferred between banks as the exchange settlement process occurs. If banks are left with excess funds in these accounts, they can lend them to the authorised dealers overnight, who typically hold a portfolio of government securities, and finance their portfolio by borrowing from banks. The interest rate at which these funds clear this market each night is the overnight cash rate.

When the government seeks to embark on a contractionay monetary policy, that is one which raises the cash rate, they enter the market as a seller of Commonwealth government securities to the dealers, leaving those dealers short of funds supply. These dealers must then borrow money from the banks, bidding up the cash rate to do so. As a response to this, banks must increase their liquidity from other sources, and thus must restrict their lending or borrow from other sources, in either case raising other interest rates. The converse occurs if the government wishes to undertake an expansionary monetary stance. The Reserve Bank enters the market as a buyer of government securities, thus increasing money supply and push interest rates down.

Changes in interest rates alter financial returns and these changes impact on the economic activity and inflation in the short and long terms. Interest rate changes will also have effects on investment, savings and consumption decisions; alterations in the cash flows between borrowers and lenders; alterations in the cost of credit and effects on money flows; effects on asset prices which may alter the distribution of wealth; and effects on the exchange rate and the relative prices of domestic and foreign goods and services. However, the key relationship is between changes in cash rates and the level of aggregate demand or domestic expenditure. Changes in domestic expenditure will in turn affect output and the price level. This is how the implementation of monetary policy is used to achieve the Reserve Bank s objectives of full employment, price stability and economic growth.

The current setting of monetary policy is quite positive, despite the world economic crisis. The Australian economy is currently growing strongly with inflation continues to stay under the monetary target and unemployment rate at a respectable level of 7.4%. While domestic economic growth is strong, other than the US, the world is still in the recession phase, with Asia and Europe still suffering from weak economic growth. This is one of the reasons why we did not increase interest rates, as global interest rates have a downward bias. Therefore, on 3rd December 1998, the RBA chose to fall in line with the G7 interest rate reductions, cutting the official cask rate target by 0.25% to 4.75%, the fist adjustment since July 1997.

Unemployment is another determinant in what monetary policy stance the RBA wished to pursuit. It effects the level of unemployment through its effects on interest rates, which effects the level of investment spending and eventually the level of unemployment. The current unemployment rate is 7.4% and although it at a relatively respectable level, many economist believes that it is at the NAIRU point and further improvement is unlikely. From current statistics, job advertisements growth is slowing and trend employment has softened to 8 700 in January from around 18 000 six months ago. Therefore, there are risks that unemployment will start to rise. Therefore, it was appropriate that the government embarked an easing monetary stance by lowering its official cash rates.

Monetary policy cannot stand alone or work against other macroeconomic policies. Policy mix should be coherent and working towards the same objectives. With Mr. Costello currently preparing his second Budget (1999/2000), there will be consideration of a similar objective of maintaining stable economic growth and encourage employment growth whilst keeping alert on inflationary pressures. The CAD has experienced a significant worsening due to fall in exports and increasing import with strong domestic demand. With the CAD at 6% of GDP and likely to rise during 1999, it could be perceived that Australia has a major external sector problem. What has alleviated the problem is Australia s low inflation rate which can be largely attributed the RBA stance.

The government has achieved major productivity increased through major labour market reform and technical and allocative efficiency gains in its microeconomic reform program. This has been assisted by the policy of low inflation as both aims to achieve increasing international competitiveness and therefore complement each other in a process which encourage allocative efficiency and optimisation of resource usage.

The monetary objective that was set out by the Reserve Bank of Australia in 1993 was to maintain stable and sustainable economic growth in a low inflationary environment with full employment. In striving to achieve this, the RBA has place its emphasis on inflation, targeting an underlying inflation rate of between 2 to 3% over the course of the economic cycle. However, from recent statistics, it has shown that rapid economic growth with inflation running very near a below target annual rate of 1.6%, the Reserve Bank have shifted its monetary objective, quoting from the RBA Governor Ian Macfarlane:

The Bank s monetary objective was to maintain sustainable economic growth.

Under present economic form, it is unlikely that interest rates will be altered in the short-term future, as recent speeches from the Reserve Bank confirms that monetary policy was forward looking and rate cuts depended on the inflationary outlook, rather than the current rate of inflation. Despite the fact that the economic growth is strong while inflationary pressures remain muted, many economists have suggested possible scope to lower interest rates even further. This speculation resulted as the consensus view is for a sharp slowdown in the economy throughout 1999 and the assumption that prolonged undershooting of inflation target would prompt a rate cut even if the economy was still running strongly.

Under current economic conditions, economic growth is at a near 5%, well above its historical average of 3.25% and despite the rest of the world is suffering from a worldwide recession. Underlying inflation has averaged 2.1% over the life of the Reserve Bank s monetary target and currently at 1.6%, well below the target range of 2 to 3%. With cuts in European interest rates recently, and outlook for inflation remaining benign, there is a likelihood of an easing in domestic interest rates. It is also unlikely that long-term interest rates – which factors in inflationary expectations V to rise as currently the economy can grow without the threat of high inflationary expectations.

From the data released in March in regard to consumer spending, ANZ Bank chief economist Mr. Saul Eslake said:

The picture we are getting now is one in which consumer spending is still strong but the other contributors to growth in 1998 are beginning to slow.

These contributors include export growth, which has deteriorated as commodity prices fall and Europe slows down. The higher dollar, since its low in August last year, has also retarded the value of exports, worsening the CAD. Figures also suggest a slump in business investment intentions and suffering of mining and manufacturing sectors. This would eventually harm employment, in turn hurting consumer confidence. Hence, a slowdown in the economy may occur in the not too distance future and this may prompt the Reserve Bank to choose to cut interest rates. However, it may not happen in the short-term given the burgeoning current account deficit, rising household debt, and continuing strength in present economic growth.

While the falls in the dollar over the past two years have not effected inflation, the RBA remain unsure whether the inflation impact has been avoided or merely postponed. The RBA is also aware that the economy will be strongly effected by the implementation of GST next year, and if they consider it to be sufficient to underpin growth, it will be less inclined to ease monetary policy until a later date, or when clear signs of a slowdown is evident.