chapter 6 · Bank of Australia (RBA), involving the ... CAPITAL MARKET Nature and structure of the...

Economics Down Under Book 2204

chapter

6Economic

management usingmacroeconomicmonetary policy

6.1 Definition of monetary policyMonetary policy is a macroeconomic instrument operated by the ReserveBank of Australia (RBA), involving the regulation of the nation’smoney and the rate at which credit flows into the economy via thefinancial sector. Most importantly, monetary policy relies heavily onchanges in interest rates to alter the cost, availability and demand forcredit (borrowed money). In turn, interest rates have the capacityto alter levels of AD, economic activity, cyclical unemploymentand demand inflation. However, as we know, interest ratechanges will also affect production costs, business profits andthe supply side of the economy. Overall, monetary policy isregarded as a fairly flexible instrument in that it can changedirection at quite short notice without requiring the approvalof parliament.

THE SUPPLY OF MONEY OR CREDIT IN THE ECONOMY

Definition of money

Money consists of items which can be used for making pur-chases of goods and services (a medium of exchange). Moneyalso fulfils other functions. For instance, it is commonlyregarded as a measure of value (a unit of accounting), it retainsits purchasing power fairly well over time (a store of value) andit enables things to be purchased using credit (a standard ofdeferred payments).

CHAPTER 6 Economic management using macroeconomic monetary policy 205

Measuring the money supply

In Australia, the money supply or volume of money is measuredby the RBA and consists of the following components:

Knowing changes in the volume of money is relevant when con-sidering factors that affect the level of economic activity and thesetting of monetary policy.

The process of credit creation

How does money come into existence? In the case of cash, theRBA supplies as much currency to the banks as is required tomeet the demand. However, these days, we are slowly becominga cashless society. Today the largest proportion of Australia’svolume of money is deposits of different types with financial insti-tutions. Bank deposits are mostly passbook or accounting entries.These deposits are not backed up with piles of cash sitting idly inbank vaults. Instead, deposits partly come about through the pro-cess of credit creation conducted by financial institutions. Assume,for instance, that you make a deposit of money with your bankand gain the advantage of receiving interest on your savings. The

bank enters this deposit against your account. Typically, part ofyour deposit is put aside to ensure that the bank retains enoughliquidity (assets easily converted in cash) to meet normal cus-tomer withdrawals, to promote customer confidence and to avoidembarrassment by institutions. Since 1998, the liquidity positionof all financial institutions has been monitored by the AustralianPrudential Regulation Authority (APRA) rather than the RBA.This organisation checks that financial institutions have an effec-tive liquidity management policy in place, as well as ensuring thatbanks meet varying capital adequacy requirements that reflectthe level of ‘risk’ involved with lending.

Now, returning to the process of credit creation, the remainderof your savings deposit is lent by the bank to some creditworthyborrower 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 sellerreceiving the money then makes a new deposit within the finan-cial sector, causing the level of total deposits to grow (now con-sisting of both your deposit plus the one by the seller). Armedagain with extra funds which they are keen to lend in order tomake a profit, financial institutions may start a second round ofthe credit creation process. Lending has multiplied the level ofdeposits which, in turn, are included as part of our volume ofmoney. In addition to this, there are also other sources of creditgrowth including endorsed bills of exchange.

Whatever, when the volume of credit grows quickly, this fuelssome types of household and business expenditure. AD(especially C + I) is affected, as is the level of domestic econ-omic activity. It is even possible that inflation may result fromtoo much credit or money in an economy which is already oper-ating at its capacity. This aspect was emphasised by an economictheory called monetarism which for this reason advocated strictgovernment control of the volume of money. By contrast to thisworry, it is also true that too little credit growth can strangleactivity. The deliberate regulation by the RBA of interest rateson savings deposits and on credit (loans) is one way of ensuringthat the growth in AD and economic activity is neither too fastnor too slow to ensure stability. This is an important stabilisingfeature of monetary policy.

� The volume of coins and notes (cash or money base)held by the non-bank public and deposits of banks withthe RBAPLUS

� The volume of both operating and fixed bank savingsdepositsEQUALS

� M3 (one commonly quoted measure of the volume ofmoney)PLUS

� Net deposits of savings in non-bank financial insti-tutions (NBFIs)EQUALS

� Broad money (a wide or comprehensive measure of themoney supply or volume of money).


THE FINANCIAL SECTOR AND CAPITAL MARKET

Nature and structure of the financial

sector

The capital market involves the borrowing (demanding) andlending (supplying) of credit at a price or cost which is calledthe rate of interest. Banks and other types of financial insti-tutions (e.g. building societies, managed funds, superannuationfunds, credit unions, insurance companies, finance companiesand the stock exchange) play a pivotal role in this market. Ascan be seen in figure 6.1, the RBA heads the financial sectorand uses its monetary policy to help avoid inflation and improvedomestic economic stability.

Deregulation of the financial system

Despite a need for supervision, over the last two decades therehas been considerable deregulation of Australia’s financial system.Deregulation involves removing unnecessary governmentrestrictions and other impediments to the efficiency of the

financial system. Deregulation has included the reforms listed intable 6.1.

Figure 6.1 The structure of Australia’s financial sector

Landmarks in the deregulation of Australia’s financial system

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

TRY SHORT ANSWER EXERCISE 1, p. 000TRY SHORT ANSWER EXERCISE 1, p. 229

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.

Table 6.1


6.2 The aims of monetary policyThe Reserve Bank Act of 1959 sets out the functions of the RBAand its board:

Given this charter, it seems that RBA policy could be used topursue any of the government’s economic objectives includingprice stability, sustainable economic growth, full employment, externalstability, efficiency in resource allocation and equity in the distributionof income and wealth. However, in practice, the main aims of RBApolicy are much narrower: it is the key instrument used tostabilise domestic economic activity.

The pursuit of price stability

Since 1993, the RBA has used inflation targeting or ‘fightinflation first’, as the priority guiding changes in monetarypolicy. These days, inflation targeting means achieving aninflation rate averaging between 2–3 per cent per year over the

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

. . . 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.’


course of the business cycle. This is the medium-term aim ofmonetary policy. Hence, when inflationary expectations existand there are signs that inflation will exceed the upper end ofthe target range, the RBA will tighten its stance (i.e. set higherinterest rates) in a counter-cyclical way, so as to depressinflationary expectations, slow rising spending and curb econ-omic activity.

The pursuit of sustainable economic

growth and full employment

Only when price stability has actually been achieved, will theRBA turn its attention to other aspects of domestic (i.e.internal) stability such as the pursuit of sustainable economicgrowth and full employment. Again, achieving these two objec-tives often means that the RBA adopts a counter-cyclical expan-sionary stance to stimulate economic activity (without causingan acceleration of inflation or an excessive rise, the CAD andthe NFD). The main reason for the RBA giving priority to thecontrol of inflation is that price stability is seen as a precon-dition for achieving these other objectives. Limiting inflation isseen as the best way to create conditions that maximise the sus-tainable rate of economic growth and minimise cyclical unem-ployment. The reasoning behind this approach is simple. Forinstance, low inflation helps to maintain consumer and businessconfidence that is needed for a steady rise in spending. Lowinflation also discourages speculative activity, promotesadequate saving and attracts resources into productive invest-ment in new plant and equipment.

During the past ten years, the RBA’s approach illustrates theidea of controlling inflation as the first step in reducing theseverity of the business cycle. For example, with inflation on therise between late 1998 and August 2000, monetary policy wastightened to slow spending. However, by late 2000 and early2001, inflation was back on target. The RBA was able to againreduce interest rates and become expansionary to stimulateeconomic growth and reduce unemployment. However,between late 2001 and late 2006, monetary policy graduallybecame more contractionary, signalling some concern over thegradual rise in inflation to the upper end of the RBA’s targetrange.

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 pro-

moting equity in the distribution of personal income. Avoiding

severe cyclical fluctuations in economic activity (i.e. main-

taining 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 inter-

national competitiveness and the exchange rate. While mon-

etary policy can have indirect effects on all government

objectives, it is clear that the main priority involves the pursuit

of domestic economic stability.

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 involveschanging interest rates through market operations.

� A less important monetary measure entails influencing theexchange rate (through a dirty float and changes in interestrates).

� Additionally, persuasion about the desired direction oflending activities of the financial sector is also used onoccasions.

RBA ‘market operations’ to affect interest ratesInterest rates are central to monetary policy and are used by theRBA to regulate the level of AD and economic activity. Ingeneral terms, interest rates represent the cost or price ofcredit. As such, they are normally determined in financialmarkets by the demand for credit by borrowers (e.g. house-holds, firms, governments), relative to the supply of credit by

TRY SHORT ANSWER EXERCISE 1, p. 000TRY SHORT ANSWER EXERCISE 2, pp. 229–30


lenders (e.g. households and businesses who place their savingsin financial institutions). However, the RBA has the capacity toaffect interest rates generally, by setting the cash rate. The cashrate is the interest rate that applies to a specialised market calledthe overnight, or short-term money market. This rate depends onthe overall supply of cash (i.e. deposits) in the overnight moneymarket which, in turn, is controlled by the RBA through itsmarket operations (to be explained shortly). These activitiesaffect the size of special balances held by each major financialinstitution (e.g. banks, building societies, finance companiesand superannuation funds) in its Exchange settlement account withthe RBA. But how does this complex system work to affectinterest rates? First, more background information is needed.

Each major financial institution is required to keep itsExchange settlement account with the RBA in credit (for whichit receives interest). These account balances exist mainly for thepurpose of settling transactions between institutions during theday’s trading. These transactions are caused mainly by the move-ment of cheques (e.g. a customer with one bank writes out acheque payable to a customer at another bank). In turn, throughthe Reserve Bank information and transfer system (RITS),cheque amounts are either credited or debited electronicallyagainst the Exchange settlement account for each institution.This settlement process does not affect the total level of cash ordeposits in these accounts (since rises in deposits for one insti-tution are offset by a fall in deposits belonging to another). As aresult, transactions of this type do not cause deposited funds tobecome either scarcer or more plentiful, and so they do not affectthe cash rate. What can add to or reduce the overall size of cashdeposits in Exchange settlement accounts are the activitiesbetween financial institutions and the RBA. For example, whencompanies and individuals use cheques or electronic fundstransfer to pay taxes to the government, the overall level of bal-ances in exchange settlement accounts falls. In reverse, when thegovernment through the RBA pays tax refund cheques into indi-viduals’ bank accounts, overall balances in Exchange settlementaccounts grow. However, while these transactions may have someeffect on the cash rate in the short-term money market, they donot allow the RBA to actually control or determine the cash rate.

The main determinant of the cash rate (along with otherinterest rates generally) is the daily conduct of market operationsthat directly affect the supply of cash in the short-term moneymarket. Market operations involve the RBA either buying backor selling secondhand government securities or bonds tomembers of the RITS through the short-term money market.Here you should think of securities or bonds as simply govern-ment IOUs for particular amounts of money that earn a givenrate of interest over a period of time. Armed with this under-standing, let us take a look at the three positions or stances oninterest rates that the RBA may want to adopt in its regulation ofeconomic activity.

How the RBA can increase interest

rates — a contractionary stance

Assume that the RBA wanted to increase interest rates. First itwould announce a rise in the cash rate target, and provide adetailed explanation of its reasons. It would then set out toachieve this target by selling government securities at a discountedrate in the short-term money market. Financial institutions,

keen to make a profit, would suddenly find these securitiesmore attractive, because when purchased at a lower price, theiryield would rise. This gives owners a better rate of return ontheir investment. Organisations taking up this good offer wouldtransfer deposits to the RBA, in exchange for receiving govern-ment securities. This directly reduces deposits or the supply ofcash held by financial institutions in their Exchange settlementaccounts. Competition among institutions for limited funds totop up their Exchange settlement accounts would increase thecash rate towards the announced target (see figure 6.2). A risein the cash rate set by the RBA, is usually indicative of a tightermonetary policy stance and is often used when inflation rises.

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 itannounced a lower cash rate target, again giving the reasons forits decision. To reach this target, the RBA would need to buy backgovernment securities from the financial institutions operating inthe short-term money market. RBA buying would cause the pricepaid for securities to increase, thereby lowering their yield, so thatfinancial institutions would be happy to get rid of them. Whenthis occurs, deposits are transferred from the RBA to financialinstitutions, in exchange for government securities. As shown infigure 6.3, this increases the supply of cash or the level of depositsheld by financial institutions in their exchange settlementaccounts, leaving the market with excess funds. The consequenceof this would be a fall in the cash rate towards the desired RBAtarget. Lower rates are often announced when economic activityis weak and usually reflect an easier or looser monetary policy stance.

Figure 6.3 How the buying back of government securities in the short-term money market can decrease the cash rate (an expansionary stance)

Quantity of cash (Q) Q2 Q1

S1 (reduced supply of cash)S2 (original supply of cash)

E1

E2

Cash

rate % Increased

cash rate

Originalcash rate

RBA undertakes sales of

government securities,lowering the supply of cash in the money market and

lifting the cash rate.

D1

(demand for cash)

Quantity of cash (Q) Q1 Q2

D1

(demand for cash)

S1 (original supply of cash)S2 (increased supply of cash)

E2

E1

Cash

rate % Increased

cash rate

Lower

cash rate

RBA undertakes buyingback of government

securities, increasing the supply of cash in the market

and cutting the cash rate


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 steadysince they are already at an appropriate level, given currenteconomic conditions. In this case, the RBA’s daily selling andbuying back operations will seek to avoid changing the overallsupply of cash in the short-term money market, so that the cur-rent cash rate remains unchanged. When the cash rate is heldsteady at around 4.5 per cent to 5.5 per cent, this is consideredto be a fairly neutral stance and within the normal range for ahealthy economy. In this situation, there are no significantevents requiring corrective action by the RBA. By contrast, if the

cash rate is kept above or below this neutral range, there mustbe inflationary or deflationary circumstances.

By being able to control the cash rate in this way, RBA policyhas the capacity, through a ripple effect, to influence other com-mercial interest rates (e.g. those on home mortgages, overdraft,credit cards and savings deposits) that are generally applicableelsewhere in the financial sector. As we shall see, changing mon-etary policy’s stance through variations in the cash rate target isa very handy instrument for stabilising the level of spending andeconomic activity.

A ‘DIRTY FLOAT’ BY THE RBA TO

AFFECT THE EXCHANGE RATEIn international trade, the exchange rate is the price at which the Aus-tralian dollar is swapped against other currencies. As part of thederegulation of Australia’s financial system, 1983 saw the intro-duction of a floating exchange rate. In the case of a clean float, theAustralian dollar’s value is dictated by the forces of supply anddemand for our currency in the foreign exchange market. Inother words, sellers (suppliers mostly living in Australia) andbuyers (often living overseas) of our currency interact in themarket to negotiate the equilibrium price or exchange rate. Atequilibrium, the quantity bought and the quantity sold areexactly equal, and the market is cleared of either a shortage orglut of Australian dollars. However, as part of its monetarypolicy, the RBA still retains the option of a dirty float.

A dirty float is where the RBA tries to affect the exchange rateby becoming a net buyer or seller of the Australian dollar in theforeign exchange market. Nowadays, it is mainly reserved forspecial occasions when changes in the dollar are uninformedand erratic, leading to great uncertainty in international trans-actions. 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 dollarwas falling in an erratic and misinformed way, it is likely that itwould intervene in the foreign exchange market. Using a dirtyfloat, the RBA would increase its net purchases of our dollar (orreducing net sales of our dollar would have a similar effect), byusing 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 arrestthe fall, especially if interest rates are also increased at the sametime. For instance, during September–October 2001, there washeavy selling of our dollar on the foreign exchange market. Thisfall reflected the perception among traders that our currencywas overvalued given the downturn in the US, Japan, Taiwanand Singapore. To an extent, the market was correct, but theRBA felt that the dollar’s fall to US$0.49 was a misinformedoverreaction. Without firm support from the RBA at the time,the currency may have gone into a free-fall. There are also othercircumstances where a higher dollar may be desirable. For onething, a stronger dollar makes imports relatively more competi-tive against our exports. Keeping the dollar fairly steady alsohelps to slow both cost and demand inflation. Although it seems

The RBA decides to smooth out or alter

the exchange rate using a ‘dirty float’.

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.

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.

1. The RBA wants to increase the exchange rate or try to prevent a further erratic and/or

uninformed fall in the A$.

2. The RBA wants to decrease the

exchange rate or to prevent a

further erratic and/or uninformed rise in the A$.

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:

Q2

Q1

P2

P1

Exch

ange r

ate

(A

$)

Quantity of A$

D1–A$

D2–A$

S–A$RBA Buys

Q2

Q1

ER1

ER2

Exch

ange r

ate

(A

$)

Quantity of A$

D–A$

S2–A$S

1of A$

RBA Sells


reassuring that the RBA can affect the exchange rate in this way,the very limited level of overseas reserves held by the RBAplaces a constraint on the amount of support that can be givento the Australian dollar. Besides, in the end it is the market, notthe 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 marketwas misinformed, causing the Australian dollar to be too high, adirty float may again be warranted. This time, instead of buyingthe dollar, the RBA may intervene in the foreign exchangemarket by increasing its net sales of our currency (or reducing netpurchases of the dollar would have a similar effect), so as to putdownward pressure on our exchange rate. If successful, a weakerdollar would tend to make exports and capital inflow moreattractive against imports and capital outflow. This has thepotential to increase AD and reduce our current account deficit(CAD). However, there is the risk that a lower dollar will igniteinflationary pressures.

RESERVE BANK OF AUSTRALIA ‘PERSUASION’ OVER FINANCIAL SECTOR LENDING LEVELSWhen the RBA makes public comment in the media, typicallybusinesses and those involved in the capital market listen andrespond accordingly.

In the past, there have been occasions where the RBA hastried to influence the direction and levels of lending by finan-cial institutions so that government economic objectives aremore effectively pursued. Sometimes there are attempts to talkup lending and spending; other times, an effort is made to talkdown activity.

CONTINUED RBA DEREGULATION OF THE FINANCIAL SECTORBetween 1982 and 2007, continual deregulation of the financialsector has been an important strategy aimed at improving theefficiency and competitiveness of domestic interest rates (seetable 6.1, p. 206). This approach does not really come undermonetary policy as such; it is better classified as part of micro-economic policy. Even so, it has had an enormous impact onhow monetary policy is conducted. Instead of relying on directcontrols over interest rates and the exchange rate, the RBA nowrelies on more subtle intervention in various markets.

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 macro-

economic instrument, used in the short to medium term, tohelp stabilise the general level of economic activity. It does thismainly by regulating the strength of AD in a counter-cyclicalway, using either an expansionary or contractionary stance. This

helps to ensure that AD does not outstrip the growth in Aus-tralia’s productive capacity (AS). In doing this, the RBA ismainly guided by its desire to ‘fight inflation first’ and keep theannual average inflation rate to within its 2–3 per cent target(over the duration of the economic cycle). Hence, in any par-ticular year, it may be a little higher than 2–3 per cent, but inothers, a bit less. This medium-term aim of monetary policy iscalled inflation targeting. However, once inflation is safely withinthis range, the RBA may turn its attention to pursuing otheraspects of domestic stability. In fact, it will usually try to achievethe highest sustainable rate of economic and employmentgrowth that is possible, without causing inflation to accelerate.



Generally, a rate of economic growth averaging around 4 percent with unemployment between 5 and 6 per cent should beachievable and consistent with the objective of price stability.

So, how does the board of the RBA, when it meets every twoweeks, go about deciding whether to adopt an expansionary orcontractionary stance? Typically, it uses a checklist of importantindicators.

After weighing up often conflicting evidence, the RBA thenadopts 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). Thesethree positions are summarised in the figure 6.5.

Figure 6.5 Changing the RBA’s monetary policy stance to help improve domestic economic stability

CHECKLIST 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.

STANCE OF MONETARY POLICY

THE MAIN INDICATORS OF THIS POLICY STANCE AIM OF THE POLICY STANCE

1. Contractionary or tighter monetary policy stance (e.g. 1999–2000, 2002–07)

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.

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.

0

2

4

6

8

Cash

rate

targ

et

(%)

The RBA’s monetary policy stance, indicated by the monthly cash rate target (%)

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009

RBA expansionary stance — five cuts in interest rates from 7.5% (1996) to 4.75%

(late 1998) when AD and economic activity slowed

RBA expansionary stance — six cuts in interest rates from 6.25% (2000) to 4.25%

(late 2001) when AD and economic activity slowed

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 unusedproductive capacity


Source: Data compiled using various RBA Monthly Bulletins (table A.2).

Let us now investigate further how the RBA has actuallyimplemented its counter-cyclical stabilisation policies involvingchanges 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 beillustrated 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 theeconomy’s productive capacity or speed limit (i.e. currently anaverage rate up to about 4 per cent a year). This is shown infigure 6.6, by AD2, and GDP1–2. At this point, prices rise (i.e.from P1 to P2) because excessive levels of expenditure causewidespread shortages of goods and services (demand–pullinflation). Cost inflation too can occur when there are shortagesof resources (e.g. wages costs rise when unemployment falls toolow). To help stop demand inflation (‘inflation targeting’ is theRBA’s main priority), monetary policy needs to gradually adopt

a tighter or more contractionary stance designed to slow expendi-ture (i.e. from AD2 to AD1), without jeopardising economicgrowth (i.e. this remains at GDP1–2) and full employment. Intightening its stance, typically the RBA places greatest relianceon its interest rate policy.

This was more or less the type of situation that occurred between1999 and 2001, and again between late 2001 and early 2007. Asshown in figure 6.5, the RBA raised its cash rate target eight timesduring this latter period, due to excessively strong AD contributingto inflation in an economy close to its capacity (peaking at 6.25 percent in August 2000 and 6.25 per cent in November 2006). Thesteps 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 short-term money market. This indicates the RBA’s new stance.

Step 2: Next, the RBA will set out to achieve this higher targetby undertaking market operations involving net sales ofgovernment securities to financial institutions, at anattractive lower or discounted price. This lifts the yield(percentage return on money) on securities and makesownership of them more desirable.

Figure 6.6 Using monetary policy in a counter-cyclical way helps to reduce cyclical instability in economic activity.

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.

STANCE OF MONETARY POLICY

THE MAIN INDICATORS OF THIS POLICY STANCE AIM OF THE POLICY STANCE

Demand inflation

Real GDP/national output

Gen

eral

pric

e l

evel

GDP1

and GDP2

=

the economy is at itsproductive capacity

AD2 = excess AD that causes

an inflationary boom. This iscorrected using a contractionarymonetary policy stance to slowspending and reduce inflation.

AD1 = ideal levels of spendingas a result of successful counter-cyclical monetary policy

P2

P0

P1

GDP0

=the economy is in arecession with high

unemployment

AS

AD0 =weak AD and recession. This

requires an expansionary monetarypolicy stance to lift spending


Step 3: As financial institutions transfer money to the RBA inexchange for government securities, there is a shortage ofcash deposits in their exchange settlement accounts. Theymust then compete among themselves for limitedfunds, in order to maintain positive balances in theiraccounts. The shortage of cash then drives up interestrates in the overnight money market.

Step 4: A higher cash rate then spreads to other interest rates inthe financial market like a ripple effect. Rates paid onmortgages, credit cards, business overdrafts and savingsaccounts, all rise.

Step 5: The final aspect of this tighter monetary policy stanceinvolves what is called the transmission mechanism or theways 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) byincreasing the level of saving and reducing thelevel of credit-sensitive spending (i.e. C + I) thatrelies heavily on borrowing. This slows AD (as seenin figure 6.6, removes shortages of goods and ser-vices, and reduces demand inflation.

2. Higher domestic interest rates relative to those over-seas, tend to cause the A$ to appreciate (e.g. between2002 and early 2007). This happens because Australiahas become even more attractive to foreign investorswho are seeking our better rates of return. Thisincreases the demand for the A$ relative to its supplyin the foreign exchange market, causing an appreci-

ation of the currency. In turn, a higher A$ slowsinflation in two ways. For one thing, the cost ofimports is cheaper for households and firms. Thisreduces cost inflation. Demand inflation also tendsto ease with a higher $A. This is because sales of ourexports are reduced relative to our spending onimports.

3. Higher interest rates can work to slow inflation byhelping to reduce inflationary expectations in the com-munity. People become confident that the RBA willnot let inflation take hold. Indeed, during both1999–2001 and 2002–07, rising interest rates did helpto keep inflationary expectations in check, therebyimproving domestic economic stability.

Although the RBA relies mostly on higher interest rates tocontrol inflation, there are also two other less important instru-ments available. One other approach is that RBA could apply adirty float to try to lift the exchange rate for the A$. This wouldinvolve the RBA buying the A$ in the foreign exchange market,by using its reserves of other overseas currencies. The rise in thedemand for dollars relative to their supply, makes the currencyscarcer, thus lifting the price or the exchange rate. In turn, astronger dollar slows inflation in two ways. First, it makes exportsdearer and less attractive relative to imports. This tends toreduce net exports and AD, ease shortages of goods and servicesand slow demand inflation. Second, a stronger currency makesimported household items cheaper and also lowers the cost ofimported materials and equipment used in production by localfirms. This, too, eases the pressure of costs on inflation.

Figure 6.7 Some of the transmission mechanisms whereby a tighter monetary policy stance controls inflation

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.

The RBA increases interest rates

Inflation slows down


Another monetary policy strategy is that RBA could use itsinfluence or persuasion (e.g. during 1999–2000 and 2004–05) toissue warnings of caution about the excessive levels of lendingby the financial sector, or high spending by households andfirms. This could help talk down economic activity and inflation,and thus improve domestic stability.

An expansionary monetary policy can

lift AD, economic growth and

employment

In theory, applying a more expansionary stance for monetarypolicy can counteract a downswing or recession in the businesscycle. As shown on the AD–AS diagram in figure 6.6 (p. 213) theRBA can use lower interest rates to stimulate AD. Starting onthis diagram at AD0, GDP0 and P0, a reduction in interest rateswould tend to accelerate expenditure from AD0 to AD1, and liftnational production from GDP0 to GDP1 (without muchincrease in the inflation rate). Clearly, domestic economicstability should be improved and recession avoided.

In more detail, the main steps involved with an expansionaryapproach 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 short-term money market.

Step 2: The RBA will then set out to achieve this lower target byundertaking market operations in the short-term moneymarket involving net repurchases or buying back of govern-ment securities from financial institutions. This actionwill tend to lift the price of securities, reduce the yield andencourage institutions to get rid of their governmentsecurities.

Step 3: As the RBA transfers money to financial institutions (inexchange for their government securities), there is asurplus of cash deposits in exchange settlement accounts. Theglut of cash drives down interest rates in the overnightmoney market.

Step 4: A lower cash rate spreads in a ripple effect to otherinterest rates in the financial market.

Step 5: Finally, a looser monetary policy stance involving reducedinterest rates should tend to stimulate economic growthand reduce unemployment. There are at least twoimportant transmission mechanisms: 1. Lower interest rates tend to boost economic

activity by accelerating AD. This happens becauselower rates discourage saving and encourage credit-sensitive C and I spending (that rely onborrowing). In turn, this tends to cause retail salesto rise and stocks to fall. Firms should respond bylifting production (GDP) and employing moreresources, including labour. Indeed, the RBA esti-mates that a real cut in the cash rate of 1 per cent,helps to accelerate economic growth in GDP byaround 0.8 per cent.

2. As seen in 2001–02, a cut in domestic interest ratesrelative to those overseas causes a fall in ourexchange rate. This is partly because there is morecapital outflow from Australia seeking better returnselsewhere. This leads to increased sales of the A$ inthe foreign exchange market, causing the exchange

rate to depreciate. In turn, AD rises due to exportsbecoming more attractive relative to imports. Againthis is helpful in stimulating economic activity duringa downturn, thereby helping to improve domesticeconomic stability.

The RBA could also reinforce expansionary interest rate cutsto correct a downturn, by using two other less importantmeasures. First, if it was felt that the exchange rate was too high,theoretically, the RBA could directly weaken the currency a littleby selling off the dollar in the foreign exchange market using adirty float. In turn, a lower exchange rate would tend to stimu-late exports relative to imports, thereby strengthening AD.Second, the RBA may use its influence (persuasion) toencourage more lending by the financial sector and to talk upthe economy by painting an optimistic picture. Persuasion likethis 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 measuredesigned to regulate AD and reduce the severity of the businesscycle, 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 hadbrought inflation under control (e.g. as in 1996–99 or 2001–02),this would tend to reduce production costs for firms with bankoverdrafts, enhance competitiveness, and strengthen businessprofitability. Firms would then be more likely to expand theiroperations and be less likely to close. As a result, structuralunemployment should be lower, thanks to improved supply-sideconditions. Using the AD–AS diagram in figure 6.8, this wouldresult 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.

Figure 6.8 How lower interest rates could have a beneficial supply-side effect on domestic economic stability

Cost inflation

Real GDP/national output

Gen

eral

pric

e l

evel

GDP2

= increased

sustainable rate of

economic growth

AD1 = ideal levels

of spending

P1

P2

GDP1

=original sustainable rate

of economic growthand employment

AS2 — how increasedproductive capacityand supply can resultfrom RBA reductions

in interest rates

AS1 —

original supply-sideconditions


Unfortunately, however, it is not always possible for the RBAto lower interest rates in this way. Sometimes, the RBA is forcedto lift interest rates to slow demand inflation. In this situation,the policy would contribute to higher production costs, businessclosures, increase structural unemployment, and an inward shiftin the AS line (i.e. a decrease in productive capacity with a shiftfrom AS2 to AS1).

Other advantages of monetary policy

Apart from promoting domestic stability by regulating the levelof AD, there are also some other advantages of using monetarypolicy to improve domestic economic stability.

Short implementation lags for monetary policy

Long time lags (i.e. delays in recognition, implementation andimpact of policy) are a worry for policy makers since they reducethe effectiveness of RBA stabilisation measures. Policy may endup being mismatched to the economic situation that it is meantto correct. Instead of measures being counter-cyclical in theirimpact on AD, they may become pro-cyclical and actually worsendomestic instability (e.g. policy reduces AD in a recession andincreases it in a boom). However, a real advantage of usingchanges in interest rates to steady economic activity is that theirimplementation lag is quite short; with delays of only two weeksbetween one RBA board meeting and the next. This lag is muchshorter than discretionary changes in budget tax rates orbudget outlays, for example, where implementation may takethe Treasurer a year or more. Despite this, there are still longimpact lags for changes in the cash rate.

Often monetary policy is able to complement budgetary policyas a domestic stabiliser

Ideally, monetary and budgetary policies should both worktogether as macroeconomic measures to help stabilise AD, slowinflation, maintain a sustainable rate of economic growth anddeliver full employment. Policies are usually most effective ifthey are compatible (i.e. complementary) rather conflicting. Inthe 10 or so years to 2007, often monetary and budgetary poli-cies have been supportive of each other. For instance, inresponse to rising inflation and strong economic growth during1999–2000 and again between 2002 and late 2006, bothbudgetary and monetary policies were tightened simultaneously

to slow the growth in AD. The RBA increased the cash rate whilethe Treasurer grew the size of the budget surplus.

Monetary policy changes are often less political than dis-cretionary fiscal measuresThe RBA board and its governor are meant to be independentand 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 pol-itical constraints in setting the cash rate target. By contrast,budgetary changes in tax rates and specific government outlaysmade by the Treasurer (as a member of the elected party andgovernment) are highly politicised. This consideration cansometimes restrict the use of fiscal measures needed for pro-moting better internal stability.

Monetary policy works best in slowing inflationMonetary policy is better at slowing inflation than it is in stimu-lating economic growth during a recession. This is because risesin interest rates designed to slow economic activity, are feltdirectly by borrowers who are forced to find extra money to meetinterest repayments on existing loans. This makes it a very effec-tive policy because spending on other things just has to bereduced and new borrowing is deferred. By contrast, cuts ininterest rates that reduce repayments, do not force people tospend more and there may be no increase in borrowing. It is alsopossible that once interest rates get close to zero as in Japan(2002–04), there is almost nothing else that monetary policy cando 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 theRBA’s monetary policy in promoting domestic economic stab-ility (i.e. the simultaneous achievement of sustainable rate ofeconomic growth, price stability and full employment). This isbecause there are so many local and international influences onthe economy. However, perhaps we could start our policy evalu-ation by looking at the statistical data contained in table 6.2.

Indicators of trends in domestic economic stability

Source: Data derived from ABS, 1350.0.

YEAR1996–

971997–

981998–

991999–2000

2000–01

2001–02

2002–03

2003–04

2004–06

2005–06

2006–07

2007–08

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

Table 6.2


Some strengths

Some commentators would say that the figures in table 6.2 lendsupport to the successful application of monetary policy in theyears to 2007. For instance, the RBA consistently and correctlyapplied its measures in a counter-cyclical way that was designedto improve domestic economic stability. For example, a contrac-tionary stance (involving higher interest rates) was always usedto slow inflationary upswings in activity when spending was run-ning ahead of production (e.g. as in 2002–07). This meant thatinflation was held down and averaged only 2.6 per cent per year.Despite two inflationary spikes of 6 per cent and 4 per cent in2000–01 and 2005–06 respectively, this figure was well within thegovernment’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 bitbelow the 4 per cent target rate, the average 3.7 per cent rate ofeconomic growth has been held at the highest sustainable ratethat would not cause inflation. The observation that rates ofgrowth have been a bit slower than expected in the last four outof five years was due only to the fact that the economy had littleunused productive capacity. Besides, economic growth overthese years has still been fast enough to cut unemployment to a32-year low (down to only 4.4 per cent in April 2007), create2 million new jobs and allow for the highest participation rateever achieved.

Some weaknesses

Despite monetary policy’s general success in the years leadingup 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 thecash rate target, the impact lag for monetary policy is quite long

and nowadays, more variable following financial sector deregu-lation. For example, the RBA estimates that a 1 per cent reduc-tion in interest rates will take nearly three years to have its fullexpansionary impact and to lift GDP’s growth by 0.8 per cent.After one year, the impact is about 40 per cent and even aftertwo years, the impact has only reached 80 per cent. This is alsocomplicated by the fact that the impact delay of a given changein interest rates is variable. This is partly because it is affected bythe state of consumer and business confidence. For example, a1 per cent rise in the cash rate designed to slow inflation, willhave either less effect or take longer to work when confidence isstrong, than it will when confidence is weak. In reverse, evenreductions in the cash rate to zero per cent (as in Japan between2001 and 2005) are almost powerless to raise spending whenconfidence is really low. The point here is that long impact lagsinvolved with changes in interest rates, may sometimes causecounter-cyclical policy to become pro-cyclical. This would destabi-lise the economy.

Sometimes monetary policy is undermined by budgetary policy

On some occasions, successful monetary policy can be under-mined by budgetary policy. An obvious instance of this was theconflict that appeared to exist between these two policies during2005 and 2007. As shown in table 6.3, budgetary policy involveda significant cut in the size of the budget surplus from$15.8 billion (2005–06) to $13.6 billion (revised estimate) for2006–07 to only $10.6 billion for 2007–08 (budget estimate).The budget also included very large discretionary cuts inpersonal income tax and rises in infrastructure spending.Strangely, this less contractionary fiscal stance came on top ofcontractionary RBA rises in interest rates in March 2005 andMay 2006. The Treasurer was also blamed for two further risesin the cash rate target announced in August and November2006. Some commentators even suggested that politicalconsiderations played a role in the tax cuts during this instance.

The conflict between the directions of budgetary and monetary policies

Source: Data derived from RBA Bulletin, November 2006.

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

August 2006

November 2006

A more contractionary rise in the cash rate target to 5.75 per centA more contractionary rise in the cash rate target to 6 per centA more contractionary rise in the cash rate target to 6.25 per cent

Table 6.3


There are also other aspects of conflict between budgetaryand monetary policies. For example, conflict can occur whengovernments run large budget deficits to stimulate activity andemployment. Financing these deficits typically requiresincreased government borrowing, often locally. With limitedsavings or credit available, upward pressure could unintention-ally be exerted on domestic interest rates. This crowds out pri-vate sector borrowers, thus contradicting the originalexpansionary aims of budgetary policy. It also undermines theRBA’s efforts to lower interest rates and stimulate the economy.In reverse, contractionary surplus budgets may tend to causeinterest rates to fall or rise less quickly than otherwise (e.g. per-haps 2001–02 to 2006–07). This may result in crowding in byborrowers and increase spending, undermining the RBA’smonetary stance.

Conflict between objectives can create problemsIn pursuing one economic objective, monetary policy canundermine the achievement of other government goals. Takethe following situations:� Higher interest rates may well slow expenditure and reduce

demand inflation. However, as a supply-side factor, rises ininterest rates on business overdrafts also add to the pro-duction costs for firms. In order to cover higher costs andprotect profit margins, some businesses may be forced toincrease the price at which they sell their goods and services,adding to cost inflation. This reduces the effectiveness ofmonetary policy. Additionally, higher interest rates may dis-courage business investment, reduce business expansion,undermine profitability and lead to the closure of somefirms. This slows economic growth and reduces AS. Further-more, when firms close down or try to cut staff costs, struc-tural unemployment rises. Clearly, higher interest rates alsohave negative effects on domestic stability.

� A decision to raise domestic interest rates relative to thoseoverseas in order to slow inflation, may attract a flood ofcapital inflow, cause the A$ to appreciate, lead to a rise inthe CAD and NFD, and undermine the achievement ofexternal stability (e.g. 2002–06). In reverse, a cut in interest

rates to stimulate economic and employment growth, maycause an exodus of investment funds seeking higher returnsabroad, weaken the currency’s exchange rate and add toinflation.Consideration of the conflict that can exist between some

government objectives, may limit the ability of the RBA to usemonetary policy to pursue domestic stability.

Monetary policy works less directly than budgetary policy

Critics note that monetary policy is less effective in overcomingrecessions. This is because cutting interest rates only works veryindirectly on the level of spending, by making interest repay-ments 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. Atthis rate, Japanese monetary policy was powerless to do anymore to aid recovery and so reliance was placed on expan-sionary budgets.

Monetary policy is a blunt and imprecise instrument

Unlike budgetary and microeconomic policies that can surgi-cally target particular sectors, industries or areas (e.g. ruralsector, textile producers) that are causing problems, monetarypolicy is blunt and imprecise. For example, it treats all bor-rowers of credit in the same way, whether it be to financehousehold consumption or for business investment in newequipment. The failure to make this distinction makes it ratherclumsy. In addition, it is possible that only some (not all) Aus-tralian states need their expenditure restrained, at a point intime. This was the case in 2006 and 2007 when unemploymentin the booming economies of WA and the ACT was around3 per cent, but it was above 6 per cent in Tasmania whereeconomic growth was quite slow. Here we have a two-speedAustralian economy. Tasmania could probably do without therecent rises in interest rates, but it will not get any choiceabout the matter.



6.5 Using monetary policy to improve external stability

For Australia, external stability means paying our way in inter-national financial transactions without this impacting adverselyon 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 directand overall. It is not the most effective policy available to pro-mote external stability. Budgetary and microeconomic policiesare probably more effective. Even so, we will now take a lookhow RBA measures might try to operate in this area.

Limiting cyclical rises in AD might reduce external instability

Perhaps the main way monetary policy can be used to promoteexternal stability is by using it to improve internal stability. If ADand economic activity grow too quickly in an economy oper-ating at its capacity (i.e. during a boom), external stabilityquickly deteriorates. Typically, this is reflected in a cyclical rise inthe CAD:GDP ratio and a fall in the exchange rate. This isbecause when AD grows too fast and outstrips production or AS,there are widespread shortages of goods and services and excessexpenditure spills over onto imports. As a result, there is acyclical rise in the CAD and weakening of the A$. In addition,cyclically strong spending locally means that there are fewergoods and services available for export, again pushing up theCAD. 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 reducespending and economic activity, in turn causing imports to growmore slowly and releasing extra production for export. Inaddition, higher interest rates help slow inflation and, in oneway, make our exports relatively more competitive againstimports. This too should help to reduce the CAD.

The RBA certainly has raised interest rates on severaloccasions over the past 10 years. For instance, there were eightconsecutive rises in the cash rate target from 4.75 per cent inlate 2001, to 6.25 per cent in late 2006. This occurred at a timewhen there was strong spending growth and the economy wasapproaching its productive capacity. National expenditure wastending to run ahead of the total production supplied, causinga blowout in the CAD. Hence the use of contractionary mon-etary policy may have helped to promote external stability andcurb the cyclical rise in the size of the CAD.

Even so, there are real problems of using higher interestrates (e.g. as between 2001 and early 2007) to reduce the CADand to lift the exchange rate. Unfortunately, higher rates havean adverse supply-side effect on local firms and reduce Aus-tralia’s international competitiveness. The reason is that

interest rates are also a production cost for most local firms. Thispushes up domestic costs and prices, relative to importscoming from countries where interest rates are lower. Exportsare depressed and imports rise. In addition, higher domesticinterest rates attract foreign capital inflow and tend to push upthe A$, making our exports less attractive relative to imports.In turn this also tends to worsen the CAD, increase the NFDand weaken external stability. Having noted these weaknessesthrows some doubt on how effective monetary policy is in pro-moting external stability. This may be why budgetary or micro-economic policies seem to have been the preferred strategiesfor promoting external stability during the past 10 years to2007.

Smooth out erratic changes in the A$

An unstable and unpredictable exchange rate means that thecost of international transactions is hard to determine until thelast moment. This discourages export sales and may increasethe CAD. However, you may recall that in these circumstances,the RBA may use a dirty float to help smooth out uninformedand erratic swings in the dollar. For example, an unpredict-able, unwarranted and dramatic drop in the exchange ratecould be partly steadied through intervention by the RBAinvolving increased buying of our currency in the foreignexchange market. In reverse, an upward surge that couldworsen the CAD might be moderated by RBA selling off thecurrency. The RBA did just this on a number of occasionsbetween 1996 and 2007. For instance, between 1999 and 2000,it was busy buying up Australian dollars in the foreignexchange market (assisted by higher interest rates) to try tostop the exchange rate plunging to an all time low (i.e. theTWI fell to 49.7 points in 2000–01). In reverse, there was inter-vention to slow the rise in the A$ in 2004–05 through sales ofthe currency by the RBA.


HAS MONETARY POLICY SUCCESSFULLY PROMOTED EXTERNAL STABILITY?Given that monetary policy has been mainly used to promotedomestic stability, it would be unfair to blame it for Australia’sexternal weaknesses shown in table 6.4. Besides monetarypolicy, there were also many other influences affecting externalstability in the past 10 years.

Some strengths

Certainly between 1996 and 2007, monetary policy did what itcould to promote external stability. After all, it helped toachieve domestic economic stability, a situation where con-ditions are more favourable for achieving external stability. Forinstance, contractionary rises in interest rates (e.g. 2002–late2006) helped to limit the increase in AD. This reduced the spill-over of excess spending onto imports in an economy near itscapacity. In addition, monetary policy successfully promotedprice stability (i.e. the average annual inflation rate was only2.6 per cent), thereby helping to maintain the competitiveness

of Australian exports. These actions by the RBA should havehelped to improve external stability.

Some weaknesses

Despite doing what it could, commentators have highlighted thelimitations of using contractionary monetary policy to pursueexternal stability.

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 onexternal stability. As already noted, although higher rates canreduce the cyclical rise in the CAD, they also add to external struc-tural problems. Higher interest rates in Australia relative to thoseoverseas, cause foreign capital to rush in and take advantage ofrelatively better returns here for foreign investors. This pushesup the A$, makes our exports less attractive relative to imports,and causes the CAD and NFD to become even bigger. This wasgenerally seen between 2001–07. In addition, increases in interestrates for business overdrafts, drive up production costs for manylocal firms. This reduces the competitiveness of our exportsagainst imports, further adding to Australia’s structural CAD.

Monetary policy and Australia’s external instability

Sources: Data derived from the ABS 1350.0, RBA Bulletin.

YEAR1996–

971997–

981998–

991999–2000

2000–01

2001–02

2002–03

2003–04

2004–05

2005–06

2006–07

2007–08

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 5.75

Table 6.4


Budgetary and microeconomic policies are more effective for external stabilityAnother reason why external stability is not the main aim of mon-etary policy is that budgetary and microeconomic policies are farmore effective and powerful. Contractionary monetary policy hasproblems, as we have seen. It is too blunt and only works indi-rectly by slowing expenditure levels and lowering inflation toimprove our competitiveness. However, for the past decade, fiscalmeasures and microeconomic reforms (including the promotionof 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 tacklingthe on-going structural problems causing the large CAD andNFD, and the long-term depreciation of our currency.

Pursuing external stability can conflict with other economic objectivesIf external stability is pursued using rises in interest rates forexample, this may conflict with the achievement of othergovernment economic objectives like efficiency in resource allo-cation. Higher interest rates discourage business investmentspending on new plant and equipment, and thus slow rises inefficiency. In addition, increases in interest rates slow AD andmay undermine economic and employment growth. This mayeven reduce equity in income distribution.

The ability to prop up the A$ is limitedNowadays, our exchange rate is determined by the forces ofdemand and supply for the A$ in the foreign exchange market.However, on some occasions when the exchange rate was fallingvery rapidly (e.g. 1999–2001), the RBA may decide to interveneusing a dirty float to smooth out erratic or uninformed changes.However, there are limits to the support that can be given to thecurrency in the event of a serious collapse. For one thing, theRBA has only limited reserves of foreign currency or gold that can beused for purchasing A$. Even then, there is no guarantee thatwhen the buying intervention has ended that the currency willnot again decline. The market, not the RBA, makes the finaljudgement as to where the dollar comes to rest.

The impact lag of interest rates may be longIn the event of excess AD causing inflation, the spillover ontoimports and a rise in the CAD, there is the problem of long timelags between the RBA increasing interest rates, and its impact.Higher rates can take up to 2–3 years to be effective, especially ifconsumer and business confidence are strong.

6.6 Using monetary policy to improve efficiency in resource allocation

A nation must use its resources efficiently in order to best satisfysociety’s wants and maximise its material living standards. Anannual rise in national productivity by 1.5 to 2 per cent isconsidered a good performance. There are four main types ofefficiency that come to mind: allocative, technical, dynamic andinter-temporal. Although there are some general things thatmonetary policy can do to lift efficiency in resource allocation, itis probably not as effective as other measures like microeconomic

reform or budgetary policy. There are three main ways that mon-etary 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 economicactivity is either too weak (recession) or too strong (boom).



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 increaseworker 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 theeconomy’s point of view, this is less desirable than capitalresources flowing into setting up new companies andexpanding productive capacity.

� Moreover, if high inflation pushes up interest rates, thisdeters investment spending, and very low unemployment ofsay less than 5 per cent, may cause some workers to slackenoff. 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 pro-moting internal stability.

Certainly when the RBA reduces interest rates in a downturnas occurred in 1996–99 and 2001–02, this should have helped toincrease efficiency in resource allocation.� Foremost, cheaper credit for businesses encourages confi-

dence and promotes investment spending on new plant andequipment incorporating the latest technology. This leads tocapital deepening and better worker efficiency (i.e. anincrease in GDP per hour worked).

� Lower interest rates not only cause a rise in investment, butalso encourage household consumption spending (e.g. onnew cars, construction of houses, holidays and electricalappliances). Together, these conditions lead to stronger AD.In an economy where there is some unused productivecapacity, this reduces unemployment or idle resources andincreases 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 busi-ness confidence, perhaps leading to recession. The RBA, there-fore, feels compelled to lift its cash rate target. However, theproblem of increasing interest rates to check inflation is thatthey encourage saving and also reduce the level of productiveinvestment that is necessary to increase business efficiency.Indeed, when interest rates are lifted, it is possible that pro-ductive investment (where returns are often smaller) will beslowed even more than speculative investment (where returnsare often higher). This has negative effects on productivity, per-haps as seen between 1999 and 2006.

Despite this dilemma, the fact remains that the RBA has actu-ally 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 thelowest real overdraft interest rates in over 30 years. In turn, thishas helped to lift productive efficiency by directing moreresources into investment in new technology.

Boosting efficiency by deregulation of

the financial sector

Most economists believe that strong levels of competition inmarkets help to promote efficiency in resource allocation. Firmsneed to try and outdo their competitors through greater prod-uctivity. This does not usually occur when there are monopolies,oligopolies or restrictions in the market. In the twenty-five yearsto 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 microeconomicreform rather than a monetary policy, it has affected the oper-ation of the financial sector, and has sought to stimulate compe-tition, keep interest rates for borrowers lower than otherwiseand increase the efficiency of Australia’s capital market.

The exchange rate’s effects on

efficiency

The exchange rate alters how competitive local goods and ser-vices 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 inorder to survive. Even so, a lower A$ means that some firmsthat import materials and equipment used in manufacture,find that they have higher production costs making them lesscompetitive.

� In reverse, when the exchange rate appreciates, as occurredbetween 2002–07, this makes it far more difficult for localfirms to survive. They have to make even greater efforts to lifttheir efficiency, although they are helped by the fact that ahigher 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 interestrates and its decisions to intervene in the foreign exchangemarket through a dirty float, also affect the pressures on firmsto improve their productivity.

HAS MONETARY POLICY

SUCCESSFULLY PROMOTED

EFFICIENCY IN RESOURCE

ALLOCATION?The trends in how efficiently Australia uses its resources shownin table 6.5 are affected by hundreds of local and internationalfactors, not just monetary policy. It is simply not possible toaccurately link cause and effect. Besides, of all government poli-cies, RBA strategies are probably the most indirect and leastimportant.


Trends in Australian productivity

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

Looking at the data, it is clear that there are cyclical phases inAustralian productivity. After record efficiency levels in phase 3between 1994 and 1999, there was a significant slowdown duringphase 4 to 2004. Even so, the conduct of monetary policy isunlikely to be the main cause of this trend because, generally, theRBA has created near record domestic economic stability (i.e.price stability, sustainable economic growth and full employ-ment) where conditions were very favourable for efficiency inresource allocation. It reduced interest rates to stimulate econ-omic growth and cut unemployment or idle resources, whenthere was unused productive capacity and no risk of inflation.The RBA only increased interest rates when its hand was forcedby rising prices (e.g. 1999–2000, 2002–06). Despite this, however,interest rates were still far lower than in the previous 30-oddyears. For instance, in the past 10 years, the average businessoverdraft rate was only 8.6 per cent, against about double thisrate in the late 1980s. Recently, this encouraged higher levels ofinvestment in new equipment and technology. In addition, theon-going deregulation of the financial sector helped to spur oncompetition and greater allocative efficiency in the use of Aus-tralia’s money capital. There is little else that monetary policycould have been expected to do in this regard.

Some weaknesses

Although the RBA has generally done what it can to improveefficiency in resource allocation, monetary policy has weak-nesses.

Higher interest rates can control inflation but may discourageinvestment

When inflation approaches 3 per cent a year or more, the RBAis forced to lift interest rates. It did this eight times in theperiod, 2002–07. Unfortunately, higher interest rates discourageinvestment spending, which is essential for lifting technicalefficiency. In turn, this may also lead to higher unemploymentand idle resources, and it adds to the production costs of somefirms (who have borrowed credit from the bank in order to pro-duce).

Limited efficiency from deregulation

The continued deregulation of the financial sector in the yearsto 2007, probably lifted efficiency in allocating Australia’scapital 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 actu-ally passed on to consumers of financial services. In supportingthese claims, mention is made of the extraordinarily high profitmargins and returns in the banking sector, along with greedilyhigh bank fees and charges by some international standards.

Monetary policy works only indirectly to increase efficiency

Unlike microeconomic policy that very directly cuts costs andencourages efficiency, monetary policy operates in less directways. It works mainly by creating a better domestic economicstability where resources are more likely to be used efficiently.

Monetary policy is a blunt and imprecise instrument

Budgetary and microeconomic policies can accurately targetspecific areas where efficiency is weak. For example, there couldbe reduced tariffs for the car industry, special assistance to sugarproducers or lower rates of company tax. However, RBAmeasures are not surgically precise and cannot single outparticular problems for attention. Cuts in interest rates, forinstance, do not just stimulate investment in new equipment,but they also direct more resources into speculative areas andinto consumer goods, housing and services, not all of which areas beneficial for efficiency.

PHASE AND YEAR1985–89 PHASE 1

1989–94PHASE 2

1994–99PHASE 3

1999–2004PHASE 4

2004–??PHASE 5

Annual average change in labour productivity by cycle — Australia

0.8 2.2 3.2 2.2

Annual change in multifactor productivity by cycle — Australia

0.7 0.9 2.1 1.0

Table 6.5



6.7 Using monetary policy to improve equity in personal income distribution

The government’s objective of an equitable income distributionmeans that everyone has access to basic goods and servicesneeded to maintain reasonable living standards. Monetarypolicy is not nearly as useful in promoting equity as saybudgetary policy. It can only work indirectly by keeping bothunemployment and inflation at low levels. In other words, whendomestic economic stability is well achieved, conditions aremost favourable for achieving an equitable distribution ofincome. So how might the RBA’s measures actually work?

HOW MONETARY POLICY MIGHT REGULATE AD TO KEEP INFLATION AND UNEMPLOYMENT DOWNEquity is unlikely to exist when there is rapid inflation or highunemployment.

Keeping inflation low

High inflation rates averaging above 2–3 per cent, reduce equityfor several reasons. For one thing, the prices of basic goods andservices (the cost of living) often rise faster than the incomes ofordinary families. Their real purchasing power is reduced. Forthe poor, food, rental accommodation, home ownership, cars,transport, electrical goods, education, health care, entertain-ment, access to the law and childcare, for example, often becomeless affordable and accessible, so their living standards fall. Bycontrast, some individuals, like speculators in shares and prop-erty, find that their incomes rise faster than inflation generally,so that their purchasing power is increased. Inflation arbitrarilylowers equity for some individuals, but improves it for others. For-tunately, the RBA’s monetary policy involving higher interestrates (via increased net sales of government securities in theshort-term money market) has successfully controlled inflationby slowing excess AD and easing shortages of goods and services.Indeed, inflation targeting has meant that Australia’s averageannual 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 andstructural unemployment undermine equity and people’s accessto basic goods and services. Unemployment causes families tosuffer from the awful effects of a sudden drop in disposableincome and purchasing power. As individuals move from averageweekly earnings of around $1050 or from the minimum weeklywage of around $512 (for early 2007), on to inadequate welfarebenefits for the unemployed of perhaps $200–250 a week for asingle, access to basic goods and services is dramatically reduced,and increased poverty is likely to occur. The wealth of theunemployed also tends to shrink because assets like property, pos-

sessions, savings and shares are sold to pay bills, leading to greaterinequality. However, by cutting interest rates and adopting a moreexpansionary stance that stimulates spending, monetary policycan help reduce cyclical unemployment and improve equity.With lower interest rates, households and firms increase theirborrowing and spending. In turn, this lifts national production,employment and incomes. Moreover, on the supply-side,reducing interest rates tends to ease cost pressures, improveprofitability, encourage business expansion and results in thefewer closures of firms. This helps to lower structural unemploy-ment, again promoting equity. Overall, it should be noted thatthe RBA’s policies have recently helped to get unemploymentdown to its lowest level in around 32 years (i.e. only 4.4 per centin April 2007). Again, by promoting domestic stability, monetarypolicy has helped to promote greater equity.

By keeping inflation and unemployment down, the RBA ishelping to increase the real purchasing power of market incomesreceived by the poor. By contrast, government redistributionmeasures 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 precisecausal connection between monetary policy and any change inthe distribution of Australia’s personal income. This is becausethere are lots of other important domestic and internationalvariables that have also had an impact.

Some strengths

Certainly it would appear that monetary policy has helped tocreate general economic conditions domestically, that are veryfavourable to an equitable income distribution. As noted, the RBAhas applied interest rates in a counter-cyclical way, successfullyregulating AD and economic activity. In the past 10 or so yearsto early 2007, booms and recessions have been avoided. Monetarypolicy has helped to maintained strong economic growth, lowunemployment (this is at a 32-year low) and rising incomes, whileat the same time delivering low inflation (average of 2.6 per cent).Although it is undeniable that inequality in personal incomes hasincreased as shown in figure 6.9, this does not necessarily meanthat equity has decreased. In fact it is likely that the poor havenever been so rich or as able to afford as many basic goods andservices, as at present. However, by contrast, it would be hard toimagine that equity would be as strong if there were high inflationrates averaging over 8 per cent (as it did in the 1980s) or if unem-ployment was at 11 per cent (as it was in 1992–93).


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 monetarypolicy to improving equity between 1996 and 2007, economistsrecognise its weaknesses.

Monetary policy is less effective than budgetary policy

Monetary policy is certainly not the most efficient or precisemeans of redistributing final incomes equitably. RBA measurescan help to create general economic conditions (i.e. lowinflation and unemployment) where equity is likely to be max-imised, and the poor can better afford to access basic goods andservices. However, budgetary measures are far more powerful inreducing the Gini coefficient. Here we think of the effects ofdirect progressive taxes that are used to help pay for direct wel-fare support and indirect benefits for the poor (e.g. free orcheap health, education). Budgetary measures can also bettertarget 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 remarkablegrowth in share and property prices. This enabled many amongthe richer quintiles, to increase their share of household wealthand make considerable capital gains. The rise in asset prices wasdriven 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 owner-ship has been reduced by house prices rising faster than theirincomes. Indeed, research released in 2006 shows that averagemortgage repayments as a percentage of household income, arenow higher than when interest rates were double back in thelatter 1980s. This is because the size of the mortgage is nowmuch bigger due to inflated house prices. This has tended todiminish equity and deprive lower income families of homeownership.

Financial sector deregulation has done little for the poor

Critics of deregulation draw attention to the dramatic rise inbank fees and charges, especially on small accounts heldtypically by the poor. In addition, these people have littlebargaining power when trying to negotiate low-interest loans.On the other side, one cannot help but notice the unusuallyhigh profits made by banks in the 1990s and 2000s. In general,the main beneficiaries of these profits are shareholders who aremostly drawn from middle and upper income groups. Moreover,deregulation and stiffer competition has caused banks to cutstaff, adding to structural unemployment and hence inequity.

Quin

tile

5

Quin

tile

4

Quin

tile

3

Quin

tile

2

Quin

tile

1

0

200

400

600

800

1000

Mean w

eekly

incom

e (

$)

by q

uin

tile

2002–03 — Mean level of equivaliseddisposable income ($ per week)

1996–97 — Mean level of equivaliseddisposable income ($ per week)

Gin

i coeffic

ient

2001–0

2

2000–0

1

1999–2

000

1998–9

9

1997–9

8

1996–9

7

2002–0

3

2003–0

4

2004–0

5

2005–0

6

2006–0

7

0.28

0.285

0.29

0.295

0.3

0.305

0.31

0.315

Gini coefficient of equivalised householddisposable income

Linear (Gini coefficient of equivalisedhousehold disposable income)

Australia’s changing level of equivalised meandisposable income ($) per week by quintile —

1996–97 to 2002–03

disposable household income —1996–97 to 2002–03


Coursework


6.8 School Assessed

226

school assessm

ent

tasks a

nd

learn

ing

acti

vit

ies

There are two SACs to be completed for VCE Economics Unit 4,one for each of the two outcomes. SAC 1 is about macroecon-omic policy and SAC 2 covers microeconomic policy.

Assuming that you have completed chapters 5 and 6 aboutbudgetary 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 assess-ment 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 tocheck the latest VCAA’s Assessment guide to ensure that all assess-ment requirements are met fully.

To help prepare you for the end-of-the-year examination andto provide some guidance for SAC 1, several sample tasks havebeen included in this section of your text. For instance, chapter6 (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, interestingand relevant.

MULTIPLE-CHOICE test questions

Instructions: You may like to complete the following revisionquestions. Using the multiple-choice answer grid below, selectthe letter (A, B, C, D) that represents the most appropriateanswer for each question by marking this with a tick (�).

Question 1Monetary policy relates to: A macroeconomic measures introduced by the TreasuryB macroeconomic measures of the RBAC measures that mostly affect the flows of credit between bor-

rowers and lendersD both (B) and (C).

Question 2Higher domestic interest rates will tend to:A accelerate demand inflationB raise the production costs of some businesses and the cost of

living for many householdsC discourage overseas borrowing and weaken the exchange

rate for the Australian dollarD increase employment.

Question 3Despite some RBA efforts to support the currency, there was a20 per cent depreciation of the Australian dollar against the USdollar between December 2000 and March 2001.

Answer grid

QUESTION 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15

A

B

C

D

QUESTION 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

A

B

C

D


school a

ssessm

ent ta

sks a

nd

learn

ing

activ

ities

This depreciation would tend to:A make Australian exports cheaper in the US relative to the

price of imports in AustraliaB decrease the burden of repaying interest on the foreign debtC cause a rise in the unemployment rate in the export sectorD slow the rate of domestic economic activity.

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 Aus-tralian dollar in the foreign exchange market.

B The RBA dramatically increases its buying back of govern-ment securities in the short-term money market and tries topersuade the financial sector to increase lending.

C The RBA cuts its net sales of government securities in theshort-term money market and increases its support of theAustralian dollar in the foreign exchange market.

D There were attempts by the RBA to discourage lending bythe financial sector.

Question 5

Nowadays, public confidence in and the security of householdsavings which are deposited in the financial sector are partly

protected by:A RBA variations in liquidity ratiosB the Australian Prudential Regulation Authority (APRA)

which monitors capital adequacy and the management ofliquidity

C both (A) and (B)D neither (A) nor (B).

Question 6

Measures involving the financial sector which can have a ben-

eficial supply-side effect on cost inflation may include:A a dirty float to support or drive up the Australian dollarB the extension of competition in and continued deregulation

of the financial sectorC neither (A) nor (B)D both (A) and (B).

Question 7

Faced with high and rising cyclical unemployment and no threatof inflation, the RBA would most likely:A undertake operations in the short-term money market

designed to achieve a lower cash rate targetB increase support for the Australian dollar involving buying

our dollar in the foreign exchange marketC talk down financial sector lendingD try all of the above measures.

Question 8

In itself, which one of the following measures would not beappropriate for the Australian economy experiencing 5 per centeconomic 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 oper-ations.

B The RBA increases its net repurchases of governmentsecurities in the short-term money market as part of itsmarket operations.

C There should be discouragement of lending by the financialsector.

D The RBA buys the A$ in the foreign exchange market.

Question 9

In 2002–06, the RBA sought to achieve a higher official cashrate target. During this time, it increased official interest ratetarget on eight separate occasions because:A demand inflation was lowB the unemployment rate was risingC economic activity was slowingD significant unused productive capacity did not exist in the

economy.

Question 10

In 2004–05, the RBA was involved with intervention in theforeign exchange market involving net sales of Australiandollars. Externally, this would tend to:A increase the CADB improve the terms of tradeC help exportersD 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 effectivenessand introduction of a contractionary monetary stance in pro-moting domestic economic stability during a period of rapidlyrising economic activity?A The existence of very strong consumer and business confi-

denceB A forthcoming election which is tipped to be very closely

contestedC Already high levels of structural unemploymentD All of the above

Question 12

Which of the following is unlikely to be a constraint on the effec-tiveness 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 measuressuch as tax cuts, increased welfare outlays or public works.

B Monetary policy may be weakened by crowding out in arecession typically caused by budget deficits financed bydomestic borrowing.

C Monetary policy is subject to the same financial constraintsin boosting AD as large budget deficits.

D Monetary policy is subject to time lags in recognition, imple-mentation and impact.

Question 13

When the RBA sets out to achieve a higher cash rate target inthe short-term money market, this might have an adverseimpact on the efficiency in resource allocation due to the factthat higher interest rates:


school ass

ess

ment

task

s an

d l

earn

ing

acti

vit

ies

A worsen demand inflation pressuresB cause the wasteful unemployment of labour and capital

resources to decreaseC Australian firms will become more cost competitive abroadD have an adverse supply-side impact and discourage invest-

ment in new plant and equipment incorporating the latesttechnology.

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 tobasic goods and services.

C The failure of the RBA to effectively control inflation (e.g. inthe 1980s) could cause an arbitrary redistribution of incomeaway from buyers and sellers of assets in favour of exporters.

D The RBA is required by government to deliver an annualaverage inflation rate of around 2–3 per cent (as measuredby the CPI) over the economic cycle.

Question 15

Concerning the RBA’s monetary policy stance between 1996–97and 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 indirectly helping to achieve:A improved equity in the distribution of incomeB strengthening efficiency in the allocation of resourcesC price stability and then perhaps fuller employmentD external stability.

Question 17

The main reason for the RBA conducting a dirty float is usually:

A smoothing out unwanted and uninformed changes in theAustralian dollar

B to achieve a particular target level for the exchange rateC to curb spending on importsD to encourage exports.

Question 18

If the RBA takes action to increase domestic interest rates, thiswill not tend to cause:A structural unemploymentB cost inflationC demand inflationD increased overseas borrowing and reduced price competi-

tiveness of our exports.

Question 19

Regarding monetary policy’s general application, which state-ment is incorrect?A A tighter monetary policy during periods of rapid demand

inflation may in some ways increase equity in the distri-bution of income.

B A tighter monetary policy can slow household and businessspending on imports, thereby helping in some ways toreduce the CAD.

C In the long term, using monetary policy to improve pricestability provides an economic climate where there is betterbusiness confidence, increased productive investment andgreater competitiveness to enhance the sales of locallyproduced goods and services.

D When the RBA undertakes market operations designed toincrease domestic interest rates, the exchange rate for theAustralian dollar usually tends to depreciate.

Question 20

Which of the following reforms involving regulation of thefinancial 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 othermajor financial institutions.

Question 21

Given the following information, what combination of monetarypolicies (Nos 1–IV) may be most effective in promoting betterdomestic and external stability?

II(I) Increased RBA net sales of government securities in theshort-term money market

I(II) Increased RBA net repurchases of government securitiesin the foreign exchange market

(III) Increased purchases of Australian dollars by the RBA inthe foreign exchange market

(IV) Persuasion by the RBA to encourage financial sectorlending

A Answers (I) and (III)B Answers (II) and (IV)C Answers (II), (III) and (IV)D None of the above.

ECONOMIC INDICATOR ANNUAL %

CAD:GDP ratio (%) 4

CPI (%) 9

GDP growth (%) 6

Unemployment (%) 3


school a

ssessm

ent ta

sks a

nd

learn

ing

activ

ities

Question 22

A budget surplus is likely to help:A reduce interest ratesB cause the Australian dollar to depreciateC reduce unemploymentD ‘crowding out’ of private sector borrowing.

Question 23

If the RBA sold Australian dollars in the foreign exchangemarket to affect the exchange rate, this would be likely to cause:A increased exportsB increased importsC increased Australian investment abroadD all of the above.

Question 24

If the RBA’s policy fails to keep Australia’s inflation rate belowthat of our major overseas competitors, the likely result could be:A a worsening CAD and a depreciating exchange rateB a rising NFD and a reduced credit ratingC both A and B aboveD neither A nor B above.

Question 25

The measure of the volume of money called broad money refersto:

A coins and notes in the hands of the non-bank publicB the value of all bank deposits and cashC the measure, M3D the value of all cash in the hands of the non-bank public,

bank deposits and net deposits held in non-bank financialinstitutions.

Question 26

The most severe constraint which operates when the RBA cutsinterest rates to stimulate domestic economic activity is:A a likely weakening of the exchange rate and a rise in

inflation

B the conflict with equity in income distributionC a generally adverse political reactionD the decline in the RBA’s holdings of overseas reserves of

currencies.

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 institutionsduring the mid to late 1990s and early 2000s saw:A generally reduced profit margins on each dollar of bank

lending than in some periodsB lower interest rates and a lending war on home loansC increased trading hours by some financial institutions to

improve customer serviceD all of the above.

Question 29

Following market operations by the RBA, increased interestrates are most likely to:A increase domestic savings but reduce investment spendingB increase consumption and unemploymentC reduce the inflow of foreign investment recorded initially as

a credit on the financial account of the balance of paymentsD cause all of the above.

Question 30

If economic growth was at 2 per cent and the inflation rate wasrising by 1.2 per cent, the RBA would probably:A tighten its monetary policy stanceB loosen its monetary policy stanceC not change its monetary policy stanceD start by tightening its policy stance before easing it.

SHORT-ANSWER test questions

Instructions: Your teacher may direct you to complete a selectionof the following questions. These questions should be usefulpreparation for the end-of-year examination.

Question 1

A Define monetary policy. (2 marks)B Briefly outline the economic role played by Australia’s finan-

cial 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 effec-

tiveness of financial sector deregulation. (2 marks)

Question 2

A Read the following extract taken from a RBA Statement onmonetary policy in 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)

‘. . . 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.


school assessm

ent

tasks a

nd

learn

ing

acti

vit

ies

B Read the following media release about monetary policyfrom the RBA in August 2006.

Referring to this statement by the RBA:(a) What specific demand-side factors at this time (extra

research needed here using the RBA website) werecausing domestic and international spending to rise sostrongly? (4 marks)

(b) Explain how these domestic and international factorswere contributing to inflationary pressures in aneconomy where there was little spare productivecapacity. (2 marks)

(c) How would the rise in the cash rate target by 0.25 percent to 6 per cent, help to slow inflationary pressurescoming from domestic and international sources? (4 marks)

(d) Outline two constraints or weaknesses of increasing thecash rate target in this way. (4 marks)

(e) In determining the stance of monetary policy, outlinethe main reason why priority is given to fighting inflation.(2 marks)

Question 3A 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)

C Assume that the RBA decided to increase its cash rate target.Clearly explain the process used by the RBA to push upinterest rates. Illustrate this approach using a labeleddemand–supply diagram representing the short-term moneymarket 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$ inthe 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 4A Examine figure 6.10 showing recent rises in the RBA’s cash

rate target. Describe what has happened to the cash ratetarget over these years. (2 marks)

B The RBA uses a checklist approach to help determine its policystance. List and briefly explain three important factors on thischecklist, that the RBA may have taken into account beforemaking its decision to lift the cash rate target between2002–07. (4 marks)

C Assume that the RBA decided to raise its cash rate targetbecause 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 thetransmission mechanism.

(c) Explain one disadvantage of the RBA’s decision toincrease interest rates.

D Referring to the previous question, discuss the main econ-omic advantage and the main disadvantage of the RBA’sdecision to raise its cash rate target during these years. (3 marks)

E Identify and explain an alternative to monetary policy thatcould be used to reduce the inflation rate.

F Explain how a rise in interest rates by the RBA would tend toaffect 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.

Figure 6.10 RBA official cash rate target

Source: Data derived from RBA Bulletin.

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.

0

2

4

6

8

Cash

rate

targ

et

(%)

20032002 2004 2005 2006 2007

January

Febru

ary

March

Apri

lM

ay

June

July

August

Septe

mber

Octo

ber

Novem

ber

Decem

ber

January

Febru

ary

Marc

h

Apri

lM

ay

June

July

August

Septe

mber

Octo

ber

Novem

ber

Decem

ber

January

Febru

ary

Marc

h

Apri

lM

ay

June

July

August

Septe

mber

Octo

ber

Novem

ber

Decem

ber

January

Febru

ary

Marc

h

Apri

lM

ay

June

July

August

Septe

mber

Octo

ber

Novem

ber

Decem

ber

January

Febru

ary

Marc

h

Apri

lM

ay

June

July

August

Septe

mber

Octo

ber

Novem

ber

Decem

ber

January

Febru

ary

Marc

h

Apri

lM

ay

June


school a

ssessm

ent ta

sks a

nd

learn

ing

activ

ities

Statistical data relating to Australian domestic conditions

Sources: Data derived from ABS 1350.0, RBA Bulletin.

G Select one of the following events and explain why this wouldcause the RBA to tighten its monetary policy stance, and onethat would cause the RBA to loosen its stance. (2 + 2 = 4marks)(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 thatfollow.

Quoting supportive statistical data from table 6.6, answerthe 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 unem-

ployment rate and the cash rate target? (2 marks)I Imagine that Australia was faced with both strong inter-

national rates of economic growth on the one hand, andvery weak domestic spending on the other. Explain howthese developments might influence the RBA’s monetarypolicy stance or settings. (6 marks)

Question 5

A Examine table 6.7 before answering the questions thatfollow.

What relationship appears to exist between the cash ratetarget and the exchange rate for the A$? Explain your reasoning

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.

Figure 6.11 Trade weighted index (TWI)


(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


YEAR1999–2000

2000–01

2001–02

2002–03

2003–04

2004–05

2005–06

2006–07

2007–08

RBA cash rate target at 1 July each year (%)

4.75 6.00 5.0 4.75 4.75 5.25 5.5 5.75

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

Table 6.6

40

45

50

55

60

65

70

TW

I in

dex f

or t

he A

$

1999–2000

1998–99

1997–98

1996–97

2000–01

2001–02

2002–03

2003–04

2004–05

2005–06

2006–07

2007–08

YEAR2002–

032003–

042004–

052005–

062006–

072007–

08

RBA cash rate target at 1 July each year (%) 4.75 4.75 5.25 5.5 5.75

Exchange rate for the A$ at July each year (TWI, 1970 = 100)

50.9 58.3 60.2 64.3 63.9

Table 6.7


school assessm

ent

tasks a

nd

learn

ing

acti

vit

ies

(c) Suggest two likely reasons for the general rise in theTWI 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’sattempts to artificially push up the exchange rate. (4 marks)

C Explain how higher interest rates might on the one handimprove 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 reducingthe size of Australia’s CAD. (4 marks)

Question 6

A What is an efficient allocation of resources? How might therecent rise in interest rates by the RBA (e.g. 2002–06), affectefficiency in Australia’s allocation of resources? (4 marks)

B Why might a reduction in interest rates by the RBA, help toincrease efficiency in resource allocation? (2 marks)

C Identify and explain one important constraint of using mon-etary 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’sefficiency in resource allocation? (2 marks)

Question 7

A ‘Individuals are affected differently by government policy’. Explainhow the distribution of income would be affected by each of thefollowing 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 stab-ility also helps to promote equity in income distribution.(6 marks)

C Monetary policy in general and interest rates in particular, isnot the most effective policy to improve equity. Outline amore effective policy. (6 marks)

AN essay

As noted already, SAC 1 for Unit 4 could require students tocomplete an essay about the nature and operation of a govern-ment macroeconomic policy. Having just completed chapter 6,you are now in a position, if directed by your teacher, to write anessay about how monetary policy can be used to manage theeconomy. A research essay about monetary policy may be struc-tured as follows:� provide a clear definition of monetary policy� define domestic economic stability and then discuss how mon-

etary policy can help achieve this objective, illustrating this byreference to recent monetary policy

� define what is meant by external stability and then discuss oneimportant strength and one important weakness of recentmonetary policy in helping to achieve this objective

� define efficiency in resource allocation and then discuss oneimportant strength and one important weakness of recentmonetary policy in helping to achieve this objective

� define equity in the distribution of income and then discussone important strength and one important weakness ofrecent monetary policy in helping to achieve this objective.

Students should be encouraged to use tables and graphs, andquote recent supportive evidence including that from recentRBA Monthly bulletins and Annual reports (see RBA’s website), thepublications of major private banks, the media and othersources.

OR

� Define internal and external stability for the Australianeconomy.

� 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 Aus-tralian economy?

� What effect would recent changes in macroeconomic policyhave on external stability and the size of the CAD?

A WRITTEN report

As noted already, SAC 1 for Unit 4 could require students tocomplete a structured report about the nature and operation ofa government macroeconomic policy. Having just completedchapter 6, you are now in a position, if directed by your teacher,to write a report about how monetary policy can be used tomanage the economy. The report could perhaps be structuredalong 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 stab-ility for Australia.

2. In theoretical terms, explain how monetary policy can be usedto pursue domestic (internal) stability in an economy. How

does the achievement of domestic (internal) stability help theachievement of external stability?

3. Explain clearly how the RBA changed its monetary policystance between 2002 and late 2006 to help improve domesticeconomic stability in Australia. Illustrate your answer byincluding and referring to tables and graphs of (e.g. officialinterest 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 ofexternal stability. How might the decision to lift officialinterest rates several times in 2006 be expected to affect theachievement of external stability?


school a

ssessm

ent ta

sks a

nd

learn

ing

activ

ities

5. Identify and clearly explain two important constraints of mon-etary policy involving higher interest rates in 2006.

OR

Using monetary policy to promote efficiency in resourceallocation1. 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’sresources.

3. Identify and explain the important means whereby monetarypolicy tended to increase efficiency in Australia’s resourceallocation between 1996 and 2007.

4. Identify and explain two important constraints that may havelimited the effectiveness of monetary policy in promotinggreater efficiency in the allocation of Australia’s resourcesbetween 2002 and early 2007. Illustrate your answer by refer-ence to actual examples of monetary policy.

OR

Using monetary policy to promote greater equity in personalincome distribution1. 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 toactual details of recent monetary policies, explain theoreti-cally how this can occur.

3. Between 2002 and early 2007, the RBA increased the cash ratetarget eight times. Explain clearly how these rises in interestrates would be likely to affect the distribution of income fromthe point of view of the following groups of individuals in Aus-tralia:� the unemployed� self-funded retirees� businesses and exporters� ordinary families� asset speculators.

4. Compare the likely effectiveness of monetary policy withbudgetary policy for promoting a more equitable distributionof income in Australia.

OTHER learning activities

Have you tried the following learning activities in your classrecently?

1. Web QuestVisit the website for this book and click on the weblinks forthis chapter (see Weblinks page 310). Use the Internet forresearching 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 inter-active game or set up a competition where the aim is to maxi-mise economic stability in a virtual economy.As always, teachers are strongly advised to check all website

addresses listed in this text for suitability, appropriateness ofcontent, operation and accuracy, before asking students toconduct 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 classpresentation.

� Get students to prepare a set of PowerPoint slides about thenature and origin of money. Use these for a class presen-tation.

4. Newspaper reportsPhotocopy or go onto the Internet to source a newspaper reportabout a recent change in monetary policy. Students could sum-marise the report, make a checklist of indicators affecting thedecision, possibly identify bias in the report, or expand on whathas been said in the article.

5. Graphs as wall chartsOn a regular basis, students could be asked to prepare and thenupdate wall charts showing trends in monetary variablesincluding:� 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 playSet up a mock board meeting for the RBA. Work out subcommit-tees where board members (students) have to research, before-hand, trends in the key checklist indicators for monetary policyduring the past 12 months. In the actual meeting, each studentor group should present a 2–3 minute report about their par-ticular indicator, followed by general discussion by all boardmembers of the case for and against a change in the cash ratetarget. 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


school ass

ess

ment

task

s an

d l

earn

ing

acti

vit

ies

� 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 Mon-etary Policy (giving reasons for the board’s decision) for releaseto the media.

Source: The basic idea for this role-play came fromEconomics, VCE Study design.

7. Crosswords

Construct a crossword using terminology and knowledge aboutrecent monetary policy and how it may help to promote

internal stability, external stability, efficiency in resource allo-cation and equity in personal income distribution. Use theInternet for software that makes this task easy.

8. Team quizDivide the class into teams. Within a team, members can consulteach other when it is their turn to answer questions about mon-etary policy that the teacher (or students) has previouslywritten. The winning team may be awarded a prize. A variationof this is the Economics Wheel of Fortune, using numbered ques-tions and token prizes.

chapter 6

CHAPTER 6 Economic management using macroeconomic monetary policy

Summary

235

sum

mary

What is monetary policy?

Monetary policy relates to measures of the RBA involving theregulation of the nation’s money and the rate at which creditflows between the financial sector and the rest of the economy.The main instrument of monetary policy is changes in the cashrate target implemented using market operations, but the RBAalso has the capacity to influence/smooth out the exchange rateusing a dirty float and to use persuasion to affect the generallevel and direction of lending by the financial sector. Monetarypolicy is normally classified as a macroeconomic policy since it ismainly aimed at regulating AD.

Aims/priorities of monetary policy

In recent times, the main aim of monetary policy is inflation tar-geting or the pursuit of price stability (CPI target of 2–3 percent a year). However, once this goal is achieved, other aimsincluding economic growth, full employment and external stab-ility can become a focus for RBA policy.

Using monetary policy to promote domestic stability

Theoretically, monetary policy can help increase domestic economicstability if it is applied as a counter-cyclical measure designed tosteady the increase in AD. Hence, the monetary policy stance isusually tightened to slow AD when inflation approaches or startsto exceed the inflation target (e.g. eight rises in the cash ratetarget between 2002 and early 2007), but then it is often easedto stimulate AD when inflation falls below the target and growthand employment slow excessively (e.g. six cuts in official interestrates during 2000–01). In this way, commentators note thatthere have generally been improved levels of domestic econ-omic stability (with good growth, fairly stable prices and fulleremployment) recently between 1996–97 and early 2007. Usingmonetary policy in these ways depends on transmission mech-anism. These have to do with the way a higher or lower cash ratetarget/interest rate affects the economy. For example, a rise inthe cash rate target by the RBA will slow inflation by increasingsaving, reducing C and I spending, AD, shortages of goods andservices and general prices. Higher interest rates also reduceinflation by pushing up the exchange rate and depressinginflationary expectations. However, monetary policy faces con-straints including time lags in impact, indirectness, bluntness/imprecision, overseas events, the psychological outlook and theconflict between government objectives.

Using monetary policy to promote external stability

Theoretically, monetary policy can help improve external stability inseveral ways. Most importantly, a more contractionary stance(i.e. higher interest rates) during a cyclical upswing in economicactivity can help avoid a blow-out in the CAD by slowing exces-sive expenditure and controlling domestic inflation. There isalso the added bonus (once inflation is controlled), that cuts indomestic interest rates make overseas borrowing relatively lessattractive helping to slow the NFD and CAD. Recent policy hasgenerally been applied in this way. However, its effectiveness hasbeen limited by external constraints and the existence of con-flicts between the various government objectives. Higher dom-estic interest rates push up the A$. While this slows inflation, itincreases the CAD by making imports relatively cheaper andexports dearer. For some firms, higher interest rates add to pro-duction costs and make exports less competitive.

Using monetary policy to promote efficiency

Theoretically, monetary policy can help improve efficiency in resourceallocation. First, it can help regulate AD in an attempt to limitinflation and unemployment, so that these problems do notresult in inefficiency. Second, when it is possible to reduceinterest rates because inflation and expectations have been sub-dued, the cost to business of purchasing new and more efficientplant and equipment, involving better technology, is made moreattractive, encouraging stronger productivity. Again in recentyears between 1992–93 and 2007, monetary policy generally hasdone these things. While not really a monetary policy, financialderegulation has also been an important efficiency developmentinvolving the financial sector. Unfortunately, there are con-straints on monetary policy’s effectiveness including the conflictbetween some objectives, time lags and external events.

Using monetary policy to promote equity

Theoretically, there are only indirect ways whereby monetary policycan promote equity. Most importantly, the counter-cyclical appli-cation of monetary policy can help curb inflation and unemploy-ment, both of which are really detrimental to equity in thedistribution of income and wealth. In recent years, monetarypolicy has done this fairly well. However, monetary policy suffersfrom constraints including long impact time lags, external eventsand its inability to redistribute income in a specific way relativeto the precision and directness of budgetary policy.


CONCEPT MAP 6 Economic management using macroeconomic monetary policy

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.

Monetary policyReserve Bank of Australia (RBA) measures that mainly affect the demand and supply of credit

chapter 6 · Bank of Australia (RBA), involving the ... CAPITAL MARKET Nature and structure of the...

Documents

Transcript of chapter 6 · Bank of Australia (RBA), involving the ... CAPITAL MARKET Nature and structure of the...