Monetary Policy Essay

Monetary Policy Activity

At its meeting today, the board decided to drop the cash rate by 25 basis points to 2.0%. This will be carried out through the loosening of monetary policy, which involves the purchasing of CGS’s back from domestic banks and financial institutions in exchange for an increase in funds into the respective banks exchange settlement (ES) accounts. The ES is a compulsory account, which all banks have with the RBA in which all payments between the banks and the RBA take place. For example if a Comm Bank customer uses a check to buy a good from a business, which has a Westpac account, the funds will have to come from Comm bank’s ES account into Westpac’s ES account. In order for this to occur some banks will have to borrow funds from other banks in order to settle these transactions and are then charged an interest rate on these loans. This is where the loosening of monetary policy takes effect, as the purchasing of CGS’s increases the money supply in the short term money market and therefore decreases the level of the cash rate and interest the banks have to pay on their borrowings. The lower cash rate causes competition amongst the banks leading to them passing on this saving to their customers in the form of lower lending interest rates.

The decision to drop the cash rate will have various effects throughout the economy. The process by which monetary policy impacts upon the economy is referred to as the transmission mechanism, which works to explain how changes in the stance of monetary policy work to achieve economic objectives. The greatest effect that the reduction in the cash rate will be on the demand for credit within the economy. The lower interest rate will make it cheaper for consumers to borrow extra capital to fund purchase of property or consumer goods and also for businesses to borrow to fund investment in capital or plant expansions. This increased borrowing leads to an increase in consumption and investment demand in the economy resulting in an increase to the level of spending and eventually increased economic growth. The lower interest rates also make existing loans servicing costs cheaper for households and businesses which increases their spending power and allows for additional spending, thus further increasing economic growth. The lower interest rates also makes the $AUD less desirable for foreign investors as its value would be lower relative to other foreign currencies. This depreciation would increase the international competitiveness Australian exports as its prices are cheaper for international importers and also domestic consumption of Australian products would increase due to the increase in import prices thus improving Australia’s balance of goods and services, level of CAD and increasing the level of economic growth. The increase in aggregate demand and economic activity will lead to increased output and increased demand for labour which will decrease the unemployment rate. However this increase in labour demand will cause an increase in the value of real wages and accommodated by an increase in prices, leading to demand-pull and cost-push inflation.

Recent economic growth figures have indicated that the Australian economy is growing below trend at 2.5%, which is below our target of 3-4%. This has resulted in an unemployment rate of 6.1%. Although during the month of April unemployment decreased by 0.2% from 6.3% there is still a degree of spare capacity in the labour market with wage pressures remaining contained keeping inflation low. This low unemployment rate is a result of low consumer confidence leading to decreased demand for businesses products. The reduction in the cash rate will work to induce customer spending habits, increase demand for businesses products and thus increase the demand for labour. Even with a sustained level of low interest rates over the last few months inflation has remained low at 1.7%, which is below the target of 2-3%. Low levels of

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