Economics Assignment Help Essay Writing Review Analysis: RBI Monetary policy and Interest rate
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Summary
Amidst the tumultuous world economy, decline in the inflation rate to 1.2 per cent in the past financial year, came as a relief to the government. It is much below the rate of inflation targeted by the Reserve Bank of Australia of around 2-3per cent. Treasurer Wayne Swan claims that the current excellent condition of Australian Economy can be attributed to the effort of the current government. However, Shadow treasurer Joe Hockey commented that the decline in the inflation rate does not reflect good times for the population. While goods like fruits vegetables and staples have become cheaper, it has been cited that the lowering of prices has been majorly on account of imported goods. Most of the unavoidable expenses including childcare, education, rent and electricity bills and goods produced within Australia have shown an upward trend. Hence, the economy is exposed to the price of import goods, an increase in which could turn the tables again. Nonetheless, the reduction in inflation rate has raised the expectations of cut in the interest rates. It has compelled most of the economists to put on their thinking caps and ponder over the issue whether interest rates be further relaxed. (THE SYDNEY MORNING HERALD, 2012)
Discussion
This tactic of cutback in the interest rates when the inflation rate prevailing in the economy is lower than that targeted by the Central Bank of the country was proposed first by Mr. John B. Taylor and hence is known as Taylor Rule. (KUDLACEK, Sandra) The responsibility of altering the interest rate forms a part of monetary policy of Reserve Banks of Australia whose objective is to maintain ‘price stability, full employment and economic prosperity’ of the Australian population. The Reserve Bank acts through adjusting the cash rate on the basis of which banks alter their rates of lending as well. (RESERVE BANK OF AUSTRALIA, 2012) This essay aims to understand the situation and analyze various factors that might be taken into consideration by Reserve Bank to come up to a conclusion.
Interest rate is considered as a tool to alter the money supply in an economy and hence change in the interest rate level affects the level of economic activity. Interest rate affects both the demand as well as the supply side of an economy. While reduction in interest rate percolates to the lending rate making it cheaper for the consumers to take loans from the banks, the consumers themselves would no longer have the incentive of saving money as well, as the deposit rate would also decline resulting in lower return on savings. (INVESTOPEDIA, 2012)This results in the expansion of demand created by household as the consumers would be encouraged to use more and more money for transaction purpose rather than holding it for speculative purpose. On the other hand, lower interest rates make it easier for the producers to borrow and expand their production, gradually leading to increase in supply in the economy. Subsequently, the national output as well as price level in the economy rises which is why reduction in interest rate is also termed as inflationary monetary policy. The same is reflected by Fig 1 where both aggregate demand and aggregate supply curve have shifted to the right leading to increase in national output as well as price level.
The last quarter inflation figure gives the central bank a lee way to drop the interest rate to boost the economic activity and facilitate growth of the feeble manufacturing sector.
Spur in economic activity would further lower the unemployment level from the current level of 5.2 per cent. (AUSTRALIAN BUREAU OF STATISTICS, 2012) Lowering of unemployment level and increased production would translate into increase in disposable income of the population resulting in further increase in demand created by the household. Hence, lowering of interest rate will have a multiplied effect as stated in Keynesian Economic theory.
Additionally, need for reduction in interest rate has increased manifold due to the current uncertainty in the global environment. With resources like iron ore and coal accounting for major chunk of exports for the economy and mining being a major contributor to the GDP, reduction in world production would bring bad news for the economy as well. In the present scenario, where most of the major export destination including China, Japan and U.S., have shown sluggish growth with no signs of recovery, the external demand have shown a downward trend. Hence, the onus of creating domestic demand and driving growth has to be taken up by the central bank through rate cuts. (BBC NEWS, 2012)
Cut in interest may affect the consumers in several other ways as well. As cited in the article, the rising price of property is also a key problem. Decline in interest rate may offer solution to consumers as it may lead to lower mortgage payment and hence lower prices.
Lowering of interest rate would also affect the exchange rates. Lower interest rate would imply low return on investment by foreigners, who may start pulling out from Australia. Flight of foreign investment from the country may put pressure on the Australian dollar leading to depreciation of the currency. This would make imported goods expensive for the people leading to decline in the domestic demand for imported goods and at the same time increase the competitiveness of the local producers vis a vis their foreign counterparts, resulting in increase in export demand. It would help in improving the balance of trade significantly which has reversed from being around AUD 3000 million in July 2011 to negative value in July 2012. (TRADING ECONOMICS, 2012) Domestic demand for goods produced locally within the country would also escalate in the backdrop of increasing price of imported goods.
Conversely, depreciation in the local currency may also hinder the growth of the economy as their might be paucity of funds available for producer to borrow when the foreign saving are drawn out. Moreover, the gross foreign loans, which amounted to around USD 1,253 bn in 2010 and was around 93 per cent of the gross domestic product (PAYNE, Alan, 2011) would become expensive disturbing the financial stability of the economy. Besides, around 85 per cent (PAYNE, Alan, 2011) of the foreign loans are owned by the private sector and may hamper their growth further.
Moreover, there is always the risk of inflation as the side effect of an inflationary monetary policy. Even though the past year’s inflation figures is even below the target inflation rate of the Reserve Bank of Australia, it might show a reversal in the trend in the current fiscal. The cost of energy and food processing may show a hike due to decrease in dollar level. Moreover, the decline in the consumer price level was largely due to decrease in price of imported items which have already shown an increase of around 0.7 (THE SYDNEY MORNING HERALD, 2012) per cent in the past three months. Hence the Reserve Bank may be very cautious in taking any steps.
Nevertheless, any effect of change in interest rate can be felt in the economy only after a while. In the current scenario where the Reserve Bank has already cut the interest rate by 0.75 per cent (THE SYDNEY MORNING HERALD, 2012) in the last 3 months it is likely that they would adopt a wait and watch strategy to see the effect of the previous cuts before they make any further slash in the rates.
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