GDP OF RESERVE BANK OF AUSTRALIA

QUESTION

SOLUTION

Pressure builds on RBA to cut rates
Summary:
This article (Wright J, Ireland J, 2012) highlights the problem that the country is facing due to high interest rates and its effect on the economy and the role of the Reserve Bank of Australia (RBA) in monitoring the economic environment in the country. Most of the bankers and economists have ridiculed the RBA for not cutting its rates in the recent monetary policy review (the current cash rate is at 4.25%) and are demanding a rate cut in order to improve economic conditions. The article states the viewpoints of the unions and the business groups that have been affected due to the low consumer and business confidence. It focuses mainly on the additional pressure on the RBA to slash down key policy rates like cash rate which would provide a relief for the borrowers by decreasing their interest cost. It is clearly mentioned that there is a decline in demand for home loans which adds to the problems that the country is facing. Moreover, the RBA Governor Glenn Stevens indicated that the decision to cut the rates depends upon the inflation outlook. It concludes by stating the importance of the monthly jobs data which if indicate higher unemployment then the pressure on RBA would further increase.
Analysis:
The article highlights many macroeconomic factors that affect an economy. First of all, an economy of a country is defined as the wealth and resources of the country in terms of goods and services that are being produced and consumed. An economy is measured either in terms of Gross Domestic Product (GDP) or Gross National Product (GNP). Both of these indicate the value of goods and services produced or provided in/by a country within a year. The article does not talk about GDP/GNP, but it does talk about the factors which will affect these figures and the economy.
The article’s primary focus is the monetary policy which is the responsibility of the Central Bank (the RBA) of a country. The objective of a monetary policy is to control the supply of money in the market in such a way so as to promote growth and curb inflation (the increase in the prices of goods and services) at the same time. The article cites two contrary views on the role of the RBA. First, the unions and the business groups accuse the RBA for not acting in their interests as they are being affected by higher rates of interest and low consumer demand in the market. On the contrary Professor McKibbin argues that cutting interest rates is not an effective tool to improve economic conditions.  As a fact it is true that due to high costs in the manufacturing industry, unions are facing problems like unemployment and the business groups are incurring losses due to sluggish demand for their goods and services in the market. The figure below explains the impact of change in interest rate:

Figure 1: Mapping out the transmission mechanisms: the effects of change in interest rates (tutor2u)
One of the main tools used by the RBA to control the money supply is increasing or decreasing cash rate, which is the rate of interest charged on overnight borrowings between financial intermediaries (Reserve Bank of Australia). The figure above shows that a decision of changing interest rates affects the GDP of the country through various intermediate steps. The change in interest rates would affect adversely or in favor of different parties involved depending on the business cycle the economy is in. For example, a cut in interest rates in a recessionary economy would result in decrease in borrowing rates for common man as well as business groups, which would  encourage people to spend and invest which further increases the demand of goods and services and as a result the production also increases. Hence, the economy recovers due to the chain of reactions just explained due to decrease in interest rates. The effect of increase in interest rates in a recessionary economy would drive the economy further into recession. Therefore, it is necessary to understand the mechanisms of the change of interest rates. Other than the GDP, interest rate change also affects the exchange rate. In the above example, it would result in increase of foreign flows, thus, increasing the demand of the local currency and making imports cheap (exports costly). The monetary policy targets the Investment and indirectly affects the Consumption and the Net imports and exports of a country. It can, therefore, be inferred that the monetary policy aims the GDP as a function of expenditure:
GDP = C+I+G+NX
Where C-Consumption,
I-Investment,
G- Government Spending, and
NX- Net of imports and exports
The current scenario in Australia is such that if RBA doesn’t announce a cut in the cash rate, it might result in more unemployment and might affect the production of goods and services due to high cost, impeding the economic growth. According to Keynes’ theory, full employment is said to exist if anyone who want jobs get employed, however, in a recessionary economy with increase in costs and decrease in demand, firms are forced to fire employees resulting in involuntary unemployment. The article points out that an increase in unemployment figure would put additional pressure on the RBA to cut rates. As explained above RBA’s decision to cut rates would trigger investment by the private sector and would result in higher employment.
Apart from the above mentioned issues, the article mentions issue related to consumer confidence and expectations in the market. This can be explained by the relation between money supply, interest rates and aggregate demand curve. The aggregate demand curve (shown below) is a graph between the price level of all the goods and services (y-axis) and the x-axis represents the real GDP.

Figure 2: Shifts of the aggregate demand curve (cliffsnotes)
With increase in price level, assuming constant money supply (cliffsnotes), the purchasing power of the money falls, as a result the demand for the goods and services decline, thus, the downward-sloping nature of the curve. A decrease in consumer confidence indicates a decrease in the aggregate demand of goods and services, which can be explained by a parallel shift in the above figure (AD1 to AD3). There is a contradiction here as the article suggests the interest rates are expected to fall, thus, the aggregate demand curve should shift to right, however, it is clearly mentioned that the households have a negative expectations about the economy. In such cases, it is very important for the RBA to consider the effect of cutting the interest rates on the real GDP.
The Governor of the Reserve Bank of Australia has announced that the decision to cut the interest rates would depend on the inflation outlook which would be published by 24th April 2012. This indicates that the central bank has been taking precautionary measures in order to ensure that the inflation doesn’t impede growth. It would be difficult to predict the decision of the RBA would be, but it can be definitely said that the interest rates will not be increased in the coming quarters. The RBA can, however, keep the cash rate constant in the next monetary policy review due in May in order to meet the objective of stable growth and controlling inflation simultaneously.

Article:
Pressure builds on RBA to cut rates
Jessica Wright and Judith Ireland
April 11, 2012

Unions and business have joined forces to pressure the Reserve Bank to cut the cash rate as consumer confidence hits its lowest level in eight months.
But former RBA board member and now Australian National University economics academic Warwick McKibbin has cautioned that rate cuts are not an economic cure-all.
Australian Manufacturing Union national secretary Paul Howes called on the Reserve Bank of Australia today to cut interest rates by between 0.25 and 0.5 percentage points when it meets on May 1.
So far this year, the central bank has kept the cash rate unchanged at 4.25 per cent.
Ahead of a meeting today of steel worker union delegates, Mr Howes said that the RBA had consistently “got it wrong” on rates decisions and that the “lack of action” on monetary policy largely responsible for the manufacturing industry’s woes.
“The RBA has made the wrong call consistently,” Mr Howes said.
“For some bizarre reason in this country, it seems like it’s religious heresy to criticise the decisions of the RBA.”
Mr Howes has been joined by the Australian Chamber of Commerce and Industry (ACCI), which has called for an 0.5 percent cut.
ACCI chief executive Peter Anderson said the RBA should cut the cash rate when the board meets in a bid to arrest declining competitiveness and help low business and consumer confidence.
“The time has come for Australia’s central bank to move decisively to cut rates by a full half a per cent, and for the retail banks to immediately pass it on,” Mr Anderson said in a statement.
“A quarter of a per cent cut would not be enough to do what is required. There needs to be significant and unambiguous signal, to support activity and to lift confidence across the next quarter.”
The RBA last cut rates in November and December 2011.
In his statement reporting no rate cut for April, Reserve Bank Governor Glenn Stevens hinted at a May cut if key prices data – due on April 24 – changed the inflation outlook.
But the ANU’s Professor Warwick McKibbin – who was on the RBA board until mid last year – has defended the Reserve Bank’s recent decisions to hold the cash rate.
“The danger here is that we cut rates too much and we think that monetary policy is going to solve the problem,” he told ABC radio.
“The problem is that the real exchange rate in Australia has to appreciate. That’s part of the adjustment process. You can either get that through a strong currency or you can get it through high inflation.”
Professor McKibbin said that the union movement could do more to help manufacturing, arguing that wages were too high.
“If the union movement were serious about saving manufacturing then they would pull back from some of the industrial action that’s going on,” he said.
“They would lower the real costs of labour in some of these sectors and they would work with industry to try and solve the problem.”
Climate Change and Manufacturing Minister Greg Combet declined today to comment on the RBA’s rates stance.
“That is a matter for the Reserve Bank that operates independently,” Mr Combet told reporters in Melbourne.
The rates stoush comes as new figures show consumer sentiment has fallen to its lowest level in eight months.
The Westpac/Melbourne Institute Consumer Sentiment Index fell by 1.6 per cent to 94.5 index points in April, from 96.1 points in March.
Westpac chief economist Bill Evans said he had not expected the negative sentiment which a lower reading suggested and that “pessimists now clearly outnumbered optimists.”
“The index is now at its lowest level since August last year when consumers were very concerned about the global outlook and warnings from the Reserve Bank and most commentators that higher interest rates were imminent,” he said.
“With conditions in the global economy improving and commentators interpreting the Reserve Bank (of Australia) governor’s latest statement as hinting strongly that rates are likely to be cut next month it seems surprising that households would have a negative reaction in April.”
The Australian Bureau of Statistics also released its monthly housing finance data that showed the number of home loans approved in February fell 2.5 per cent to 46,322, down from 47,490 in January.
But while the figures were down, it failed to reach levels predicted by economists who had forecast housing finance commitments to fall 3.4 per cent for February.
The Bureau of Statistics figures also showed total housing finance by value fell 1.3 per cent in February, seasonally adjusted, to $20.295 billion.
Monthly jobs data will be issued tomorrow and is predicted to place further pressure on the Reserve Bank to cut interest rates when it meets next month.
References
Cliffsnotes, Aggregate Demand (AD) Curve, Retrieved April 14, 2012, from: http://www.cliffsnotes.com/study_guide/Aggregate-Demand-AD-Curve.topicArticleId-9789,articleId-9737.html
Reserve Bank of Australia, About Monetary Policy, Retrieved April 14, 2012, from: http://www.rba.gov.au/monetary-policy/about.html#the_transmission_of_monetary_policy
Figure 1: Mapping out the transmission mechanisms: the effects of change in interest rates, tutor2u, from AS Macroeconomics / International Economy, tutor2u, Retrieved April 14, 2012, from: http://tutor2u.net/economics/revision-notes/as-macro-monetary-policy.html
Figure 2: Shifts of the aggregate demand curve, cliffsnotes, from Aggregate Demand (AD) Curve, Retrieved April 14, 2012, from: http://www.cliffsnotes.com/study_guide/Aggregate-Demand-AD-Curve.topicArticleId-9789,articleId-9737.html
Wright J, Ireland J, (2012 April 11). Pressure builds on RBA to cut rates. Brisbane Times, Retrieved April 13, 2012, from : http://www.brisbanetimes.com.au/opinion/political-news/pressure-builds-on-rba-to-cut-rates-20120411-1wpu5.html

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