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Contemporary Monetary Policy

Economics (Year 12) - Monetary Policy

Ben Whitten

Aggressive Monetary Policy?

The current cash rate in writing this page is 1.5% which is the lowest ever recorded cash rate. This says something about the state of the world economy, to which the cash rate only dipped to 3% when the Global Financial Crisis struck. The accommodative stance by the RBA has been in a response to a shrinking world economy that is still feeling the effects of the GFC. So why the aggressive expansionary monetary policy? The answer is inflation.

The RBA has a target band for inflation of 2-3%. If inflation falls below 2% and is expected to continue to be below 2% then the RBA will conduct expansionary monetary policy in the hope of increasing aggregate demand and hence, price levels towards the target range. What's notable about the first graph is that contemporary monetary policy (that is those within the last 3 years) has been failing. Since 2013, the cash rate has been reduced from 3% to 1.5%, however, inflation has continued to fall from 2.5% to 1.3%. The real cash rate, that is the cash rate minus the inflation rate is close to and in some cases, even below 0%. In theory, this means the interest rate that banks pay is close to the rate at which the price of goods and services rise, which means the banks are effectively paying no interest. This shows the aggressiveness of contemporary monetary policy where the RBA wants the low real cash rates to encourage the banks to lend more to increase economic activity and hence, price levels.

Limits of Monetary Policy

The fact that economic growth and inflation are still failing to rise to meet their targets show the limits of monetary policy. Despite the low levels of cheap credit, Australia is still recovering from the mining downturn and the GFC to which there is a low level of confidence in the economy, reducing the willingness for households and businesses to spend and invest. Other external events such as the UK's Brexit and Donald Trump's winning the election has created a sense of economic uncertainty in the direction of the world economy.

Limited Impact on Exchange Rates

Despite RBA continual easing of the cash rate, the Australian Dollar has remained relative stable for a floating exchange rate. This is because, despite low cash rates, the interest rate differential between Australia and the US is still relatively large. The Australian Dollar has remained within $0.76 USD and $0.73 USD despite the cash rate halving in value. On the traded weighted index, a measure of the Australian dollar to a basket of other currencies weighted according to their importance of trade flows, the TWI index has actually increased in the last few years. Between 2014 and 2016 the Nomial TWI has increased from 60 to around 65 while real TWI has increased from 67 to 73.

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