Sample Economics Paper on Evaluation of the July 2016 RBA Policy

Evaluation of the July 2016 RBA Policy

The Reserve Bank of Australia (RBA) is a statutory organ that protects the monetary system and economy of Australia through various financial instruments. The RBA analyzes the economy as well as foreign nations to determine their impacts on the financial stability and employment level. It then sets monetary policies and cash rate targets that align the Australian economy for a stable price level and employment rate. This enables the domestic economy to increase the competitiveness of its output resulting in better welfare and economic prosperity for the people of Australia (Reserve Bank of Australia, n.d., p.1). It also regulates the monetary system and supervises the financial institutions to maintain low financial risk and avoid catastrophes such as recession or a global financial crisis. The RBA left the July 2016 monthly cash rate target unchanged at 1.75% based on its analysis of the domestic and world economy. This essay shall analyze the July 5th, 2016 media release by the RBA using components of the Australian economy as well as its trading partners.

RBA Monthly Cash Rate Target

There has been a cyclical trend in the monthly cash rate targets since 1st August 1990 to 5th July 2016. However, the RBA has, for a substantial part of the period under review, lowered the cash rate target or maintained it with occasional hikes corresponding to changes in the macro environment. The highest rate was 14% in August 1990 while the 5th July 1.75% is the lowest target rate. The RBA has made 72 changes to the target rate but has contained the changes within 1%. The 1% reduction in the rate corresponds to economic downswings such as the 2008/09 global financial crisis while a similar rate increase matches periods of economic prosperity such as the Australian commodity booms in 2000. The graph below charts the trend in the monthly cash rate target in the period under review.

 

Source: Created from Reserve Bank of Australia, 2016.

Real GDP Growth Rates for China and Australia

The growth in the real income of China has been on the decline since 2007 that marks its economic booms with a rate of 14.2% and   2010 when its economy expanded by 10.6%. Since then, its economy has gradually reduced to 6.9% in 2015. Similarly, the Australian economy declined from a high of 3.8% in 2007 to a low of 1.8% in 2009, which was followed by a gradual expansion to 3.6% in 2012. The domestic economy shrunk from 2.5% in 2014 to 2.3% in 2015, which quite contradicts the assertions of the RBA. The graph below illustrates the growth in real income for Australia and China.

Source: World Bank, 2016.

China and Australia are close trading partners. China exports manufactured goods while Australia is a resource-based economy and relies on commodity exports to the former. The level of output in China indicates the level of its demand for resources from Australia. Thus, the RBA has to closely monitor China to develop policies that maintain the competitiveness of its exports to China, as one of its statutory responsibilities is to maintain full employment in the domestic economy (BBC, n.d., p. 3).

An evaluation of the interest rates as defined by the monthly cash rate target set and growth in real income illustrates a positive relationship between the two variables. The increase in the interest rates corresponds to economic growth while the drop matches the contraction of the economy. The close relationship indicates the attempt by the RBA to maintain the inflation rate during an economic boom. On the contrary, the reduction in rates shows a deliberate move to stimulate investments that are significantly affected by the cost of borrowing that is pegged to the cash rate.

 

Business Investment in Australia

A business investment is the money incurred on starting, expanding, or running a business with the expectations of future returns. It is equivalent to the additional private sector investment in an economy. The RBA categorizes the business investments in Australia into machinery and equipment, buildings and engineering. The business investment is adjusted for the second-hand transfer of property between the private and the rest of the economic sectors. The level of business investment as a share of GDP has been cyclical since 2011. It rose from 15% to 18% from 2011 to 2013 before declining to 13.5% in 2016. The table below presents the business investment as a share of GDP.

Year Business Investment as Share of GDP (%)
2011 15%
2012 16%
2013 18%
2014 17%
2015 14.50%
2016 13.50%

Source: Created from Reserve Bank of Australia, 2016.

The business investment is part of the expenditures considered when measuring the gross domestic product using the expenditure approach. The level of business investment is significantly tied to the interest rates as most enterprises expand through borrowed funds. The RBA is concerned about the decline in the share of business investment in the GDP because it is one of the most vulnerable component of aggregate expenditure to changes in interest rate. The RBA has to ensure that the interest rates are optimal for investments because an economy can only expand through an increase in capital and labor productivity.

Household Consumption

The circular flow model of economy considers the households as units that provide firms with factor inputs such as labor and land in exchange for income that is either saved or spent on consumer durables. The household consumption determines the aggregate demand for the output of the firms and thus a significant factor to the RBA as a slump in demand increases inventories that in turn lowers the level of business investment (Hubbard et al., 2015, p. 150). The cash rate influences the level of household consumption because some consumers borrow to purchase consumables. The Australian share of household consumption in the national income has been cyclical since 2011. It rose from 2011 to 2012, dropped for the next two years and gradually increased from 2015 onwards.

Inflation Rate and GDP

The graph below shows the nominal and real GDP for Australia from September 1990 to March 2016.

Source: Created from Reserve Bank of Australia, 2016.

The consumer price inflation measures the rate of inflation using a market basket of goods of a typical consumer using a base year level of prices. The CPI inflation rate thus shows the percentage change in the cost of living of a household (Hubbard et al., 2015, p. 105). It is thus a useful tool for the RBA because it has a responsibility of protecting and improving the welfare of the people of Australia. The graph below shows the CPI inflation rate for Australia from September 1990 to June 2016.

 

Source: Created from Reserve Bank of Australia, 2016.

The nominal GDP measures the output at the current market prices and is inclusive of the inflation rate while the real GDP shows the output using the base year prices, thus a more accurate measure than the former. Consequently, the real output growth is adjusted for the changes in the rate of inflation because relying on the nominal GDP growth rate does not necessarily imply an increase in the volume of output of a nation. The two graphs are closely related because they show the trend in the national income relative to the level of inflation as indicated by the gap between the nominal and real GDP growth rate. The nominal GDP growth rate is positively correlated with the CPI inflation rate while the actual output growth reacts inversely to the level of inflation (Saymeh and Orabi, 2013, p. 341).

The real GDP is inversely related to the interest rate while the nominal GDP moves in an opposite direction following a change in interest rate. This shows that a rise in the inflation and interest rates constrain the real output because of the rise in the cost of inputs, wages, and finance expense as firms typically rely on borrowed funds to expand. On the contrary, an increase in the inflation rate corresponds to a hike in the cash rate target illustrating a deliberate move by the RBA to tame the cost of living using by manipulating the interest rate.

Labor Market

The following is a graph representing the unemployment and employment rates in Australia from 2007 to 2015.

Source: Created from Australian Bureau of Statistics, 2016.

The rate of employment indicates the extent to which labor is used in the production of national output. It is the percentage of the ratio of the employed persons to the working-age population, which is typically fifteen to sixty-four years. Conversely, the unemployment rate is the percentage of unemployed individuals in the labor force (Hubbard et al., 2015, p. 180). The labor force is inclusive of the employed and unemployed persons thus the unemployment rate shows the idle labor resource. The employment rate of Australia since 2007 has been stable at around 72% with slight variation within one percentage point. Notably, it dropped below 72% in 2013 and 2014 from 71.98% to 71.58%, matches with the slump in GDP growth rate of Australia and China, before reverting to 72.16% in 2015. The level of unemployment rose from 4.38% in 2007 to 6.06% in 2014 and 2015 showing a decline in the ability for the economy to create jobs, which can be attributed to the drop in commodity demand and prices following the economic slowdown in China during the same period (Yueh, 2013, p. 1).

The participation rate computes the proportion of working population that is employed or unemployed; labor force. It indicates the availability of labor in an economy, as it does not include people that are unwilling to work and thus an accurate measure for the available labor (Hubbard et al., 2015, p. 190). The participation rate can only decline due to an increase in the working age population or a decline in the labor force. Assuming the latter, the unemployment rate is understated because the labor force would be inclusive of labor that does not constitute the employed or unemployed.

Summary and Conclusion

Investments increase the capital stock that raises the labor productivity and consequently the national output. The interest rates affect not only the level of business investment but also consumption, which illustrates their importance in steering the economy. The level of business investment is inversely related to the interest rate and has been on the decline since 2015 showing the need for the RBA to stimulate it through low-interest rates (Justiniano, Primiceri and Tambalotti, 2011, p. 105). Households purchase consumer durables such as a house or car using debt that is also pegged to the interest rate showing the need to manipulate the cash rate to maintain optimum consumption levels (Crossley, Low and O’Dea, 2013, p. 207). The GDP includes consumption and investment expenditure, which are reliant on the level of interest rates. Notably, the investment level is highly volatile to variation in the interest rates because it depends on the cost of borrowing that is, in turn, reliant on the supply of loanable funds. Inflation increases the nominal interest rate that further dampens investment and unemployment (Hubbard et al., 2015, p. 208).

The resolution of the RBA to maintain the annual cash rate is appropriate. The slump in real output growth corresponds to the drop in business investment and inflation rate, but to a rise in unemployment rate. The decline in the inflation rate increases the real interest rate that discourages investment level resulting in the high unemployment level in Australia. The RBA fulfilled its responsibility of maintaining full employment by sticking to a low cash rate to stimulate investment and prevent the vicious cycle of unemployment and low aggregate consumption demand (Tanveer Choudhry, Marelli and Signorelli, 2012, p. 78). The resolution also seeks to support consumption in durables that increases aggregate demand and the economic prosperity of Australia in the near future.

 

 

Reference List

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BBC, (n.d.). BBC NEWS | In Depth. [online] News.bbc.co.uk. Available at: http://news.bbc.co.uk/2/shared/spl/hi/guides/457000/457022/html/nn3page1.stm [Accessed 3 Sep. 2016].

Crossley, T., Low, H. and O’Dea, C. (2013). Household Consumption through Recent Recessions*. Fiscal Studies, 34(2), pp.203-229.

Hubbard, G., Garnett, A., Lewis, P. and O’Brien, A. (2015). Macroeconomics. 3rd ed. Belmont: Pearson Education Canada, pp.50-223.

Justiniano, A., Primiceri, G. and Tambalotti, A. (2011). Investment shocks and the relative price of investment. Review of Economic Dynamics, 14(1), pp.102-121.

Reserve Bank of Australia, (2016). Cash Rate. [online] Reserve Bank of Australia. Available at: http://www.rba.gov.au/statistics/cash-rate/ [Accessed 2 Sep. 2016].

Reserve Bank of Australia, (n.d.). Our Role. [online] Reserve Bank of Australia. Available at: http://www.rba.gov.au/about-rba/our-role.html [Accessed 3 Sep. 2016].

Saymeh, A. and Orabi, M. (2013). The effect of interest rate, inflation rate, GDP, on real economic growth rate in Jordan. Asian Economic and Financial Review, 3(3), p.341.

Tanveer Choudhry, M., Marelli, E. and Signorelli, M. (2012). Youth unemployment rate and impact of financial crises. Int J of Manpower, 33(1), pp.76-95.

World Bank, (2016). World Development Indicators| World DataBank. [online] Databank.worldbank.org. Available at: http://databank.worldbank.org/data/reports.aspx?Code=NY.GDP.MKTP.KD.ZG&id=af3ce82b&report_name=Popular_indicators&populartype=series&ispopular=y# [Accessed 2 Sep. 2016].