Unit 1
Unit 4
Policy Approach
Policy Options
In terms of interest rates, the RBA has two effective options for the implementation of monetary policy. They have two options: either try and stimulate the economy (increase aggregate demand) by lowering interest rates, or they can try to reduce the level of aggregate demand in the economy by increasing interest rates. This second option would normally be used to try and dampen inflationary expectations in the economy.
We can relate these options to the course of the business cycle. During a recession, the Australian economy will be experiencing low (or negative) rates of economic growth and increasing unemployment. It is also likely that the CAD will be at relatively low levels, and inflation is probably not a problem at this time. To counteract the problem of increasing unemployment, the RBA will respond by decreasing interest rates. This should help to increase the number of people employed.
Alternatively, during a boom it is very likely that we will be experiencing inflation. However, growth rates will be strong, and the unemployment rate will be low. However, recall that the RBA is very keen to ensure that the inflation rate is maintained at a reasonable level. As such, they will act to reduce the level of aggregate demand, and therefore reduce pressure on prices. During boom conditions, the RBA will run a contractionary monetary policy stance.
Some authors also speak of a “neutral” monetary policy stance. This would be, the rate set to neither increase nor decrease aggregate demand. This stance would be adopted when the economy is running smoothly, and as such we do not need to intervene in the market mechanism to artificially affect the level of aggregate demand.
It is also important to understand that it is the change, not the rate, which results in the stance being labelled either expansionary or contractionary. For example, if interest rates have been set at 5.5%, and it becomes apparent that the economy is moving into recession, the RBA will respond by lowering interest rates. Let’s assume that they choose to reduce the rate to 5.25% (a reduction of 25 basis points). In this instance, 5.25% would be a mildly expansionary stance.
On the other hand, if rates were at 5%, and it became apparent that inflationary expectations were increasing, the RBA may act to increase rates to 5.25%. In this instance, the rate of 5.25% would be considered a mildly contractionary stance.
The important point to remember is that a policy stance can only be determined when you examine any change in interest rates in context. One of the best ways to do this is to read the quarterly Statement on Monetary Policy that is issued by the RBA in February, May, August and November each year. (You can find these statements on the RBA website, which can be found from the links page.)
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