This article explores how the effectiveness of monetary policy in recent times has been questioned, with its limitations increasingly at play.
Monetary Policy has been historically very effective. Over the past 20 years, the average inflation rate has been 1.5% and Economic growth at 3%. During the GFC, despite globally recessive economic conditions, Australia was able to maintain an economic growth of 1.4%. This is largely attributable to RBA’s massive cash rate cuts of 100 basis points from 7% to 6% which allowed for the vigorous monetary growth that Australia needed at the time. In addition during the Mining Boom of 2011, unprecedented levels of investment and export growth catapulted GDP growth to 4.2% and inflation to 3.2%. A contractionary monetary policy stance initiated by the RBA prevented the overheating of our economy, with inflation being contained within 2-3% and GDP growth dropping to 3.9%.
However, the effectiveness of monetary policy has been questioned in recent times. The RBA has been gradually slashing the cash rate for the past 16 months, in an attempt to increase aggregate demand through the transmission mechanism, and thereby stabilise our economic fundamentals.
At the beginning of 2019 the cash rate stood at a figure of 1.5%, but this declined to 0.25% as of April 2020, a historic low. However, economic growth, inflation and unemployment still remain out of their respective target bands.
GDP growth has ranged between 1.4% and 2.2% in the past year and a half, considerably lower than the medium term trend in the past 5 years of about 2.8%. Inflation has hovered around 1.5% since 2016, and is currently 1.8%, below the RBA’s target band of 2-3%. Moreover unemployment has remained between 5-6% in the last 4 years, above the NAIRU of 4.5%.
The reason why the transmission mechanism has been largely unsuccessful is because the limitations of monetary policy are now increasingly at play. These include the long and variable impact time lag of monetary policy, the contradiction of fiscal and monetary policy and the blunt instrument effect, to name a few (will be further discussed in the syllabus links section). Perhaps, monetary policy is losing its power and we need to consider newer, more radical approaches such as quantitative easing or modern monetary theory (will be explored in upcoming extension articles).
Economists describe the process through which monetary policy impacts upon the economy as the transmission mechanism. It explains how changes in the stance of monetary policy pass through the economy to influence objectives such as inflation, economic growth and unemployment.
The first transmission mechanism is known as the savings channel. The RBA’s rate cuts in the past 16 months mean consumers have less incentive to save due to lower returns. Since Y = C + S, a fall in savings will correspond to an increase in consumption, which then directly stimulates Aggregate Demand (AD = C + I + G + X - M). This leads to greater GDP growth, inflation and lower unemployment in the short run.
The next transmission mechanism is the investment channel. A reduced cash rate and therefore interest rates reduces the cost of borrowing for newly established businesses looking to undertake investment and expand their firm. Existing borrowers also now need less money to service corporate loans, leading to additional spending and further investment. Investment is a direct component of aggregate demand (AD = C + I + G + X - M). Therefore an increase in the level of business investment would also correlate with an increase in GDP growth and hence demand pull inflation in the medium term. The investment channel is best captured through the diagrams below.
The final transmission mechanism is the exchange rate channel. A fall in the level of interest rates would discourage financial inflow into Australia, leading to a decrease in demand for the AUD, and therefore a depreciation. A depreciation makes Australia more competitive in both domestic markets (since imports are more expensive), and overseas markets (since exports are cheaper). Therefore, with greater exports and lower imports, Aggregate Demand increases (AD = C + I + G + X - M) , stimulating economic growth and adding to inflation. Higher output also generates greater levels of employment, as labour is a derived demand.
Monetary policy has a wide range of limitations, which has significantly downplayed its effectiveness in the past 16 months. These limitations include:
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