What is monetary policy and how does it operate? What are its advantages and disadvantages compared to fiscal policy with reference to the current state of the economy (domestic and global), discuss the kind of monetary policy the reserve bank of Australia should be pursuing. Monetary policy is a powerful force effect on economy, it closed relate to our life. It is all the actions taken by the central bank which involves changes in the base rate of interest influence the rate of the growth of aggregate demand, the money supply and price
inflation. This essay will talk about how it operates, and to explain the advantages and disadvantages of monetary policy comparing with fiscal policy. Also will discuss the kind of monetary policy the Reserve Bank of Australia (RBA) should be pursuing.
The process of monetary policy is when monetary policy takes actions to make the interest rate higher or lower by changing the money supply. The central bank can effect investment, net export and consumption in the short term. When central bank buys bonds in the open market, it increases the money supply and the interest rate falls. Conversely the money supply decreases and the interest rate rise. It is called open market operation. Thus, it causes the departure of real GDP from potential GDP between boom and recession period. Furthermore, the central bank uses monetary policy to speed the real GDP return to potential GDP during the recoveries from recessions. Finally, monetary policy also determines the inflation rate, which can affect productivity and the growth of potential GDP in the long run.
It has become apparent that economic developments over recent months point to continued good growth of the Australian economy. Major factors contributing to the continually increasing economy include positive investment expectation, and consumer confidence with regard to the consumption of the goods. In addition, the Australian election is likely to further accelerate the expansion of the economy in domestic, which is due to the rising government expenditure in order for the major parties to gain advantages in the election campaign. For instance, according to the statement of monetary policy in August 2004, in the March quarter, the terms of trade was 10 per cent higher than a year earlier, and they are likely to have risen further in the June quarter. Hence, there is a lot of evidences that the real GDP is currently above potential GDP. Monetarists say “that fiscal policy is less effective than monetary policy or not effective at all…. Because of political constraints and budget cycles, fiscal policy is generally less flexible than monetary policy.”
So what are advantages and disadvantages compare to fiscal policy, first of all, monetary policies have much less interferes with the freedom of the market than fiscal policy. It is not interferes particular sectors of the economy. For example, it cuts downs the rate of total spending by using a tight monetary policy. But that tight monetary policy can affect whole economy and it does not just affect a particular sector of the economy. It can let market to decide which expenditures should increase, or not. In recently, the oil price has increased very significantly which hits the history record. It has big impact on the interest rate. The high oil prices force the Reserve Bank to put interest rate on hold at 4.5 per cent in Australia and the high oil price will also slow down the globe economy growth. The oil price example shows us a particular sector that can also affect the Reserve Bank’s monetary policy.
Secondly, monetary policy is more flexible than fiscal policy. In Australia because the Reserve Bank Board normally meets eleven times each year, they almost meet every month. That can let them to make decision more often which can help Australia to use better monetary policy to deal with economy changes. But for the fiscal policy is hard to change that because in Australia, fiscal policy is defined as the government’s plans for spending, for taxes and for borrowing to finance the budget deficit. The Federal Government submits a new budget to Parliament each year for the following financial year that is why economists frequently disagree about fiscal policy. For example, the cost of war on Iraq will give big change for government spending and borrowing. So the fiscal policy is not as flexible as monetary policy.
Finally, because the central bank is independent it may can act in the best interests of the country. It is insulated from political pressures. Politicians’ can use fiscal or monetary policy to affect the outcome of their election. For example, the government uses economic policy to cause a boom just before election and let the economy slow down right after the election. The both policy can raise the GDP in short term, but not for long term. So it is the best to keep central bank independence. For example, the Australian election on 9th Oct likely to further accelerate the expansion of the economy in Australia, which is due to the rising government expenditure in order for the major parties to gain advantage in the election campaign. There is also a disadvantage for the central bank independence that because those in charge of central bank could say, high inflation is not harmful, or at other extreme. If the economy is in recession during that period the central bank could make existing recession worse.
Although monetary policy has more advantages than fiscal policy, and it is more powerful then fiscal policy, it can only stabilize short- term economic activity, but can not affect employment and output in the long run.
In conclusion, although the Australian economy has been in a boom in recent times, it still could be noticed that the Reserve Bank faces something of a dilemma as it tends towards increasing the interest rates, which results from political implications and concerns of the inflation outlook for 2005. However, based on the sufficient economic data and the rising trajectory of the inflation forecasted by lots of economists, a lift in interest rates in the future could be justified by the recent economic situation. Therefore, in order to adjust the boom and avoid the impacts of the inflation, the RBA should impose its tightened monetary policy in response to the recent economic problems in the society.
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‘Statement of monetary policy’, Reserve Bank of Australia (August 2004), [Electronic],Available:
Carew, E (2004) “the language of money”
Taylor, J.B& Moosa, I (2002). Monetary policy, Macroeconomics, 2nd edition, pp.358-374