Recession And Expansionary Monetary Policy Of Australia Economics Essay

Recession And Expansionary Monetary Policy Of Australia Economics Essay Introduction: Australia economy went through contraction in 2008-2009. however, since expansionary monetary policy was executed, Australia started to recover step by step. Business cycle refers to fluctuations in economic activity. The economy doesnt always stay still. It shifts over time between expansion and recession. In order to prevent economy from going too far from balance, the monetary authority of a country executes monetary policy. Monetary policy is used to control the supply of money, often targeting a rate of interest, so as to attain goals of growth and stability of economy. When economy is in expansion, a contractionary policy works. Under such circumstances, the government reduces the size of money supply, or if it raises the interest rate. When economy is in contraction, an expansionary policy works. It increases the total supply of money, or if it reduces the interest rate. The Reserve Bank of Australia (RBA) serves as the central bank of Australia. It holds the duty of keeping the nations economy sound and stable. RBA has several monetary policy tools available to influence the business cycle: increasing interest rates, reducing the monetary base, and increasing reserve requirements. All contracts the money supply, and, if reversed, expand the money supply. Increasing interest rate leads to higher opportunity cost of investment, thus more people choose to deposit instead of investing. This stops economy from being too heated up. While reducing interest rate means lower opportunity cost for investing, encouraging investment in a recession. Such is the role of RBA in counter cyclical policy. The year 2008 till now is a period of economic extraction. The financial crisis of 2008, considered to be the worse financial crisis since the Great Depression of the 1930s, is triggered by a liquidity shortfall in the United States banking system caused by the overvaluation of assets. Financial institutions collapsed, stock markets turned down all around the world. Economic activity declines significantly. Australia, as a small, open economy with a financial sector that is well integrated with the rest of the world, is not immune to the enfolding financial crisis despite the robustness of the Australian financial system. The crisis contributed to the failure of key businesses, declines in consumer wealth and substantial financial commitments incurred by the government. The economic indicator-GDP slowed down significantly, as we can see in the following table. Year Mar Jun Sep Dec Average 2010 0.50 0.50 2009 0.80 0.70 0.30 1.10 0.73 2008 1.00 0.60 0.30 -0.90 0.25 Table1GDP Growth QoQ Source: Trading Economics Economy went through a tough time in 2008. GDP growth kept declining from Q1 to Q4. To be detailed, GDP growth declined at a rate of 40% from Q1(1.00) to Q2 (0.60), 50% from Q2(0.60) to Q3(0.30), shockingly 400% from Q3(0.30) to Q4(-0.90)! Businesses broke. Nation wealth shrinked. Economy fell into abyss. Worse still in 2009, Australian economy had a rather difficult time with bad economic growth performance. The economic activity in Australia has slowed and is set to continue to slow before starting to rebound in 2009. Indicators of Australian Activity (Table 2) show how the recession was like in 2007-2009. GDP and consumption in 2008 dropped to half of their prior years level, while inflation in 2008 reached twice the level of its prior year. Business investment dropped by over one point from 2007 to 2008, and it was even worse in 2009. Though wage cost index decreased from 4.1(Year 2007) to 3.7(Year 2009), labor market unemployment rate increased from 4.4 to 5.2. Source: Melbourne Institute Before 2007, the monetary policy was concerned with bringing inflation down. However, within the space of one year, the landscape of macroeconomics has changed due to three concerns-recession, retrenchment and risks. In this recession, Australia needs an expansionary monetary policy, which can provide liquidity to further financial collapse. Inflation is no longer the top concern, since it is more important to keep a sound financial system and a low rate of unemployment. Inflation rise to 4.4 in 2008, and came down to around 3.0 in 2009. In the wake of the global financial crisis, the RBA began a policy of monetary loosening, reversing the trend of tightening. It has enacted similar procedures to the United States Federal Reserve to inject liquidity in domestic credit markets (such as moving funds into the cash market and introducing a term deposit auction facility). In response to both weaker domestic and global economic data, the Reserve Bank Board moved to an expansive monetary policy: the cash rate target was reduced by a full percentage point in October 2008, by a further 0.75 percentage point in November and, most recently in December, by another full percentage point. Lets take the monetary policy executed in October as an example. In October 2008, RBA lowered the cash rate by 100 basis points to 6.0 percent. The Board judged that a material change to the balance of risks surrounding the outlook had occurred, requiring a significantly less restrictive stance of monetary policy. At the same time, measures are taken to provide authorized deposit-taking institutions greater flexibility to manage their liquidity. Specially, relax the current restriction that prevents an institution from using residential mortgage-backed securities and asset-backed commercial paper of a related party as collateral in its repo operations with the Bank. Whats more, restrictions on substituting collateral within an existing rep, with the exception of general collateral, will be removed. Where the substitution includes changes in the asset class of collateral, the margin applying to that collateral will be adjusted accordingly. Though Australia has not been immune to the financial woes, the economy has been cushioned by solid growth in China. Domestically, the loosening in monetary policy and the series of fiscal stimulus packages are likely to steer the economy away from a recession.