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Issues of Monetary Policy in Australia
In its most recent meeting, the Reserve Bank of Australia (RBA) decided to cut the cash rate, to a historical low of 1.25 percent, in an attempt to stimulate expenditure in the economy and to achieve its three objectives. However, to use further expansionary monetary policy (or to cut the cash rate) given the current economic climate is inappropriate, or irrelevant. What are the objectives of the RBA and how does it achieve them? What are some reasons for its ineffectiveness? Are there alternatives? Without further ado, let’s get started.
A good place to start is to discuss what are the goals of the RBA. As mentioned in the Reserve Bank Act 1959, the Reserve Bank Board, through its conduct of Monetary (and Banking) Policy, will best contribute to:
- The stability of currency in Australia;
- The maintenance of full employment in Australia; and
- The economic prosperity and welfare of the people in Australia.
Briefly, the first objective is achieved through the RBA’s regime of inflation targeting and achieving an inflation rate of 2-3 percent. Next, if the unemployment rate is consistent with a rate of around 5 percent, then the RBA will have accomplished its second objective. Last, when the economy is achieving a rate of growth consistent with rising real incomes and improved employment opportunities, but without accompanying inflationary pressures or a deterioration in the economy’s external stability, then the last objective has been satisfied.
We have talked about the objectives of monetary policy, but how does the RBA exploit its unique position (as the Central Bank of the Australian economy) to achieve these objectives? Without getting into the “nitty-gritty,” the RBA will influence the money supply (or amount of liquidity) in the cash market or short-term money market, which will influence the cash rate — the interest rate paid on funds lent overnight in the cash market. To do this, the RBA will buy or sell Commonwealth Government Securities (CGSs), or other money market assets, to influence the supply of cash in the short-term money market, effecting the cash rate and eventually other variable rates throughout the economy. This process is known as open market operations and the accounts that these financial assets are transacted in are known as Exchange Settlement Accounts (ESAs).
A brief background has been established with respect to the goals and conduct of monetary policy, so why do I think the RBA’s most recent decision will prove to be ineffective? There are a few reasons, but I would like to keep this discussion relatively short. A “textbook” reason as to why monetary policy could be ineffective is the concept of the liquidity trap. As interest rates approach zero, the public may be prepared to hold whatever amount of money that is supplied, and do not invest and keep funds in deposit accounts, in anticipation of interest rates increasing in the future. As a result, monetary policy carried out through open market operations has no effect on the level of income or interest rates (Dornbusch et al. 2013). Thus, money and interest-bearing assets are seen as perfect substitutes.
The next point I would like to highlight is Australia’s excessively high level of household debt. The household debt-to-income ratio is currently at a multiple of just under 2, as can be observed from the below graph (Reserve Bank of Australia n.d)
This will help us understand why recent monetary policy has been ineffective. Most households with an already high level of debt could be incentivised to paydown their existing debt given the current low interest rate environment. Therefore, as households retire existing debt and not use this access to cheap credit to fund consumption, this breaks down the transmission mechanism of monetary policy.
But, with an already substantial amount of debt, asking households to borrow more for expenditure purposes is problematic. Requiring households to take on further borrowing presents a huge risk to the economy, especially exposing households (and firms) when interest rates gradually rise. Therefore, extremely loose monetary policy only results in a greater level of risk and debt beared by those incapable of doing so had interest rates been higher. This idea of risk and debt can also be extended to firms. Firms are capable of acquiring additional funding as it is now cheaper for them to fund their operations. But, had interest rates been higher, these firms would have had less funds available to them which would have also been more expensive to finance, but these firms would be exposed to less risk. Therefore, asking households and firms to increase the amount they owe to stimulate expenditure in the current climate results in an inefficient allocation of risk.
We can also extend this discussion from borrowing to facilitate expenditure to speculative investment. With easy access to credit, this promotes speculative bubbles, or excessive price increases in the market for speculative assets. This can be observed especially with respect to the Australian real estate market. With easy access to credit, and already rising prices, households were able to re-finance and securitise their properties, which further accelerated the price of property, mainly in Melbourne and Sydney. However, we have seen a slowdown in the Australian housing market and seen house prices fall quite sharply, as can be observed from the above graph. With already excessive amounts of financial distress, households could be faced with the possibility of negative equity — where the value of an asset is less than the amount borrowed. This could have huge ramifications, as households see their wealth wiped out and face a greater debt burden, as well as increased unemployment and a further fall in house prices due to changed market sentiment.
I would like to mention that there could be a forthcoming article explaining the state of the real estate market (so watch this space!)
We have discussed, in some detail, the conduct of monetary policy, its potential ineffectiveness, and the issues of extremely loose monetary policy if pursued for extensive periods. Are there alternatives available to us rather than just increasing the money supply? Well, it turns out there is. First, we need to understand the quantity theory of money, or the relationship between the level of nominal income, the nominal money supply, and the velocity of money (Dornbusch et al. 2013, p. 454).
MV = PY
Where M is the money supply, V is the velocity of money, P is the price level, and Y is output, or real GDP. What does this expression tell us? It tells us that the level of nominal income is solely determined by the quantity of money (Dornbusch et al. 2013). So why do I bring this up? As you could have probably guessed, monetary policy has some influence over the M parameter in an attempt to increase the level of inflation or nominal income. Is there a method through which we can influence the V parameter and increase the price level and output in the economy? Well, it turns out there is, but I must discuss what the velocity of money means, which should make the idea of demurrage concrete.
The velocity of money refers to the frequency with which a typical dollar changes hands during the year (Dornbusch et al. 2013, p. 639). If we can increase how fast a dollar circulates in the economy, then we can increase nominal income, through an increase in the price level, an increase in the level of real GDP, or a combination of both. This is the motivation behind demurrage, developed by German economist Silvio Gesell (1862-1930).
How does it work? For the bill or currency to retain its face value, the currency holder must pay a regular, periodic payment (a tax) before some period — whoever holds the paper currency must pay this tax (Goodwin 2013). This tax reduces the purchasing power of the paper currency, but unlike inflation, demurrage gradually reduces the value of the currency and acts like a negative interest rate — it doesn’t have adverse effects on the value of real savings like that from inflation (Mitchell 2010).
Let’s say that a paper note is introduced into circulation and will last one month, where a 20% tax on a $10 note must be paid by whoever holds the note at the end of each week. If I hold the note at the end of the first week, I must pay the 20% tax ($2) to the authorities. If I still hold the $10 at the end of the following week, then I must pay an additional $2, and so on. Therefore, this 20% that I have paid each time effectively reduces the purchasing power of the fiat currency.
Households now have an incentive: to avoid paying this tax, spend the money so somebody else holds the note. By replicating a fall in the purchasing power of the paper currency, households are incentivised to spend this money before it is worth less in future periods. Alternatively, households are dis-incentivised to hoard the currency as they must pay the tax if they do so. As the velocity of money increases in the economy, this puts upward pressure on prices, as well as potentially increases the level of output by firms, improving employment opportunities and increasing the level of nominal income in the economy.
Story Time (The Plan for the Future 2018)
In the midst of the Great Depression (1933) the Mayor of Wörgl, Michael Unterguggenberger, in Austria, decided to introduce a new currency in exchange for the 40,000 Austrian Schilling available to him rather than fund public spending. He deposited this money in a local savings bank and issued a currency known as stamp scrip. This money required a monthly stamp, equating to 1 percent of the note’s value, to be stuck on the note to keep them valid, with the money raised from this “tax” used to fund soup kitchens. This scheme ran for a 13-month period and exceeded expectations, as the council was able to build new houses, reservoirs, a ski jump and bridge. In fact, unemployment in Wörgl decreased while it increased throughout Austria. This system was eventually replicated in six neighbouring villages.
There are potential issues with trying to introduce such a proposal, especially given the scale of the Australian economy. Its implementation would be quite exhaustive — for example, an open market operation-like scheme must be developed to introduce this currency into circulation, a rate of exchange with the existing currency must also be considered, as well as household and firm compliance. However, given the low interest rate environment post-GFC, accompanied with low economic growth, low inflation, and low labour productivity, it is important to introduce and discuss different ideas that have been trialled throughout history and proven to be successful.
What are your thoughts? Let me know in the comments sections below!