Limits to policy effectiveness

The RBA has engaged on a series of interest rate cuts in order to stimulate demand in the economy. If you are asked to explain a demand side policy in the last year it is a pretty good example to use.

The key with answering VCE Economics questions about policy is to use the data available and link it to the economics you have learned to explain how the policy works and if why it will be/will not be effective.

So with interest rate cuts, which you should describe,  the key thing is to link it to Consumption and Investment spending, both components of Aggregate Demand. Interest rate cuts should encourage borrowing by households and firms and reduce payments on existing loans, so raising household discretionary income and firms retained profits.

According to this logic Aggregate Demand AD should shift to the right and lead to a higher level of GDP, reducing unemployment, but raising inflationary pressure. (Draw the diagram to make this process clear.)

Of course you can explain ANY of the transmissions mechanisms channels that lead to a rise in AD. But the reason why the savings and investment channels are relevant is how current events can be used to evaluate the effectiveness of monetary policy.

The recent RBA rate cuts, which seem certain to continue of Cup day, are not being fully passed on to borrowers. This means that AD will not rise as much as hoped and so the policy is less effective than it could be.

The Age surveys how actual rates in the market have tracked the RBA rate. Remember to explain the transmission mechanism carefully so that you can explain where it can fail and gain full marks for explaining, analysing and evaluating the process.

The Age article is here