Monetary policy is impotent - RBA Governor

The article linked below is as much an opinion piece as a news article (so not that suitable for IA's). However there is an important message in it. Monetary policy alone won't work to manage the economy.

Ever since the idiot Costello conned everyone into believing a Budget surplus was the equivalent of good economic management Australian governments have not really distinguished themselves in fiscal (budgetary) policy planning and execution. The one exception was the Rudd governments textbook response to the GFC.

Glenn Stevens, the retiring Governor of the RBA, has given a clear message to th government. Stop obsessing about the deficit, it isn't the problem, start spending on infrastructure to boost demand and build capacity.

VCE students will recognise this as a question of the policy mix. IB students will see the liquidity trap and he ineffectiveness to monetary policy as well.

The SMH article is here

As above for VCE and IB interest.

Quantatative Easing in Europe

Australian monetary policy remains 'conventional'. The RBA adjusts the cash rate to influence interest rates throughout the economy. Those changes (although there have been none since  2013) work through the various monetary transmission mechanisms to affect Aggregate Demand (AD) and so inflation.

However when AD is very low and economic growth is really weak there is a limit to the amount conventional monetary policy can do. This occurs where interest rates approach zero. There are no more interest rate cuts possible to boost consumption and investment spending.

In the Eurozone the European Central Bank has set a cash rate of 0.05%. While some countries have set small negative rates (Switzerland for example) it is thought that changes at the rate at this level makes little difference to economic behaviour (Keynes talked of a liquidity trap at low interest rates which might be applicable here).

So the solution adopted in the US, the UK and Japan has been to print money to boost economic activity. This is called Quantitative Easing. The money is used to buy 'bonds' and this drives the price of those bonds up, meaning that they pay holders a lower real rate of interest. This helps by making borrowing cheaper in the economy and also boosting the money supply.

While some might worry about inflation when money is printed in this way they are missing the point. The aim is to inflate the economy, boosting AD and raising the level of economic activity leading to higher GDP and employment. The Eurozone badly needs this stimulus, as do all the countries that trade with Europe. 

The BBC page explains the plan and how QE works. Why is this important for VCE? The same monetary transmission mechanisms work in Australia as work in Europe. It is essential you understand them for Unit 4.

The BBC article is here