Effect of an Inflation Target in Monetary Policy Rule - Assignment Example

Economics Student’s Name Institutional Affiliation Introductory Macroeconomics Question 1: Gross Domestic Product (GDP) The national total income and output measures in a given one year period are considered as Gross Domestic Product (GDP). It relatively measures wealth, prosperity and both growth or decline of the economy in a specific country. Gross Domestic Product has advantages as well as disadvantages in economic perspective. These strengths and weaknesses include; Advantages of Gross Domestic Product GDP provides the best analysis of measuring the economic activities in growth rate and changes experienced in the economy (Tommy & Lutz, 2013). Policy makers and economics analysts use it to guide, adjust, and implement economic policies. It is used a measure of business performance as it provides with useful information for both government and business. In measuring the social and economic welfare, GDP guides the economists with information to compare different sectors performances. It is the best economic tool that is used in comparing different countries performance in development and growth. Disadvantages of Gross Domestic Product GDP does not provide accurate economic development and growth as it does not cover non-market activities (Tommy & Lutz, 2013). It does not include and reflect the domestic household product or even black market. GDP does not express whether the national wealth is equally distributed. Its measures of expenditures do not relate to the economic welfare (Matt, 2013). It does not account the quality of goods and services (Mankiw, 2012). Alternative Gross Domestic Product measures Index of Sustainable Economic Welfare (ISEW): This is an economic indicator that focuses on more details beyond Gross Domestic Product. This factor includes income distribution and unsustainable costs such as cost associated with pollution (Richard & Kevin, Jan 2016). Human Development Index (HDI): It is a comparative measure that deals with the measuring of the wellbeing of people. It focuses in distinguishing whether a country is in categories of under-developed, developing or developed and measuring the economic impact of policies relating to the quality of life. HDI rank country’s economic performance regarding human development rather than relying on GDP and other economic factors only (Philip, 2013). Preferred Measure The best measure of economic development and growth is the Index of Sustainable Economic Welfare (ISEW). ISEW is better than GDP and HDI as it incorporates unsuitable costs that influence human welfare. It covers economic factors in GDP and human development welfare in HDI to come up with a comprehensive economic performance and development. Question 2 The income-expenditure model impacts The income-expenditure model consists of four different parts that are aggregate expenditure in consumption, investment, government, and net export. All of these components except aggregate consumption expenditure from the autonomous or independent factor of current income (Mankiw, 2012). Therefore, the autonomous expenditure is summarized by C + I + G + NX equation. The aggregate consumption equation is C = A + MPC + YD. This shows the relationship that exists between the consumer spending and disposable income. In a fixed planned investment, the aggregate expenditure (AE) reflects the total economy spending. This can be expressed as follow; AE Planned = C + I Planned The impact of investment in infrastructure and innovation would raise the planned aggregate expenditure (AE Planned) as indicated in figure 1 below. Figure 1: Income-expenditure approach to equilibrium real GDP. Copyright 2012 by Mankiw According to the Figure 1, the aggregate expenditure curves are represented by three different curves namely EA1, EA2 and EA3. These cures are positive and hence upward sloping and hence positive mpc. As more investment in infrastructure and innovation is realized in the economy, the national income raises. Y = AE denotes the equilibrium real GDP in the figure. Effects of Superannuation Changes in Capital Market Superannuation program or tax policy is an incentive that encourages and supports household saving. Its impact to the financial system portfolio leads increased domestic savings. The corporate and institutions as investors tend to focus on the less risky and same time more liquid assets. The more liquid portfolio that is less risky gets a positive response from investors for its attractiveness (Stiglitz, Walsh, Guest, & Tani, 2014). The government securities or stocks tend to be more attractive due to the relative risk factor and yielding high returns. The effect in the capital market is experienced through the demand of the securities and rate of returns expected by investors. The capital market would depend on by the level of demand from investors, availability of liquid assets and the risk factors. The labor force tends to focus on saving for their retirement through investing in less risky portfolios such as government bonds (Stiglitz et al., 2014). The capital market would respond depending on the level of demand for securities and availability of government bonds. Superannuation avails more funds as an incentive to household saving that relates appropriate investments depending on risks and maturity rate of returns. Therefore, the impact of superannuation changes would influence the capital market operations depending on interest rate, returns, and demand of securities portfolios. Budget Surplus and Budget Deficit A budget deficit occurs when the expenditure exceeds revenue. The current expenses tend to exceed the income level. In the national standard, the deficit can be corrected through cutting down on some expenditures or seeking avenues to increase in revenue generation. In most cases, the two strategies are employed. The budget deficit reflects the percentage at which the GDP may reduce. This is connected to the economic standards through lowering unemployment rate, increasing the economic growth, increasing tax revenue and reducing the government funded programs (Mankiw, 2012). On the other hand, if the government spending is higher than income revenue, the investors are certain of higher inflation rates reducing the real value of debt hence resulting in higher interest rates. A budget surplus occurs when income or receipts are more than the expenditures. It indicates the government is effectively managed through reduced expenditure comparing to income revenue, and that the government has more funds that can be allocated to different functions (Graeme & Helen, 2015). It also contributes to reducing taxes, funding existing development programs and social security. Furthermore, budget surplus leads to decrease in the consumer demand, hence, lowering the consumer prices. This has an indirect impact on the economy through slowing down growth. Figure 2: Budget Deficit and Supply. Copyright 2012 by Mankiw Budget surplus and budget deficits are essential in the determination of the government position in development. Government budgets to control its funds by ensuring the spending and expenditure are only subjected to economically viable programs. Budget surplus and deficits provide an indication to the government on the state of the economy and appropriate macroeconomic or microeconomic decision to be undertaken (Matt, 2013). Therefore, a budget surplus and budget deficit are essential in the balance of payment, and determination of budget position in the economy. The 2016 Budget The 2016 budget has expressed improvement in the Australian economy. The expenditure and current incomes do not portray great difference and hence nothing to worry about the economic performance. I like the 2016 budget as it shows potential development in a standard economic performance. The expenditure and income level shows promising performance as the government has considered spending on development programs such as financing projects. The income generation helps in outsourcing enough resources required in development. Question 3 Nature of Open-market operation required in bringing cash rate down The nature of OMO that Australian central bank should consider in bringing cash rate down by 25 basis points is by selling or buying government bonds. The central bank implements open market operations through initiating monetary policy. This is done by supplying the commercial banks with liquid and also taking the surplus liquid. The process is essential in manipulating the interests especially in the short term (Stiglitz, Walsh, Guest, & Tani, 2014). Furthermore, the open market operation is undertaken through controlling money supply in the economy using the base money indirectly. It helps in expanding the money or contracting the money supply. Meeting base money in influencing the demand and supply, the central bank works to the interest rate through buying or selling government securities and other financial instruments. Inflation, interest rates, and exchange rates are used to guide in the implementation and determining cash rate. In bringing down the overnight cash rate by 25 basis points, the Australian central bank through the avenue of open market operation would consider selling government bonds. This includes Treasury bills, notes, and bonds (Richard & Kevin, Jan 2016). Opening these government bonds to public and commercial banks would contribute to lowering the cash rate to the point need by the central bank. In this case, the Australian government targets to cash rate of about 25 basis points. Main reasons behind the RBA’s move to cut the overnight cash rate The main reasons that led RBA’s move in cutting down cash rate are connected to the domestic and international economic conditions. Financial market and monetary policy consideration also played parts in the decision made by RBA in the cash market. On the domestic economic, the issues of consumer price index played a major role in ensuring intervention by RBA in cutting down cash rate (Stiglitz, Walsh, Guest, & Tani, 2014). The level price trending by May 2016 was showing signs of inflation and hence appropriate measures were to be immediately taken. Another concern is the employment growth whereby Australian employment rate was, and the trend predicted a decline in employment. Furthermore, household consumption had increased, and intervention mechanisms were appropriate to restore the normal standards. International economic conditions helped in reflecting the trading partners’ performance and how they influence Australian economy. Some economies such as China have shown improvement over the past years. Australia has to consider and figure out some of the factors making its economy grow slowly and unemployment level (Tommy & Lutz, 2013). Financial market also contributes RBA decision regarding the cash rate during exchange settlement (ES). The monetary policy is influenced by interest rate and exchange rates. The Australian government considers cutting the cash rate base to restore the favorable monetary economy. Aggregate demand-inflation (ADI) analysis Using aggregate demand-inflation (ADI) analysis, the inflation rate rises making the difference between the actual GDP and potential GDP to decrease. The negative slope is essential in indicating the rise in inflation contributes to GDP gap falling. Using this analysis, the central bank uses the monetary policy in developing a systematic relationship that connects interest rate and inflation (Stiglitz, Walsh, Guest, & Tani, 2014). It is monetary policy that indicates that if inflation rate rises, the central bank has the mandate of increasing the interest rates instruments. Figure 3; Figure 1: Aggregate demand-inflation (ADI). Copyright 2012 by Mankiw In the short run, the increase in the interest rate would contribute to lowering the aggregate demand. In the long run, the aggregate demands the monetary and fiscal policies have no effect on real GDP. Therefore, the reason why the RBA considered an overnight cash rate cut is to realize the impact in the real GDP. Effect of an Inflation Target in Monetary Policy Rule The inflation target must be maintained at the lowest level. The monetary policy should be maintained at 2 to 3 percent level as an underlying inflation. The CPI considers some factor such as prices and labor cost in a level of domestic inflationary pressure. The downward revision of inflation outlook helps in improving the wage growth in the economy. In conclusion, the monetary rule ensures there is room for employment expansion. Economy has never experienced full employment rate or inflation rate. Monetary policy focused on the material changes that have influenced unemployment rate through revising the inflation rate. Interest rate is the key factor that requires supervisory measures to ensure economic standards are met. Macroeconomic factors are essential in influencing the economic development and growth. The support of the inflation rate variation of 2 to 3 percent provides platform for regulating the unemployment rate to achieve maximum production. Therefore, RBA consider the monetary policy tool in ensuring the economic response to the cash rate of 25 basis cut to achieve 2 to 3 percent inflation rate. References Graeme, W., & Helen, S. (2015). Australian government budget balance numbers. Accounting Research Journal. Vol. 28 Issue 2, 120-142. Mankiw, G. (2012). Principles of macroeconomics. Mason, OH: South-Western Cengage Learning. Matt, W. (2013). Principles of Macroeconomics. American Journal of Agricultural Economics. Jan, Vol. 95 Issue 1, 200-201. Philip, L. (2013). The failure of the ISEW and GPI to fully account for changes in human-health capital — A methodological shortcoming not a theoretical weakness. Ecological Economics. Vol. 88, 167-177. Richard, H., & Kevin, K. (Jan 2016). Economic growth, inequality, and well-being. Ecological Economics. Vol. 121, 231-236. Stiglitz, J., Walsh, C., Guest, R., & Tani, M. (2014). Introductory Macroeconomics. 1st Australian Edition: Wiley. Tommy, S., & Lutz, W. (2013). The Taylor principle in a medium-scale macroeconomic model. Journal of Economic Dynamics & Control. Dec, Vol. 37 Issue 12, 3034-3043. Read More