Over the past year, the economy of Australia has remained below average (Rahman, Shahbaz, & Farooq, 2015). However, in the March quarter this year, the country received a higher economic growth but the growth was not repeated in the June quarter. Most of the key forces the shape the economic growth in the country remained as they have been for some time. Most of the business continued to decline particularly in the mining sector while other sectors have remained stagnant. There have been concerns over the slow economic growth and the reserve bank of Australia is proposing to shift its policy reaction functions to inflation and put greater weight on output and employment (Rahman, Shahbaz, & Farooq, 2015). The paper will use aggregate demand and aggregate supply curve to explain the likely consequences to the macro economy both in short-run and in the long-run.
Over the years, the Reserve Bank of Australia has been using monetary policies that target inflation. The Bank controls the money supply in the country with an aim of maintaining a stable rate of inflation. According to Woodford, (2012), inflation occurs when there is large money supply in the country which triggers demand for products and services since citizens have a large amount of money to spend. High demand usually results to high prices of goods and services and hence high inflation rate. The high inflation rate usually results in the high unemployment rate and low production in the economy. To prevent this, the bank implements monetary policy that put more weight to prevent inflation. Such policies aim at reducing the money supply in the country by increasing interest rates to discourage borrowing. The monetary policy targeting inflation has been attributed to slow economic growth since the level of investment has been very low as well as production (Hossain, 2014).
Changing policies that put much weight in output and employment is likely to promote economic growth. The bank is likely to lower interest rate in order to encourage investment in the economy. Lowering interest rate encourage borrowing which increase the money supply in the country. The graph below show the effect of lowering interest rate to money supply in the economy
Large money supply in the economy will increase aggregate demand since citizens will have more money to spend. In the short-run, high aggregate demand will make the price of goods and services go up since the aggregate supply will be low. Therefore, in the short-run there will be high inflation rate due to high prices of goods and services (Woodford, 2012). However, the increase in aggregate demand will lead suppliers to increase the aggregate supply in order to meet the rising aggregate demand. The suppliers will increase the production and hence high output in the country. The graph below show the effect of lowering interest rate to aggregate demand and aggregate supply:
The increase in aggregate supply is coupled with a high investment in the production side will create employment for the citizens hence lowering the unemployment rate in the country. The high rate of employment will mean that citizens will have a large amount of money to spend, and this will raise the aggregate demand in the country (Blanchard, Romer, Spence, & Stiglitz, 2012). Policies targeting output and employment will impact various macro-economy factors both in the short-run and in the long-run (Mahadeva, Sterne, 2012). In the short-run, the policies are likely to lead to high inflation rate as a result of an increase in the aggregate demand. The policies are also likely to have an impact to exchange rate. There will be the high importation of goods and services to increase aggregate supply to meet the rising aggregate demand hence the exchange rate will be low. The policies will trigger production of goods and services hence there will be a high level of employment in the production sector (Mahadeva, Sterne, 2012).
In the long term, the policies will lead to huge economic growth in the country. The rising aggregate demand will lead to investment in the production side of the economy. These will see some sectors such as agricultural sector mining sector and labor sector receive significant growth in the long term. The low-interest rate will also encourage borrowing and as a result, most people are likely to invest in businesses or in the asset such as houses. The graph below show the effect of lowering interest rate on investment:
Thus, in the long-term, there will be high growth in the business sector as well as in the housing sector. The high level of investment will create several job opportunities in the country and hence there will be low unemployment rate in the long-run (Ball, DeLong, & Summers, 2014). The low exchange rate will lead to growth in some sectors such as tourism since most foreigners will be encouraged to visit the country. Nevertheless, the policies can result in low level of investment in the long-term. The low-interest rate will discourage saving and stimulate spending. Low saving will affect investment in future since saving is equal to investment. The policies can also result in high inflation in the long-term, low-interest rate increases the supply of money in the economy, and this leads to high prices of goods and services (Mahadeva, Sterne, G. 2012).
The reserve bank of Australia should consider shifting its monetary policy from inflation targeting and put more weight on output and employment to encourage economic growth. Focusing on output and employment will increase growth in the agricultural sector, mining sector, tourism sector, housing and business sector. Additionally, the policy will lower the employment rate in the country.
Ball, L., DeLong, B., & Summers, L. (2014). Fiscal Policy and Full Employment. Center on Budget and Policy Priorities.
Blanchard, O. J., Romer, D., Spence, M., & Stiglitz, J. E. (2012). In the wake of the crisis: Leading economists reassess economic policy. MIT Press.
Hossain, A. A. (2014). Monetary policy, inflation, and inflation volatility in Australia. Journal of Post Keynesian Economics, 36(4), 745-780.
Mahadeva, L., & Sterne, G. (Eds.). (2012). Monetary policy frameworks in a global context. Routledge.
Rahman, M. M., Shahbaz, M., & Farooq, A. (2015). Financial development, international trade, and economic growth in Australia: new evidence from multivariate framework analysis. Journal of Asia-Pacific Business, 16(1), 21-43.
Woodford, M. (2012). Inflation targeting and financial stability (No. w17967). National Bureau of Economic Research.