Strengths and Weaknesses of MP compared to BP

Question 1

List of Strengths of Using MP instead of BP to Affect AD

Answer 1

• No political bias / constraints
• Short implementation lag
• No financial constraints

Question 2

Description of - No Political Bias - in terms of a Strength of MP

Answer 2

• As the RBA is not elected by the public and has no political affiliations, they make decisions purely based on economic factors (not political factors)
• This gives them the freedom to make economically sound but politically unpopular decisions.

Question 3

List of Weaknesses of Using MP instead of BP

Answer 3

• Long impact lag
• Is blunt
• Creates asset bubbles and high household debt

Question 4

Description of - Short Implementation Lag - in terms of a Strength of MP

Answer 4

• The RBA meets up every month to make a decision about the cash rate target.
• This gives them the flexibility to ‘wait-and-see’
• They can wait for key economic data before making decisions because they meet 11 times a year + (potential extraordinary meetings)

Question 5

Description of - No financial constraints - in terms of a Strength of MP

Answer 5

• Unlike budgetary policy, the RBA does not have financial constraints.
• It can purchase as many bonds or change the CRT without limitations, as necessary, in order to meet the domestic macroeconomic goals.

Question 6

Description of - Long impact lag - in terms of a Weakness of MP

Answer 6

‘Monetary policy has long and variable (impact) lags’

It takes time for changes in the cash rate target to make its way through the transmission mechanisms and into the economy.

• Some households have fixed mortgage rates (eg. they are not immediately impacted)
• Savings buffer

Statistics:
- only 40% of IR change will be felt after 12 months
- with 80% felt after two years and
- 100% after three years.

This lag means there’s a greater chance that MP could become pro-cyclical.

Question 7

Description of - MP being Blunt - in terms of a Weakness of MP

Answer 7

Changes in interest by the RBA affect the overall levels of savings, consumption, investment, and net exports.

Because the economic impacts of the policy are so wide-spread, the policy can not precisely target particular areas of concern.

Question 8

Description of - Creating asset bubbles and high household debt - in terms of a Weakness of MP

Answer 8

There is a strong correlation between interest rates and asset prices. Prior to this tightening cycle, the RBA cut interest rates over a 10-year period which drove share and house price accumulation.

Asset ‘bubbles’ can be created in times of expansionary monetary policy. But these bubbles can burst.

((An asset bubble refers to a situation in which the prices of assets (like real estate, stocks, or commodities) increase rapidly to unsustainable levels driven by exuberant market behavior, rather than their underlying intrinsic value.))