The economic debate 2024 - monetary policy

Ms=Md in equilibrium i.e

In February 1990, the RBA announced the Cash Rate would become the official monetary policy instrument. The transmission mechanism for monetary policy then became the domestic overnight bank rate for interbank transactions which ultimately determines the supply price of domestic credit. In the equation above, the Cash Rate determines the price of bank credit to manage domestic credit creation .Consequently, the demand for bank credit becomes supply side determined.

In 1993, the RBA announced it would target inflationary expectations within a proposed 2% - 3% target range over a set period of time. The level of inflation was to be maintained at the equilibrium aggregate output level at which the actual rate of unemployment equalled the Non- Accelerating Inflation Rate of Unemployment or NAIRU. This measure of unemployment is sometimes referred to as the natural rate of unemployment NRU. However, there is a technical difference. NRU refers to an econometric model in which all markets clear under pure competition. NAIRU however, assumes some market imperfection; but, markets still clear. Originally the terms were used to distinguish between employment in the USA and employment within the European economic system.

The real problem with monetary policy lies not in its definitions of the labour market; but, in its underlying economic philosophy. The terms NAIRU and inflation targeting are directly identifiable with Friedman's inflation-augmented Phillips curve. Consequently, monetarism is clearly a dominant economic philosophy underwriting Australian monetary policy. The other economic philosophy which underwrites econometric modelling is neoclassical general equilibrium theory. Combined, these two economic philosophies underwrite both the New Neoclassical Synthesis and the New Keynesian Synthesis. The difference between the two synthesis revolves around a New Keynesian Synthesis additional assumption of monopolistic competition in its DSGE model.

Significant change in monetary policy emerged with the announcement that the RBA recognised the money supply being endogenous in 1988. Whilst this was consistent with global monetarism, the assumption of an endogenous money supply officially moved applied monetary policy from post War demand management to supply management of the monetary policy arm.

Supply side monetary policy dates back the 1920's and R.G. Hawtrey's monetary trade cycle theory. It is a theory from the forgotten economic philosophies of Classical, Neoclassical, Monetarism, and Austrian economics which had nothing to offer during the dislocation of the Great Depression. In 1936 Keynes released his General Theory of Employment, Interest and Money in which monetary policy is a demand side policy arm.

In February 1990, the RBA announced that the Cash Rate would be the official policy instrument. This announcement identified the supply side monetary policy instrument that would influence the price of bank credit. From that point onwards, if a demand side problem arose, then monetary policy had to firstly adjust the supply side price of credit consistent with monetary policy stance. Then the policy stance must work its way through the transmission mechanism of the banking system to influence the demand for credit. By influencing the price of credit to industry, aggregate demand response influences the demand for labour and hence the unemployment rate. This of course is a convoluted application of early nineteenth century Say's Law of Markets interpreted by Professor Pigou in 1926

As monetary policy is concerned with inflation measured in a basket of goods, an important question becomes what happens to prices not measured in the CPI basket of goods particularly in asset markets?

Negative gearing provides an attractive policy option for two obvious groups: high income earners and lowly encumbered middle-income groups. As interest rates rise, these groups can utilise negative gearing taxation advantage to minimise tax imposts whilst building an asset wealth portfolio. The DCE component of the domestic money supply increases to meet the rising demand for bank credit to purchase assets. Asset inflation then becomes the unrecognised outcome of supply side monetary policy. In a modern densely populated urbanised economy, home ownership for rental income becomes a prime asset target.

The flow on from asset accrual affects living standards of low-income groups as rentals rise to offset mortgage repayments of asset owners. Low income groups face financial pressure as disposable incomes must manage increases in home mortgages; and or, rising rental payments. The current crisis of homelessness can be attributed to supply side monetary policy generating asset inflation in the residential home market forcing low-income groups into tents and cars for shelter.

Asset inflation destroys the social fabric of society by structuring a wealth-based class system. The favoured group of high incomes build wealth whilst the remainder low-income groups endure declining living standards as monetary policy does its work. In the real world, supply side monetary policy directed to bringing actual unemployment equal to NAIRU is devoid of any semblance of morality as it implies enlightened self-interest always operates in the public interest. Consequently, the economy divides into a two-class system comprising an asset wealthy class and a lower income underclass. The impact of asset inflation on the social fabric must be profound as it highlights that enlightened self-interest does not always serve the public interest.

Resentment within the lower income strata would be expected to increase social discontent and fuel a rising crime rate. Moreover, youth resentment would be expected to be high generating youth rebellion and rising crime levels. Resentment of a two-class system would be expected to fuel activism in other social areas of society as the underclass seeks a political voice to express discontent with a failing economic system.