For my degree, i was told to review an article. Well i did it, and scored 15/20, 75%, and i thought id share this Macroeconomics Economics Article Review with you
"Atkin, T and La Cava undertake the task of reviewing the transmission of monetary policy and explaining the channels through which monetary policy influences the Australian economy. The article surmise’s that the transmission occurs under 2 main stages, alteration of the cash rate (interbank overnight lending rate) and subsequent changes in the interest rates (cost of borrowing and reward for saving). It is implied that understanding the transmission process is key for achieving macroeconomic objectives such as 0 cyclical unemployment and for controlling economic activity.
The article states that the first stage of the transmission process is when the central bank alters the cash rate. This causes the interest rates for households and businesses in the economy to change affecting the borrowing and lending markets. Estimates suggest lowering the cash rate by 100 basis points leads to GDP being ½-¾% higher across 2years. Atkin, T and La Cava imply that the size of the change is not dependent on the “interest rate pass through”, whilst others such as Apergis and Cooray would disagree stating that the asymmetric character of pass-through remains active in Australia (Apergis N and A Cooray 2015). Other factors such as risk also effect these interest rates and data from the article shows that interest rates and the cash rate move in the same direction (interest rates>Cash Rates).
The second stage of transmission is the knock-on effect of the change in the interest rate upon 4 sub channels: The exchange rate, asset prices, investment & saving, and the cash flow. The change in these sub channels alters GDP and consumer expectations allowing the government to manipulate price level and output in the economy.
Upon the investment channel the article states that durable goods such as cars and housing investment are the most sensitive components of expenditures to changes in the interest rate. Thus, lower interest rates would increase investment and the change would largely be accounted for by new expenditure in these two categories, along with business investment as lower interest rates justify new investment projects due to higher expected returns. This implies that these are key components for governments to manipulate in the transmission process. Lawson and Rees found concluding evidence of this in their 2008 study, A Sectoral Model of the Australian Economy, as dwelling investment was the most sensitive component to structural shocks.
However, their sensitivity analysis was based on the period of 1983-2007 which notably is dated. The 1990s ICT revolution and increased transport efficiency have altered the structure of world economies since. This means that sensitivity levels assumed in the article based on Lawson and Rees study may be unrepresentative. As accessibility of overseas funding and imports of machinery have become a lot easier, consumption and investment are likely to be less dependent on domestic interest rates, as firms can now cheaply import machinery from China (substitution effect), meaning the government won’t be able to adjust GDP as much as the article suggests.
Furthermore, via the exchange rate channel, the article states that contractionary monetary policy, increasing the cash rate thus increasing the interest rate, causes appreciation of the AUD, as demand pull inflation occurs due to overseas investors gaining a higher return. This would lead to a decrease in net exports, as exports would become more expensive to foreigners, and thus reduce GDP.
However, Australia has an open, mixed-market economy, with around 19% of GDP coming from exports meaning that the economy is not dependent on exports (Trading Economics, 2018). This represents that this channel, is not as influential in the transmission of monetary policy which is backed up by: “estimates suggest that a 10% depreciation lifts export by 3%” representing inelastic elasticity of demand for Australian exports in relation to price.
The cash flow channel mainly affects borrowers as a lower interest rate reduces the amount of monthly interest home owners pay pack on their mortgages. Owner occupier home loans for Australia in July 2018 were very high at $21.2 billion demonstrating how lower interest rates could significantly increase consumers disposable income along with their expenditure (80% variable loans in Australia) (Australian Bureau of Statistics, 2018). This explains the authors emphasise upon the importance of the housing market for the transmission process, as it largely impacts upon the main component of GDP, consumer expenditure.
The final channel is asset prices and wealth. Lower interest rates stimulate demand for assets raising their price. Subsequently the borrowing capacity of entities increase as banks are willing to lend larger amounts thus investment increases. Estimates for Australia suggest a 1 dollar change in housing wealth equals a 3-cent change in non-housing consumption showing once again that “increased wealth leads to increased consumption”. (Windsor, Jääskelä, & Finlay, 2013) (La Cava, Windsor, & Hansen, 2015).
Overall the article shows how all the above channels cause a change in GDP, via altering its components. The explanations of the change show the transmission phases while the magnitude of monetary policy is discussed in minimal depth although it likely depends on the size of the intertemporal substitution effect and MPC."