Monetary Policy

This article discusses the purpose of monetary policy and why it is impossible to control the interest rate, inflation, and exchange rate simultaneously. The Reserve Bank of Australia no longer uses the exchange rate to manipulate the market, and instead focuses on reducing inflation and spurring economic growth. The article explains the relationship between the variables and how they impact each other. It also discusses the effects of inflation on the interest rate and the exchange rate on the prices of goods and services.

Running head: Monetary policy
Monetary Policy
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Monetary policy
QUESTION ONE
The main purpose of monetary policy is to maintain price stability in the economy according to
the Reserve Bank of Australia. Instruments used in monetary policy have varying degrees of
effect on certain variables such as the interest rate, inflation and the exchange rate. We will study
why the three mentioned variables cannot be controlled simultaneously by the RBA to achieve
monetary policy goals. To begin with, the RBA no longer uses the exchange rate to manipulate
the market as it views the instrument as a buffer against foreign market swings and allows
monetary policy to be deployed domestically in reducing inflation and spurring economic growth
(RBA, 2018).
Reserve Bank of Australia has implemented an inflation targeting regime and does not target a
specific level of exchange rate. The reason behind the impossibility of simultaneously juggling
the three is the relationship between the variables, for example the exchange rate has an effect on
the prices of goods (Jordi, 2015). Exchange rates dictate the amount of money that exporters and
importers earn through trade as it impacts on demand and competitiveness of Australian goods in
the international market. Therefore, the exchange rate impacts on the prices of goods and
services in the country and the rate at which they increase or decrease (inflation) (Manalo, 2014).
Under the current set up of floating the local currency, shifts in the exchange rate directly affect
the prices of commodities through changes in the value of goods and services. This phenomenon
is generally referred to as ‘exchange rate pass-through’ (Manalo, 2014).This relationship makes
it absurd to try to influence each variable independently in the quest to achieve monetary goals.
The relationship can further be explained using the previous regime of pegging the exchange rate
of the Australian dollar to another currency namely the GBP and much later the US dollar. Under

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Monetary policy
such a fixed environment, the local economy simply imported price increases from the nation
under which it had pegged its currency. A higher inflation rate in the pegged currency nation was
simply soaked up by the local currency and any measures to influence the inflation were
countered by these inflationary pressures from the pegged currency.
The interest rate is the rate of return on investment or can be viewed as a cost of borrowing
money and is affected by the supply and demand for money (Macfarlane, 2001). Significant
increases in the inflation rates tend to lead to an upturn in the interest rate as borrowing money
becomes riskier. There is normally a strong positive relationship between the rate of interest and
inflation as can be shown in the graph below from the Canadian economy.

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Monetary policy
If the RBA set the interest rates too low which created a strong demand in the market, it would in
the long run lead to inflationary pressures with a fixed nominal rate (Macfarlane, I.J. 2001). As
shown above, it is incomprehensible to try and affect all the three policies simultaneously and it
would be advisable to find a good monetary policy that creates the needed effects.

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Monetary policy
References
Jordi, G. (2015). Monetary Policy, Inflation, and the Business Cycle: An Introduction to the New
Keynesian Framework and Its Applications. Princeton University Press. 296-
114,241
Macfarlane, I.J. (2001). The Movement of Interest Rates. Retrieved from:
https://www.rba.gov.au/speeches/2001/sp-gov-180901.html
Manalo, J, D, Perera. & Rees, D (2014), ‘Exchange Rate Movements and the Australian
Economy’, RBA Research Discussion Paper RDP2014-11.
Reserve Bank of Australia. (2018). the Exchange Rate and the Reserve Bank's Role in the
Foreign Exchange Market. Retrieved from: https://www.rba.gov.au/mkt-
operations/ex-rate-rba-role-fx-mkt.html#four