Monetary Policy

Running head: Monetary policy
Monetary Policy
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2
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