Goals of monetary policy
Role of underlying inflation
Implementing monetary policy
Tightening of MP
Loosening of MP
How other rates change
'Open mouth operations'
Exchange rate intervention
Monetary policy stance
Monetary policy neutrality
MP and economic goals
MP strengths and weaknesses
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Monetary policy to achieve low inflation
A restrictive monetary policy stance will typically involve a tightening of policy that leads to an increase in interest rates across the economy. These higher interest rates eventually reduce inflationary pressure in three main ways:
- First, via containment or restrictions in the growth of AD via the transmission channels referred to earlier. This reduction to the growth in AD over time makes it less likely that the economy will be producing at its productive capacity, limiting any price increases from profit maximising producers operating under capacity constraints. Similarly, the slower growth in AD and GDP should contain growth in labour demand, reducing pressure on wage costs, further limiting inflationary pressure.
- A tightening of monetary policy will tend to have its full effects felt in the economy up to two years after the cash rate is lifted. That is, there can be a 'time lag' of up to two years before a tightening of policy actually reduces the rate of inflation! This is a weakness of monetary policy.
- Given the time lag affecting monetary policy, all RBA deliberations must be forward looking or anticipatory, to gauge what inflationary pressures are building over the next couple of years rather than what is happening to inflation at the current time.
- Second, to the extent that higher interest rates cause an appreciation in the value of the currency, there is a direct and favourable impact on inflation. The prices of imported consumer goods should fall, having a more immediate impact on containing the CPI. Similarly, there should be a fall in the prices of producer imports (including the cost of capital equipment) which assist in containing the CPI over the medium term once some of these cost reductions are passed onto consumers.
- Third, the policy tightening signals to economic agents (consumers, producers and governments) that the RBA is serious about containing inflation and this helps to contain inflationary expectations. The inflation targeting by the RBA (i.e. 2-3%), combined with a clear commitment to achieve this target, are keys to ensuring that the expectations of inflation are low. With low inflationary expectations, price rises are not factored into decision making by economic agents, helping to keep actual price rises to a minimum. For example, if unions do not expect high inflation, they will not commence negotiations from a starting point of X % wage increase to protect the real wages of its members. This prevents the expectations becoming self-fulfilling as higher wages tends to increase costs and increase prices, which can precipitate a wage-price spiral.