Monetary policy   Goals of monetary policy   RBA Charter   Role of underlying inflation   Implementing monetary policy   Tightening of MP   Loosening of MP   How other rates change   Pre-emptive decisions   'Open mouth operations' Exchange rate intervention  Monetary policy stance   Expansionary policy  Monetary policy neutrality    Restrictive MP   Transmission mechanisms   MP and economic goals   low inflation Growth/jobs  MP strengths and weaknesses

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 Course notes quick navigation

1 Introductory concepts 2  Market mechanism  3 Elasticities  4 Market structures 5  Market failures  6  Macro economic activity/eco growth  7 Inflation 8  Employment & unemployment  9  External Stability  10  Income distribution 11.Factors affecting economy  12  Fiscal/Budgetary policy  13  Monetary Policy   14 Aggregate Supply Policies  15 The Policy Mix

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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:

  1. 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.

  1. 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.

  1. 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.  
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