ECNM10024 Monetary Policy

"Why can the RBA only maintain the interest rate, the inflation rate or the exchange rate but not all three variables together? For instance, if it chooses to maintain the inflation rate, why does the interest rate and the exchange rate change over time?"

Answer

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 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.

                                   

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.

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