Tushaar Garg

Analyse the impact of monetary policy on economic growth, inflation and unemployment
within the Australian economy.
Introduction
Monetary policy forms the back-bone of the Australian economy, and is a vital facet of its prosperity in
uncertain economic times. The Reserve Bank of Australia (RBA) is Australias primary regulator of
monetary policy, through manipulation of the cash rate and interest rates; chiefly through its liquidity
management in the cash market. As a macroeconomic manager the RBA has used monetary policy,
since 1959, to effectively monitor the nations growth, inflation and unemployment levels. In the hope
of achieving internal balance the RBA has maintained a neutral monetary stance of late, responding to
economic events such as the Global Financial Crisis and Resources Boom.
Economic Growth
Sustainable economic growth is one of the RBAs primary objectives in the implementation of
monetary policy, as they must maintain the benefits achieved through 21 consecutive years of positive
growth. The RBA aims to maintain a variable target of 3-4%, just above the long term average of 3%.
This target is achieved and regulated through Domestic Market Operations (DMOs), as liquidity
management in the overnight money market has a flow on effect to the entirety of the economy.
The Transmission Mechanism, the flow-on effect, is exemplified in the reaction to, for example, the
purchase of Commonwealth Government Securities (CGS) from banks by the RBA. This will force banks
to sell CGSs, which will increase the quantity of cash in the overnight cash market; resulting in a
decreased cash rate. Banks will then proceed to pass this decrease in interest rates onto consumers,
who will now not only have to pay less on borrowed capital but also have a greater disposable income
as they can access more money at lower rates. This will primarily affect low income earners, as their
high average propensity to consume will result in increased spending within the economy. This acts as
loosening of monetary policy and will result in an increase in Aggregate Demand (AD), which indicates
the total demand for all goods and services within the economy over a period of time, in the short
term. John Keynes developed the following formula to calculate this expansion in productive capacity;
AD = C + I + G + (X-M). Thus, loosening of monetary policy will clearly increase AD, through great
consumption (C) and investment (I). Hence, through the transmission mechanism, expansionary
monetary policy clearly improves economic growth.
Prior to the GFC, long term sustained growth allowed the RBA to have a cash rate of 7.25% (2008), with
an aim to restrict growth to below 4%, as per the target band. As the GFC impacted on the Australian
economy by reducing economic growth, employment levels, the terms of trade and business
confidence, the RBA adopted an expansionary monetary policy stance and reduced the cash rate. Due
to the measures taken by the RBA prior to the GFC, they were able to drop the cash rate to an
emergency level of 3% (2009). In stark contrast, many developed nations such as Japan and the USA
already had such low interest rates, in desire of exponential growth, that they were unable to provide
a significant difference to consumers, and hence were unsuccessful in stimulating growth. However, in
Australia the drop of 4.25% resulted in mass increases in consumption and investment, allowing for
positive growth of 1.2% (2009).

Tushaar Garg
Inflation
Although economic growth is often at the forefront of macroeconomic policy use, the RBA also
conducts monetary policy to manage the nations inflation levels. Inflation is the reduction in
purchasing power from a sustained increase in price levels over a period of time, measured using the
Consumer Price Index (CPI). The RBA has conducted monetary policy to target 2-3% of CPI since 1998,
and have been very successful in maintaining one of Australias economic objectives of price stability.
In times of positive economic growth the likelihood of demand-pull inflation is often imminent, and
hence wage earners may expect a rise in the price level and may seek higher nominal wages. If
successful, this will result in a decrease in Aggregate Supply (AS) and result in cost push inflation, as the
businesses costs increase due to greater labour expenses. Hence, the wage-price inflation spiral may
occur, as the economy experiences demand pull and cost push inflation simultaneously. However, due
to the RBAs 2-3% target band, contractionary monetary policy is used to restrict the possibilities of
excessive inflation, thus limiting the chances of a wage-price spiral occurring. This is primarily through
implementation of such policy in increasing interest rates, as inflationary expectations will be
significantly reduced due to the contractionary stance implemented. However, give the publicised
nature of the 2-3% target band, it naturally acts as a jaw-boning mechanism, as consumers inherently
understand that the RBA will not allow the rate to pass the specified parameters; thus also reducing
inflationary expectations.
Monetary policy often targets broader aspects of the economy, such as economic growth, and hence
as interest rates drop to stimulate growth, inflation is adversely affected. Through the Transmission
Mechanism it is evident that loosening of monetary policy by the RBA results in lowered interest rates,
and consequently higher economic growth. However, if this resultant increase in expenditure is greater
than the economys total output, there will be mass pressure for the prices of goods and services to
rise, so they must be rationed amongst consumers, resulting in demand-pull inflation.

Figure 1.1

As seen in Figure 1.1 the AS curve will start to curve as resources start to become scarce until it
reaches a vertical angle for a set level of GDP. This is due to all resources being fully employed and no
more can be produced, therefore any increase in AD will only cause demand-pull inflation. This will
reduce the standard of living for low income earners, as their wages are not adjusted for short term
inflation, whereas the wealthy will have mass appreciation in the value of their assets, and hence,
reflects the detriment of expansionary monetary policy. Due to the ongoing effects of the GFC,
accentuated by the Eurozone Debt Crisis, the government has been forced to implement expansionary
monetary policy, which although has been largely successful in increasing growth has adversely
affected inflation, as seen in the rise of CPI from 1.4% (2011) to 2.6% (2013).

Tushaar Garg
Unemployment
Another one of the RBAs major objectives, and thus a concern of monetary policy, is the maintenance
of full employment within the nation. Unemployment occurs when people are without work and are
actively seeking work. It is measured as a percentage of the Australian labour force; all persons of
working age, 15 to 67, either employed in work or unemployed but actively looking for it. The effect of
monetary policy upon economic growth is what instigates an increase or decrease in unemployment
levels, as the holistic approach of macroeconomic policy does not allow for direct action upon
unemployment.

Figure 1.2

As the RBA adopts expansionary monetary policy, in the aim to increase economic growth, AD is
significantly increased. As seen in Figure 1.2, this increase in AD will subsequently increase Real GDP to
Real GDP1. This will increase the quantity and price businesses receive, thereby generating more funds
for the businesses to grow by employing more resources, seen in the Resources Gap. This resource is
often labour, and hence, will reduce unemployment. As cyclical unemployment is dependent on the
stage of the business cycle which the economy is in, this boom period, featuring an increase in AD, will
have it significantly reduced. During Australias sustained period of growth prior to the GFC, the
unemployment rate hit a decade low of 4.3% (2007), thus reflecting the positive result of expansionary
monetary policy upon unemployment.
However, overuse of expansionary monetary policy can lead to excessive growth, and as a result,
structural unemployment. As of late Australia has been affected by the Dutch Disease, resulting in a
two speed economy. Australia has experienced high rates of economic growth following greater
consumption and investment into the mining sector as interest rates are at record lows, this has been
accentuated by the Resources Boom; generating increased demand for the AUD as foreigners seek
returns in investing Australia. The appreciating AUD results in a loss of international competitiveness,
which although moot to the primary industry hubs in Western Australia and Queensland, adversely
affects the rest of the nation. Significantly reduced investment into non-primary industries forces them
to restructure and hence leads to retrenchment at the hands of innovation or closure. In 2011, uneven
growth due to the dual speed economy led to mass retrenchments, with unemployment rising to 5.2%.

Conclusion