The Objectives of Monetary Policy (HSC SSCE Economics): Revision Notes
The Objectives of Monetary Policy
What is monetary policy?
Monetary policy involves actions taken by the Reserve Bank of Australia (RBA), the nation's central bank, to influence both the cost and availability of credit throughout the economy. As a macroeconomic policy tool, it works alongside fiscal policy to smooth out fluctuations in the business cycle and influence key economic variables including activity levels, employment, and price stability.
In Australia and other advanced economies, monetary policy serves as the primary macroeconomic stabilisation tool over the short to medium term. The RBA operates independently from the Federal Government when making monetary policy decisions, though it works within a framework established by legislation and agreed statements with the government.
The RBA's authority stems from two key documents:
- The Reserve Bank Act 1959 sets out the formal objectives and powers
- The Statement on the Conduct of Monetary Policy is a complementary agreement between the Commonwealth Government and the RBA Governor that clarifies how these objectives should be pursued
The three formal objectives
The Reserve Bank Act 1959 establishes three formal objectives for monetary policy:
1. Stability of Australia's currency
This objective now means maintaining low and stable inflation and preserving the purchasing power of the Australian dollar. When prices remain relatively stable, the currency retains its value over time.
2. Maintenance of full employment
The RBA aims to sustain a low level of unemployment in Australia. Full employment is understood as the point where demand and supply in the labour market are balanced, with inflation at target. This represents the sustainable level of employment consistent with price stability over the longer term.
3. Promotion of economic prosperity and welfare
This objective primarily means maintaining a stable and sustainable economic and financial environment that allows households and businesses to prosper.
Recent reforms: the dual mandate
Following an independent review of the RBA in 2023, the first since inflation targeting was introduced in the early 1990s, significant recommendations were made about how these objectives should be understood and applied.
The 2023 review recommended clarifying the objectives as a dual mandate focused on:
- Price stability
- Full employment
Under this recommendation, the promotion of economic prosperity would not be a separate third objective but rather an overarching purpose for the RBA's work. This clarification aims to reduce discretion and help the RBA focus more clearly on two core goals.
The Government agreed in principle with all 51 recommendations from the review, which also included:
- Increased information sharing between the RBA and Treasury
- Reducing Board meetings from 11 to 8 per year
- Creating two separate boards (one for RBA governance, one for monetary policy)
- Improving transparency through public communication
- Implementing five-yearly reviews of monetary policy frameworks
The challenge of multiple objectives
Achieving all three objectives simultaneously can be difficult. Since the early 1990s, the RBA has generally prioritised the stability objective through its inflation-targeting regime. This prioritisation can sometimes come at the expense of the employment objective.
Example: The Inflation-Employment Trade-off
When inflation rises above the target range, the RBA will increase interest rates to bring prices back under control. However, higher interest rates can restrict economic activity and lead to rising unemployment in the short term.
This trade-off demonstrates why clarifying priorities is important for effective monetary policy.
Inflation targeting framework
What is inflation targeting?
Since the 1990s, Australia has followed international examples (such as Canada and New Zealand) in adopting an inflation-targeting framework. Under this approach, the central bank operates independently of government to keep inflation within a predetermined target range. The target is jointly agreed upon by the central bank and government.
The RBA's specific inflation target is to keep annual inflation between 2 and 3 per cent.
Why use inflation targeting?
The adoption of inflation targeting reflects several important characteristics of monetary policy:
Effectiveness against inflation
Monetary policy is particularly effective at fighting high levels of inflation. By making price stability the primary focus, the RBA can deploy its most powerful tool where it has the greatest impact.
Clarity of purpose
When assigned multiple goals simultaneously, monetary policy often struggles to achieve them all. Establishing one clear primary objective makes monetary policy more certain, consistent, and predictable for households and businesses.
Political independence
When governments control monetary policy directly, decisions can be distorted by political pressures. This is particularly problematic during election periods, when politicians may want to keep interest rates low even if that creates economic problems.
Giving the central bank independence in conducting monetary policy helps insulate interest rate decisions from short-term political considerations.
Supporting broader objectives
Inflation targeting has generally succeeded in keeping inflation low and stable without requiring excessively high interest rates that would harm growth and employment. Maintaining low and stable inflation over the medium to long run actually helps the RBA achieve its other objectives as well. This explains why price stability is the primary objective for the RBA and other central banks.
Managing expectations
To sustain low and stable inflation, inflation targets need to anchor expectations in the economy. If households and businesses expect inflation to remain low and stable, this expectation itself becomes a significant factor in keeping actual inflation low.
Flexibility in the target
The inflation target is deliberately expressed as a range (2–3%) rather than a precise number. This flexibility is important because:
- Inflation can be affected by external shocks outside the RBA's control (such as the COVID-19 pandemic or international conflicts)
- The RBA must use judgment to navigate these shocks and return inflation to near the midpoint of the target range
- Short-term deviations from the target are acceptable if the RBA is taking appropriate action to restore price stability
The target was previously expressed as "two and three per cent, on average, over time." However, the 2023 review recommended removing the qualifying words "on average, over time" because they weakened the RBA's accountability for inflation outcomes. The revised target maintains flexibility but with stronger accountability.
Price stability and economic prosperity
Price stability is desirable because it allows households and businesses to make decisions with confidence about the future. When prices are stable, people can plan investments, make purchases, and set wages without worrying about rapid changes in the value of money. This stability improves overall welfare in the economy, which is the overarching goal of monetary policy in Australia.
The RBA pursues this prosperity goal even if it means short-term inflation numbers temporarily fall outside the target range. The focus remains on achieving the target over the medium term while supporting sustainable economic growth.
Government support for the framework
Successive governments have consistently supported the RBA's flexible inflation target since its introduction in the early 1990s. This support is formalised through written agreements between the RBA Governor and the Australian Government.
The most recent agreement is the 2023 Statement on the Conduct of Monetary Policy, which followed the RBA review. This statement reaffirms:
- The Government's commitment to RBA independence
- Support for the inflation-targeting framework
- Recognition that both price stability and full employment are important objectives
Track record of inflation targeting
The inflation-targeting regime has now been in place for approximately three decades. The 2023 review of the RBA recognised that this regime "remains the best operational framework for monetary policy."
Successes
Since the regime was introduced:
- Inflation has averaged around 2.6% (very close to the midpoint of the target)
- Expansionary monetary policy successfully supported economic activity during major crises including:
- The Asian financial crisis (late 1990s)
- The global financial crisis (2007–08)
- The COVID-19 pandemic (2020–21)
Recent criticisms
Despite this overall success, monetary policy in Australia has attracted criticism in recent years:
Pre-pandemic criticism: In the years leading up to COVID-19, critics argued the RBA's monetary policy stance was not sufficiently expansionary, particularly when inflation was running below the target band. They suggested interest rates should have been lowered more aggressively.
Post-pandemic criticism: When inflation increased sharply in 2022, critics argued the RBA's response to COVID-19 had been too expansionary. Some blamed the low interest rate environment for contributing to subsequent inflation pressures.
These contrasting criticisms were part of the impetus for the independent review of the RBA completed in 2023.
Main economic indicators monitored by the RBA
When implementing monetary policy to achieve its objectives, the RBA monitors a wide range of economic indicators:
- Current inflation levels
- Expectations of future inflation
- Wages growth
- The unemployment rate
- Economic growth (GDP)
- Interest rates (both domestic and international)
- The exchange rate
- Commodity prices
- Terms of trade
- Global economic conditions
This comprehensive monitoring allows the RBA to assess the current state of the economy and make informed decisions about the appropriate stance for monetary policy.
Remember!
Key Points to Remember:
- Monetary policy in Australia is conducted by the RBA to influence the cost and availability of credit in the economy
- The three formal objectives are: stability of the currency (low inflation), full employment, and economic prosperity
- The 2023 review recommended clarifying these as a dual mandate: price stability and full employment
- Since the 1990s, Australia has used an inflation-targeting framework with a target range of 2–3% annual inflation
- Inflation targeting is effective because it provides clarity, supports RBA independence from political pressure, and helps the RBA achieve its broader objectives
- The target is flexible to allow for external shocks and requires the RBA to exercise judgment
- Over three decades, inflation targeting has been successful, with inflation averaging 2.6% since the regime's introduction