The present implementation of tight monetary policy is directed towards the alleviation of the current account deficit (CAD). This thesis investigates the effectiveness of a monetary contraction, operating through the channel of relatively high interest rates, in reducing private imports of goods and services.
Traditional Mundell-Fleming theory identifies two main effects of monetary policy. Firstly, the higher interest rates may reduce income, thereby curbing domestic expenditure and concomitantly the demand for imports. Secondly, relatively higher interest rates also encourage capital inflow into Australia, which may appreciate the Australian dollar (AUD). The stronger AUD may reduce the domestic price for imports and induce expenditure-switching from Australian goods to imports, thereby exacerbating the CAD.
Empirical examination suggests Australia has a high income-elasticity of demand and low price-elasticity of demand for imports. The income-reduction effect therefore dominates the expenditure-switching effect in the short-run.
Consequently, the effectiveness of high interest rates in curbing domestic demand is a vital issue. Empirical analysis shows a negligible relationship between interest rates and demand, which implies monetary policy may not be the most appropriate policy instrument with which to dampen demand.
Explanations for the seemingly weak linkage between interest rates and demand focus on uncertain time lags and the impact of deregulation. Excessive reliance on tight monetary policy may also crowd out investment - to the detriment of the longer-term growth of the Australian economy. Consequently, tight monetary policy is not considered the most expedient policy with which to reduce the CAD.