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Lesson M20.L06: AUD and Monetary Policy: RBA in an Open Economy

Module: Open Economy Macroeconomics Part I Level: intermediate Duration: 30 minutes Learning Objective: Evaluate the exchange rate channel of monetary policy transmission for Australia. Data as of: 2024 Provenance: RBA Exchange Rate Research | Productivity Commission

Explanation

When the Reserve Bank of Australia (RBA) tightens monetary policy — raising the cash rate — the transmission to the real economy operates through multiple channels. In an open economy like Australia, the exchange rate channel is one of the most important.

The exchange rate channel — two pathways:

1. Direct (import price) channel: - RBA raises cash rate i - Australian assets more attractive → capital inflows → AUD appreciates - Stronger AUD → import prices fall (measured in AUD) - Lower import prices directly reduce headline CPI (imports are ~20% of the consumer basket) - Inflation falls without requiring a major output contraction

2. Indirect (net exports) channel: - AUD appreciation → Australian exports more expensive in foreign currency → export volumes fall - AUD appreciation → imports cheaper → import volumes rise - NX falls → aggregate demand falls → output gap widens → labour market loosens → wage and price pressures ease - Inflation falls via reduced domestic demand pressure

Australia's unique feature: the commodity currency. The AUD is strongly correlated with global commodity prices, particularly iron ore and coal (Australia's two largest exports by value). This means the exchange rate moves partly in response to terms-of-trade shocks independently of RBA policy:

  • Iron ore prices ↑ → AUD↑ → import prices fall → inflation down (without any RBA action)
  • Iron ore prices ↓ → AUD↓ → import prices rise → inflation up → RBA may need to tighten

This "commodity currency" property means the RBA effectively gets some exchange rate stabilisation "for free" during commodity booms, but faces headwinds during commodity busts when the AUD depreciates and import inflation rises.

Quantifying the exchange rate channel. RBA research (Jääskelä and Jennings, 2011; and subsequent RBA MARTIN model estimates) suggests the exchange rate channel accounts for approximately 20% of the total transmission of monetary policy to inflation in Australia. The remainder flows through: the credit channel (~35%), the asset price/wealth channel (~25%), and the cash flow channel on variable-rate mortgages (~20%).

2022–23 case study. The RBA raised the cash rate by 4.25pp (from 0.10% to 4.35%) between May 2022 and November 2023. Despite this, the AUD depreciated from ~USD 0.76 to ~USD 0.63 in 2022 — the opposite of what the exchange rate channel predicts. Why? The US Federal Reserve raised rates by ~5.25pp, strengthening the USD globally. The AUD-USD differential favoured USD assets, overwhelming the domestic rate rise effect. This illustrates that the exchange rate channel depends on relative interest rates (UIP: i − i* = expected depreciation), not just the absolute RBA rate.

Notation: - i = RBA cash rate; i* = world (US Federal Funds) rate - e = AUD/USD exchange rate (lower = more depreciated AUD) - P_M = import price index (in AUD); CPI = consumer price index - ToT = terms of trade (export prices / import prices) - NX = net exports; Y = aggregate output

Worked Example

Question: The RBA raises the cash rate by 1 percentage point (100 basis points). Assume: - AUD appreciates by 3% (using a rule of thumb: 1pp rate rise → ~3% AUD appreciation) - Imports are 20% of the CPI basket - A 3% AUD appreciation reduces import prices by 3% - The indirect demand channel reduces output by 0.4% after 4 quarters - Phillips curve: each 1% output gap reduces inflation by 0.2pp

Calculate the total effect on inflation from: (a) direct import price channel; (b) indirect demand channel; (c) total.

Step (a) — Direct import price channel:

\[\Delta P_{imports} = -3\% \quad (\text{AUD appreciates 3\%})\]
\[\Delta CPI_{direct} = \text{import share} \times \Delta P_{imports} = 0.20 \times (-3\%) = -0.6\text{pp}\]

Direct channel reduces inflation by 0.6 percentage points.

Step (b) — Indirect demand channel:

Step b.1 — Output effect:

\[\Delta Y / Y = -0.4\% \quad (\text{output gap from NX contraction})\]

Step b.2 — Inflation effect via Phillips curve:

\[\Delta \pi_{indirect} = -0.2 \times (-0.4\%) = \mathbf{+0.08\text{pp}}\]

Wait — this is a reduction in inflation (output gap negative → inflation falls):

\[\Delta \pi_{indirect} = 0.2 \times \Delta \text{output gap} = 0.2 \times (-0.4\%) = -0.08\text{pp}\]

Indirect channel reduces inflation by 0.08 percentage points.

Step (c) — Total exchange rate channel effect:

\[\Delta \pi_{total} = \Delta \pi_{direct} + \Delta \pi_{indirect} = -0.60 + (-0.08) = -\mathbf{0.68\text{pp}}\]

A 1pp RBA rate rise, operating purely through the exchange rate channel, reduces inflation by approximately 0.68 percentage points (mainly via the direct import price route).

Step (d) — Context: full monetary transmission.

If the exchange rate channel represents ~20% of total monetary transmission, then:

\[\Delta \pi_{total\_all\_channels} = \frac{\Delta \pi_{exchange\_rate}}{0.20} = \frac{-0.68}{0.20} = -3.4\text{pp}\]

A 1pp rate rise is estimated to reduce inflation by approximately 3.4pp across all channels (exchange rate + credit + asset prices + cash flow). This is a rough upper bound; actual transmission is slower and spread over 12–24 months.

Step (e) — 2022–23 RBA tightening:

Cash rate rose from 0.10% to 4.35% = +4.25pp.

Expected exchange rate channel (if AUD had appreciated as predicted): - AUD appreciation: 4.25 × 3% = ~12.75% - Direct inflation reduction: 0.20 × 12.75% = ~2.55pp

Actual AUD depreciated ~17% (from 0.76 to 0.63), implying the exchange rate channel worked in reverse — adding to inflation pressures. The RBA had to rely more heavily on domestic demand channels (credit, mortgage cash flow) to tighten conditions.

Common Misconception

Misconception: "If the RBA raises rates, the AUD will always appreciate and inflation will always fall through the exchange rate channel."

Correction: The AUD appreciation from a rate rise requires that the interest rate differential (Australian rate minus world rate) increases. If other central banks — especially the US Federal Reserve — raise rates by the same or more, the AUD-USD differential may not improve or may worsen, leading to AUD depreciation despite the RBA tightening. In 2022, the Fed's aggressive 5.25pp tightening outpaced the RBA's 4.25pp, resulting in AUD depreciation and adding to Australian import prices. The exchange rate channel of monetary policy is always conditional on global monetary conditions, not just domestic RBA actions.

Practice Prompts

  1. Conceptual: Explain two channels through which RBA rate tightening reduces inflation in an open economy. Which is more direct and faster-acting?

→ Answer: (1) Direct import price channel: higher i → AUD appreciates → import prices fall in AUD terms → CPI falls directly. This is faster (exchange rate moves within days to weeks; import prices follow within months). (2) Indirect demand channel: higher i → AUD appreciates → NX falls → aggregate demand and output fall → labour market loosens → wage and price pressures ease → inflation falls. This is slower (works through the output gap and labour market, taking 12–24 months for full effect). The direct channel is faster and more predictable but only addresses traded goods inflation (~20% of CPI), while the indirect channel affects the broader inflation process.

  1. Numerical: Import share of CPI = 0.18. AUD depreciates 12% due to a global commodity price crash. Calculate the direct pass-through inflation effect. If the RBA wants to fully offset this with rate cuts that cause AUD appreciation, and each 1pp rate cut causes 2.5% AUD appreciation, how many basis points of rate cuts are needed?

→ Answer: - Direct inflation effect: 0.18 × 12% = 2.16pp (AUD depreciation adds 2.16pp to CPI) - To offset: need AUD to appreciate 12% - Required rate cuts: 12% / 2.5% per pp = 4.8pp = 480 basis points of rate cuts

This illustrates why a large depreciation shock requires substantial monetary easing to offset via the exchange rate channel alone — and why the RBA typically relies on multiple transmission channels simultaneously.

  1. Application: The AUD is often called a "commodity currency." During a global iron ore price boom, how does this commodity-currency property affect the RBA's inflation management task?

→ Answer: During an iron ore boom: (i) commodity export revenues rise → current account improves → AUD appreciates independently of RBA policy; (ii) AUD appreciation → import prices fall → CPI decreases (helpful for inflation control); (iii) higher mining incomes → domestic demand rises → upward pressure on non-traded goods and services prices (wage inflation, housing). The RBA faces a mixed picture: tradeable inflation is suppressed by AUD appreciation, but non-tradeable inflation may rise from mining-income-driven demand. The commodity-currency AUD appreciation provides some automatic monetary tightening (import prices fall), allowing the RBA to be less aggressive with rate rises. Conversely, when commodity prices collapse and AUD depreciates, the automatic tightening reverses, and the RBA may need to cut rates less than it otherwise would — or may even face a depreciation-driven inflation surge requiring tightening despite weak domestic conditions.

Further Resources