Reference no: EM13376051

Using the aggregate demand/aggregate supply model, and the information in the below quote, present a rationale for why the Board of the Reserve Bank of Australia kept the cash rate steady even though "underlying inflation is expected to remain relatively high in 2012 and 2013"1. In underlying terms, year-ended inflation is expected to pick up over the forecast period. While some moderation in quarterly rates of inflation is expected, it now looks likely that underlying inflation will be at, or above, 3 per cent in 2011.

The high exchange rate and subdued consumer spending are putting downward pressure on some prices, although increases in global prices for food and manufactured goods as well as a range of domestic cost pressures are working in the other direction. Based on the central scenario for the Australian economy, and the technical assumption of unchanged interest rates, underlying inflation is expected to remain relatively high in 2012 and 2013, Since November last year the Board has held the cash rate steady at 4.75 per cent.

The various financial indicators suggest that this setting of monetary policy is exerting a degree of restraint on the economy. Interest rates on most loans are a little above average, credit growth is very subdued, asset prices have generally declined and the exchange rate is high. While each of these variables is affected by other factors as well, together they point to financial conditions being tighter than normal. In view of the medium-term outlook for inflation, at its recent meeting the Board considered whether it was appropriate to tighten monetary policy further. On balance, its judgment was that it was prudent to maintain the current setting of the cash rate, particularly in view of the acute sense of uncertainty in global markets, which has contributed to heightened downside risks to global growth.