Monetary policy affects the level of aggregate demand which can be shown using the Keynesian model or the classical model. For this section, we will use the Keynesian model to show the effects of monetary policy stances.

Expansionary Monetary Policy

The effect of the expansionary monetary policy is shown above, where low cash rates encouraged aggregate demand through the transmission mechanism. The increase in aggregate demand from AD1 to AD2 will increase real GDP from Y1 to Y2, which will also stimulate employment. The change from AD1 to AD2, as shown above, will also increase price levels from P1 to P2. This is appropriate as there is still spare capacity within the economy and the cash rates are stimulating inflation towards the target band of between 2-3%.

Contractionary Monetary Policy

The effect of the contractionary monetary policy is shown above. High levels of aggregate demand are reduced by high cash rates, which through the transmission mechanism, discourages private spending and net exports. The contractionary monetary policy reduces aggregate demand from AD1 to AD2. While this results in a fall in real GDP from Y1 to Y2 and some increases in unemployment, it is beneficial to the economy as it results in a larger fall in price levels from P1 to P2. P2 represents the target inflationary band of the Reserve Bank at 2-3%.

Beneficial Topics

Economic Government Policy Objectives The topics below explain the importance of the effects of monetary policy. The reason the RBA changes the cash rate is to best achieve the three main economic policy objectives.

• Sustainable Economic Growth

• Price Stability

• Full Employment