The primary objective of monetary policy is to reduce and contain inflation and inflationary expectations. Keeping this objective in view a number of OECD (Organisation for Economic Co-operation and Development) economies adopted the Direct Inflation Targeting Monetary Policy. New Zealand was the first to adopt the same in 1990, but this also included sweeping changes to infuse autonomy and accountability in the functioning of the monetary authority, in this case the Reserve Bank of New Zealand. Over the years to strengthen the case of inflation targeting, it also introduced a stringent act to contain fiscal profligacy which led to fiscal deficits, rendering the monetary policy useless. Over time the economy stabilised with a steadying of the inflationary expectations and a gradual reduction of unemployment rates. The fluctuations in the GDP also moderated over time. The most significant outcome was the stability of prices and inflation expectations for this small resource constrained small open economy. The pedagogical objectives are: (1) to provide an understanding of the dynamics of monetary policy; (2) to analyse the interaction between monetary and fiscal policy; (3) to provide a thorough understanding of monetary and fiscal policy in the case of a small open economy; and (4) to provide a thorough analysis of the effect of inflation stabilising and containing monetary policy on long run unemployment and gross domestic product of an economy.
