The high Australian dollar is not an unwanted side-effect of tighter monetary policy - it’s actually a key part of the way higher interest rates work.

The Reserve Bank of Australia (RBA) is not coy about this.

For those who are interested, its website has a helpful section titled “The Transmission of Monetary Policy to the economy”.

It includes a handy illustration showing five elements of the economy - interest rates, the exchange rate, price expectations, prices, and activity.

For activity, read gross domestic product (GDP).

The diagram shows interest rates affecting activity directly, but also via the exchange rate.

Higher interest rates squeeze consumer spending and business investment, the effect most people would consider the main transmission mechanism for monetary policy.

But higher interest rates suck hot money in from overseas, bidding up the price of the Australian dollar.

Research published by the RBA has found a 25 basis points (quarter percentage point) increase in the cash rate can push the exchange rate up as much as two per cent, all other things being equal, and the effect can last for over a year.

So far in the current cycle, we have had five such increases and the futures market is betting there will be another three.

That’s not to say all other things really are equal.

Export commodity prices are a key driver of demand for the Australian dollar over the medium term.

And they have bounced back on international markets after the shock of the global financial crisis, rising by 19 per cent since last May to be more than double their level six years ago, according to RBA data.

As a result of this - and Australia’s status as the last man standing as the other industrialised economies slipped into recession - the Australian dollar has been pushed higher.

At just under 93 US cents, it is 28 per cent above the average for the period since it was floated in December 1982 and nearly 40 per cent higher than it was in the period of steady economic growth between the early-1990s recession and the beginning of the commodities boom in 2004.

A higher exchange rate has its effect by diverting demand offshore.

Exporters will be undercut by foreign competitors, while local businesses will find their market share being eroded by importers.

So for any given level of demand, both globally and within Australia, exports will be lower and imports higher, and production of goods and services by Australian businesses will consequently be less.

In the parlance of economists, this amounts to a negative contribution to growth from net exports, a blow to the economy comparable to the direct impact of higher interest rates on consumer spending and business investment.

And slower growth in output means slower growth in the employment of labour used to produce that output.

Balancing that, the booming mining sector with its boost to incomes will be a major generator of activity.

The RBA will be trying to contain inflationary pressures by limiting the economy’s growth rate to around its long-term average pace.

But, thanks to rising interest rates and the soaring exchange rate, variations within the economy around the average could be extreme.

It should not be long before economists once again start comparing the economy to someone lying with their feet in the fire and their head in the fridge: just right on average, but still not all that comfortable.

AAP