2014 a ‘litmus test’ for Australia economy: Goldman

How will Australian markets fare this year?

Australia – often referred to as the "lucky country" for its wealth of natural resources – will face a litmus test this year as the economy continues to transition from its reliance on commodities towards broader-based growth, Goldman Sachs said.

"2014 will be the litmus test for the Australian economy. Hopes appear high that the asset price gains of 2013 will transition into accelerating final demand growth in 2014," Tim Toohey, head of Economics, Commodities and Strategy (ECS) Research, Australia and New Zealand at Goldman Sachs wrote in a report on Monday.

"Expectations for better U.S.-led developed market economic growth, a clear turn in housing activity and easy domestic financial conditions, a consensus has formed across the economics community and financial markets that a recovery has commenced in Australia," Toohey added.

(Read more: End of boom? Not for Australia's iron ore miners)

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But Goldman Sachs is less upbeat about its outlook for the economy, forecasting a slowdown in growth to 2 percent in 2014 - below an expected 2.5 percent in 2013 and consensus estimates of 2.7 percent this year.

As a result, it believes interest rate cuts by the Reserve Bank of Australia (RBA) are more likely than hikes this year. The bank's base case is for a 25 basis point rate cut in March.

The country's cash rate currently stands at a record low of 2.5 percent. The central bank has cut rates eight times since November 2011.

(Read more: RBA says low rates working, won't rule out more cuts)

Macquarie: Australian sentiment is improving

"We believe the combination of rising unemployment and benign inflation dynamics, together with a challenging income environment and intensifying fiscal drag, will warrant further policy accommodation from the RBA," he said.

Australia's jobless rate rose to 5.8 percent in November from 5.7 percent in October, nearing a post-financial-crisis high.

(Read more: Why the Aussie dollar may spiral to 85 cents)

In addition, while a recovery in the non-mining sector appears underway, it is building too slowly ahead of the mining growth drag, Toohey noted.

"The response of the non-mining economy to previous interest rate reductions has been usually slow," he said.

Gross National Expenditure – a broad measure of domestic economic demand – for example, had declined in three out of the last four quarters, according to the bank.

(Read more: Has the tide turned for corporate Australia?)

"The delay in moving financial conditions into clear expansionary mode, high household deposits vis-à-vis history, fiscal restraint, domestic political uncertainty and an uncertain global backdrop were all reasons why the transmission mechanism from monetary policy may have been weaker in the post commodity peak period," he said.

—By CNBC's Ansuya Harjani. Follow her on Twitter: @Ansuya_H