Ch 2: The Economic Environment

Question 1

Microeconomics vs macroeconomics

Answer 1

Microeconomics:

• study of each basic economic unit within the economy (businesses, households, individuals, industries)
• focus on how these units determine the pattern of production, distribution of G&S and what products consumers purchase

Macroeconomics:
- analysis of nation’s economy as a whole, interrelationship of each of the individual sectors, using aggregate data like price levels, unemployment, inflation and industrial production

Question 2

Any financial system can be viewed as a ‘flow of funds”

Flow of funds is interplay between which 5 broad sectors:

Answer 2

5 broad sectors:

• household
• business
• finance
• government
• overseas

Question 3

General characteristics of flow of funds: (5)

Answer 3

1. the general public and households are net investors
2. government and semi government entities are net borrowers (given a long term perspective)
3. corporate sector is a net borrower
4. financial intermediaries are net neutral, with funds borrowed and lent being approximately equal
5. overseas sector is a net lender to the Australian economy

Question 4

Interest rate:

• how optimised
• factors taken into consideration

Answer 4

Interest rate:

• how optimised: where the demand for funds from those in deficit equals the supply of funds from those in surplus
• factors taken into consideration: inflation, risk, liquidity and the transaction term

Question 5

Inflation

• define
• measured by
• alternative measure

Answer 5

Inflation

• define: rise in price level over a given period (average level of prices for G&S)
• measured by: quarterly CPI
• alternative measure: implicit price deflator for GDP; “GDP deflator”

Question 6

Effects of inflation:

Anticipated inflation = ?

Answer 6

Effects of inflation:
Anticipated inflation = increase in prices that people expect to pay and for which they can make adjustments in their transactions
Nominal rates of interest rise in accordance with expected rate of inflation to maintain constant expected real rates of return
- When inflation is constrained or within acceptable levels, people do not feel the need to switch frmo cash / sec urities into real assets like property or gold

Question 7

Unanticipated inflation = ?

Answer 7

Unanticipated inflation = surprise. Allowance not made. Therefore some incomes fail to rise as much as other prices, which leads to redistribution of real income within economy.

Question 8

2 ways in which the level of inflation affects interest rates:

Answer 8

1. RBA has low inflation as its key MP target (high infl -> adverse effects, such as declining income standards for fixed income earners, potential fall in A$, lack of confidence in system. Persistent inflation above target band would lead RBA to raise interest rates to slow down economic activity and decrease supply of money
2. inflation erodes wealth. increased inflation -> decreased purchasing power. To mitigate; higher level of interest is demanded by investors to maintain real rates of return

Question 9

Inflationary pressures caused by: (3)

Answer 9

1. increase in manufacturing costs eg increase cost of imports or fall in A$.. Also, increase in salaries (cost push)
2. increase in demand for G&S due to excess cash in economy (demand pull)
3. expectations of future inflation

Question 10

Nominal vs real

Answer 10

Nominal: actual value of G& S
Real: actual value of G&S adjusted for the effects of inflation

Question 11

Fiscal policy =

Main vehicle for implementation =

Answer 11

FP = use of expenditure and revenue raising powers of government to achieve macroeconomic policy objectives
Main vehicle for implementation = Commonwealth budget (can be expansionary, contractionary or neutral

Question 12

A neutral fiscal policy = xxx budget
Deficit = xxx budget
Surplus = xxx budget

Answer 12

A neutral fiscal policy = balanced budget
Deficit = expansionary budget
Surplus = contractionary budget

Question 13

Is FP more or less flexible vs MP?

Answer 13

Less: due to time and detail needed to change.

has little effect on short end of yield curve, main impact is on longer maturities

Question 14

Monetary Policy =

Answer 14

Monetary Policy = attmpts to achieve one or more policy objective by influencing monetary variable such as the money supply and interest rates and hence the volume of aggregate demand.
Responsibility of RBA

Question 15

Incomes Policy =

Answer 15

Incomes Policy = coordinated govt actions to influence wages and prices.
- likely to be ineffective in conditions of full employment and excess demand

Question 16

RBA sets interest rates to achieve objectives in RBA Act 1959.
3 objectives:
Practical target:

Answer 16

1. stability of the currency in Australia
2. maintenance of full employment
3. economic prosperity and welfare of the people of Australia

Practical target:
Cpi in 2 - 3% band over medium term to preserve the value of money

Question 17

How does RBA achieve macroeconomic policy objectives?

Answer 17

• Use domestic market operations to keep cash rate as close as possible to target set by RBA board, by managing supply of funds available to banks in money market
• Cash rate determined by demand / supply of overnight funds. RBA controls supply at which banks use to settle. = exchange settlement funds.
• If RBA supplies more exchange settlement funds than required; banks try to shed by lending in cash market, which causes cash rate to fall.

Question 18

RBA & FX

Answer 18

• floating of A$ is a dirty float, as RBA may intervene from time to time for smoothing and testing
• will intervene if there is a misalignment of exchange rate; undertaking more routine operations in FX (eg rebuilding reserve holdings); cover sales of FX to customners; adjust mix of currencies that it holds

Question 19

Interest rates and exchange rates

• Interest rates affect economic activity by…
• Increase in aggregate demand leads to…
• Inflation is influenced by….

Answer 19

• Interest rates affect economic activity by influencing savings & investment behaviour, spending behavious, supply of credit, asset prices and the exchange rate; all of which affect level of aggregate demand
• Increase in aggregate demand (together with increase aggregate supply) leads to inflation in economy.
• Inflation is influenced by the effect that changes in interest rates have on the price of imported goods via the exchange rate; and through inflation expectations

Question 20

Important determinant of country’s exchange rate:

Answer 20

Whether it has a higher or lower inflation rate than trading partners. If higher, then exchange rate will depreciate to prevent progressive loss of competitiveness.

Question 21

Interrelationship between interest rates and equity prices

Answer 21

Equity market responds to economic fundamentals, therefore is closely tied to the economic growth of the country
Increase interest rates -> equities tend to sell off as investors grow concerned about increased costs to business of servicing this debt and impact on profitability

Question 22

trade weighted index:

- define

Answer 22

trade weighted index:

• define: strength of A$ vs basket of currencies of major trading partners.
• Composition is determined by Aus 2-way trade with major trading partners.

Question 23

International trade multiplier

- define

Answer 23

International trade multiplier

- define: process whereby changes in imports or exports from one country affect the income of another

Question 24

Influence of overseas interest rates on Aus interest rates:

Answer 24

• eg if Fed Reserve raises rates, it may attract inflow of funds from other countries, causing USD to appreciate. This causes outflow of capital from other coutnries, including Aus