Economic and Financial Fundamentals

Question 1

 Explain the causes of inflation

Answer 1

o Inflation refers to the general increase in price and fall in the purchasing value of money

o	Cost-Push Inflation
	        Large increases in the costs of production
•	                Wages
•	                Oil Prices
•	                Other Inputs

o	Demand- Pull Inflation
	        Strong Growth in the spending of:
•	                Consumption
•	                Investment
•	                Government
•	                Net Exports

o Inflation occurs when demand for goods and services grows faster than the economy’s ability to produce them.

o Spending in economy grows faster than ability to produce; where spending increases by e.g. 7% more than growth in productive capacity of e.g. 3%

o Inflation Inertia: if we expect high inflation, we will get it due to changing the way consumers act, act in ways that deliver high inflation e.g. firms increase prices by 10% because u expect 10% increase

Question 2

 Explain the costs of inflation

Answer 2

o Impacts upon the level of output, income and employment

o Can affect the distribution of income and wealth in the economy

o Can impact on economic efficiency
 E.g. inflation diverts resources away from productive to speculative activities

o Promotes uncertainty
 Savings and investment are discouraged therefore reducing the potential economic activity
 Investment decisions are riskier as uncertainty and cannot determine profits

o Capital for labour substitutes
 When wages increase faster than production, causes replacement of machinery and unemployment increases

o Living standards of low income earners or those with fixed incomes will fall unless indexed

o Creditors lose money and debtors gain, unless interest rates are charged with cover inflation

o PAYG taxpayers suffer bracket creep

Question 3

 Explain the causes and costs of deflation

Answer 3

o Most often caused by protracted recession / depression (stagnating economic growth and not enough spending -> causes prices to fall)

o OR strong productivity growth (can put downward pressure on prices, eg. Early 2000’s, surge in business in I.T.)

o Encourages consumers to delay consumption and discourage investment (as you cannot cut wages), to wait and delay until prices are lower. Opening a new firm is risky as prices in a year will be lower than they are now so you lose more

o Implies high interest rates, which makes economic recovery extremely difficult (use formula for real interest rate)

Question 4

 Explain the difference between nominal and real interest rates

Answer 4

o Nominal interest rate = doesn’t consider inflation

o Real interest rate = NIR-Inflation

Question 5

 Term Structure of Interest Rates

Answer 5

o The price of money, which are determined by the forces of demand and supply

o Short term debt = 1 year

o Long term debt = 1 year and longer

o In wholesale money markets, borrowing/lending occurs for different periods of time resulting in different money markets.

o Each money market has a different interest rate that is determined by the forces of demand and supply (wholesale)

o The participants in this market are usually big companies, governments not individuals

o Interest rates rise as the terms of maturity increases, reflecting the increased risk associated with longer loans.

o Bonds
 Buying bonds = pushing price of bonds up

Question 6

 Describe how monetary policy operates in Australia

Answer 6

o The use of money, interest rates or the exchange to influence inflation and/or growth

o In Australia, the use of money and interest rates to influence inflation / growth

o Monetary policy is changing of retail interest rates (mortgage rates, personal loan, business loan interest rates) indirectly through overnight cash rate

o Use ESA and market participants borrow and lend money inside the market at the cash rate.

o Change in cash rate -> change in bank bill rates (move almost 1:1 for cash rate) -> Change in weighted average cost of bank loan book funding (customer deposits, short term debt, long term debt, equity, securitization) -> banks pass on these higher costs to customers (cost of funding by raising retail interest rates they charge)

Question 7

 Describe the three main ways in which the money supply can be increased and their associated effects

Answer 7

o Central bank prints excessive quantities of paper money
 Money is not just notes and coins, it also includes bank deposits
 Money supply * velocity of money = price level * GDP (equation of exchange)
 Increase in money supply by printing more, fuels increasing inflation and then people starts spending quickly. Velocity increases and then increases inflation even further and can lead to hyperinflation.

o Credit creation process in the banking sector
 Bank acquires new money through selling a bond, loans it out, spent, loaned out and then comes back again
 Bank deposits are increasing, it is creating new money and if this process is strong it can fuel inflation
 Central banks can control this process by raising interest rates
 Increasing required reserve ratio, reduces the amount of money banks can loan out and determines the potential strength of this process.

o Quantitative easing
 An unconventional type of monetary policy in which a central bank purchases government securities or other / and electronically creates money and uses that money to buy assets.
 Inflate asset prices

Question 8

 Describe how and why money moves between countries

Answer 8

o Comes in through bond market, stock market, and direct foreign investment

o Interests rates of world influence domestic interest rates (long term interest rate)

o B-A = Net inflow of foreign savings, recorded in the CFA as a positive entry

o Foreign inflow sending savings to invest in Australia, making up the shortfall of b-a

o Flows in through financial account, and then leaves through current account