Monetary Policy

Question 1

Natural Rate Hypothesis / Neutrality of Monetary Policy

Answer 1

o Should be non-neutral in the short run as it effects real variables (real GDP, real interest rates, real wages etc)
o Should be neutral in the long run as it has no effect on real variables
o Therefore, should not be able to generate permanent increases in living standards by increasing the amount of money in circulation
o Monetary policy is useful in managing short run, demand driven cyclical fluctuations in economic activity

Question 2

Quantity Theory of Money

Answer 2

V = PY/M

V: velocity
M: quantity of money

Question 3

Velocity of Money

Answer 3

Shows how fast money is circulating/number of transactions made with a given amount of money over a period of time

Question 4

M0

Answer 4

Measure of money supply that the central bank can control, including cash and reserves

M = kM0
k depends on the intensity of lending by banks

Question 5

Assumptions of Quantity of Money Theory

Answer 5

o Long run monetary neutrality so Yt is independent of Mt
o Velocity is constant so Vt = V̅
o Money supply is wholly controlled by the central bank
o Therefore, P and M are directly proportional

Question 6

Problems with Quantity Theory

Answer 6

o Mt is a broad measure of money supply while central banks only control a narrow supply (M0)
o Quantity theory cannot predict short run changes to inflation

Question 7

Money Supply and Demand

Answer 7

• Exchange Settlement Accounts (ESA) manage daily transactions and are used by financial institutions to settle payment obligations
• ESA balances need to be in credit by the end of the day → shortfalls require borrowed funds from the overnight cash market
• Overnight cash is supplied by banks with surplus ESA funds and by the RBA
• RBA cash rate is the interest rate used in overnight interbank loans
• RBA takes ESA balances at the floor rate – 0.1% below cash rate target and RBA supplies ESA balances at the ceiling rate – 0.25% above cash rate target → no incentive for others to supply so RBA is monopoly supplier of funds
• Buy bond and pay with ESA balances → increase supply of ESA
• Buy ESA balances and pay with bonds → decrease supply of ESA

Question 8

Unconventional Monetary Policy

Answer 8

• Negative interest rates
• Extended liquidity programs - extension of lender of last resort facilities offered by central banks during time of temporary market liquidity → aims to prevent financial institutions from failing when they are fundamentally sound
• Asset purchases / quantitative easing - aims to increase demand for assets, to drive down interest rates
• Forward guidance

Question 9

Growth in Velocity

Answer 9

gV = gP + gY – gM