Monetary Policy/Structural Change/Productivity Measures

Question 1

Definition of Monetary Policy

Answer 1

Carried out by the RBA and involves the management of interest rates in order to influence the level of economic activity.

Question 2

Objectives of Monetary Policy

Answer 2

Price Stability - keeping inflation rate low (between 2-3%)
Full employment - keeping unemployment low (5-6%)
Economic prosperity and welfare - increasing living standards

Question 3

Ways to measure inflation for Monetary Policy

Answer 3

Headline inflation - most common way of measuring inflation by using the consumer price index (CPI). CPI is a basket of goods which contain over 100,000 individual goods and services made locally and overseas.
Underlying inflation - this is the headline inflation rate minus volatile and seasonal elements and is meant to provide a more accurate measure of inflation.

Question 4

The Cash Rate/Interest Rate

Answer 4

Interest rates represent the price of money and credit. They are pro cyclical so they move with the business cycle. An increase in demand funds (or decrease in supply of funds) will increase rates.

Question 5

Factors affecting interest rates are:

Answer 5

• The level of economic activity
• The level of Government borrowing - an increase in the budget deficit will increase demand for funds and increase interest rates
• Inflation - will cause normal interest rates to rise
• Decisions by the RBA in changing the cash rate will flow onto other rates

Question 6

How does monetary policy work?

Answer 6

The RBA’s monetary policy instrument is the cash rate. The RBA adjusts this flow of money to the big banks depending on whether they want to increase or decrease the growth of the economy.
Expansionary measures include lowering the cash rate so the interest rate falls enticing investment and greater consumption.
Contractionary measures include raising the cash rate so the interest rate rises and slows down the economy because it will then cost more to take out loans and invest/consume.

Question 7

Transmission mechanism

Answer 7

Explains the effect a change in interests have on the level of economic activity.
Consists of four elements:
- Savings and investment decisions
- Cash flow of households and firms 
- Asset prices
- The exchange rate

Question 8

Affect of monetary policy on consumption

Answer 8

A fall in interest rates causing:

• a time shift effect - encouraging consumption and discouraging saving
• A cash flow effect - by leaving more money left over in households and businesses for other spending and interest payments
• An asset price effect - by increasing property prices and share values, and hence increasing the level of wealth
• An expectations effect - by creating an expansionary economic mood or climate

Question 9

Affect of monetary policy on planned investment

Answer 9

A fall interest rates affect planned expenditure through:

• a time shift effect, encouraging investment by reducing the price of borrowing
• a cash flow effect, by reducing interest payments of debtor businesses

Question 10

Affect of monetary policy on net exports

Answer 10

A fall in interest rates affects net exports through:

- An exchange rate affect, by causing the exchange rate to depreciate and in time narrow the trade gap

Question 11

Monetary policy’s strengths:

Answer 11

• Very flexible - changes can be made at any time
• Very short inside lag (decision and action lags are shorter than Fiscal Policy)
• Politically neutral
• More effective in the boom phase of the business cycle
• Very effective with a floating exchange rate

Question 12

Monetary policy’s weaknesses:

Answer 12

• may be ineffective during a recession - even low interest rates may not encourage higher levels of spending if economic confidence is low
• Effect lag is much longer than Fiscal policy (big 4 banks take a long time to pass down changes)
• Indirect and blunt instrument - all sectors are affected by a change in interest rates

Question 13

Definition of structural change

Answer 13

Involves adjustments in the composition and location of production and employment in an economy over time.
- Involves a shift of resources from slower growing areas of the economy to faster growing areas.
Structural change is a constant process that is always necessary

Question 14

Domestic factors causing structural changes

Answer 14

• income growth (difference in income elasticity)
• Economic reform measures (privatisation)
• Productivity change
• Technology changes
• Research development

Question 15

International factors causing structural change

Answer 15

• competition from East and South-East Asian producers
• demand for resources
• change in product prices
• exchange rate adjustments
• change in relative inflation rates
• change in relative productivity
• free trade agreements/change in the level of protectionism

Question 16

Effect of structural change

Answer 16

Results in:
- higher GDP growth,
- better use of resources,
- structural unemployment
Involves:
- changes in composition and location of production and employment
Overall Composition:
- services 78% of GDP rising
- Manufacturing 12% of GDP and falling (eg car manufacturing)
- Mining 7% of GDP and steady
- Agriculture 3% of GDP and steady
But more complex due to
- changes within the sectors
- outsourcing by manufacturing (457 visa)
- relative change (mining growth hits manufacturing and services)
Caused by:
- resource curse (complacency in that the government was getting lots of revenue from the mining boom and didn’t support the other sectors of the economy or plan for the “rainy day” when it ended)
- Dutch disease (high exchange rate as a result of high demand for mined resources meant the rest of the economies exports became uncompetitive like the car manufacturing industry)

Question 17

Two way relationship between economic growth and structural change

Answer 17

Economic growth causes structural change:
Growth in the economy (GDP) raises income and material living standards which changes the pattern of consumption. Unbalanced growth leads to some sectors growing quickly and some growing more slowly or decline. A positive demand side shock like industrialisation of China contributed to the mining sector growing but reduced growth in manufacturing sector. Higher exchange rate reduced growth in manufacturing.

Structural change causes economic growth:
Structural change reflects a reallocation of resources. If this reallocation is the result of changes in deregulated, competitive markets, allocative efficiency and productivity increases.

Question 18

Definition of productivity

Answer 18

Productivity refers to the efficiency with which people or firms convert productive resources into the outputs of goods and services.

Question 19

How is productivity measured?

Answer 19

- Labour productivity is a ratio of output to the input of labour (usually measured in terms of hours worked)
              GDP
--------------------
Labour Hours Worked
- Multifactor productivity is a ratio of output to the combined input of labour and capital. GDP is a measure of output in the economy as a whole
           GDP
------------------
Labour Hours + Capital Inputs

Question 20

Relationship between productivity and economic growth

Answer 20

Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output.
Lowered costs increase demand for goods and services.
Economic growth is defined as any production increase of a business or nation. It is usually expressed as an annual growth percentage depicting growth of the company output.

Question 21

Recent government policies that promote productivity and economic growth

Answer 21

• Labour market reform (Howard government “work choices” policy, 457 visa - involves a company sponsoring a worker to come from overseas and fill the job in Australia)
• Taxation reform (lower marginal rates for income tax reform tax brackets, abolish negative gearing for investment properties, emission trading scheme in the form of carbon tax)
• Trade liberalisation (free trade agreement eg. Trans pacific trading partnership and China-Australia free trade agreement)
• Deregulation and competition policy (
• Investment in infrastructure (Qantas and Chinese)
• Education and training (
• Research and innovation (

Question 22

What factors lead to the growth of the economy’s level of potential output?

Answer 22

The three P’s:
Population
Participation
Labour productivity of labour

Question 23

Governments role in promoting productivity

Answer 23

Market oriented:
Create conditions where appropriate that allow markets to work efficiently and to reduce or fix up government failure

Interventionist:
Provide public and merit goods and where appropriate regulate to prevent or fix up market failure.

Question 24

Factors affecting level of productivity:

Answer 24

Increase in quality of resources

• improvements in human capital
• increase in the number of skilled migrants
• greater levels of motivation linked to better management and improved rewards and incentives
• technological progress
• improvements in transport and communications infrastructure
• research and development

Improved use of resources

• more deregulated competitive markets
• freer international trade and a rise in trade intensity leads to statistic and dynamic gains such as economies of scale
• improvements in the country’s institutional framework