Topic 2: Economic & Financial Policies

Question 1

Macroeconomic Objectives

1. Benchmark for economic policy = ?
2. Potential growth = ?

Answer 1

1. Benchmark for economic policy = achieve actual growth as close to potential as possible and the fastest potential economic growth as possible
2. Potential growth = that sustainable rate of growth that keeps inflation and employment both as low as possible (internal balance) and avoids balance of payments crises (external balance).
3. Potential growth rate is fixed in the short term but adjustable in the long term
4. Potential growth is estimated but not observable
5. Output gap = difference between actual and potential growth. If negative, there is spare capacity. If positive, there is excess demand which could increase inflation and decrease unemployment. In the BoP: excess domestic demand, buy from o/s, deficit.

Question 2

Key drivers of potential GDP (4)

top 3 are main

Answer 2

1. Population
2. Labour force participation
3. Productivity (technology shifts production frontier +vely)
4. Politics / policy reform

Question 3

Labour productivity

vs

Multi Factor Productivity

Answer 3

1. Labour productivity = real GDP per hours worked & is the most commonly used measure of productivity and the most straightforward to calculate
2. affected by amt of capital available per worker per hour worked + changes in efficiency when labour & capital are combined
3. Therefore - Multi Factor Productivity: measured in terms of real GDP per unit of labour & capital (better reflection of overall efficiency)
4. Australia’s productivity slowdown has been masked by the terms of trade surge

Question 4

NAIRU

Answer 4

Non Accelerating Inflation Rate of Unemployment

Question 5

Phillips Curve

Answer 5

Phillips curve = trade off between inflation and unemployment.
Lower unemployment means higher inflation. In the long run, higher inflation leads to lower growth and higher unemployment

Question 6

Fiscal Policy

Discuss surplus and deficit

Answer 6

A country in surplus can pay off debt. G - T < 0.

Question 7

Principals of sound fiscal management:

Australian Charter of Budget Honesty 1998

Answer 7

• manage financial risks prudently, maintain debt at prudent levels, ensure FP contributes to adequate national saving & cyclical fluctuations are moderate
• pursue spending & taxation consistent with stability & predictability, maintain integrity of tax system, have regard for future generations
• financial risks include excessive net debt, commercial risks from ownership of PTEs, erosion of tax base, management of assets & liabilities.

Question 8

Sustainability requires increased Fiscal / Govt savings

• why
• how

Answer 8

Why: create room to manoeuvre - insurance against future shocks. Create stronger, more balanced growth over longer term.

How:

• deficit reduction - increasing world savings to lower equilibrium world real interest rate and promote growth
• lower distortionary taxes / subsidies (on labour & capital) that discourage investment & lower potential effetcs on investment & growth.
• tax consumption & raise efficiency of government spending
• credibility

Question 9

What determines what is sustainable growth/

Answer 9

1 / (r - g)
p + r = real interest rate - (g+p*)
g is determined by the 4ps.
Watch out if r>g

Question 10

MOnetary Policy

- Aims of central banks

Answer 10

1. Price stability (low & stable inflation)
   - high inflation is negative for growth & stability (creates uncertainty, transfers wealth away from those with nominal incomes)
2. Provides nominal anchor for the economy
   - stabilise inflation expectations, stabilise interest rates, stabilise the fundamental value of the exchange rate
3. Other nominal anchors
   - gold, money supply, fixing exchange rates

Question 11

Monetary Policy

Aims of central banks

Answer 11

1. Price stability
2. HIgh / Full employment
3. Economic Growth
4. Stability in Financial Markets
5. Interest rate stability
6. Exchange rate stability

Question 12

Monetary Policy

US Federal Reserve

Answer 12

1. 12 Regional Banks & Board of Governors.
2. FOMC comprised of 7 members of the Board of Governors and Reserve Bank presidents, 5 of whom serve as voting members on a rotating basis.
3. President appoints Board of Governors of the Federal Reserve System
4. Goals: “In setting monetary policy the Committee seeks to mitigate deviations of inflation from its longer-run goal (core inflation 2% and deviations of employment from the Committee’s assessments of its maximum level” (unemployment - 6%)

Question 13

Monetary Policy

ECB

Answer 13

• ECB is responsible for MP covering 17 member states of Eurozone. Established by EU in 1998. HQ = Frankfurt
• Governing Council composed of 6 members of executive board and governors of national central banks that have adopted the euro
• Meets monthly to make MP decision
• Maastricht Treaty: overriding long term goal is price stability (primary objective)
• Support high level of employment & sustainable & non inflationary growth
• ECB have defined price stability as target inflation of below but close to 2%
• “Whatever it takes” Draghi, 2012

Question 14

Monetary Policy

RBA

Answer 14

• Reserve Bank Act of 1959: “ the powers of the Bank… are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to
• the stability of the currency of AUstralia
• the maintenance of full employment in Australia; and
• the economic prosperity and welfare of the people of Australia”
• 9 members: 3 RBA officials, Secretary to the Treasury, 6 external members who are appointed by the Treasurer
• meets 11 times per year, 1st Tues of month
• aims to keep inflation 2 - 3% over the cycle

Question 15

Monetary Policy

Council of Financial Regulators

Answer 15

• role is to contribute to efficiency & effectiveness of financial regulation & promote stability of Aus financial system
• RBA chair; APRA, ASIC & Treasury

Question 16

Monetary Policy

People’s Bank of China

Answer 16

1. est 1948
2. Needs to report to State Council its decisions concerning annual money supply, interest rates and other important issues specified by the State COUncil. Must also submit work report to the Standing Committee of the National People’s Congress on conduct of MP
3. Objective: maintain the stability of the value of the currency and thereby promote economic growth
4. Tools: FX, deposit & lending rates, reserve requirements

Question 17

Monetary Policy - China

Answer 17

China has managed exchange rate and price & quantity instruments. Also active macroprudential tools

Question 18

Monetary Policy Transmission Mechanisms (3)

Answer 18

1. Impacts via real variables (real interest rate, real exchange rate)
2. Money supply and the money multiplier (Friedman and MV = PY)
   Money * velocity = price * output
3. Short and long term interest rate changes impact
   - cost of capital for investment & housing
   - wealth effects via shifting asset prices
   - cashflows - household & business income after (net) interest payments

Question 19

Monetary Policy

Central Bank tools

Answer 19

1. Money supply…. quantitative easings
2. Reserve ratios and lending requirement
3. Short term interest rates
4. Exchange rates

Question 20

What happens when real interest rates rise:

Answer 20

1. decrease C, decrease I, increase exchange rate.
   Increase imports, decrease exports
   Displace domestic demand (demand curve shifts to the left
   Displaced demand curve leads to increased unemployment and decreased wages, and lower pressure on inflation.

Question 21

Fisher effect (monetary policy, look at real rates

Answer 21

Fisher: increases in expected rate of inflation should generally result in higher nominal rates of interest because inflation redistributes purchasing power between debtors and creditors.
1 + r = (1 + i) / (1 + p)
if p is very low; r = i - p
r = long run real interest = potential / trend output rate
p = expected rate of inflation

Question 22

Judge whether MP is tight by:

Answer 22

judge whether MP is tight by real interest rate.

Fisher Rule: cash rate = neutral real rate + rate of inflation

Question 23

Taylor Rule

Monetary Policy

Answer 23

1. Rule for monetary policy
2. Equilibrium real interest rate (r), nominal interest rate (i), inflation rate (p), actual GDP growth (y), potential GDP growth (y) and inflation target (p)
   EQUATION: i = p + r + 0.5 x ((y - y) + (p - p)) (note the 0.5 can be changed)
   Qn, when does Fisher Rule = Taylor Rule

Question 24

Taylor Rule needs modification, flexibility, judgment:

Answer 24

1. shifts in potential growth (y* ie GDP)
2. shift in equilibtrium real interest rate (r)
3. changes in intermediation costs/ borrowing spreads (central bank rate i c bank borrowing rates)
4. availability of credit and its impact on growth (y)
5. Exchange rate targets (impact p & y)
6. Temporary shifts in p (v core / underlying cpi)
7. one-off shift in p (tax change)
8. financial instability risks - upward bias during busts

Question 25

why are policy rates lower than what would be indicated by the taylor rule?

Answer 25

• high savings
• slower growth
• gearing / leverage is too high
• lower level of equilibrium real interest rates

Question 26

Quantitative Easing:

Answer 26

• injecting money (large scale asset purchases funded by central bank reserves) so to increase nominal spending consistent with inflation target
• aim: encourage spending and avoid deflation

Question 27

QE impacts asset prices and increases wealth of asset holders via 3 channels:

Answer 27

1. announcement effects (consistent with keeping cash rates low for an extended period
2. lower long term bond yields & beneficial impact on other asset values
3. lower liquidity premium

Question 28

Forward Guidance - added stimulus and reduce risk

Answer 28

1. need to clarify policy path
   - clear - spell out conditionality
   - credible/believable to public / markets
   - correctly interpreted by markets
2. risks
   - conditionality - necessitates credible revisions
   - disruptive financial market reactions
   - encourage excessive risk taking

Question 29

Current issues with monetary policy

Answer 29

1. shown little ability to reduce asset & financial bubbles
   - size of financial sector relative to real economy
   - growing proportion of financial assets on b/s
2. Moral hazard & Greenspan put
   - central banks favour growth over LT financial stability with speed & size of easing
   - regulators tend to keep institutions afloat rather than unwind

Question 30

Difference between microprudential and macroprudential

Answer 30

Microprudential: individual rules for individual banks
Macroprudential: rules around entire financial system, eg GSIBs capital rules

Question 31

3 characteristics of bubbles

Answer 31

1. rapid credit growth
2. rapid asset price growth, relative to income / earnings
3. physical over-build of the asset (excessive supply)

Question 32

Depreciation of currency, vs appreciation

Answer 32

Depreciation: financial conditions are easier and activity improved; a permanent fall in real A$ will increase inflation 0.25 to 0.5% over next 2 years because cost of imported goods increases and indirectly through demand for domestic goods & higher prices
Appreciation: financial conditions are tighter. Temporarily, a decline in cost of imports leads to a decrease in inflation.

Question 33

FX styles

Answer 33

1. Capital controls: difficult to be pervasive / effective, prohibitive costs, setback to financial devt
2. Free floating: best in theory - automatic stabiliser to external shocks; but prone to under / overshooting with effects on real economy & financial conditions
3. Managed: could be set too high / low; fear of floating eg small countries

Question 34

Exchange rate drivers; purchasing power parity

Answer 34

The purchasing power between two economies drives the exchange rate
PPP: nominal exchange rate (e) is a simple product of the price level in one currency (p) in terms of the price level in the other currency (p)
e = p/p
Actual exchange rate can move a long way from PPP for many years and in wrong direction

Question 35

Terms of trade =

Answer 35

Terms of trade = price of exports / price of imports

Question 36

Drivers of A$

Answer 36

• interest rates (Aus) minus interest rates in the world (real interest)
• foreign direct investment
• commodity prices
• terms of trade ((price exports / price imports), difficult to forecast)

Question 37

Impact of real exchange rate depreciation

Answer 37

1. lower the price that foreigners face when buying exports from a country
2. raise the price of imports
3. depreciation should therefore improve the trade balance.

Question 38

Real exchange rate: impact on trade balance

Answer 38

There is a differential impact of exchange rate on tradeable goods & services and non tradeables
Tradeables prices usually rise quite soon if local currency depreciates (quick passthrough).
Non tradeables respond more slowly

Question 39

Nominal vs real trade weighted index

Answer 39

TWI = weighted bilateral pairs by importance of foreign country in domestic country’s total external trade
Published TWI by RBA is NOMINAL
If it is adjusted for inflation, then th TWI would be REAL

Question 40

Current Account Deficits

Answer 40

1. Developed countries often run deficits while emerging countries run surpluses
2. Can reduce CAD by increasing X vs M
3. Sometimes considered living beyond your means - but not always bad
4. CAD means country is importing more G & S than it is exporting
5. Can also be viewed as a difference between national savings and investment - ie may reflect low level of net savings relative to investment; or a high rate of investment; or both

Question 41

Current account: define

Answer 41

Part of balance of payments

Current account = X & M of G&S and income payments to/from countries

Question 42

Capital account: define

Answer 42

part of balance of payments

Capital account = transfers of capital (mainly debt & equity) into or out of the country

Question 43

A current account deficit in Australia must be balanced by:

If sufficient private capital flows do not flow in of their own accord:

Answer 43

A current account deficit in Australia must be balanced by: capital account surplus
If sufficient private capital flows do not flow in of their own accord: either the exchange rate will have to fall to attract required inflows, or central bank will have to run down foreign exchange reserves (sell foreign assets buy A$)

Question 44

Purchasing Power Parity
- semi strong
- strong
-

Answer 44

• very important property of mean reversion
  Strong:
• exchange rate should be = price level in one currency in terms of the other
  Semi Strong
• exchange rate will change to EXACTLY offset a change in relative price levels between to currencies to maintain price competitiveness. In doing so, the CHANGE IN NOMINAL EXCH RATE LEABES REAL EXCH RATE UNCHANGED. Not a reliable forecasting tool.