Weeks 4 & 5 - Monetary Policy

Question 1

Key Outcome: How does a change in the target cash rate influence other interest rates in the economy?

Answer 1

x

Question 2

Key Outcome: To what extent does the Reserve Bank influence interest rates?

Answer 2

x

Question 3

Key Outcome: What does a POLICY REACTION FUNCTION describe?

Answer 3

x

Question 4

Key Outcome: What does the AGGREGATE DEMAND curve show?

Answer 4

z

Question 5

Key Outcome: Why does the AGGREGATE DEMAND CURVE slope downwards (or has a negative slope)?

Answer 5

x

Question 6

Key Outcome: Under what circumstances the does AGGREGATE DEMAND CURVE shift?

Answer 6

x

Question 7

Key Outcome: Under what circumstances does is there a movement along the AGGREGATE DEMAND curve?

Answer 7

x

Question 8

Key Outcome: Under what circumstances will the short-run AGGREGATE SUPPLY curve shift?

Answer 8

x

Question 9

Key Outcome: When is the economy is short-run equilibrium?

Answer 9

x

Question 10

Key Outcome: When is the economy in long-run equilibrium?

Answer 10

x

Question 11

Key Outcome: How does the economy transition from a short-run equilibrium to a long-run equilibrium?

Answer 11

x

Question 12

Key Outcome: How does INFLATION TARGETING work?

Answer 12

Inflation, or the change in prices, is slow. Typically Reserve Banks use inflation targeting to manage the public’s expectations of inflation, and in-turn the pricing typically follows these expectations.

Question 13

What is meant by the term VELOCITY?

Answer 13

It measures the rate at which a unit of money circulates around an economy (in a given unit of time).

Question 14

What is meant by the RATE OF INFLATION?

Answer 14

The rate of growth of a nation’s money supply.

Question 15

What does the QUANTITY THEORY OF MONEY say about inflation?

Answer 15

Eq: Mt x Vt = Pt x yt

Velocity, Vt, and Real GDP, yt, are relatively slow to change and can be considered constant.

Hence, any change in M (Money Supply) is reflected in a change in P (price level - inflation).

Question 16

True or False: %(change)M = %(change)P.

What theory does this follow?

Answer 16

True.

The Quantity Theory of Money.

Question 17

What area of the EXTERNALITY CURVE shows the SOCIAL WELFARE LOSS?

Answer 17

There is a SOCIAL WELFARE loss prior to government intervention.

This is the area where FREE MARKET quantity shows the Marginal Social Cost is greater than the Marginal Utility (demand curve).

Question 18

What measurement is used to measure inflation within Australia?

Answer 18

CPI.

CPI is the weighted average cost of a basket of goods.

Question 19

What does the REAL INTEREST RATE affect?

Answer 19

Borrowing, lending, expenditure etc.

Question 20

How does MONETARY POLICY work? What function does an EXCHANGE SETTLEMENT ACCOUNT play?

Answer 20

The RBA sets an interest rate on overnight loans in the money market.

The EXCHANGE SETTLEMENT ACCOUNT is held between banks and the RBA. If the RBA wants to decrease the interest rate, the RBA will purchase government securities from the banks, crediting their ESA and increasing the amount of available funds. Banks loan these funds on the market, decreasing the interest rate.

Question 21

What is the TAYLOR RULE also known as?

Answer 21

The POLICY REACTION FUNCTION.

Question 22

What are the two KEY variables of the PRF?

Answer 22

INFLATION (x-axis) and REAL INTEREST RATE, r (y-axis)

Question 23

What causes a movement along the PRF?

Answer 23

Any inflation based change.

If r is adjusted in response to inflation, this causes a shift along the curve.

Question 24

What causes a shift of the PRF?

Answer 24

If the change in the real interest rate, r, is not related to INFLATION the PRF will be shifted.

Question 25

What does the PRF show?

Answer 25

It shows how a change in the real interest rate will affect inflation.

It shows when inflation increases, policy makers will react with an increase in r.

Question 26

What happens to the PRF is there is change in production (or change in the output gap).

Answer 26

The PRF will shift either up or down. An increase in OG will shift the curve up, and a decrease will shift the curve down.

Question 27

What is the mathematical formula for the PRF?

Answer 27

r = 0.01 + 0.5 x O.G + 0.5 x (Inflation)

Question 28

What happens to EXPORTS when the RBA drops rates?

Answer 28

If RBA decreases rate, demand for AUD will drop, and hence the exchange rate will decrease.

This increases international competitiveness, and increases the amount of EXPORTS (and reduces IMPORTS).

Question 29

What is the AGGREGATE DEMAND curve?

Answer 29

The FLOW of PLANNED EXPENDITURE.

Holding everything other than INFLATION constant, the AD shows the FLOW of planned expenditure in the economy.

Question 30

What is the composition of AGGREGATE DEMAND?

Answer 30

C - Consumption
I - Investment
G - Government Spending
NX - Net Exports

Question 31

What is an EXOGENOUS event?

Answer 31

Exogenous means external, and an EXOGENOUS EVENT is an event that occurs outside of an AGGREGATE DEMAND model; ie independent of inflation.

Question 32

When is it possible to move along the AGGREGATE DEMAND curve?

Answer 32

When an event is triggered by INFLATION.

Question 33

What is it possible to shift the AGGREGATE DEMAND curve?

Answer 33

When an event is triggered by something OTHER THAN INFLATION.

Question 34

True or False: AGGREGATE DEMAND shows peoples’ combined spending plans?

Answer 34

True - it shows what people “would like to do”.

Question 35

What are the building blocks of AGGREGATE SUPPLY?

Answer 35

1 - prices are slow to change in the short-run.
2 - quantity changes in response to demand; not price. Firms will supply whatever is demanded.
3 - Inflation responds systematically to an OG.

Question 36

What theory supports that AGGREGATE SUPPLY curve, in that prices are slow to change?

Answer 36

INFLATION INERTIA - inflation this period is not too different to inflation last period.

Question 37

What does the SRAS show?

Answer 37

What firms are prepared to supply to the market for varying levels of INFLATION.

Question 38

What does the LRAS show?

Answer 38

The Long-Run AGGREGATE SUPPLY. The potential output of an economy.