Weeks 4 & 5 - Monetary Policy Flashcards
Key Outcome: How does a change in the target cash rate influence other interest rates in the economy?
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Key Outcome: To what extent does the Reserve Bank influence interest rates?
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Key Outcome: What does a POLICY REACTION FUNCTION describe?
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Key Outcome: What does the AGGREGATE DEMAND curve show?
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Key Outcome: Why does the AGGREGATE DEMAND CURVE slope downwards (or has a negative slope)?
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Key Outcome: Under what circumstances the does AGGREGATE DEMAND CURVE shift?
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Key Outcome: Under what circumstances does is there a movement along the AGGREGATE DEMAND curve?
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Key Outcome: Under what circumstances will the short-run AGGREGATE SUPPLY curve shift?
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Key Outcome: When is the economy is short-run equilibrium?
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Key Outcome: When is the economy in long-run equilibrium?
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Key Outcome: How does the economy transition from a short-run equilibrium to a long-run equilibrium?
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Key Outcome: How does INFLATION TARGETING work?
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.
What is meant by the term VELOCITY?
It measures the rate at which a unit of money circulates around an economy (in a given unit of time).
What is meant by the RATE OF INFLATION?
The rate of growth of a nation’s money supply.
What does the QUANTITY THEORY OF MONEY say about inflation?
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).
True or False: %(change)M = %(change)P.
What theory does this follow?
True.
The Quantity Theory of Money.
What area of the EXTERNALITY CURVE shows the SOCIAL WELFARE LOSS?
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).
What measurement is used to measure inflation within Australia?
CPI.
CPI is the weighted average cost of a basket of goods.
What does the REAL INTEREST RATE affect?
Borrowing, lending, expenditure etc.
How does MONETARY POLICY work? What function does an EXCHANGE SETTLEMENT ACCOUNT play?
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.
What is the TAYLOR RULE also known as?
The POLICY REACTION FUNCTION.
What are the two KEY variables of the PRF?
INFLATION (x-axis) and REAL INTEREST RATE, r (y-axis)
What causes a movement along the PRF?
Any inflation based change.
If r is adjusted in response to inflation, this causes a shift along the curve.
What causes a shift of the PRF?
If the change in the real interest rate, r, is not related to INFLATION the PRF will be shifted.
What does the PRF show?
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.
What happens to the PRF is there is change in production (or change in the output gap).
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.
What is the mathematical formula for the PRF?
r = 0.01 + 0.5 x O.G + 0.5 x (Inflation)
What happens to EXPORTS when the RBA drops rates?
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).
What is the AGGREGATE DEMAND curve?
The FLOW of PLANNED EXPENDITURE.
Holding everything other than INFLATION constant, the AD shows the FLOW of planned expenditure in the economy.
What is the composition of AGGREGATE DEMAND?
C - Consumption
I - Investment
G - Government Spending
NX - Net Exports
What is an EXOGENOUS event?
Exogenous means external, and an EXOGENOUS EVENT is an event that occurs outside of an AGGREGATE DEMAND model; ie independent of inflation.
When is it possible to move along the AGGREGATE DEMAND curve?
When an event is triggered by INFLATION.
What is it possible to shift the AGGREGATE DEMAND curve?
When an event is triggered by something OTHER THAN INFLATION.
True or False: AGGREGATE DEMAND shows peoples’ combined spending plans?
True - it shows what people “would like to do”.
What are the building blocks of AGGREGATE SUPPLY?
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.
What theory supports that AGGREGATE SUPPLY curve, in that prices are slow to change?
INFLATION INERTIA - inflation this period is not too different to inflation last period.
What does the SRAS show?
What firms are prepared to supply to the market for varying levels of INFLATION.
What does the LRAS show?
The Long-Run AGGREGATE SUPPLY. The potential output of an economy.
