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# TUTORIAL 8 (12 – 16 MAY) – ANSWER KEY

Monetary Policy
Textbook Reference: Chapter 8
Main Concepts
Bonds
Inflation target
Policy instrument
Policy reaction function
Taylor-rule
Review Questions
Question 1
An economy is described by the following equations:
(
)
̅

(i)
Find the equation relating planned aggregate expenditure to output and the real
interest rate. If the real interest rate is 0.10 (10%), find the equation relating planned
aggregate expenditure to output only. What is short run equilibrium output?
Equation for PAE in 4-Sector Model
(

(

)

)

(

)

(

)

(

)

̅
(
If

)

:

In short run equilibrium PAE=Y:

(ii)
If potential output is \$25000, what interest rate should the RBA target if it would
like to achieve full employment for the economy?
Sub:
For

and

in:

To yield:
(

Solve for :

)

which is higher than the current setting of 2. the banking system may suffer a credit shortage and firms that may not be able to refinance their debt obligations. The ES accounts are used to manage the flow of funds between banks generated by the commercial activities of the banks customers. in the overnight cash market. . and if a bank has a deficit in its ES account. the fractional reserve money creation process leads to an expansion of the money supply. How does the RBA’s setting of the overnight cash rate compare with what would be predicted by the Taylor rule? The Taylor rule: ( ) Using the figures above: The Taylor rule: ( ) ( Or 0. The ES accounts cannot go into deficit overnight. If the RBA were not to intervene by making these funds available. (ii) Explain how a shortage of funds in the overnight cash market may affect the economy if the RBA were not to intervene.35%. it must borrow from a bank that has a surplus of funds in its ES account. (iii) Explain how the RBA could create a surplus of funds in the overnight cash market and how this leads to an expansion in the money supply. Question 3 (i) How do exchange settlement accounts and the overnight cash market work? P201: The private banks hold their reserves in accounts at the RBA called exchange settlement (ES) accounts. which implies a nominal interest rate of: ) Or 3.5%. the cash rate will begin to increase. The [overnight] cash rate is the rate charged on interbank borrowing in the overnight cash market. At the same time the RBA is holding the nominal interest rate at 2.5%. This implies that the RBA is being aggressive in its expansionary monetary policy stance. Banks can borrow from the RBA at a rate 25 basis points greater than the cash rate.05%. As surplus funds are lent to private borrowers.Question 2 Suppose that the rate of inflation is 2. If there is a shortage of funds in the overnight cash market. The RBA could create a surplus of funds by making an open market purchase of Commonwealth government securities (CGS’s) from banks which would increase the funds available in banks’ ES accounts.7% and the contractionary gap is estimated to be 2% of potential output.

Describe how it would do this. Note that if the RBA fixes the rate without influencing the money base. the money supply curve becomes horizontal and the RBA could lose control of the money supply. In fact. . Give some examples of possible instruments for monetary policy. To be an effective instrument. but in practice central banks don’t really have direct control over the money supply (particularly broader measures of money). The current policy target of the RBA is the overnight interbank rate (called the cash rate). the quantity variable used as an instrument is bank reserves. In some countries the reserve requirements have been used for monetary policy. Key is to distinguish between an instrument and the final objectives of monetary policy (eg. What instrument is currently used by the RBA in implementing monetary policy? A monetary policy instrument is what a central bank uses to implement is policy objectives or targets. In textbook discussions (as in BOF) the money supply is treated as the policy instrument. since most banks supply currency on demand. (iii) Suppose rather the RBA had to use open market operations to implement monetary policy. Show using the model of the money market how an increase in nominal interest rates would be achieved. inflation and the output gap).Discussion Questions Question 4 (i) Explain what is meant by a monetary policy instrument. Most often the RBA need only announce the target for this rate in order to implement monetary policy. An open market sale of CGS’s would reverse the money creation process leading to a decrease in the money stock from M to M’ and the money supply curve would shift leftwards. (ii) Suppose the RBA wants to increase the cash rate. So if central banks want to use a quantity variable they tend to focus on base money (currency + reserves). An excess demand for money would lead to higher short term nominal interest rates. In this sense the cash rate becomes a form of instrument. it must be a variable over which the central bank has good control. central banks can either use an interest rate or a quantity variable as a policy instrument. In general.

the interest rate on the longer term securities also increases.  Exclusion based measures – strip out a bunch of items from the CPI that are traditionally highly volatile  Trimmed mean measures – remove a certain fraction of the largest and smallest price changes.2. The inflation targets of central banks are typically specified in terms of headline or actual inflation.gov. However monetary policy should (ideally) respond to persistent or secular tends in inflation and these are (hopefully) better captured by core inflation. (ii) Briefly explain two methods for estimating underlying inflation. and since the interest rate on a bond is inverse to its price. (v) Explain how monetary policy will affect aggregate expenditure? From http://www. A good measure of underlying inflation should display the effects of inflation that is generated by demand in the economy.rba. From http://www. This will reflect temporary or oneoff changes in the price level. How does it differ from actual or headline inflation.html : Interest rates affect economic activity via a number of mechanisms. Headline inflation is measure of inflation based on CPI. Page 213. Question 5 (i) Explain what is meant by the concept of core or underlying inflation. Underlying (or core) inflation measures seek to remove the noisy or temporary movements in prices that are captured in headline inflation. the supply of credit. the spending behaviour of households.(iv) Show in a market for longer term bonds how the effect in part (iii) affect longer term interest rates.au/monetary-policy/about. figure 8. (iii) Discuss the role that is played by measures of underlying inflation in the setting of monetary policy.gov. What properties would a good measure of underlying inflation possess? There are a number of approaches to measuring core inflation. However measures of underlying or core inflation attempt to remove the temporary or one-off price effects and produce a measure of the persistent or generalized rate of inflation. So central banks often use core inflation measures and their forecasts of these as a guide to setting the level policy rate. . the demand for bonds falls as the return on short term money market securities increases. The price of the longer term securities decreases. (A good example is the effect of the introduction of the GST on the CPI measure of inflation).rba. asset prices and the exchange rate. So in a sense it is headline inflation that central banks are responsible for controlling.au/monetary-policy/about. They can affect savings and investment behaviour.html : Movements in the cash rate are quickly passed through to other capital market interest rates such as money market rates and bond yields. all of which affect the level of aggregate demand.