ECO10004: ECONOMIC PRINCIPLES

WEEK 11_Tutorial Questions

The key concepts covered in this topic are as follows:

− Cash rate vs. Interest rate (Tutorial Question 1).

− Expansionary Monetary Policy & Contractionary Monetary Policy (Tutorial Question 2 &
3).
− Transmission channels of monetary policy (Tutorial Question 3).
− Inflation targeting (Self-study questions).
− Different measurements of money (Self-study questions).
− Fractional reserve banking & the modern monetary system (Self-study questions).
− What does the RBA do? (Self-study questions).

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Short-answer Questions
Question 1)

a. In your own words, clearly explain what the “cash rate” means.
Hint: Page 542 of the textbook will help.

- Cash rate is the interest rate that financial institutions (aka commercial banks, RBA)
charge on loans or pay to borrow funds in the overnight money market.

- Also known as the interest rate on inter-bank loans.

- "Overnight money market" means that borrowings must be repaid the next day (i.e.,
"overnight").

b. Are the cash rate and the interest rate the same?
Clearly explain.

- They are not the same

- The cash rate is the inter-bank rate (special interest rate) in the overnight money
market

- Interest rate is a broad concept: depending on the type of loans, borrower and lender.

 Interest rate on mortgage (home) loans (~2%)

 Interest rate on personal loans (~5%)

 Interest rate on credit cards could go as high as ~20%

 Interest rate varies between banks.

 Cash rate is one kind of interest rate.

- RBA (central bank) can only control the cash rate.

RBA hopes that commercial banks will flow the change through other interest rates (this
does not always happen)

c. As of October 2021, the cash rate in Australia stood at 0.1% per annum.
Who do you think can borrow funds at the cash rate? Clearly explain.

- Only commercial banks can borrow from each other at the cash rate.
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 - No individuals nor companies, can hope to borrow at 0.1% per annum.

- Commercial banks can borrow from the RBA at cash rate too (during Covid in
Australia

Question 2)

Suppose the current conditions of the Australian economy are as follows.

Overall growth is very soft due to a considerable decline in business investment. Demand in
the labour market is weaker than usual, and unemployment rate is showing signs of
increasing. At the same time inflation is sitting lower than the targeted range of 2 – 3%.

Required:

a. Draw an appropriate AD – AS graph to reflect the above conditions the Australian

economy is currently experiencing (e.g., soft growth, declining investment, rising
unemployment, and lower inflation rate).

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b. Given the economic conditions described above, what type of monetary policy does
the Reserve Bank of Australia (RBA) need to implement?
Clearly explain why such a policy is needed.

- The RBA should undertake expansionary monetary policy.

- Y 1 <Y p-> boost AD so to increase GDP

- Inflation rate is currently below the targeted range of 2 - 3% -› The RBA have some
room for expansionary monetary policy

c. Clearly explain the steps the RBA must undertake with its Open Market Operations
(OMOs) to implement the monetary policy recommended in part (b).
Hint: Page 543 of the textbook will help.

Expansionary monetary policy.

- RBA buys securities (usually short-term government securities) from commercial

banks.

- In exchange, RB will pay commercial banks with money, which will be deposited in
banks' reserve.

- Banks' reserve increasing means more funds available in the overnight money market.

- Cash rate in the overnight money market will fall.

- RBA hopes that commercial banks will "pass the rate cut" to their borrowers.

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Question 3)

Back in 2009 – 2010, the Reserve Bank of Australia (RBA) found itself in a rather odd
situation.
Interest rates set by central banks around the world were slashed to record low due to the
devastating impacts of the Global Financial Crisis (GFC).
For example, the federal funds rate in the US was hovering between 0% and 0.25%, while the
refinancing rate in the European Union was rooted at 1%.
(Note: the federal funds rate and the refinancing rate are the equivalent to the cash rate in
Australia).

Yet, in Australia, the RBA continued to raise the cash rate, from 3% in September 2009 to
4.75% in November 2010. The hikes in the cash rate were to combat rising inflationary
pressure, caused by a massive export boom.

Required:

Explain how the RBA’s decision to raise the cash rate, as described above, will affect the
aggregate demand in the Australian economy.
Clearly explain how each component of aggregate demand would be affected.

- Discount rate (~cash rate) were low globally, except Australia

- Note how China's boom helped Australian economy avoid recession
- Discount rates set by central banks around the world were slashed to record low due
to the devastating impacts of the Global Financial Crisis (GFC) -› expansionary MP.
- China's boom meant Australia was booming too, creating inflationary pressure -›
contractionary MP

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Question 4)

Let’s wind the clock back to November 2019 before Australia was hit by COVID-19.
The cash rate set by the RBA was already as low as 0.75%. In response to the colossal
economic meltdown caused by COVID, the RBA proceeded to slash the cash rate down to
0.5% in March 2020, then 0.1% in November 2020.

Required:

a. Do you think the RBA’s efforts to cut the cash rate from 0.75% to 0.1% would be
effective in reinvigorating the economy?
Clearly explain why.

- Only have limited impact

- Interest rates were already at a very low level when CR= 0.75%.

- Due to lockdowns, isolations, business confidence is low -> low demand for further
borrowings, apart from keeping themselves afloat.

- Households suffered, will increase S, unlikely to borrow to C

-> Expansionary MP through reduction of CR may not flow through to other interest
rates.

b. What does it tell you about the effectiveness of monetary policy in combating a severe
economic downturn?

- Conventional monetary policy is not as effective in fighting a downturn if interest rate

is already low

- Nominal interest rate only go as low as zero.

- Even if cheap credit available, firms and households still would not risk borrowing
when confidence is low

- Monetary policy is more effective in taming a boom. During a bust, fiscal policy is
considered to be more effective.

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c. Sensing that its conventional monetary policy had run out of gas, the RBA resorted to
some “unconventional” monetary measures that it had never tried before.
Do some research to find out the type of “unconventional monetary measures” the
RBA pursued during 2020 while the Australian economy was torn apart by COVID
and lockdowns.
Hint: The links below will help:
Term funding facility - $188 billion of super cheap loans to banks
Quantitative Easing – A $237 billion program

Quantitative easing (QE):

- Buying long-term government bonds (as opposed to short-term bonds with OMOs) ->
lower long-term rates, not just the cash rate

- The RBA has mostly focused on three-year government bonds and would keep buying
to maintain the yield on these bonds at 0.1%.

Term Funding Facility:

- RBA would lend money to commercial banks at an interest rate of 0.25%, then 0.1%
(same as the cash rate) for three years.

- The more money commercial banks lend to businesses, the more borrowings they are
eligible under the Term Funding Facility.

- This scheme contributed to banks posting record-breaking profits while the economy
was in tatters.

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