Question

Consider a recessionary Australian economy. a/ If the cash rate is currently 0.5%pa and RBA contractionary policy is going to move it by 50 basis points. What cashrate corridor will the RBA likely construct? Explain your working and answer in words. b/ Explain how forex swaps and repos can be used to achieve the same target cash rate. c/ Explain why decreased unemployment may lead to an increased cash rate in the short run in Australia. d/ Explain the difference between frictional and structural employment. Also explain what can or cannot be done to fix each. e/ a forex swap is used by the RBA to target a 1.2%pa cashrate with a spot purchase of AUD/USD and forward sale of AUD/USD in 1 month. If the spot price is 0.6501 then what is the forward price? Explain your working and answer in words.

Answer 1

a) 50 basic points implies 50 * 0.01% = 0.5%

As the cash rate is currently 0.5% pa, movement of 50 basis points or 0.5% is going to give the cash rate target. Now, as it is a recessionary economy, govt will want to reduce the cash rate. So, cash rate target is 0%. The cash rate is the rate at which banks charge when lending to each other in the overnight market.So, when the fed reserve will lower the cash rate, it leads to other interest rates in the economy to fall. Lower interest rates then stimulate spending, increased economic activity, employment and increased inflation. The Fed has an inflation target of 2-3%. The cash rate corridor refers to a range of values, within which banks possess an incentive to trade Exchange Settlement (ES) amongst themselves. The cashrate corridor gives way to a ceiling and floor on the cash rate target at 25 basic points above and 25 basis points below the cash rate target. So, the cash rate corridor is most likely going to be (0 - 0.25) to (0 + 0.25) or from -0.25% to 0.25%. At the floor, banks have the incentive to deposit as little amount as possible and at the ceiling, banks have an incentive to borrow as little as possible.

b) A repo is a type of contract between two counterparties, one party agrees to sell a bond to the other and repurchase the same at a specified date and time in the future. The federal reserve recieves the bond and gives cash money to the counterparty. This will add liquidity in the economy and inceases the surplus ES balances. Then in the future, in the second half, the federal reserve will give back the bond and get back its cash. This is known as withdrawal of liquidity. Now, in the first half, supply of cash is appropriate for demand, the appropriate amount of liquidity has been supplied which keeps the cash rate close to target. The forex works in a very similar way to the repo, the only distinction being here, instead of bonds, foreign exchange is used as collateral. US dollars or Japanese Yen is exchanged with the Fed reserve at a future time thats known as end of swap period. All of these are open market tools to maintain liquidity and keep cash rate close to target.

c) Decreasing unemployment leads to bad news for the economy in form of inflation and reduced productivity. In order to maintain a target inflation between 2-3%, government wants a certain level of unemployment in the economy. So, to bring the inflation to desired levels, fed reserve may increase the cash rates which will make the borrowing of money more expensive. This will reduce the liquidity in the economy and inflation will come down. As when there was higher liquidity in the economy previously, so people had a tendency to spend more, there was greater circulation of money in the economy which led to an increased inflation. So, the reduced liquidity brings down inflation. So, decreased unemployment leads to higher cash rates in the short run.

d) Frictional unemployment is not a direct impact of economic factors. It occurs when workers are in search of jobs and is voluntary. On the other hand structural unemployment is a direct impact due to shifts in the economy, such as changes in technology or declining of an industry. So, it makes it harder for workers to find a job. The former type is a temporary phenomenon while the latter could last for years. The former one is considered to be unavoidable while the latter is very concerning to economists and factored into unemployment rate.

What can be done to fix frictional unemployment?

1) It will require better maching of labour with the vacant job positions. Internet job finding portals help to find quicker job vacancies for the unemployed.

2) Also, reducing unemployment benefits will encourage people to take a job quicker.

What can be done to fix structural unemployment?

1) Educational/training schemes which will enable workers to gain necessary qualifications and find work in new industries.

2) The government could try to provide housing subsidies and benefits to motivate the unemploed take jobs in areas which are expensive but high in employment.

3) Even more effective is if govt could offer incentives for the hiring firms to relocate to depressed areas.

4) Also, allowing part-time jobs, temporary, varied job options could provide greater opportunities to the unemployed.

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