Question

Let’s say the economy has fallen into a recession and the inflation rate falls to zero percent.

a) What open market operations is the Reserve Bank of Australia likely to engage in?

b) Why is the interest elasticity of investment important to the Reserve Bank’s decision regarding interest rates?

Answer 1

Ans A) Here in case of recession an expansionary monetary policy is required by the central bank .For example if Australian Central bank can use open market operations.

Open market operations refers to buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system.The type of OMO ( open market operation ) is Buying of government securities through private bond dealers and deposits payment into bank accounts of the individuals or organizations that sold the bonds which results in increase in the amount of money that commercial banks have available to lend ,commercial bank will actively want to loan cash reserves and try to attract borrowers by lowering interest rate. This increases the money supply and curb out recession

Ans b ). Interest elasticity of investment is the responsiveness of investment to a change in interest rates.If investment is interest elastic then a fall in interest rates will cause investment to rise by a large amount.Conversely if investment is interest inelastic ,then a fall in interest rates will cause investment to rise by a small amount.If investment is interest elastic ,if interest rates are increased than it will discourage the investment ,with higher interest rate the borrowing becomes costly also if interest rates are increased ,then firm will need to gain a better rate of return to justify the cost of borrowing.If investment is inelastic to interest rate then an economy is the state of liquidity trap ,here lower interest rate have little effect on boostering levels of investment.hence this type of situation should be a great concern for the economy .The reserve bank should ensure the right balance of interest rate with a purpose to derive an efficient level of on investment.