Question

1. Concerned for the current state of the Australian economy the Reserve Bank of Australia (RBA) has decided to reduce interest rates. Describe the mechanism that the RBA will undertake to achieve this outcome.
2. Explain how this reduced interest rate will transmit through the economy.
3. What do you think would be the impact on the economy of this policy if the velocity component of the quantity theory of money equation M*V=P*Q was much slower than anticipated?
4. What would be the likely affect if the RBA misjudged the state of the economy and it was closer to full employment than anticipated? A diagram would assist your answer here and attract more marks.

Answer 1

- Mechanism that the RBA will undertake to achieve its desired outcome can be as follows :

- Monetary policy refers to action taken by a nation’s central bank to affect aggregate output and prices through changes in bank reserves, reserve requirements, or its target interest rate.

- Most countries have fractional reserve banking systems in which each bank must hold reserves (vault cash plus deposits at the central bank) at least equal to the required reserve ratio times its customer deposits. Banks with excess reserves can lend them to banks that need reserves to meet their reserve requirements.

- The central bank can increase the money supply by

o 1) buying securities from banks,

o 2) lowering the required reserve ratio, and/or

o 3) reducing its target for the interest rate at which banks borrow and lend reserves among themselves.

- In each case, the opposite action would decrease the money supply.

- Reduced interest rate will transmit through the economy by way of banks and financial institutions and demand in the economy is sensitive to the interest rates.

- Tf the velocity component of the quantity theory of money equation M*V=P*Q was much slower than anticipated, it will impact as follows:

o If this ratio remains stable around a constant or a historical trend, they see reason to look for relative price stability.

o If velocity falls, it could suggest a surplus of money that might have inflationary potential, but much depends on why it has declined. If velocity has fallen because a cyclical correction has brought down the GDP numerator relative to the money denominator, then practitioners view prospects as more likely to lead to a cyclical upswing to reestablish the former relationship than inflationary pressure. If velocity has fallen, however, because of an increase in the money denominator, then inflationary pressure becomes more likely.

o If velocity rises, financial analysts might be concerned about a shortage of money in the economy and disinflation or deflation

- if the RBA misjudged the state of the economy and it was closer to full employment than anticipated it will lead to higher supply of money in economy and less demand and leading to deflation.

-

- The vertical scale represents the rate of interest; the horizontal scale plots the quantity of nominal money in the economy. The supply curve (MS) is vertical because we assume that there is a fixed nominal amount of money circulating at any one time. The demand curve (MD) is downward sloping because as interest rates rise, the speculative demand for money falls