Question

Question 4                                                                       

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

a) Reserve bank can decrease the interest rate by increasing the money supply that is through monetary policy expansion.

Fig shows money market equillibrium ( Money demand = money supply)

• Increase in money supply can be attained by multiple ways. 2 of the ways are -
  • Open market operation - Reserve Bank can buy government bond from bank in exchange of money. Banks will use this money for lending --> money supply increase.
  • Printing money

b) Decreasing the interest rate --> taking loan become cheaper ---> Investment will increase --> investment through multiplier effect, will increase output (GDP)

c) MV = PQ

==> V = PQ/M

=> V is directly proportional to output.

• Thus if V actually is lower than what was anticipated this means anticipated Q is larger than actual Q.
• So actual output will be lower.

d) if economy is closer to full employment it means that incraese in money supply will decrease the interest rate --> increase in investment and increase in demand. But increase in output will be much lower than increase in money supply (or increase in demand) instead, now prices will increase more. Explanation;

• Consider market equillibrium where aggregate supply(AS) = aggregate demand (AD)
• Aggregate demand - it is negatively sloped in P -Y plane because as price increase demand decrease.
• AS curve has 3 range;  
  • Horizontal - Keynesian range (a to b) for short run
  • Intermediate range (b to c)
  • Vertical range (classical) - (above c) long run, here economy is at full emoloyment. So increase in demand will not increase output and only increase price --> AS is vertical
  • Let's see the diagram

• From the diagram, we can see that closer we get to full employment, increase in aggregate demand increase output by less and this is translated into increase in price. And once we reach full employment then increase in AD will only increase price without any increase in output.