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

a) The central bank has the authority over monetary policy in the country so RBA is responsible for carry out decisions regarding monetary policy. The central bank can increase the money supply by open market operations or by reducing the cash reserve ratio for the banks. These steps increase the loanable funds available in the market and that leads to the decrease in the interest rates.
The Reserve Bank of Australia can also decrease the reference rate which directly lowers the interest rates in the economy.

b) The reduction is interest rate lowers the borrowing cost for investors as well as for consumers. The businesses view this as an opportunity to expand operations and raise their investments in machinery and plants. Consumers can also borrow at lower cost which facilitates a higher consumption. A higher consumption create a higher aggregate demand and that raises output in the economy.

c) The quantity theory of money depicts the relation between output and money supply. The equation is given as follows

(Money Supply * Velocity of Money) = (Price * Quantity)

So in this equation if the velocity of money is quite slow but if the M or money supply increases then resulting output will rise because it is directly proportional to the money supply level.

d) The full employment scenario suggests that the economy is in the optimal mode there is no need to try to increase employment further. In this situation, the reduction in interest rate or increase in money supply only creates a higher inflation without any material growth in the economy.
A higher inflation without growth is termed as 'stagflation'.