Question

Consider an economy that is operating at its potential GDP (that is, GDP is on trend) and the inflation rate is equal to the target rate. Suppose there is a shock to Australian imports; specifically, Australian consumers increase their imports of Chinese manufactured goods as they are perceived to have even greater value than before while at the same time maintaining their imports from other countries.

(a) Describe what happens in the economy in the current period using the standard IS- MP and Phillips curve analysis, assuming a policy response from the Reserve Bank of Australia. Use the reasoning the RBA staff might have. What would happen to investment as a result of the RBA action?

(b) Suppose investment becomes less sensitive to the interest rate. How would that change (if at all) your answer in part (a)?

(c) In the market for interbank loans (the ‘cash’ market), is the interest rate bounded? If it is, explain why and if it is not, explain why not

(d) If the target cash rate is 2% and the equilibrium cash rate is 2.1% what would the RBA do?

(e) If the current target cash rate is 1.5% and the RBA wants to increase it to 3% what would it do?

Answer 1

In the figure 1 we see the philips curve.It shows a downward sloping curve ,the higher the unemployment rate is the lower the rate of inflation in other words increase in the price level increases the rate of inflation it reduces the rate of unemployment as it is given australias inflation rate is equal to target rate but the higher import from china reduces the domestic price level intern it will lead to higher rate of unemployment therefore RBA is forced to increase the rate of interest of imported goods.As it is seen in figure 2 the monetory policy curve MP we can see that rate of interest increases the price level and reduces the quantity of output.Here as the rate of interest increase the price of imported goods also increases .As a result the australians will reduce the purchasing of imported goods.This will increase intern the demand for the domestic product resulting in higher price and less unemployment rate.As a result of the RBA action the investment increases because the higher price level will encourage the producers to produce more .The RBA staff might have reasoned that if the same situation continue it will lead to higher unemployment rate and deflation

b) If the investment is less sensitive to the rate of interest the producers continue to produce the current level.It will lead to shortage in output .Inturn the price level will increase and reduce the unemployment rate.

c) In the inter bank market the domestic produces may not be encouraged to invest if the interest rate is high.They may say more.In the long run the RBA can reduce the rate of interest leading to higher investemnt.

d )If the target rate is 2 percent and equilibrium rate is 21% it can create a higher demand.The RBA can reduce interest rate then the output investment would increase reducing the price

e)  If the current target cash rate is 1.5% and the RBA wants to increase it to 3% then it must try to increase the level of employment .An increase in price level can lead to higher employment level so the RBA can raise the rate of interest which will lead to higher saving and investment through the output shoartage and higher price the rate of unemployment reduces and bring the economy to the higher rate of employment