Question

a) Explain how the RBA sets a target cash rate to conduct expansionary monetary policy to move an economy towards long-run equilibrium. Use an AS-AD diagram to illustrate your answer. [4 marks] b) Explain why households or firms will still be willing to buy bonds that yield a negative return or to save into bank accounts that pay negative interest rates. [3 marks]

Answer 1

(a)

In following graph, initial long-run equilibrium is at point A where AD0 (aggregate demand), LRAS0 (long-run aggregate supply) and SRAS0 (short-run aggregate supply) curves intersect with long-run equilibrium price level P0 and long-run equilibrium real GDP (which is equal to potential GDP) Y0.

When economy is in recession, aggregate demand falls, so AD curve will shift leftward from AD0 to AD1, intersecting SRAS0 at point B with lower price level P1 and lower real output Y1, with short run recessionary gap of (Y0 - Y1).

To restore long run equilibrium, RBA will conduct expansionary monetary policy, increasing money supply, which can be conducted by decreasing the cash rate. Lower cash rate will boost investment, increasing aggregate demand. AD1 will shift rightward to AD0 until long-run equilibrium is established at point A.

(b)

Firms or households will buy bonds with negative return, or save in assets paying negative interest rate, if they expect inflation to decrease in future. Since lower inflation will increase real value of assets, lower future inflation will benefit the bondholders or savers in future, by increasing real value of their interest income from bonds or savings.