Practice Questions 11 - Monetary Policy PDF

Preview

Summary

Mores questions...

Description

Tutorial 11 Practice Questions: “Monetary Policy”

1. Describe how the Reserve Bank of Australia uses open market operations to change short-term and long-term interest rates.

2. What is inflation targeting? How does inflation targeting help to achieve the main goals of monetary policy?

3. Explain the effect that each of the following has on the demand for money curve. a) A decrease in real GDP. b) An increase in interest rates. c) An increase in the general level of prices.

4. In Australia in 2014, the housing market was very strong; however, at the same time, the rate of unemployment rose and the economic growth rate remained below trend. How might RBA activity help explain these seemingly contradictory economic occurrences?

5. The hypothetical information shows what the situation will be if the RBA does not use monetary policy. Potential GDP Real GDP Price Level

$1000 billion $1030 billion 104

a)

If the RBA wants to keep real GDP at its potential level in 2016, should it use an expansionary policy or a contractionary policy? Should the RBA be buying financial securities or selling them?

b)

If the RBA’s policy is successful in keeping real GDP at its potential level, state whether each of the following will be higher, lower or the same as it would have been if the RBA had taken no action.

c)

i.

Real GDP

ii.

Potential GDP

iii.

The inflation rate

iv.

The unemployment rate

Draw an aggregate demand and aggregate supply graph to illustrate your answer. Show where the economy would end up in the absence of RBA intervention in the long run.

Multiple choice

6. According to the Reserve Bank Act (1959), which of the following is not a goal of monetary policy? A) Price stability B) Economic growth C) Maximising the value of the dollar relative to other currencies D) Low rate of unemployment

7. The Reserve Bank of Australia's main monetary policy target is A) the money supply. B) the inflation rate. C) real GDP. D) the unemployment rate.

8. Refer to the figure above. In this figure, a movement from point A to point B would be caused by A) a decrease in real GDP. B) an increase in the price level. C) a decrease in the price level. D) an increase in the interest rate.

9. If interest rates rise, this will A) lower the cost of buying new homes and fewer new homes will be purchased thereby reducing consumption expenditure. B) lower the cost of buying new homes and fewer new homes will be purchased thereby reducing investment expenditure. C) raise the cost of buying new homes, and fewer new homes will be purchased thereby reducing investment expenditure. D) raise the cost of buying new homes, and more new homes will be purchased thereby increasing investment expenditure.

10. Expansionary policy refers to the action of the central bank A) to commence open market operations by buying short-term securities. B) to add to the effect of a contractionary monetary policy using an increase in the reserve supply. C) to offset the effect of a very high cash rate. D) to commence open market operations by selling short-term securities.

11. In the figure above, suppose the economy in Year 1 is at point A and expected in Year 2 to be at point B. Which of the following policies could the Reserve Bank of Australia use to move the economy to point C? A) Decrease income taxes B) Increase government spending C) Buy financial securities D) Sell financial securities

12. Refer to Figure 16.5. In this figure, if the economy in Year 1 is at point A and expected in Year 2 to be at point B, then the appropriate monetary policy by the Reserve Bank of Australia would be to A) lower interest rates. B) raise interest rates. C) lower income taxes. D) raise income taxes.

13. Which of the following is not a major function of the Reserve Bank of Australia? A) Maintaining the integrity of the financial system. B) Monitoring credit growth. C) Determining taxation rates. D) Controlling the cash rate.

14. Lowering the interest rate will normally A) decrease spending on consumer durables. B) increase investment projects by firms. C) decrease spending on new homes. D) decrease the value of the dollar and lower net exports.

15. Which of the following is the main goal of monetary policy in Australia? A) Lowering the rate of unemployment B) Increasing the value of the Australian dollar relative to other currencies C) Economic growth D) Price stability

Model Answers

Question 1 The RBA sets the cash rate (not sets the money supply by omo). Let’s say the RBA increases the cash rate. This causes a move along the Money Demand curve (in this case a fall in Quantity of money demanded). The RBA then has to adjust quantity of Money supplied so that it matches the Quantity of Money demanded through open market operations. In this case the RBA sells bonds to reduce Quantity of Money Supplied to equal Quantity of Money Demanded. Both short term and long term rates are affected by the change in the cash rate but the impact is less for long term interest rates and there is a longer lag between changes in cash rate and longer term interest rates.

Question 2 Inflation targeting refers to conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. In Australia, the RBA aims to keep the rate of inflation between 2 per cent and 3 per cent on average over the business cycle. Establishing an inflation rate target strengthens the commitment of the RBA to price stability. Central banks can come under political pressure to engage in expansionary monetary policy in order to increase real GDP and employment in the short run, even though the result of the policy may also be an increase in inflation. An explicit target for inflation may help the RBA to resist this political pressure. Maintaining a low and stable rate of inflation can assist in establishing a sound basis for economic growth in the long run. A low and stable rate of inflation can help to provide an economic environment that is supportive of economic growth, and therefore low rates of unemployment and economic wellbeing and prosperity. In fact, both the Reserve Bank and the government agree on the importance of low inflation. Low inflation assists business and households in making sound investment decisions. Moreover, low inflation underpins the creation of jobs, protects the savings of Australians and preserves the value of the currency.

Question 3a A decrease in real GDP would decrease the amount of buying and selling of goods and services, decreasing the demand for money as a medium of exchange and therefore decreasing the quantity of money held at each interest rate. There would be a shift of the money demand curve to the left.

Question 3b An increase in interest rates would not shift the money demand curve, but would see a movement along the curve, with a decrease in the quantity of money demanded.

Question 3c An increase in the general level of prices would increase the quantity of money required for a given amount of buying and selling of goods and services. There would be a shift of the money demand curve to the right.

Question 4 By the end of 2011 with inflation not increasing and unemployment increasing, the RBA began cutting interest rates and by early 2014 the interest rate (cash rate) remained at a historical low of 2.5 per cent. The lower interest rates allowed more households to afford mortgages and the increase in demand for houses grew at a greater rate than supply, pushing house prices up by an average of almost 10 per cent in 2014 in Australia’s capital cities, and over 14 per cent in Sydney. This is an example of the complications involved with implementing monetary policy. Low interest rates contributed to large increases in housing prices, but rates needed to be low due to rising unemployment and economic growth rates that were below trend.

Question 5a The RBA should pursue a contractionary monetary policy to reduce the rate of growth of real GDP. The RBA should use reverse repurchase agreements, or the outright sale of bonds and securities, to reduce liquidity and increase the cash rate and other interest rates.

Question 5b (i) Real GDP—lower; (ii) potential GDP—the same; (iii) the inflation rate—lower; (iv) the unemployment rate—higher.

Question 5c In the following diagram short-run equilibrium is illustrated GDP being beyond potential GDP, to point C, creating an inflationary gap. If policy is successful, the AD curve will shift to the left (AD1 to AD2) leading to a short-run equilibrium at the long-run equilibrium output level, at point B. The price will be lower. If the RBA does nothing then, at point A wages will increase causing costs to increase and a shift in the SRAS curve to the left until it reaches the long run AS curve. GDP will be the same but price level will be higher than 104.This will however take time (more time than if the RBA were to actively influence AD via interest rates).

Multiple choice answers

6 Answer: C 7 Answer: B 8 Answer: D 9 Answer: C 10 Answer: A 11 Answer: C 12 Answer: B 13 Answer: C 14 Answer: B 15 Answer: D...