Question

Part 1: Background knowledge: what is the role and objectives of the RBA (reserve bank of Australia) ? Using a graph created in a package like Excel, show how the cash rate has changed over time starting from 1990.

Part 2: What are the current domestic conditions you think are relevant for deciding what to do to the cash rate?

Part 3: What are the current external (foreign) conditions you think are relevant for deciding what to do to the cash rate?

Part 4: What is the likely impact of these conditions on the AD curve? (See pages 6-7 of these guidelines.)
* Note: to decide this, you need to take all relevant factors in parts 2 and 3 into account and draw only one shift or no change.

Part 5: What is the likely impact of these conditions on the AS curve? (See pages 6-7 of these guidelines.)
* Note: to decide this, you need to take all relevant factors in parts 2 and 3 into account and draw only one shift or no change.

Part 6: Based on the above, what do you think the RBA should do and why?
* Note: here, you should also explain any assumptions that you made to reach your recommendation and any limitations of your recommendation (hint: see notes for parts 4 and 5).

AD-AS MODEL

Demand-side variables (AD curve – planned aggregate expenditure on domestic goods and services = domestic output)

• Household spending (C) – (consumer purchases)

• Investment spending (I) – (business purchases on new capital goods)

• Government spending (G) – (public sector purchases)

• Exports (X) – (foreign spending on domestic goods and services)

• Less imports (M) – (domestic spending on foreign goods and services)

  Examples of demand shocks leading to an injection of new spending shifting the AD curve right

• Higher profits through better technology raising business investment

• Expansionary fiscal policy leading to higher government spending

• Higher foreign income or weaker exchange rate raising export spending by foreigners

• An increase in wealth from higher house prices or share prices raising household consumption

• A change in expectations leading to more optimism (more confidence) raising spendingExamples of demand shocks leading to a withdrawal of spending shifting the AD curve left

• Higher savings (increased saving ratio)

• Contractionary fiscal policy leading to higher taxation (reducing household after-tax income)

• Stronger exchange rate leading to higher Imports (import spending on foreign goods and services)

• Higher interest rates raising the cost of borrowing, reducing business investment

• An increase in pessimism (less confidence)

  Movement versus shifts of the AD curve:

  • The above examples lead to shifts of the AD curve

  • Changes in the inflation rate lead to movements along the AD curve e.g. an increase in the inflation rate tends to decrease equilibrium output (all else being equal)

    Supply-side variables (AS curve – relationship between output gap and changes in inflation rate)Examples of supply shocks leading to higher inflation by shifting the AS curve left

• An increase in costs possibly also reducing potential output, caused by:
o higher wages (due to e.g. stronger trade unions)
o higher raw materials prices (e.g. oil)
o higher commercial rents (due to inadequate building construction)o falling productivity (due to e.g. reduced training and education)

• A decrease in available resources and technology possibly also reducing potential output, caused by:

ECON 110 Session 2 2019

o Innovationsthatmakeworkersandmachineslessefficient
o A reduction in unemployment benefits resulting in a smaller available labour poolo Less access to natural resources e.g. through successful campaigning

• Higher inflation expectations.
Examples of supply shocks leading to lower inflation by shifting the AS curve to the right

• A decrease in costs possibly also raising potential output, caused by:
o lower wages (due to e.g. more competition from abroad – globalisation)o lowerrawmaterialsprices
o lowercommercialrents
o improved productivity (due to better technologies)

• An increase in available resources and technology possibly also increasing potential output, caused by:

o Innovations that make resources e.g. workers more efficient
o Social acceptance of more women working resulting in a larger available labour

pool
o Greater access to natural resources e.g. water bodies

• Lower inflation expectationsMovement versus shifts of the AS curve:

• The above examples lead to shifts of the AS curve

• Changes in output lead to movements along the AS curve e.g. an increase in output tends to

  an increase in inflation (all else being equal)

Answer 1

Part 1: RBA is Reserve bank of Australia.,Just like any other reserve Bank in the world its responsibility is related to the monetary policy.
Monetary policy means handling of money in the market by various measures, One of such measures is the cash rate.

The aim of The reserve Bank of Australia is to maintain the stability of the currency maintain maximum employment it and increase the welfare of the people of its Nation

The Aim of The reserve Bank of Australia is also to control inflation and meet the inflation targets.

Now what is cash rate ??

Cash rate is that rate of interest that reserve Bank of Australia charges to, all the other banks. It is that rate of interest at which reserve Bank of Australia gives loans to all the other banks. If this rate of interest of cash rate is low then many banks will get loans from RBI and for the they will further provide loans at low rate of interest to the consumers for consumption and investors for investment and also government will borrow for more government expenditure on public services such as health care education and other important infrastructure. [Please find the graph in the picture i have uploaded]

Part 2 : Reserve Bank of Australia has further lower the cash rate by 25 basis points to effectively at 0.75% on 1st October 2019, to increase investments increase government expenditure and increase household consumption over all increase the aggregate demand.
Low levels of interest rate would help boost up employment and would help the Australian economy to reach the levels of full employment and also achieve the inflation targets

Part 3 : Lowering of the cash rate is also affected by global reasons, like the reason being global economy is headed towards slowdown
Us China trade war
and international trade flows are uncertain.
Investments in businesses are becoming low due to uncertainty in the world economies.
Interest rates are also low around the world so it is natural for the RBA to keep the cash rate low.

Part 4 : The AD curve would definately move to the right (Upwards) , as lower Interest rates would act as an incentive for business to increase investment expenditure and households to increase their consumption expenditure, investments would increase so production would increase and exports would increase and therefore net exports would increase, it would move the AD curve further ahead, giving us better levels of GDP and employment.

In the above figure, we can see the shift in AD curve, Due to lowering of the interest rates, there is increase in Consumption expenditure and so increase in inflation (Demand > Supply).

In the above figure we can see that now as there was increase in demand, which led to increase in prices, now investments also have increased due to low cash rate, so production has increased, there is increase in supply of products as well, so there is shift in the AS curve also, after the shift of the AS curve we find that, the price level comes back to its original value, but there is further increase in the output / income / GDP which is always better for the economy.

Part 6 : RBA is doing very well to keep the monetary policy stable and is definately keeping the worldwide slowdown in mind before making the changes in cash rate, but RBA should also be very careful about the liquidity trap, as interest rates are so low, people would want to hoard the money they have and they wont save in bank as they wont get any sizable returns in the form of interest, so they would think better to keep the money as liquid. Bank if dont get savings of the people, so they wont have the liquidity to provide loans to firms for investments. So such things also need to be considered.