TUTORIAL 8 (12 16 MAY) ANSWER KEY

Monetary Policy
Textbook Reference: Chapter 8
Main Concepts
Bonds
Inflation target
Policy instrument
Policy reaction function
Taylor-rule
Review Questions
Question 1
An economy is described by the following equations:
(
)

(i)
Find the equation relating planned aggregate expenditure to output and the real
interest rate. If the real interest rate is 0.10 (10%), find the equation relating planned
aggregate expenditure to output only. What is short run equilibrium output?
Equation for PAE in 4-Sector Model
(

(
If

In short run equilibrium PAE=Y:

(ii)
If potential output is $25000, what interest rate should the RBA target if it would
like to achieve full employment for the economy?
Sub:
For

and

in:

To yield:
(

Solve for :

Question 2
Suppose that the rate of inflation is 2.7% and the contractionary gap is estimated to be 2%
of potential output. At the same time the RBA is holding the nominal interest rate at
2.5%. How does the RBAs setting of the overnight cash rate compare with what would be
predicted by the Taylor rule?
The Taylor rule:
(

Using the figures above:

The Taylor rule:

(
)
(
Or 0.35%, which implies a nominal interest rate of:

Or 3.05%, which is higher than the current setting of 2.5%. This implies that the RBA is
being aggressive in its expansionary monetary policy stance.
Question 3
(i)
How do exchange settlement accounts and the overnight cash market work?
P201: The private banks hold their reserves in accounts at the RBA called exchange
settlement (ES) accounts. The ES accounts are used to manage the flow of funds between
banks generated by the commercial activities of the banks customers. The ES accounts
cannot go into deficit overnight, and if a bank has a deficit in its ES account, it must borrow
from a bank that has a surplus of funds in its ES account, in the overnight cash market. The
[overnight] cash rate is the rate charged on interbank borrowing in the overnight cash
market.
(ii)
Explain how a shortage of funds in the overnight cash market may affect the
economy if the RBA were not to intervene.
If there is a shortage of funds in the overnight cash market, the cash rate will begin to
increase. Banks can borrow from the RBA at a rate 25 basis points greater than the cash
rate. If the RBA were not to intervene by making these funds available, the banking system
may suffer a credit shortage and firms that may not be able to refinance their debt
obligations.
(iii)
Explain how the RBA could create a surplus of funds in the overnight cash market
and how this leads to an expansion in the money supply.
The RBA could create a surplus of funds by making an open market purchase of
Commonwealth government securities (CGSs) from banks which would increase the funds
available in banks ES accounts. As surplus funds are lent to private borrowers, the
fractional reserve money creation process leads to an expansion of the money supply.

Discussion Questions
Question 4
(i)
Explain what is meant by a monetary policy instrument. Give some examples of
possible instruments for monetary policy. What instrument is currently used by the RBA in
implementing monetary policy?
A monetary policy instrument is what a central bank uses to implement is policy objectives
or targets. Key is to distinguish between an instrument and the final objectives of monetary
policy (eg. inflation and the output gap). To be an effective instrument, it must be a variable
over which the central bank has good control.
In general, central banks can either use an interest rate or a quantity variable as a policy
instrument. In some countries the reserve requirements have been used for monetary
policy. In textbook discussions (as in BOF) the money supply is treated as the policy
instrument, but in practice central banks dont really have direct control over the money
supply (particularly broader measures of money). So if central banks want to use a quantity
variable they tend to focus on base money (currency + reserves). In fact, since most banks
supply currency on demand, the quantity variable used as an instrument is bank reserves.
The current policy target of the RBA is the overnight interbank rate (called the cash rate).
(ii)

Suppose the RBA wants to increase the cash rate. Describe how it would do this.

Most often the RBA need only announce the target for this rate in order to implement
monetary policy. In this sense the cash rate becomes a form of instrument. Note that if the
RBA fixes the rate without influencing the money base, the money supply curve becomes
horizontal and the RBA could lose control of the money supply.
(iii)
Suppose rather the RBA had to use open market operations to implement
monetary policy. Show using the model of the money market how an increase in nominal
interest rates would be achieved.

An open market sale of CGSs would reverse the money creation process leading to a
decrease in the money stock from M to M and the money supply curve would shift
leftwards. An excess demand for money would lead to higher short term nominal interest
rates.

(iv)
Show in a market for longer term bonds how the effect in part (iii) affect longer
term interest rates.
Page 213, figure 8.2, the demand for bonds falls as the return on short term money market
securities increases. The price of the longer term securities decreases, and since the
interest rate on a bond is inverse to its price, the interest rate on the longer term securities
also increases. From http://www.rba.gov.au/monetary-policy/about.html :
Movements in the cash rate are quickly passed through to other capital market interest
rates such as money market rates and bond yields.

(v)

Explain how monetary policy will affect aggregate expenditure?

From http://www.rba.gov.au/monetary-policy/about.html :
Interest rates affect economic activity via a number of mechanisms. They can affect savings
and investment behaviour, the spending behaviour of households, the supply of credit, asset
prices and the exchange rate, all of which affect the level of aggregate demand.

Question 5
(i)
Explain what is meant by the concept of core or underlying inflation. How does it
differ from actual or headline inflation.
Headline inflation is measure of inflation based on CPI. This will reflect temporary or oneoff changes in the price level. (A good example is the effect of the introduction of the GST
on the CPI measure of inflation). However measures of underlying or core inflation attempt
to remove the temporary or one-off price effects and produce a measure of the persistent
or generalized rate of inflation. Underlying (or core) inflation measures seek to remove the
noisy or temporary movements in prices that are captured in headline inflation.
(ii)
Briefly explain two methods for estimating underlying inflation. What properties
would a good measure of underlying inflation possess?
There are a number of approaches to measuring core inflation.
Exclusion based measures strip out a bunch of items from the CPI that are traditionally
highly volatile
Trimmed mean measures remove a certain fraction of the largest and smallest price
changes.

A good measure of underlying inflation should display the effects of inflation that is
generated by demand in the economy.
(iii)
Discuss the role that is played by measures of underlying inflation in the setting of
monetary policy.
The inflation targets of central banks are typically specified in terms of headline or actual inflation.
So in a sense it is headline inflation that central banks are responsible for controlling.
However
monetary policy should (ideally) respond to persistent or secular tends in inflation and these are
(hopefully) better captured by core inflation. So central banks often use core inflation measures and
their forecasts of these as a guide to setting the level policy rate.