End-chapter question chapter 3 The Reserve Bank of Australia and interest rates Flashcards Preview

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Flashcards in End-chapter question chapter 3 The Reserve Bank of Australia and interest rates Deck (20):
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1. Why do the financial markets pay so much attention to the cash rate?

1. Why do the financial markets pay so much attention to the cash rate?
 
Financial markets consider the cash rate to be the base interest rate in the economy and it is the most closely watched of all interest rates. It is the unsecured overnight interbank lending rate and represents the primary costs of short-term loanable funds. This interest rate underpins all the different interest rates charged for loans of various types. A margin for risk and illiquidity are added to the various interest rates such as mortgage interest rates, 10-year bond interest rates, and personal loan rates. The greater the risk the greater the margin added to the cash rate.

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2. Describe the likely consequences for GDP growth when the RBA sells  CGS  to raise funds for the Commonwealth Government.

2. Describe the likely consequences for GDP growth when the RBA sells  CGS  to raise funds for the Commonwealth Government.
 
If the RBA conducts sales of CGS the sequence of events that occurs in both the financial sector and the real sector of the economy is the reverse of the process demonstrated in Figure 3.6. The sale of CGS is a means whereby the government borrows funds from the public. As this occurs the money supply (notes and coins in the hands of the public) decreases. The shortage of money stimulates interest rates to rise, business investment and consumer borrowing and spending all fall with the subsequent impact causing GDP growth to decrease. The exchange rate is likely to increase (as the higher interest rate attracts capital inflow from the rest of the world), exports decrease and imports increase.

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3. What defensive actions do you suppose the RBA takes during  days when  pensions are paid and cash holdings by the public increase? In other words,  how does the RBA offset these cash increases?

3. What defensive actions do you suppose the RBA takes during  days when  pensions are paid and cash holdings by the public increase? In other words,  how does the RBA offset these cash increases?

Given that the crediting of pensions to pensioners’ bank accounts causes an injection of funds into the money supply; the monetary base increases and the cash interest rate falls. The RBA would undertake offsetting actions so that there would be no change to the cash interest rate and it would aim to reduce the excess cash holdings. They achieve this by “mopping up” the excess cash holdings by selling commonwealth government securities (CGS) to the public. As the public pay for these securities their bank accounts are debited and there is a transfer of funds from the public to the RBA reducing the amount of cash in circulation.

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4. As a student who will be entering the workforce soon, if not already in it,  which of the objectives of monetary policy would you like the RBA to  focus  on in the coming years?

4. As a student who will be entering the workforce soon, if not already in it,  which of the objectives of monetary policy would you like the RBA to  focus  on in the coming years?
 

Given that the objectives of the RBA are to use monetary policy to best achieve

(a) the stability of the currency of Australia;

(b) the maintenance of full employment in Australia; and

(c) the economic prosperity and welfare of the people of Australia.
 
As a student wishing to enter the workforce, the preferred objective would be the maintenance of full employment as your prime desire is to gain employment followed by economic prosperity and welfare. It could be argued that they will follow if you are gainfully employed.

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5. What would happen to the money base if the Commonwealth government  collected $1 billion in taxes and the RBA bought 0.5 billion in the CGS in a  single day? How would the cash rate become involved in these transactions? 

5. What would happen to the money base if the Commonwealth government  collected $1 billion in taxes and the RBA bought 0.5 billion in the CGS in a  single day? How would the cash rate become involved in these transactions?  
 
$1 billion paid out of money supply (MS) and $0.5 billion paid into MS, making a $0.5 billion net reduction. The reduction in funds theoretically reduces loanable funds and therefore puts upward pressure on the cash rate. The cash rate is involved through the clearing mechanism between banks and the ESA accounts held with the RBA.
 

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6. Do payments received by Australian cotton growers for their direct exports  of cotton affect money supply? Explain your answer.
 

6. Do payments received by Australian cotton growers for their direct exports  of cotton affect money supply? Explain your answer.
 
No. If the payments are received in forex, then they exchange the currency for AUD already in the MS; if the payments are received in AUD, then other agents have already exchanged the forex for AUD.
 

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7. Does an increase in the age pension payments affect money supply? Explain. 

7. Does an increase in the age pension payments affect money supply? Explain. 

Yes. The total amount of transfer payments including pensions will increase, thus increasing MS.

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8. What is the essential difference between the Keynesian and the monetarist  views on how money affects the economy?

8. What is the essential difference between the Keynesian and the monetarist  views on how money affects the economy?  
 
Keynesians trace changes in money supply to changes in interest rates. They believe that when people and banks have more money, they will tend to buy more securities and make more loans, driving down interest rates and increasing credit availability which in turn affect activity in the economy (lower interest rates stimulate borrowing and investment). Monetarist economists, on the other hand, believe that when people have more money relative to their needs, they will spend more freely and thus will stimulate the economy directly. Conversely, if people have less money than they need, given their income and expenditure levels, they will spend less so they can accumulate more cash. So for monetarists, the key variable that drives changes in economic activity in the economy is the money supply as measured by the monetary base. Monetarists therefore believe increases in MS directly affect spending and therefore economic activity.

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9. The RBA raises $500 million from money-market dealers in ten-day repos.  Explain the cash flows involved and the effects on money supply.
 

9. The RBA raises $500 million from money-market dealers in ten-day repos.  Explain the cash flows involved and the effects on money supply.
 
To raise the funds with repos, the RBA sells the dealers securities with provisions to buy back in 10 days. At the expiry of the 10 days, the RBA buys the securities back again. MS is first reduced and then increased.
 

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10. Why are there so many measures of money?

10. Why are there so many measures of money?

Each measure has a different purpose and measures (slightly or largely) different concepts. We have M1, M3, Broad Money and the Money Base. 

M1 consists of financial assets that people hold to buy things with (such as currency and current accounts at depository institutions)

M3 is M1 plus all other bank deposits of the private nonbank sector (including savings deposits, money-market deposit accounts, overnight repurchase agreements, money-market managed funds and term deposits). 

Broad money is M3 plus borrowings from the private sector by nonbank financial institutions (NBFIs) less currency and bank deposits of NBFIs. M3 and broad money are the concepts of money that emphasise the role that money plays as a ‘store of value’.

Money base is the value of currency held by the private sector plus the value of the deposits made by banks with the RBA (ESAs) and any other liabilities to the private sector held by the RBA

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11. Why do holders of ESAs try to minimise their daily balances, subject to  precautionary levels?

11. Why do holders of ESAs try to minimise their daily balances, subject to  precautionary levels?
 
Even though the RBA pays interest nowadays on ESA balances, the interest rate is not as high as the holders can earn by using those funds in the market. Hence there is an opportunity cost in holding ESA balances and holders try to optimise their balances.

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12. If the RBA thinks the Australian dollar is selling for a good price in US  dollars and decides to sell $100 million, what is the likely (micro) effect on the  exchange rate and on money supply?

12. If the RBA thinks the Australian dollar is selling for a good price in US  dollars and decides to sell $100 million, what is the likely (micro) effect on the  exchange rate and on money supply?
 
Every sale of AUD and purchase of USD marginally puts pressure on the price of each currency – downward on the AUD and upward on the USD. If the RBA sells $A100 million to Australian market dealers for USD, the MS will rise by $100 million.

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13. Why does the RBA restrict its trading transactions to government and  semigovernment securities in the main? 

13. Why does the RBA restrict its trading transactions to government and  semigovernment securities in the main? 

The RBA is risk-averse and needs to deal in low-risk, highly traded securities where the pricing mechanism is likely to work well and adjust efficiently virtually instantaneously.  
 
There has been an ongoing shortage of low risk securities over the period June 1997 through to June 2008 as the Australia Federal Government had paid off much of its public debt by the sale of public assets and by running budget surpluses (where tax receipts are greater than government expenditures). The shortage of CGS on issue and available for trading forced the government to expand the range of securities it would accept for repo agreements In 1997, it agreed to accept state government securities and, in 2001 and 2002, it decided to accept some other low-risk securities issued abroad but denominated in Australian dollars (euro-Australian dollars). In 2004, it expanded the list of acceptable securities even further. 

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14. Outline the effect an RBA unsterilised intervention in foreign currency  markets would have on the money supply and cash interest rates? Why  would the RBA want to sterilise these actions?

14. Outline the effect an RBA unsterilised intervention in foreign currency  markets would have on the money supply and cash interest rates? Why  would the RBA want to sterilise these actions?


 Occasionally the RBA trades in the forex market with the intention of directly influencing or supporting the value of the Australian dollar (AUD). These forex interventions do have an impact on the money supply and the cash interest rate. An unsterilised intervention occurs when the RBA enters the Forex Market with either a purchase or a sale of AUD. If the monetary effects are not offset it is considered an unsterilised intervention. For example, if the RBA believes the AUD value is too high it may sell AUD (and purchase foreign currency) in the forex market, increasing the amount of AUD in circulation. This increases the money supply and causes a fall in the cash interest rate or vice versa if they consider the AUD value is too low. In this case, the RBA buys AUD (sells foreign currency) in the forex market reducing the money supply with a subsequent increase in the cash interest rate. This strategy is considered an unsterilised forex intervention by the RBA.   

The RBA would want to sterilise these actions if they wished to influence the value of the AUD without the liquidity effects on the money supply and interest rates. Sterilised intervention or the neutralisation of the RBA’s intervention in the Forex market is achieved by taking offsetting sales or purchases of CGS. When the RBA is selling (buying) AUD it would sell (buy) CGS and reduce (increase) liquidity and the money supply thereby sterilising or neutralising its actions in the forex market and the impact on the money supply and interest rates.
 
 

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15.  Why would active investors in fixed-interest securities such as bonds watch  the cash rate closely and try to “read between the lines” of RBA  announcements?

15.  Why would active investors in fixed-interest securities such as bonds watch  the cash rate closely and try to “read between the lines” of RBA  announcements?
 
The traded prices of bonds are affected by market interest rates which in turn are affected by the cash rate. As there is an inverse relationship between bond prices and interest rates, active investors would attempt to predict which way the RBA will move the cash rates. If investors believe the cash rate is likely to rise, then the price of bonds will fall. Active investors would either like to sell their securities before the price falls or post-pone purchases and buy securities after the interest rate rise and price fall.

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16. Why is rampant inflation considered “a bad thing” for an economy when  obviously house prices rises and home owners receive windfall gains?
 

 16. Why is rampant inflation considered “a bad thing” for an economy when  obviously house prices rises and home owners receive windfall gains?
 
Rampant inflation severely affects the distribution of welfare and wealth within an economy. Physical asset holders and the indebted are favoured as these asset prices tend to rise with inflation (example gold, house prices); whereas debt holders are punished as they receive a fixed repayment over the life of the loan. Workers with market power are favoured, that is they can negotiate higher wages to take account of the higher inflation; fixed-income recipients are punished as they cannot change their income so have lost purchasing power.
 

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17. The more goals you have, the less likely you will achieve all to the same  degree. Which goals do you think are the most important for the RBA to  achieve? Why?
 

17. The more goals you have, the less likely you will achieve all to the same  degree. Which goals do you think are the most important for the RBA to  achieve? Why?
 The RBA is charged with the responsibility to use monetary policy to best achieve

(a) the stability of the currency of Australia;

(b) the maintenance of full employment in Australia; and

(c) the economic prosperity and welfare of the people of Australia.

Inflation control and steady economic growth are considered the most important goals but there are a number of political and social goals which centre on preserving individual rights, freedom of choice, equality of opportunity, equitable distribution of wealth, individual health and welfare and the safety of individuals and society as a whole. Economically, the goals typically centre on obtaining the highest overall level of material wealth for society as a whole and for each of its members. Some under-employment of resources is often inevitable and can stem from factors other than monetary policy.
 

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18.  How is an increase in the cash rate likely to affect imports?

18.  How is an increase in the cash rate likely to affect imports?
 
An increase in the cash rate may attract an additional flow in of foreign investment funds which will increase the AUD exchange rate. Foreign goods priced in a currency against which the AUD has appreciated will be cheaper in AUD terms and thus the quantity of the goods sold may will increase.

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19. How is an increase in the cash rate likely to affect the exchange rate?

19. How is an increase in the cash rate likely to affect the exchange rate?
 
An increase in the cash rate may attract an additional inflow of foreign investment funds which will increase the AUD exchange rate (appreciate the currency).
 
 

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20.  Will a drop in the cash rate affect inflation? Explain.

20.  Will a drop in the cash rate affect inflation? Explain.
 
Theoretically a lower cash rate will cause inflation to rise. This occurs through the following mechanism: a drop in the cash rate will stimulate borrowing, investment and economic activity. The increased demand for resources will put upward pressure on the prices of resources and may lead to inflation.