Effects Of A Central Bank Lifting Interest Rates Economics Essay

AD1According to Solomon and Norris (2008) when the central bank within the economy lifts interest rates cost of borrowing rise. Thus firms and households reduce their borrowing loans. C↓ A↓ I↓ AD↓ Unemployment rise and ultimately economy will face recession.

AD = C + I + G + (X-M)

E

P

E1

P1

GDP1 GDP real GDP

Price Money

S1On the other hand in the international sector due to high interest rate the investors will invest into the economy (safest yields) (Sloman, J. & Norris, K., 2008). In 2011 after RBA decided to increase interest rates which is more compared to other economy such as USA, Japan, and Europe the demand of Australian currency increased, there was a shortage in supply and thus it appreciated in exchange rate/value, the reason is more demand of Australian currency from international investors.

D

D1

S

1.09

US$ = AU$

.80

Quantity Money

There is an increase in private domestic investment spending.

Private domestic investment is determined by the following formula I = GDP- C-G-NX. When private domestic investment increase in short run GDP decrease and price level decrease but I↑ and AD↑ (Solomon and Norris, 2008).

An increase in international oil prices.

Price

AS1Oil is an important production commodity, so cost of production will increase.

AS

P1

P

AD

real GDP

GDP

GDP1

So, AS will decrease to AS1 price of commodities will increase from P to P1 which will result in a decrease on GDP. The economy will face stagnation or economic immobilism (in other word the growth of economy will be slower than the potential growth, 2-3%) (Sloman, J. & Norris, K., 2008).

An appreciation in the foreign exchange rate value of the economy’s currency.

An appreciation in exchange rate of the economy’s currency means the value of domestic currency increase, example: previously 1 AU$ = 0.80 US$ now it increased to 1 AU$ = 1.10 US$. The value of a currency increase along with an increase in demand for that currency in the international economy it can be for increase in interest rates which will attract international investors looking for safest investment (this is what happened in Australia early 2011), or increase in exports of the economy thus all foreign market will seek the currency of that economy to payback (this is what happened with China). But then if the currency appreciate in value then the products of the economy become more expensive compared to international market, exports will decrease as it will be less competitive and more expensive and imports will increase as locals will then be interested to buy more foreign goods and services which will then be cheaper to local made goods and services. This will also positively affect production which uses foreign made resources like oil as imports will become cheaper. X↓ M↑ (Sloman, J. & Norris, K., 2008).

Price

AD1

AD

AS

P

AD=C+I+G+(X-M)

P1

GDP

GDP1

real GDP

A fall in real estate prices in the capital cities of the country (hint: think of the effect upon one’s wealth level)

Consumer and business confidence measures the degree of optimism that consumers feel about the overall state of the economy and their personal financial situation. (Sloman, J. & Norris, K., 2008). A fall in real estate prices in the capital cities of the country will decrease consumer confidence who usually wish for a capital gain from property. Thus both consumers and business will buy less. This will lead to a decrease in aggregate demand so AD will shift left from AD to AD 1 and GDP will decrease from GDP to GDP1. Plus equlibriam point will move from E to E1.

P

E

E1

AD1

AD

AS

P1

GDP1

GDP

real GDP

The country’s main exports fall in price while the goods the country imports from abroad rise in price

If the country’s export fall in price the demand for the country’s export will increase in international market as a result export will increase, AD will increase, GDP will grow, domestic investment and production will increase, and unemployment will decrease. When the price of import increase then consumers tend to buy less of foreign goods and buy more local goods, this demand for local goods will increase, price of local goods are likely to increase, supplier will supply more, unemployment will decrease, GDP grow. The gap of balance of payment will decrease and the economy may even enjoy a surplus (Sloman, J. & Norris, K., 2008).

Why is are quarterly movements in a country’s GDP measure so important? What is it called when a country has two successive negative quarters of economic growth?

For a sensible comparison between GDP of country, changes of price are taken into account and GDP of one period of compared with another. . It is measured frequently in that most countries provide information on GDP on a quarterly basis, allowing trends to be seen quickly (Nasira Pathan, 2011). Recession is a period of at least two quarters during which the real GDP falls (Sloman, J. & Norris, K., 2008, p.225)

Why does a market based economic system need to be monitored or is, in fact, a market system basically self-stabilising?

Market based economy is not self-sustaining/stabilising, it is volatile (because information flows very fast and investors/consumers react even faster) and so this economy needs to be monitored (Sloman, J. & Norris, K., 2008).

Currently Australian consumers are paying off their debts and not spending. Using the simple Keynesian model to assess the implications for equilibrium GDP and the level of savings of an increase in the savings function. Conversely what would happen to equilibrium income if there is a sustained rise in private investment spending?

Consumer paying of their debts and not spending means Saving ↑ and consumption ↓ but in short and long run it have different impact on the economy. In short run AE will decline (since consumers will not be spending), thus GDP will fall from GDP to GDP1. In long run AE will increase (since the money consumers saved and payed off will be borrowed by other investors, firms and consumers) thus GDP will rise from GDP to GDP2 (Sloman, J. & Norris, K., 2008).

If there is a sustained rise in private investment spending the equilibrium will increase over time. Private companies investment in R&D to gain new technology, and management to-do, plus to get new capital assets which increase production efficiency and quality, so output will increase and as a result GDP will go up. (Sloman, J. & Norris, K., 2008).

5. State the difference between:

-uncertainty and risk.

According to Marrim-Webster dictionary Uncertainty means something that is not certain, something we have doubt or lack of sureness. On the other hand risk is the possibility of loss (in investment it is the loss in value of stock or commodity). Frank Knight in his seminal work Risk, Uncertainty, and Profit established the important distinction between risk and uncertainty “Uncertainty must be taken in a sense radically distinct from the familiar notion of Risk, from which it has never been properly separated…. The essential fact is that ‘risk’ means in some cases a quantity susceptible of measurement, while at other times it is something distinctly not of this character; and there are far-reaching and crucial differences in the bearings of the phenomena depending on which of the two is really present and operating…. It will appear that a measurable uncertainty, or ‘risk’ proper, as we shall use the term, is so far different from an unmeasurable one that it is not in effect an uncertainty at all.”

“Risk is defined as uncertainty based on a well-grounded (quantitative) probability. Formally, Risk = (the probability that some event will occur) X (the consequences if it does occur). Genuine uncertainty, on the other hand, cannot be assigned such a (well grounded) probability. Furthermore, genuine uncertainty can often not be reduced significantly by attempting to gain more information about the phenomena in question and their causes.” (Andersen et. al., 2004.)

-between the interest rate and the exchange rate

Interest rate is the rate of interest that the borrower have to pay in money to the

lender. Example: A (borrower) took a loan of $100 from B (lender) on 5% interest (rate).

Interest rate is a tool of monetary policy used by the government to control investment,

supply of money, inflation, and unemployment. Two type of interest rates are nominal

and real. Nominal interest rate is the amount in money term is payable where real interest

rate measure the purchase power of the interest receipt. Exchange rate is the value of one currency in international market which measure the how much of another foreign currency can be gained in exchange of a domestic currency for example 1 A$ is currently U$1.09 or BDT 80. (Sloman, J. & Norris, K., 2008).

– between the supply side shocks and demand side shocks

Economic shocks will cause unpredictable changes in AD (demand side shocks) and AS (supply side shocks). As a result new equilibrium level of national output is achieved.

The Supply side shocks cause cyclical instability by shifting AS in short run, but in long run it is likely to have any major impact. For example the rise in world oil price due to political instability in Middle East.

The Demand side shock is when there is a shift in AD due to sudden fall in demand due to some unexpected reason. This demand can be both domestic demand of international demand (export). An example can be during 2009 recession in USA the disposable income of US consumers fall as a result their import from other countries decreased, say for example Australia is the country they import from, so now the export or AD for Australian goods and services will decrease due to a recession in USA. And its also going to have negative effect on circular flow of income and spending in Australia (tutor2u).

-between a trade deficit and net foreign debt

“Trade deficit is a negative balance of trade, i.e: when imports exceed exports.” Trade deficit means there will be an outflow of the economy’s currency to foreign market (Investorword, 2011).

On the other hand net foreign debt is equal to gross foreign debt less non-equity assets such as foreign reserves held by the Reserve Bank and lending by residents of Australia to non-residents (Parliamentary Library of Australia, 2001).

6. Assuming that the money market is initially in equilibrium, trace through the effects of a rise in the money supply on the money market on the interest rate and also on output, employment and the price level.

Rise in money supply effect output, employment, price level through interest rate.

When money supply increase, interest rate decrease.

When interest rate decrease (lower borrowing cost), output increase.

When Output increase (to increase output firms need more labor), employment increase.

AD will shift right and price level increase. At full employment (fe) with a very level change in AD (from AD2 to AD1) there will be a great change in price (from P2 to P1). Since price will increase AD will decrease again (Sloman, J. & Norris, K., 2008).

Why do professional and market economists monitor a whole number of economic and business indicators? What are they trying to achieve in doing this?

Professionals and market economists monitor a whole number of economic and business indicators to establish the phase of business cycle and find out the GDP trend line of the economy. Upward GDP trend line means the GDP is growing and downward GDP trend line means the GDP is shrinking.

Why is a depreciation of a country currency not necessarily a bad thing?. Why is a country’s appreciation of its currency on the foreign exchange market not necessarily a good thing?

Depreciation of a country’s currency not necessarily a bad thing because when a currency depreciate (lose in value) then the domestic products look cheaper for the international consumers and thus export increase.

Appreciation of and economy’s currency is when the exchange rate of the currency rise, that means then the domestic products will be expensive for international consumers and thus they will buy less and export will decrease, also that the local consumers will buy more foreign goods and import will increase. (Bized, 2011)

The central bank decided to implement an expansionary policy action. What would you expect to happen to the nominal interest rate, the real interest rate and the money supply? Under what economic circumstances would this type of policy action be appropriate?

Expansionary policy is a macroeconomic policy that rise money supply to increase economic growth or combat inflection. Money supply can be increased by increasing government expenditure or decreasing tax.

When money supply increases it reduce nominal and real interest rates in the economy.

This policy is a useful tool to for managing low growth period of the economy (Australia used this policy during 2009 recession). Inflation is a side effect of this policy (Investopedia, 2011)

Why under flexible exchange rates does a nation not have to worry too much about a balance of payments deficit? What other specific advantages do flexible exchange rates give to the operation of economic policy with specific regard to the effectiveness of fiscal policy and monetary policy?

A flexible exchange rate is a determination of demand and supply by the private market.

This exchange rate fluctuates depending on the supply and demand of a currency in relation to other currencies. If there is a high demand for a particular currency, its exchange rate relative to other currencies increases, on the other hand, if there is less demand, its value decreases. This contradicts the fixed exchange rate.

Unlike a fixed exchange rate, independence of the fixed exchange rate to correct itself leads to self-regulation. The nature of the floating exchange rate is such that if the AUD appreciates then Australian goods are now more expensive in the world market than before thereby reducing the AUD demand. This translates disfavorably in the Australian balance of payment where a fall in import effects the current account negatively. Due to the free nature of the floating exchange a depreciation of the AUD occurs to make AUD exports comparatively cheaper than before. This stimulates a rise in exports. The process may repeat itself until an equilibrium is reached. Needless to say a floating exchange rate is constantly changing. For his reason a country should not worry too much since under a floating exchange rate circumstances are bound to correct itself even without intervention. The situation would have different under a fixed exchange rate where intervention might be necessary to remove disutility of the economy.

As the exchange rate does not have to be kept at a certain level anymore interest rates are free to be employed as domestic management policies. The floating exchange rate is adjusting itself to keep the current account balanced, in theory. As the reserves are not used to control the value of the currency it is not necessary to keep high levels of reserves (like gold) of foreign countries.

We find that a domestic balanced budget fiscal expansion results in an appreciation of

the equilibrium exchange rate. The very reason for this lies in the feature that increased

government expenditures raise overall domestic money demand because taxes have to be paid

with cash and private consumption is only partially crowded out. As we do not consider an

accommodating monetary policy and prices of domestically produced goods are fixed in the

short run, the required increase of real balances can only be brought about through cheaper

imports. This in turn implies that the exchange rate has to appreciate. As an appreciation of the short run exchange rate implies lower competitiveness of domestic firms, home production is

shortened. Therefore, our results caution about possible output stimulating effects of expansive

fiscal policy in the short run.

Monetary policy with floating exchange rates

A reduction in the money supply increases interest rates (by shifting the LM curve to the left) and reduces price inflation (as explained by the quantity theory of money). Under floating exchange rates, higher interest rates will increase the value of the currency. A higher exchange rate will reduce both cost push inflation and demand pull inflation (by reducing net exports). Thus, floating exchange rates make monetary policy more effective at controlling price rises.

Fiscal policy with floating exchange rates

An increase in government expenditure tends to increase interest rates (as the IS curve shifts to the right). Under a floating exchange rate the rise in interest rates will lead to an increase in the value of the currency. The increase in the value of the domestic currency will reduce net exports, worsening the effects of crowding out. Thus fiscal policy is less effective with floating exchange rates.

When the government embarks upon a expansionary fiscal policy under a flexible exchange rate:

An increase in the government expenditure

The IS curve would shift to the right

A BOP deficit would result

Devaluation of the home currency: An increase in e; A reduction in R

An increase in exports and a reduction in imports: further shifts in the IS curve

BOP line would shift to the right to a higher level of Q and a higher interest rate as well as a higher exchange rate

Expansionary Monetary Policy:

Open market purchase of bonds

The LM curve would shift to the right

Lower interest rates and outflow of funds

Depreciation of home currency

Increase in exports and decrease in imports

The Is curve would shift to the right

If monetary policy is perceived as temporary expected e will not change and the BOP payment line will shift down to a lower i

If monetary policy is perceived as permanent, BOP line would not shift; further shift of IS curve

A comparison of the outcomes of the two policies

Fiscal policy:

Higher interest rates crowds out private spending in favor of public spending

Lower exchange rate would increase imports and could harm export industries

Monetary Policy:

Lower interest rates favor private consumption and investment

Higher exchange rates would help the export sector while making imports more expensive

(Investorwords, 2011) (Ingo P, Dirk S, 2004) (State University of NY, 2011) (ActEd Forum, 2009)