ECON 205: MACROECONOMIC THEORY AND POLICY

Tutorial # 04 ANSWERS  After Mid-session Test

Topic # 18: Conventional Monetary Policy in Australia

Question 1
What is conventional monetary policy?

Answer
Conventional monetary policy presupposes that the economy is not in the “liquidity trap” and
consists of influencing the policy rate (e.g. cash rate) to attain the objectives of a central bank. For
example, conventional monetary policy stimulates the economy by reducing the cash rate.

Question 2
Why is inflation so persistently low in Australia? Answer this question using the economic logic of
the Reserve Bank of Australia and illustrate your answer diagrammatically.

Answer

If wages growth remains subdue, monetary policy is one way to induce a gradual reduction in the
unemployment rate and provoke a gradual pick-up in wages growth. By easing monetary policy,

U ← Actual unemployment rate

¿
would converge to U ← NAIRU and P ← Domestic price level would progress toward the
inflation target. Diagrammatic Illustration: See Figure B.

Figure B

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Question 3

Why is inflation so persistently low in Australia? Answer this question using an alternative
economic logic.

Answer

If there is an unlimited supply of labour the labour supply function is perfectly elastic. In this polar
case, the nominal wage is constant, and therefore, the rate of growth of nominal wage is
identically equal to zero. In symbols,

^ ≡0
W [6]

This means that the domestic inflation rate by ^

P is independent of the wages growth.

Figure C illustrates how the polar case combined with rapid convergence to the labour market
equilibrium renders monetary policy impotent to increase inflation via wage growth. The link
between wage growth and inflation rate breaks down and – as indicated on the right panel of
Figure B– the Price Phillips curve is vertical in the short-run.

Figure C

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Question 4

What factors may be at work causing a nearly flat supply curve?

Answer

Australian workers are not just competing with fellow workers in Australia but also with
those abroad. This threatens labour’s bargaining power. Technological progress also
threatens labour’s bargaining power – think of smart machines as opposed to foreign
workers.

Additional factors that may contribute to low nominal wage growth include the following:

 High rates of immigration;

 RBA’s inflation target imposing a strong nominal anchor in wage negotiations;

 Very low levels of inflationary expectations;

 More adjustment along the intensive, rather than extensive margin;

 Decline in unionism; and

 End of the mining boom.

Topic # 19: Unconventional Monetary Policy in Australia

Question 1
What do economists mean by “liquidity trap”?

Answer

The economy falls into a “liquidity trap”, when the interest rate is so low that the public is
prepared to hold whatever amount of money is supplied at the prevailing interest rate.

Question 2
Conventional monetary policy is ineffective when the economy has fallen into a liquidity trap.
What are the two main tools of unconventional monetary policy?

Answer

Yield-curve control and quantitative easing (QE).

Question 3

“Forward guidance” is an unconventional monetary policy tool intended to offer greater

transparency in central banking. How does it work?

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Answer

Forward guidance consists of providing specific information about the future path of interest
rates. For example, when the Reserve Bank of Australia announces that it will keep interest rates
near zero until ”2024 at the earliest” the RBA is doing forward guidance.

Question 4

What is a yield curve? Is the yield-curve a buzzword or an enduring term?

Answer

A yield-curve is the graphical representation of a function that assigns to each category of bonds
the corresponding market yield. An example is given in Figure 1.

The yield-curve occupies a place in the history of diagrammatic economics along with the demand
and supply curves.

Question 5
In normal times, the yield-curve is positively sloped. Why?

Answer

In normal times, long-term interest rates are higher than short-term ones.

Figure 1

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Question 6
The yield-curve control policy reduce short-term interest rates by targeting longer-term rates.
Draw a diagram to illustrate the effects of yield-curve control.

Answer

See Figure 2.

Critical Thinking

Question 7

What is wrong in the following reasoning?

“Unconventional monetary policy” is an expression that we often hear these days, but
misconceptions abound as to what it really is. The two main tools of unconventional monetary
policy are Yield-Curve Control (YCC) and Quantitative Easing (QE). In both cases, when an economy
falls into a liquidity trap the central bank buys large amounts of government bonds in the
secondary market. It should hardly be necessary to add that YCC and QE can be implemented in
parallel because they are indistinguishable. The most appropriate reaction is to ask central
bankers what all the fuss is about. Anyone can understand this.”

Answer

It is true that in both cases (YCC and QE) the central bank buys large amounts of bonds in the
secondary market. It is also true that these tools can be used together. However, there is a
fundamental difference between YCC and QE.

Figure 2

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YCC and QE are quite distinct monetary policy tools.

With YCC, the central sets a price for a well-defined category of bonds of short maturity (e.g. 3
years) and announces that it will buy any quantity of bonds at that price (note that the central
bank does not know the quantity of bonds that will have to buy. With QE, the central bank
announces that it will buy a fixed quantity of bonds of larger maturities (e.g. 10 years) at the
prevailing market price.

With YCC, the demand for bonds is perfectly elastic at the price announced by the monetary
authority. With QE, the demand for bonds shifts to the right.

Topic # 19: Appendix 1 (2020 – 2021)

Question 1

The Reserve Bank’s policy response to the 2020 pandemic was an integral part of the national
effort to build the bridge to the recovery and constituted the beginning of unconventional
monetary policy in Australia.

(a) When did unconventional monetary policy start in Australia?

(b) What was the target for the yield on three-year Australian Government bonds?
(c) What did the RBA promise to achieve this target?

Answer

(a) Unconventional monetary policy started in March 2020.

(b) The yield target was 0.25 per cent .
(c) To achieve the yield target of 0.25 per cent the RBA promised to buy as many Australian
Government bonds as needed in the secondary market.

Question 2

The cash rate in Australia during March-November 2020 was

a. 0.65 per cent

b. 0.55 per cent
c. 0.45 per cent
d. 0.35 per cent
e. 0.25 per cent

Answer

The correct answer is e.

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Question 3

In November 2020, the RBA Board supplemented the package of measures to support job creation
and the recovery of the Australian economy from the pandemic. Which of the following is not
true?

The package included

(a) A return to conventional monetary policy.

(b) A reduction in the cash rate target to 0.1 per cent .
(c) A reduction in the target for the yield on the 3 year AustralianGovernment bond to
around 0.1 per cent .
(d) The purchase of $ 100 billionof government bonds of maturities of around 5 ¿ 10 years.
(e) A combination of two unconventional monetary policies: yield−curve control that was in
place since March 2020) and Quantitative easing QE .

Answer

The correct answer is a. The RBA did not return to conventional monetary policy in November 2020.

Question 4

How the RBA Governor did explain the amalgamation of of YCC policy and QE?

Answer

Dr Philip Lowe explained the amalgamation price/quantity target as follows.

 Targeting the yield of the 3-year Australian Government bond is a direct way to reduce
funding costs.
 The supplementation of the price target with a quantity target is the inevitable response to
the QE approach adopted by many other central banks.
 Australia has displayed higher long-term bonds yields that elsewhere further along the YC .
 Large-scale purchases of bonds by the RBA will ameliorate upward pressure on the
exchange rate.

Question 5

What made the RBA taper bond purchases in July 2021?

Answer

The RBA tapered its bond-buying program due to robust economic expansion characterized by a
boom in the property market and emerging labour shortages.

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Question 6

This question refers to the RBA ’ s guidance for interest rates, which is also a component of
unconventional monetary policy. Minutes of the RBA ’ s 5 October board meeting showed the
bank remained determined not to raise interest rates until 2024 (despite rising housing prices)
because it saw no signs of wage growth emerging in the labour market. The RBA ’ s guidance for
interest rates constitutes a promise that the cash rate would remain unchanged to any particular
date. True or False? Explain briefly.

Answer

False. The RBA is not promising anything about the level of the cash rate. Each policy statement
provides the RBA ’ s best expectationof the time on when the cash rate might change.

Question 7

What were the two decisions of the RBA Board concerning the cash rate and purchase of
government securities in the last meeting of 2021?

Answer

At its last meeting for the year 2021, the RBA Board decided to keep the cash rate constant at a
historical low of 0.1 %. Furthermore, the RBA decided to continue to purchase government
securities at a rate of $ 4 billiona week until at least mid February 2022.

Topic # 19: Appendix 2, 2022

Question 1

What are the four interactive factors deciding the RBA monetary Policy Decisions?

Answer

 Factor 1: Inflation

Actual and expected inflation consistent with the RBA target band .

 Factor 2: Labour Market (Employment)

Actual and expected progress towards the goal of full employment .

Behaviour of nominal wages .

 Factor 3: Bond Market

How the Australian bond market is functioning.

 Factor 4: Other Central Banks

Actions of other central banks .

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 Critical Thinking

Question 2

The narrative of the RBA concerning changes in the cash rate revolves around three elements:
cash rate, inflation target band and wages growth. This narrative was characterized in “Statement
by Philip Lowe, Governor: Monetary Policy Decision,” published on 02 November 2021:

The Board will not increase the cash rate until actual inflation is sustainably
within the 2 ¿ 3 per cent target range . This will require the labour
market to be tight enough to generate wages growththat is materially
higher than it is currently. This is likely to take some time. The Board is
prepared to be patient (…), [Italics added]

Do you find this narrative evasive? If so, what is the word that introduces fuzziness into the
narrative?

Answer

The word introducing fuzziness is “sustainably.” The RBA does not define the meaning of
“sustainably within the 2 to 3 % target range.” Dr Philip Lowe has explicitly recognized this
(intentional) ambiguity:

We do not have a specific a definition as to what “sustainably in the

target range” means. The actual rate of inflation is relevant as are the
trajectory and the outlook. So too is the breadth of price increases and
the factors driving them.

Quotation from Lowe, Philip, ‘The Year Ahead’, Address to the National Press Club of Australia,
Reserve Bank of Australia, 02 February, 2022.

Topic # 19: Appendix 3

Economic Predictions

Question 1

The familiar concept of prediction is a statement announcing an event that will occur in the future.
Why is it appropriate to exclude statements that are tautologies from any definition of prediction?

Answer

Because if we allow tautologies we will have predictions that are always true, irrespective of what
happens in the future.

As a reminder, a tautology is a statement that is always true such as, for example, “The RBA will
increase, decrease or keep the cash rate constant in 2023.” If an economist makes a prediction like
this, he will be truly vulnerable to the gibe that he is only a charlatan.

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Question 2

A strong conditional prediction differs from an ambiguous conditional prediction in that the strong
prediction

a. is concerned with an event that will occur.

b. takes into account the ceteris paribus clause.
c. requires the specification of conditions which are quantifiable.
d. considers the World Out There.
e. assumes economic freedom and private property.

Answer

The correct answer is c.

Question 3

For a statement to be classified as a strong conditional prediction, two conditions must be present:

a. It is not a tautology and it is empirically true.

b. It is not a tautology and the ceteris paribus clause.
c. It is not a tautology and the event will happen under quantifiable conditions.
d. It is a conditional prediction and it is not ambiguous.
e. It is both a conditional prediction and a conclusion of a mathematical model.

Answer

The correct answer is c.

Question 4

Classify the following economic predictions:

Prediction 1: There will be inflation, deflation or even price stability in Australia.

Prediction 2: There will be inflation in Australia.
Prediction 3: There will be inflation in Australia if the actual unemployment rate is low.
Prediction 4: There will be inflation in Australia if the actual unemployment rate is less than 1%.
Prediction 5: There will be inflation in Australia if nothing change.

Answer

Prediction 1: This is not a prediction (it is a tautology)

Prediction 2: Unconditional prediction

Prediction 3: This prediction is conditional but ambiguous

Prediction 4: Strong conditional prediction

Prediction 5: Weak conditional prediction

Topic # 20: The Economic Logic of the Yield-Curve Control Policy

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 Preparatory Questions (Not explicitly covered in the Lecture Slides)
Questions Explicitly Covered in the Lecture Slides

A. Preparatory Questions (Not explicitly covered in the Lecture Slides)

If you feel confident about the concept of Present Value, please go directly to

“B. Questions explicitly covered in the Lecture Slides”.

 Decimal Rate

Question 1

If p is the interest rate presented as a percentage, what is the corresponding rate i expressed as a
decimal?

Answer

p
i=
100

Question 2

Fill in the blanks in Table 1.

Interest rate (percent) Interest rate (decimal)

5%
10 %
12 %
0.5 %
0.1 %

Table 1 (Incomplete)

Answer

Interest rate (percent) Interest rate (decimal)

5% 0.05
10 % 0.10
12 % 0.12
0.5 % 0.005
0.1 % 0.001

Table 1 (Complete)

 Present Value

The Present Value ( PV ) of $ D in the future is calculated with the following formula:

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 $D
Present Value ( PV ) = t
(1+i)

where i is the annual interest rate expressed as a decimal, and t is the number of years into the
future.

Question 3

The market interest rate is 10% and is expected to stay at that level. Would you prefer a $ 50,000
gift today or a $ 54,000next year?

Answer

The present value of $ 50,000today is $ 50,000.

The present value of $ 54,000next year is

$D $ 54,000
Present Value ( PV ) = = =$ 49,091
(1+i) (1+0.1)
t

Therefore, I would prefer $ 50,000today.

Question 4

Assume that the interest rate is 5 % and consider the Present Value (PV ) of $ 100 to be received
one year from now, two years from now today, and three years from now. Fill in the blanks in
Table 2.

$ 100 to be received $ 100 are worth today

Today
One year from now
Two years from now
3 years from now
Table 2 (Incomplete)

Answer

$ 100 to be received $ 100 are worth today

Today $ 100
Next year $ 95.24
Two years from now $ 90.70
3 years from now $ 86.38
Table 2 (Complete)

 Present Value (Cont.)

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To find the value of money one year in the future today, you divide by one plus the interest rate.
For example, assuming an interest rate of 5 % the value today of $ 100 payable one year from
now is

$ 100 $ 100
= ≈ $ 95.24 ← PV
(1+0.05) 1.05

Similarly, the value today of $100 payable two years from now is

$ 100 $ 100
2
= 2
≈ $ 90.70 ← PV
(1+0.05) 1.05

the value today of $100 payable three years from now is

$ 100 $ 100
3
= 3
≈ $ 86.38 ← PV
(1+0.05) 1.05

And so on.

Intuitively, the longer you have to wait for a sum to be paid, the less it is worth today, ceteris
paribus.

Question 5

Assume that the prevailing interest rate is 5 %. Consider a promise to pay $ 100 one year from
now, $ 100 two years from now, and $ 100 three years from now. This is technically speaking an
annuity consisting of three payments of $100. How much is the deal worth?

Answer

By now, it is clear that the naïve answer ($ 100+ $ 100+ $ 100=$ 300) is incorrect because it
assumes that one dollar in the future is exactly equivalent to one dollar in the present. Without
taking present values, adding up dollars from different points in time is like adding up apples and
oranges. The correct approach is to convert each year’s amount to its present value and then add
them up.

In brief, the deal is worth

$ 100 $ 100 $ 100

PV = + + ≈
(1+0.05) (1+0.05) (1+0.05)3
2

≈ $ 95.24+ $ 90.70+$ 86.38 ≈ $ 272

Question 6

Assume that the interest rate is 12 % and consider the PV of $ 2 million to be received today,
next year, two years from now, and nineteen years from now. Fill in the blanks in Table 3.

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 $ 2 million to be received $ 2 million are worth today
Today
Next year
Two years from now
19 years from now

Table 3 (Incomplete)

Answer

$ 2 million to be received $ 2 million are worth today

Today $ 2 million
Next year $ 1,785,714
Two years from now $ 1,594,388
19 years from now $ 232,214

Table 3 (Complete)

Question 7

In 1984, a Chicago printer named Michael Wittkowski became famous when national headlines
announced that he had won $ US 40 million in the Illinois State Lottery. Forty million dollars is a
huge amount of money. Under the terms of the Illinois lottery, prizes are distributed in 20 equal
instalments; wittkowski received $ 2 million in 1984; another $ 2 million in 1985, and continued
to receive $ 2 million per year until 2003. The long-term interest rate at that time was 12% per
year. How much was this prize worth in 1984?

Answer

The $ 2 million he received in 1984 had a present value of $ 2 million in that year; the present
value of the 1985 payment was $ 1,785,714 ; the 1986 payment was $ 1,594,387, and so on. The
last present value of the last check, payable in 2003 was $ 232,214 .

Adding together the present values of each year’s payment yields a sum of $ 16,731,553.

Thus, the “ $ 40 million ” prize was really $ 16,731,553.

Topic # 20: The Economic Logic of the Yield-Curve Control Policy

B. Questions Explicitly Covered in the Lecture Slides

Question 1

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What is a bond?

Answer

Generally speaking, a bond is a type of security under which the issuer owes the holder a debt,
and is obliged to repay the principal of the bond at the maturity date as well as interest over a
specified amount of time. Interest is usually payable at fixed intervals.

Question 2

The price of a bond P is the present value of the bond. What do you need to know to compute the
price of a 3-year bond issued today?

Answer

You need to know the sum of money D to be paid to the holder each year (this value is called
coupon) and the interest rate. Then you apply the formula:

D D D
PV = + +
( 1+i ) ( 1+ i ) (1+i )3
2

where i is a decimal rate.

Question 3

A 3-year government bond issued today pays $ 10,000 a year and the prevailing interest rate is 3%
per year. What is the price of this bond today?

Answer

The present value of these three payments of D=$ 10,000 is discounted at 3% per year

D D D
PV = + +
( 1+i ) ( 1+ i ) (1+i )3
2

10,000 10,000 10,000

¿ + + 3 ≈
1.03 1.03
2
1.03

≈ 9708.74 +9425.96+ 9151.42

PV ≈ 28,286.12 ← Price of the 3− year government bond

Question 4

A 3-year government bond issued pays $ 10,000 a year and the market price of these bonds is
$ 28,286 . Assume that you are the Governor of the Reserve Bank of Australia and you want to
reduce the prevailing interest rate to 0.25 % implementing Yield-Curve Control Policy. What
would you do?

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 A. Buy any quantity of bonds at the current price.
B. Buy any quantity of bonds at $ 28,286
C. Issue any quantity of 3-year government bonds paying $ 10,000 a year, and sell them at
$ 29,850 approximately.
D. Ask the government to issue an unlimited quantity of 3-year government bonds paying
$ 10,000 a year
E. Buy any quantity of bonds at $ 29,850 approximately.

Answer

The correct answer is E.

I will be buying any quantity of bonds at $ 29,850.63 because

D D D
PV = + + =¿
(1+i) (1+i) (1+i)3
2

10,000 10,000 10,000

¿ + + ≈
1.0025 1.00252 1.00253

≈ 9975.06+ 9950.19+9925.38

PV ≈ $ 29,850.63 ← Price of the 3− year government withYCC

Question 5
¿
A 3-year government bond issued today pays $ D a year. Starting with the equilibrium price P in
the bond market, explain how the equilibrium yield of a 3-year bond is determined.

Answer
¿
The equilibrium price P results from the intersection of the demand and supply curves for bonds
(See Figure 1 left panel)

The equilibrium price of a 3-year bond must be equal to the present value of the sequence
D , D ,∧D so that
¿
P =PV

That is,

¿
P=
D
+
D
+
D
(1+i ) ( 1+i ) ( 1+i )3
2 { D← Value of the coupon(Known)
i← Yield (Unknown)

This is one equation for one unknown i (the yield of the bond).

The free market acts like a gigantic computer and quickly solves this equation, that is, the market
¿
calculates the equilibrium yield i (see Figure 1 right panel).

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 Figure 1

Question 6

The history of finance shows that the bond market was the next big thing after the rise of banks.
The bond market is a financial innovation introduced in

(a) Wall Street in 2007

(b) 1936 by John Maynard Keynes
(c) the US after the Great Depression of the 1930s
(d) the Italian Renaissance (14th and 15th centuries)
(e) None of the above

Answer

The correct answer is d. The war among the medieval city-states of Florence , Pisa , Siena, and
Tuscany were at marked the beginning of the bond market. For more details, see Topic # 20,
section 3, Bond Market: Historical Perspective.

Question 7

The Yield−Curve Control ( YCC ) policy consists of announcing that the central bank will buy any
quantity of bonds at a price selected by the monetary authority in order to reduce the yield of a
specified category of bonds, e.g. 3-year government bonds. Illustrate diagrammatically the
YCC policy .

Answer

When the central bank announces the purchase of any quantity of 3-year bonds at a price

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 ,
¿
¿∗¿>P ¿
P

¿ ¿∗¿¿
the demand for bonds becomes perfectly elastic and the equilibrium price jumps from P to P
(see Figure 2, left panel). The financial markets solve the equation

P
¿∗¿=
D
+
D
+
D
( 1 +i ) ( 1+i )2 ( 1+i ) 3
¿
{ D← Value of the coupon(Known)
i← Yield (Unknown)

and a new equilibrium yield

,
¿
¿∗¿<i ¿
i

emerges in the right panel of Figure 2.

Figure 2

Topic # 21: Financing the Budget Deficit

Question 1

What is the difference between the government’s primary budget and the overall budget?

Answer

The government’s primary budget PB, is tax revenue less government spending:

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 PB=T −G where: {G:Government spending
T :Tax revenue

To simplify things, the Overall Budget can be defined as PB less interest payments on the
government debt:

Overall Budget=¿ PB−Interest payments

Interest has to be paid when there is debt outstanding.

Question 2

We define the Overall Budget Deficit(OBD ) as the negative of the Overall Budget :

OBD=−Overall Budget

The overall budget will be in deficit unless the interest payments on the debt are more than
matched by a primary surplus. If the Overall Budget is −$ 300 billion, what is the OBD ?

Answer

OBD=$ 300 billion

Question 3

How does the government make payments when there is a budget deficit?

Answer

The government has four possibilities, which are not mutually exclusive:

(1) Raise Taxes;

(2) Reduce government purchases;
(3) Borrow from the private sector; and
(4) Print money

Topic # 21: Appendix

Government Debt: Australia 2020 – 2022

Question 1

The fiscal strategy of the Morrison Government consisted of two phases. Briefly describe the first
phase.

Answer

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Phase 1: Government Support

Direct economic support of $ 314 billion included JobKeeper , the Cash Flow Boost ,and the
Coronavirus Supplement . The first phase of the fiscal policy strategy is completed.

Question 2

The Reserve Bank of Australia ( RBA )was buying large amounts of government bonds in 2021.
Was the RBA monetizing the government deficit? Answer this question following the line of
reasoning of Philip Lowe and then present the point made by Malcom Edey. What is your take?

Answer

Dr Philip Lowe: The RBA is buying government bonds in the secondary market, not buying bonds
directly from the government. The large purchases of bonds lower the cost of government finance
but they are not providing finance to the government.

Malcom Edey: The RBA is monetizing the deficit because at the end of the day the government is
doing the spending and the RBA will hold the bonds.

My take: Edey is right.

Question 3

The fiscal strategy of the Morrison Government consisted of two phases. Briefly describe the
second phase.

Answer

Phase 2: Sustainable Reduction of Gross Debt

Pathway to government debt stabilization and reduction as a proportion of GDP.

Question 4

A government budget involves the quantification of factors that may determine the economic
performance of a country. The Australian Budget 2022-23 forecasts that Gross debt will peak at
$1.2 trillion in 2025 and Net debt will peak at $865 billion in 2026.

(a) What are the values of the corresponding debt-income ratios?

(b) Are these forecasts unconditional predictions? If not, identify the kind of predictions
associated with budget forecasts.

Answer

(a) What are the values of the corresponding debt-income ratios?

Gross debt will peak at 45% of GDP in 2025

Net debt will peak at 33.1% of GDP in 2026

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 (b) Are these forecasts unconditional predictions? If not, identify the kind of predictions
associated with budget forecasts.

They are not unconditional predictions. They are strong conditional predictions.

Question 5

Which of the following economists said: “The only function of economic forecasting is to make
astrology look respectable”?

a. John Maynard Keynes

b. Joseph Alois Schumpeter
c. Milton Friedman
d. John Kenneth Galbraith
e. Robert Solow

Answer

The correct answer is d. John Kenneth Galbraith (1908-2006) was a Canadian-American Economist.
He was one of the foremost advocates of incorporating Keynes' guiding principles into the
economic policies of the US government during the 1930s and after.

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