Question 6 Money, Financial Markets and the Reserve Bank 30 marks
The real interest rate r is given by r=i-π where i nominal interest rate and π the rate of inflation.
Suppose the economy-wide demand for money is given by MD=P(0.6Y – 40000i) where P is the price level, Y is real GDP and i nominal interest rate.
i. If inflation is π=6%=0.06 and what level does the nominal interest rate need to be in order for the real interest rate to be r=1.25%=0.0125?
(2 marks)
ii. What value should the Reserve Bank set the nominal money supply MS if the price level is P=5, real GDP is Y=60,000 and it wants the real interest rate to be be r=1.25%=0.0125?
(5 marks)
iii. Recall the nominal money supply consists of currency held by the public equal to CP plus bank deposits to DB. Assume the economy is as described in part ii and the MS=165,000. If the currency held by the public is given by CP=P(0.2Y) and bank reserve-deposit ratio is R =20%=0.20 calculate the size of the banks’ reserves?
(5 marks)
iv. Explain what happens to the money supply if the reserve-deposit ratio increases?
(3 marks)
v. Explain what happens to the money supply if the public holds less money as currency and keeps more in banks?
(3 marks)
b. In response to the COVID-19 pandemic the reserve bank reduced the cash rate from 0.25 per cent in March 2020 to 0.1 per cent in November in November 2020. Explain using the Money-Demand/Money-Supply framework explain the following:
i. How the new equilibrium cash rate was reached.
(4 marks)
ii. What impact lowering the cash rate would have on consumption and investment.
(4 marks)
iii. If inflation were to rise significantly how could the RBA intervene.
(4 marks)