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ECON1020

Question Answer
L6 What are the three functions of money a) medium of exchange
b) store of value
c) unit of account
L6 What is the medium of exchange (functions of money) – Accepted as payment for goods and services
– divisible, portable, durable,
– e.g. complex supply chains – allows interaction between goods
L6 What is the store of value (functions of money) – Can be stored for a period and still retain its value – money can be stored vs bread
– Allows unlimited long-term wealth accumulation
e.g. perishable crops – can be sold for money once harvested
L6 what is the unit of account (functions of money) – measure for the value of an economic item (income, assets, goods and services etc)
– e.g. business planning – allows businesses to plan precise budgets because prices and costs are very clear
L6 what are reserves (in the balance sheet) – phsyical cash held by banks in their vault (or in an account at the reserve bank
– when people hold cash = currency
– when bank holds cash = reserves
L6 what are securities (in the balance sheet) – various financial instruments owned by banks and investors.
– Shares, bonds and derivative contracts
– worth money and can be sold
L6 what are loans (in the balance sheet) the total amount lent by the bank to people and firms that the bank expects to be repaid
L6 what are deposits (in the balance sheet) the total amount deposited by people and firms into accounts held at the bank
L6 what is equity (in the balance sheet) the “value” of the bank to its owners (i.e. shareholders).
L6 Aaron finds $100 and decides to deposit in the bank. reserve ratio = 5%, what is maximum amount of loans the bank can make. Reserves = 5% of 100
= $5
therefore, bank can loan up to $95
L6 Equation: how to use the deposits multiplier RESERVE RATIO = reserves/deposits
SIMPLE DEPOSITS MULTIPLIER = 1/ reserve ratio
deposits = 1/ RR x reserves
L6 How much would a bank be able to lend if it obtained $100 from selling a bond Selling a bond leads to bank receiving $100 in reserves, without increase in deposits.
does not retain any of this $100 in reserves – can lend entire amount.
L6 Equation: how to find the maximum amount of loans the banking sector can make e.g. $100 deposited with 5% reserves TOTAL LOANS = 1 / reserve ratio x initial amount leant
= 1 / 0.05 x 95
L6 Equation: how to work out the change in M Change in M = excess reserves initially x 1/R
L7 What is inflation An increase in the price level
– more interested in the rate of inflation (the % increase in the price level from year to year)
L7 what is deflation decrease in the price level
L7 What is disinflation slowing in the rate of inflation (e.g. from 6% to 5%)
L7 Why do most countries have small, positive inflation targets? – Small, positive levels of inflation are viewed as a positive for an economy.
– Inflation facilitates real wage adjustments (helps economy return to trend growth during a slump)
L7 how is inflation a 'monetary phenomenon' – proportional increase in all prices (including the prices of labour, people’s wages) doesn’t make anything more expensive in comparative terms.
– inflation’s effect = decrease purchasing power of a given amount of money.
L7 what is the quantity theory of money – assume changes in Y=Y* and V are stable and caused by other things
– means – changes in M are responsible for changes in P.
– inflation caused by changes to the money supply.
L7 If real GDP grows at 4% per year, velocity is fixed and the price level increases by 2% per year, what growth rate of the money supply is consistent with the quantity theory of money? MV = PY
gm + 0 = 2% + 4%
gM = 6
L7 describe the current level of inflation if the IR increases from 900% to 1000% – inflation is very high, although not quite hyperinflation.
– inflation rate of over 50% a month is generally regarded as hyperinflation
L7 how does inflation undermine the medium of exchange becomes difficult to use money as a medium for transactions if it is worth a substantially different amount from day to day and month to month
L7 how does inflation undermine the store of value inflation reduces the real value of money
– $100 note will not be able to buy as much if prices rise substantially, so over time inflation reduces the value ‘stored’ in the money supply.
L7 how does inflation undermine the unit of account values recorded in a currency that is experiencing high inflation would be misleading.
– would need to be updated frequently to be accurate
L7 why would a rational govt choose to hyperinflate – stress to the govt budget e.g. war/its aftermath, collapse in export prices, difficult to collect tax rev
– print more money as a result
L7 Which is better? QT or cyclical inflation – in long run –> QT = better predictor, economy is on trend Y=Y* and V grows at steady rate
– in short run, Y + V are changing therefore unrealistic to impose QT restrictions
L7 “If prices decrease by 5% every year, people would be better off because everything would be cheaper.” Is this true or false False – Purchasing power = same. IF prices decrease 5%, wages as well as G/S decrease by same amount
take home a 5% smaller salary but purchases would cost them 5% less.
L7 what happens to consumer spending if money supply and price level is cut by 5% Consumers would delay expenditure on many items to potentially save money
L7 what is the general relationship between inflation and the business cycle (booms and slumps) Inflation tends to rise in booms and fall in slumps
L7 “During a boom, the money supply and the price level increase. Therefore, increases in the money supply during economic fluctuations cause inflation”. true or false? False. correlation does not cause causation
L8 When is the long run the period of time in which all prices can change to fully reflect demand.
– no output gap in long run because Y=Y* (GDP = potential GDP).
– still part of short TERM
L8 when is the medium run prices begin to reflect new demand and the output gap starts to close
L8 when is the short run Pricing doesnt reflect change in demand.
firms may experience increase demand however won't immediately change prices unless sure it isnt temporary and limited to the firm
L8 difference between short TERM and long TERM Keynesian theory (fluctuations in demand) vs classical explanations (trend growth with L, Ka, Te)
L8 what is the short term The short run, medium run and long run are part of the short term. The short term deals with fluctuations in demand that have Keynesian explanations (eg prices haven’t fully adjusted).
L8 What is the long term The long term deals with trend growth and has more Classical explanations (eg labour, capital, technology).
L8 Which of C, I, G and X are most likely to drive fluctuations? Investment – most volatile component
Exports – often volatile
government spending – sometimes volatile
Consumption -generally stable
if investment or exports rise – extra employment causes C to increase.
L8 what is the marginal propensity to consume (MPS) – the portion of an extra dollar in income that will be spent by consumers
– MPC is change in consumption divided by change in income, which is defined as cC / cY (c = change)
L8 How do households fun their consumption? from the flow of income from firms, which incorporates investment and previous consumption.
L8 (circular flow) To close the output gap, the central bank needs to set an INTEREST RATE. what is the equation to use (find change in I) CHANGE IN Y = CHANGE IN I / 1 – MPC

MPC = change in C/change in Y

L8 what is the equation for the leakage rate Leakage rate = total leakages / Y
therefore, T + Im + S /Y
L9 How could austerity (i.e. a decrease in government spending) make the government budget balance worse? lower government outlays mean lower injections into the circular flow, which destroys leakages and reduces income.
BUDGET BALANCE = taxes – (G + Transfers)
L9 How would a cut in government healthcare purchases of $20bn affect the budget balance in an economy with an expenditure multiplier of 1.5 – tax rev always 25% of GDP Affect GDP through multiplier affect
change in G x expend. multip. = change in Y
-30 = change in Y
25% of 30 = 7.5 (tax change)
L9 what is the budget balance equation BUDGET BALANCE = change in tax – (change in G + change in transfers)
L9 (automatic stabilisers) what happens to T, G and Tr when a slump occurs and govt implements no changes Unemployment increase (people seek benefits) – increase transfers
GDP decrease = tax decrease, and income tax decrease as people move down tax bracket
GS does not change (discretionary)
L9 (automatic stabilisers) what happens to real GDP when there is a slump and the govt implements no changes Higher transfers + lower taxes cause Real GDP to be higher than would otherwise be – prevent people’s incomes from falling quite as far
L9 how to find the cyclical surplus + determine whether the fiscal policy stance is contractionary or expansionary actual surplus (where real GDP is) = structural surplus (Y=Y*) + cyclical surplus
– if structural surplus is <0 = expansionary
L10 How does a change in the interest rate alter each type of spending (C, I, G and NX) C – increase when i decrease (income effect)
I – cost of borrowing $ to invest decreases = increase I
NX – increase (lower i = less money = reduce demand for AUD = AUD depreciates = foreigners buy
L10 how does the RBA achieve its cash rate target The RBA uses open market operations to offset liquidity changes in the financial system in order to keep the cash rate at the target level. Changes in the cash rate tend to flow through to other interest rates.
L10 what are Open market operations (OMO) RBA buying/ selling financial instruments such as Comm. govt Sec. and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements
-increase money supply =CB buys bonds
– decrease money supply =CB sells bonds
L10 will interest rates increase or decrease if the RBA sells $500m of bonds` sell bonds = decrease money supply = increase interest rates
(When the supply of money is lower, the price of money (the interest rate) will be higher).
L10 how to you work out the real interest rate
e.g. annual inflation rate = 2.8%
nominal interest rate = 6.5%
REAL INTEREST RATE = NOMINAL RATE – INFLATION
L10 Is the real or nominal interest rate more important RiR =more important – reflects actual cost of borrowing and lending in the economy.
real expenditure responds more to real interest rates than to nominal rates. RIR reflect what borrowers actually pay to borrow money (nominal is the figure set by bank)
L10 What is the “Zero Lower Bound” theory? What countries have disproved this assumption? Predicted that nominal interest rates could never go below zero.
Japan, Switzerland, Sweden, Denmark have all experienced negative interest rates.
L10 Why is it possible for central banks to reduce interest rates below zero? It is very useful, if not essential, to keep money in a bank account. Investors and savers are willing to pay for this convenience through negative interest rates.
L10 What alternatives to cutting interest rates do central banks have if interest rates are low? QUANTITATIVE EASING = involves buying huge volumes of government bonds to try inject liquidity into markets. The hope is that this will prevent asset prices from collapsing and encourage private sector lending. (large scale OMO)
L10 What role may central banks have played in causing the Global Financial Crisis (GFC)? low interest rates allow more borrowing that bids up asset prices, further fuelling speculative increases in the supply of new houses, offices etc. resulting in supply glut lasting years
L11 If there is an increase in oil prices from US$46m to 92m, what is the impact in the short run sharp increase in $ = cost-push inflation
inflation rises, but output decreases due to increase cost of production
stagflation -> econ stagnation + rising inflation
L11 the phillips curve reads positive GDP and low inflation, what is the expected trajectory for the economy in the medium run positive GDP = low unemployment + demand for g+s
this puts pressure on input prices and wages, therefore increase inflation which will lower output
L11 What is the Phillips curve and is it useful for prediction the relationship between inflation and real GDP gap shows the average expected relationship between inflation and real GDP gap over time (not the movement of the economy) Economies don’t smoothly move along the Phillips curve – they tend to move in loops around potential GDP.
L12 What are the three accounts that make up the balance of payments? BoP = CA + KA + FA = 0
L12 How do you work out the Current account Net Exports + Net Primary Income + Net Secondary Income.
NPI = income received from overseas investments – income paid to overseas residents
NSI= transfers from overseas to Australian residents – transfers to overseas residents from Australians
L12 How do you work out the financial account Net direct investment + Net portfolio investment. Includes financial derivatives, other investments and RBA assets
L12 What does the financial account record CROSS BORDER ACCOUNTS FOR ASSETS
The financial account records a credit for foreign purchases of Australian physical assets and financial assets and a debit for Australian purchases of foreign physical and financial assets.
L12 Australia’s current account is in surplus. Now suppose a large number of domestic residents receive money from relatives overseas for Christmas. increases CA surplus and increases FA deficit.

The current account surplus increases because of the increase in net secondary income. An increase in the current account surplus must correspond to an increase in financial account deficit

L12 Is monetary policy more effective when the exchange rate is fixed or floating? floating
decrease int. rate = increase X and decrease IM (cheaper to produce domestically) – would not occur with a fixed currency
L12 the AUD/USD exchange rate rose from 0.86 (1 Australian dollar bought 0.86 US Dollars) to a peak of 1.07. What was the cause of this increase? The price of resource exports, namely iron ore and thermal coal, rose significantly over this period. This increased demand for the Australian dollar, causing it to appreciate.