ECS3701 EXAM PACK

ECS3701 Oct/Nov 2017 1. Explain the following terms i. Inflation targeting Monetary policy strategy that involves public announcement of a medium-term numerical target for inflation. ii. Interest rate risk The riskiness of earnings and returns that is associated with changes in interest rates iii. Monetary Policy Monetary policy can be defined as the measures taken by the monetary authorities to influence the quantity of money or the rate of interest with a view to achieving stable prices, full employment and economic growth. Monetary policy in South Africa is conducted by the South African Reserve Bank iv. Money Money or money supply is defines as anything that is generally accepted in payment for goods or services or in the repayment of debts. Money is linked to changes in economic variables that affect all of us and are important to the health of the economy. 1.2 Differentiate between hierarchical and dual mandates of monetary policy Hierarchical versus Dual Mandates Hierarchical mandates is when an economic goal, such as price stability, is put first and the say that as long as it is achieved other goals can be pursued. Dual Mandate is when a central bank is required to achieve two co-equal objectives; price stability and maximum employment (output stability) 1.3 Can monetary policy alleviate South Africa ‘s high unemployment problem? Explain The goals of employment and economic growth appear particularly important because of the high unemployment rate, and the prevalence of poverty among large sections of the population. ECS3701 EXAM PACK 2 | P a g e The SARB is under pressure to lower interest rates, particularly from the trade unions. Many believe that the advantages of a low interest rate (perceived as higher employment) far outweigh the problems of a low interest rate (a higher rate of inflation). Monetary policy is an ineffective tool to achieve this goal. Several reasons can be put forward in support of this view: 1. Structural unemployment occurs when there is a mismatch between the supply of worker skills and the demand for skill required. Raising the skill level of workers calls for structural solutions, such as a good school system and the development of worker skills and entrepreneurship through education and training. Structural problems of a long term nature are best solved by long term structural solutions. Shortterm solutions like lowering interest rates to solve the structural unemployment problem are generally ineffective and often not sustainable. 2. The case for lower interest rates rests on the assumption it will lead to a higher level of economic activity and employment. The problem is that this may lead to price inflation, and the lack of price stability has negative effects on long term growth. Although it is generally accepted that low interest rates do boost production in the short term, Mishkin (2009) notes that in the long term, price stability actually supports the other goals like economic growth. Thus, in the long term, there is no trade-off between price stability and growth. The impact of lower interest rates on aggregate demand is also much more certain than its impact on employment. Theoretically lower interest rates increase disposable income of households and increases borrowing. This increases aggregate demand, that is, the capacity of consumers and firms to spend. The first problem is, however, that when the increased spending is on imported goods (for example luxury goods and machinery), then there is very little impact on the domestic economy, that is, on its level of production. 3. Analysts point out that the South African production structure – which ultimately affects employment, is not very sensitive to interest rates. Some industries sell in fixed price markets (e.g. mining) which are not affected by interest rates. 4. Even if lower interest rates increase production, then it will not necessarily affect employment. This is particularly applicable to unskilled and low skilled jobs which is where the problem lies. 3 | P a g e 5. Monetary policy controls the repo rate which is a short-term interest rate. Output and employment will react to medium and long term interest rates. There are lags before a lower interest rate impacts on the economy, 3-24 months, making it difficult to asses the impact. Low interest rates can also have adverse affects. Because higher interest rates are likely to lead to lower inflation, this implies that lower interest rates might lead to higher inflation. Lower interest rates might lead to a depreciation of the value of the Rand and reduce the inflow of foreign currency which may cause the value of the Rand to depreciate making imports expensive and lead to higher inflation. Higher inflation has a number of adverse affects on the economy. It increases uncertainty which complicates planning, it corrupts information which disrupts markets, it leads to all sorts of unproductive activities trying to escape the adverse effects of inflation, it causes an unfavourable redistribution of income, it reduces social cohesion and leads to social unrest. Everybody can gain by low inflation, particularly the mass of workers who are more likely to be adversely affected by inflation. The best way to judge interest rates is to use the real interest rate (nominal interest rate minus the inflation rate) because this is what motivates most economic agents. A high nominal interest rate does not necessarily imply that the real interest rate is also high. The best contribution the SARB's monetary policy can make is to maintain price stability and contain cyclical variation in production employment levels creating favourable conditions for sustainable growth in income and employment. Question 2 2.1 Name the two partial equilibrium approaches to the determination of interest rates The bond supply and demand framework The liquidity preference framework 2.2 Mention the two ways in which the credit channel of the monetary transmission mechanism affects the economy The monetary policy effect balance sheets of households and firms 4 | P a g e 2.3 Using the two ways mentioned above discuss the credit channel through which an expansionary monetary policy can influence the real output and price level(16) The monetary policy effect is represented as: ↓repo rate → ↑bank deposits → ↑bank loans → (↑Inv, ↑C) → ↑Y This channel operates, firstly, through bank lending. Certain borrowers will not have access to credit markets unless they borrow from banks. Expansionary monetary policy increases bank reserves and bank deposits, thus increasing the amount of loans available. This increase in loans will cause fixed capital formation and consumer spending to rise. A significant implication is that monetary policy through this channel will have a greater effect on those more reliant on bank loans, such as smaller firms, since larger firms have recourse to obtaining funds by issuing new share capital. As circumstances and restrictive regulatory frameworks change to allow banks greater ability to raise funds, the potency of this channel will be reduced. Secondly, credit affects the balance sheets of households and firms and also arises from asymmetric information in credit markets: ↓repo rate → ↑price expectations → ↑cash flow → ↓adverse selection → → ↓moral hazard → ↑lending → (↑Inv, ↑C) → ↑Y Question 3 3.1 Define cost push inflation and demand pull inflation Cost-push inflation – results from either a temporary negative supply shock or a push by workers for wage hikes beyond what productivity gains can justify. Demand-pull inflation – results from policymakers pursuing policies that increase aggregate demand. 3.2 A cost -push inflation can be initiated by a demand pull inflation. Is this statement true. Explain