Tutorial assignment: week 10 2022
Answer guide
1. Suppose that the central bank decision making committee is operating in accordance with the
Taylor rule. Assume the following:
• The inflation target is 2.5 per cent
• Actual inflation is 5 per cent
• The neutral real interest rate is 3.5 per cent
• Real GDP is estimated to be 1 per cent below potential
Using these assumptions, calculate (a) the nominal policy interest rate that would be set by this
committee and (b) the real policy interest rate.
(a) R = inflation rate + neutral real rate + 0.5(excess inflation) + 0.5(output gap)
So R = 5 + 3.5 + 0.5*(5 – 2.5) + 0.5*(-1) = 9.25 per cent
(b) Real R = 9.25 – 5 = 4.25 per cent
2. What are the main ways that uncertainty can affect the monetary policy decision process?
Why might this result in long periods of time when policy interest rates are unchanged?
The main sources of uncertainty for decision makers were set out in lecture 6.2. They are:
• Tracking error. The difficulty of determining accurately the current state of the economy
when key pieces of information are only available with a lag
• Recognition lags. It takes time to recognise a significant change in economic trends because
of the difficultly in distinguishing signal from noise
• Statistical and measurement error. Many key economic variables are subject to
measurement error because based on incomplete data or sampling error (eg the
employment survey)
• Impact lags. It takes time for policy decisions that have already been taken to have their full
effect. Eg, the housing market may still be influenced by interest rate decisions taken in
earlier periods. So policy has to take into account expected (but unobservable) effects of
decisions already taken.
• Inherent unpredictability of the economy. Policy decisions taken now will be affecting the
economy in a future period when economic conditions are uncertain, even if we have good
information about conditions at present.
• Unpredictability of policy impacts. A decision, for example, to raise the policy interest rate
will be likely to reduce spending below what would otherwise have occurred, but the size of
the impact is uncertain.
To answer the second part of the question:
• Policy makers try to set the interest rate at a level that is most likely to result in economic
outcomes that are in line with the inflation targeting framework
, • They will usually only change the interest rate if there is a sufficiently clear case to do so
• This would mean they need clear information that inflation will go off target if there is no
change in the policy rate
• Because of the uncertainties, most of the time there is not sufficiently clear information to
support a case for changing the policy rate
• But information accumulates over time
• Over time, when sufficient information has accumulated to make a case that inflation is
likely to go off target, the central bank will make a policy change
Another way of saying this is that most of the time, the signal-to-noise ratio is fairly low. But
occasionally when there is a major development, the signal-to-noise ratio is high. These are times
when the central bank would be likely to make a series of large interest rate changes in quick
succession. This is what happened during the GFC.
3. Suppose it were suggested that the decision process for setting the policy interest rate could
be fully automated, with the central bank being required to set the interest rate at the level
given by the Taylor rule. Would this be a good way to conduct policy? Give reasons for your
answer.
This idea might at first seem plausible. It would mean the CB is responding systematically and
consistently to the major trends in output and inflation.
But there would also be problems with this approach:
• The key variables are not observed in real time. Both inflation and output are measured with
lags of several months. So a policy that had to wait for publication of these statistics would
always be late in responding to actual developments.
• This suggests that policymakers could improve upon a mechanical Taylor rule by
incorporating responses to more up-to-date sources of information.
• The variables on the RHS of the Taylor rule are measured with error. For example, the
neutral real interest rate is not observable. Inflation (the CPI) and output (GDP) are both
measured with error. So mechanically linking the policy decision to these variables would
bring these errors into the policy process
• Policy needs to be able to respond to large unforeseen events, like the GFC or the pandemic.
The Taylor rule would not have generated quick responses to these events, because the
effects on prices and output were only measured with a lag.
4. During 2021 house prices in Australia increased by 22 per cent. Does this mean there was a
real estate bubble? And what considerations would the RBA need to take into account in
deciding how to respond to this situation?
• Some but not all observers thought this was a bubble at the time
• It is never possible to be sure whether this kind of situation is a bubble or not
• We can only say that the rapidly rising house prices meant it could be a bubble
• Other things to take into account would be:
o How long had prices been rising at these sorts of rates (the longer, the more likely it
might be considered a bubble)
Answer guide
1. Suppose that the central bank decision making committee is operating in accordance with the
Taylor rule. Assume the following:
• The inflation target is 2.5 per cent
• Actual inflation is 5 per cent
• The neutral real interest rate is 3.5 per cent
• Real GDP is estimated to be 1 per cent below potential
Using these assumptions, calculate (a) the nominal policy interest rate that would be set by this
committee and (b) the real policy interest rate.
(a) R = inflation rate + neutral real rate + 0.5(excess inflation) + 0.5(output gap)
So R = 5 + 3.5 + 0.5*(5 – 2.5) + 0.5*(-1) = 9.25 per cent
(b) Real R = 9.25 – 5 = 4.25 per cent
2. What are the main ways that uncertainty can affect the monetary policy decision process?
Why might this result in long periods of time when policy interest rates are unchanged?
The main sources of uncertainty for decision makers were set out in lecture 6.2. They are:
• Tracking error. The difficulty of determining accurately the current state of the economy
when key pieces of information are only available with a lag
• Recognition lags. It takes time to recognise a significant change in economic trends because
of the difficultly in distinguishing signal from noise
• Statistical and measurement error. Many key economic variables are subject to
measurement error because based on incomplete data or sampling error (eg the
employment survey)
• Impact lags. It takes time for policy decisions that have already been taken to have their full
effect. Eg, the housing market may still be influenced by interest rate decisions taken in
earlier periods. So policy has to take into account expected (but unobservable) effects of
decisions already taken.
• Inherent unpredictability of the economy. Policy decisions taken now will be affecting the
economy in a future period when economic conditions are uncertain, even if we have good
information about conditions at present.
• Unpredictability of policy impacts. A decision, for example, to raise the policy interest rate
will be likely to reduce spending below what would otherwise have occurred, but the size of
the impact is uncertain.
To answer the second part of the question:
• Policy makers try to set the interest rate at a level that is most likely to result in economic
outcomes that are in line with the inflation targeting framework
, • They will usually only change the interest rate if there is a sufficiently clear case to do so
• This would mean they need clear information that inflation will go off target if there is no
change in the policy rate
• Because of the uncertainties, most of the time there is not sufficiently clear information to
support a case for changing the policy rate
• But information accumulates over time
• Over time, when sufficient information has accumulated to make a case that inflation is
likely to go off target, the central bank will make a policy change
Another way of saying this is that most of the time, the signal-to-noise ratio is fairly low. But
occasionally when there is a major development, the signal-to-noise ratio is high. These are times
when the central bank would be likely to make a series of large interest rate changes in quick
succession. This is what happened during the GFC.
3. Suppose it were suggested that the decision process for setting the policy interest rate could
be fully automated, with the central bank being required to set the interest rate at the level
given by the Taylor rule. Would this be a good way to conduct policy? Give reasons for your
answer.
This idea might at first seem plausible. It would mean the CB is responding systematically and
consistently to the major trends in output and inflation.
But there would also be problems with this approach:
• The key variables are not observed in real time. Both inflation and output are measured with
lags of several months. So a policy that had to wait for publication of these statistics would
always be late in responding to actual developments.
• This suggests that policymakers could improve upon a mechanical Taylor rule by
incorporating responses to more up-to-date sources of information.
• The variables on the RHS of the Taylor rule are measured with error. For example, the
neutral real interest rate is not observable. Inflation (the CPI) and output (GDP) are both
measured with error. So mechanically linking the policy decision to these variables would
bring these errors into the policy process
• Policy needs to be able to respond to large unforeseen events, like the GFC or the pandemic.
The Taylor rule would not have generated quick responses to these events, because the
effects on prices and output were only measured with a lag.
4. During 2021 house prices in Australia increased by 22 per cent. Does this mean there was a
real estate bubble? And what considerations would the RBA need to take into account in
deciding how to respond to this situation?
• Some but not all observers thought this was a bubble at the time
• It is never possible to be sure whether this kind of situation is a bubble or not
• We can only say that the rapidly rising house prices meant it could be a bubble
• Other things to take into account would be:
o How long had prices been rising at these sorts of rates (the longer, the more likely it
might be considered a bubble)
