Tutorial assignment: week 3 2022
Answer guide
1. Recent media reports suggest that the general level of interest rates may soon begin to
increase worldwide. What effects do you think this would have on the decisions of savers,
borrowers with a mortgage, businesses and governments? Hence, what would be the
likely effect on the economy overall?
Savers are people with surplus funds which can be loaned at interest, for example in the form of
bank deposits or direct loans. An example would be retirees with accumulated assets. If interest
rates rise, savers are better off because their interest income rises. The effect on their spending
decisions is ambiguous. The increase in income would allow them to spend more, but the higher
interest rate also provides an incentive to save more. The overall effect will depend on which of
these effects is stronger.
Mortgage borrowers will be worse off because their loan repayments are increased. They will be
likely to reduce their spending on goods and services because disposable income is reduced. In
addition, the higher interest rate will give them an incentive to pay off their loans more quickly than
otherwise. This reinforces the downward impact on their likely spending decisions.
Businesses generally have significant debts, so their interest payments will rise and profits fall. This
will make it more difficult for them to employ workers or to invest in productive capacity (like
machinery, equipment, premises). Furthermore, when interest rates are higher it will be more
difficult for businesses to justify borrowing to fund new activities, because those activities would
need to earn a higher rate of return to be profitable after interest payments.
Governments also usually have large debts (recall the data from the lecture showing the amount of
government bonds on issue). So government interest payments will rise and fiscal deficits will rise.
Governments may respond by cutting spending or increasing taxes to limit the rise in their deficits.
The overall impact is likely to reduce spending, employment and incomes for the economy as a
whole, since most of the effects described above work in that direction. These effects also interact
with and reinforce each other: when spending in one part of the economy is reduced, it tends to
reduce incomes and spending in other parts of the economy at the same time. Reduced spending
and employment would in turn be likely to lead to lower inflation: when there is less demand for
goods and services, prices are likely to rise less quickly than otherwise.
2. Based on your answers to the previous question, what considerations might a central bank
take into account in deciding whether to change the policy interest rate?
Note that interest rates can move either up or down: a reduction in interest rates would have the
reverse of the effects described for Q1.
In deciding whether to change the policy interest rate, and in which direction, a central bank would
aim to have a stabilising influence on the economy as a whole. Hence, if the central bank thought
that spending and inflation were likely to be higher than desired, they would consider raising the
policy rate to counteract that. Conversely, if spending and inflation were likely to be lower than
, desired, they would consider lowering the policy rate. (These decision-making principles will be
studied in more detail later in the course.)
3. How would a rise in the value of the Australian dollar against other currencies be likely to
affect the following: (a) an Australian mining company selling aluminium abroad at a price
fixed in US dollar terms; (b) international travellers who are considering whether to have
their next holiday in Australia or elsewhere; (c) an Australian manufacturer of medical
supplies competing with imported products; (d) a retiree from Italy now living in Australia,
who has a pension denominated in euros.
(a) Profits of this company would fall. Since this is an Australian producer, the cost of production
can be assumed stable in Australian dollar terms. At the same time, the revenue from selling
aluminium is fixed in US dollar terms, so revenue in Australian dollar terms will fall when the
exchange rate appreciates. A simple numerical example can illustrate, assuming the AUD
appreciates from 1AUD=0.50USD to 1AUD=1USD:
Period 1 Period 2
Exchange rate (USD per AUD) 0.50 1.00
Price of Aluminium per tonne (in USD) 2,000 2,000
Price of Aluminium per tonne (in AUD) 4,000 2,000
Cost of production per tonne (AUD) 1,500 1,500
Profit per tonne (AUD) 2,500 500
(b) International travellers are less likely to come to Australia. The AUD is now more expensive and
so the relative cost of an Australian holiday has increased compared to other destinations.
(c) The relative price of imported products falls. Hence, an Australian producer would find it more
difficult to compete and would likely face reduced demand for the Australian product.
(d) This is essentially the same situation as (a), since income is fixed in foreign currency terms. The
pensioner’s income falls in AUD terms. And since they are resident in Australia, their cost of
living in AUD terms is unchanged, so the person is worse off.
4. From the RBA website, find the most recent statement (prior to March 2022) by Governor
Lowe announcing the outcome of a meeting of the RBA Board. What does the statement
say about the RBA’s current thinking and intended policy actions?
The most recent statement was on 1 February 2022. Key points:
The Omicron outbreak has affected the economy but not ’derailed the recovery’.
Growth over the next two years is expected to be strong, but the pandemic is still the main
source of uncertainty.
The labour market is performing strongly with high employment growth, falling
unemployment and rising wages.
Consumer price inflation is rising. Part of that is due to temporary supply chain disruptions
caused by the pandemic, but there is also an underlying trend towards higher inflation.
But this follows a period when inflation undershot the target, so the RBA wants inflation to
rise.
Answer guide
1. Recent media reports suggest that the general level of interest rates may soon begin to
increase worldwide. What effects do you think this would have on the decisions of savers,
borrowers with a mortgage, businesses and governments? Hence, what would be the
likely effect on the economy overall?
Savers are people with surplus funds which can be loaned at interest, for example in the form of
bank deposits or direct loans. An example would be retirees with accumulated assets. If interest
rates rise, savers are better off because their interest income rises. The effect on their spending
decisions is ambiguous. The increase in income would allow them to spend more, but the higher
interest rate also provides an incentive to save more. The overall effect will depend on which of
these effects is stronger.
Mortgage borrowers will be worse off because their loan repayments are increased. They will be
likely to reduce their spending on goods and services because disposable income is reduced. In
addition, the higher interest rate will give them an incentive to pay off their loans more quickly than
otherwise. This reinforces the downward impact on their likely spending decisions.
Businesses generally have significant debts, so their interest payments will rise and profits fall. This
will make it more difficult for them to employ workers or to invest in productive capacity (like
machinery, equipment, premises). Furthermore, when interest rates are higher it will be more
difficult for businesses to justify borrowing to fund new activities, because those activities would
need to earn a higher rate of return to be profitable after interest payments.
Governments also usually have large debts (recall the data from the lecture showing the amount of
government bonds on issue). So government interest payments will rise and fiscal deficits will rise.
Governments may respond by cutting spending or increasing taxes to limit the rise in their deficits.
The overall impact is likely to reduce spending, employment and incomes for the economy as a
whole, since most of the effects described above work in that direction. These effects also interact
with and reinforce each other: when spending in one part of the economy is reduced, it tends to
reduce incomes and spending in other parts of the economy at the same time. Reduced spending
and employment would in turn be likely to lead to lower inflation: when there is less demand for
goods and services, prices are likely to rise less quickly than otherwise.
2. Based on your answers to the previous question, what considerations might a central bank
take into account in deciding whether to change the policy interest rate?
Note that interest rates can move either up or down: a reduction in interest rates would have the
reverse of the effects described for Q1.
In deciding whether to change the policy interest rate, and in which direction, a central bank would
aim to have a stabilising influence on the economy as a whole. Hence, if the central bank thought
that spending and inflation were likely to be higher than desired, they would consider raising the
policy rate to counteract that. Conversely, if spending and inflation were likely to be lower than
, desired, they would consider lowering the policy rate. (These decision-making principles will be
studied in more detail later in the course.)
3. How would a rise in the value of the Australian dollar against other currencies be likely to
affect the following: (a) an Australian mining company selling aluminium abroad at a price
fixed in US dollar terms; (b) international travellers who are considering whether to have
their next holiday in Australia or elsewhere; (c) an Australian manufacturer of medical
supplies competing with imported products; (d) a retiree from Italy now living in Australia,
who has a pension denominated in euros.
(a) Profits of this company would fall. Since this is an Australian producer, the cost of production
can be assumed stable in Australian dollar terms. At the same time, the revenue from selling
aluminium is fixed in US dollar terms, so revenue in Australian dollar terms will fall when the
exchange rate appreciates. A simple numerical example can illustrate, assuming the AUD
appreciates from 1AUD=0.50USD to 1AUD=1USD:
Period 1 Period 2
Exchange rate (USD per AUD) 0.50 1.00
Price of Aluminium per tonne (in USD) 2,000 2,000
Price of Aluminium per tonne (in AUD) 4,000 2,000
Cost of production per tonne (AUD) 1,500 1,500
Profit per tonne (AUD) 2,500 500
(b) International travellers are less likely to come to Australia. The AUD is now more expensive and
so the relative cost of an Australian holiday has increased compared to other destinations.
(c) The relative price of imported products falls. Hence, an Australian producer would find it more
difficult to compete and would likely face reduced demand for the Australian product.
(d) This is essentially the same situation as (a), since income is fixed in foreign currency terms. The
pensioner’s income falls in AUD terms. And since they are resident in Australia, their cost of
living in AUD terms is unchanged, so the person is worse off.
4. From the RBA website, find the most recent statement (prior to March 2022) by Governor
Lowe announcing the outcome of a meeting of the RBA Board. What does the statement
say about the RBA’s current thinking and intended policy actions?
The most recent statement was on 1 February 2022. Key points:
The Omicron outbreak has affected the economy but not ’derailed the recovery’.
Growth over the next two years is expected to be strong, but the pandemic is still the main
source of uncertainty.
The labour market is performing strongly with high employment growth, falling
unemployment and rising wages.
Consumer price inflation is rising. Part of that is due to temporary supply chain disruptions
caused by the pandemic, but there is also an underlying trend towards higher inflation.
But this follows a period when inflation undershot the target, so the RBA wants inflation to
rise.
