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Tutorial 2: Fundamental monetary arrangements. Week beginning 21st March


Reference:

* Mundell, R. A. (1961). “A Theory of Optimum Currency Areas.” American Economic Review 51: 657-65



Questions

1. Why do people hold money?

2. What desirable properties should some “item” have for it to be useful as “money”? (Hint: Start with the simple case of gold.)

3. It is said that money is subject to a “network effect”. That is, the more people use a certain form of money the more valuable it becomes, just like a computer network or a language. A network with nodes can be represented by a matrix:



where is the volume of traffic that flows from node i to node j. The matrix A can also be used to represent the money flows from person i to person j . Illustrate the “network externality” of money by considering the effect of an additional person using money by augmenting the A matrix with an additional row and column:



Why is this an “externality”?

4. Who or what controls the supply of money? (Hint: Again start with the case of gold.)

5. Should the supply of money be regulated by the government or left to market forces?

6. Should Australia abandon using the Australian dollar and adopt the US dollar instead? What are the costs and benefits? (Hint: (i) Read the Mundell article. (ii) Refer back to Question 3 above.)

Tutorial 3: The importance of the demand for and supply of money. Week beginning Monday 28th March


References:

* Laidler, D. E. W. (1985). The Demand for Money: Theories, Evidence and Problems. Third edition. New York: Harper and Row. Chapter 2.



* Viswanath, G. (2009). “The Comparative Statics of the IS-LM Model.” Unpublished notes, Business School, University of Western Australia.

* Yiannopoulos, N. (2006). “IS-LM Summary”. Unpublished notes, Business School, University of Western Australia.



Questions

  1. The goods market:

  1. What determines the slope of the IS curve?

  2. What causes a shift in the IS curve?

  3. What causes a movement along the IS curve?

  1. The assets market:

  1. What determines the slope of the LM curve?

  2. What causes a shift in the LM curve?

  3. What causes a movement along the LM curve?

  1. Using the IS-LM model, explain the impact on interest rates and output of expansionary monetary policy. Under what conditions is GDP highly sensitive to monetary policy? Why?

  2. Explain the economic impact of expansionary fiscal policy. Under what conditions are interest rates highly sensitive to fiscal policy? Why?

  3. Given that the Reserve Bank of Australia now targets interest rates instead of the money supply, what can be said about the shape of the LM curve in Australia? What consequences does this have for the effectiveness of fiscal policy?


Tutorial 4: Money demand. Week beginning Monday 4th April

Reference:

* Laidler, D. E. W. (1985). The Demand for Money: Theories, Evidence and Problems. 3rd edition. New York: Harper and Row. Pp. 50-54, 59-64, 69-77.



Questions

  1. In recent times financial markets have been particularly volatile. This would increase the demand for money. Discuss. (Hint: Refer to Topic 3 in Lecture Notes in Monetary Economics.)

  2. The Baumol-Tobin model provides a theory of holdings of cash balances. Use this model, combined with estimates of your own cost of ‘a trip to the bank’ and foregone interest to calculate your optimal average cash balances. Is this amount close to what you usually keep in your wallet? Why might these two figures differ?

  3. Two companies, A and B, are affected differently by the removal of tariffs on imported products. Profits of Company A rise due to its ability to source its inputs from international suppliers at substantially reduced prices and thus become more competitive and gain market share. Company B, however, sees its profits fall markedly as it struggles to compete with the now cheaper imports. Suppose these changes can be represented by the following net cash flows over a given year (all in $m):

    Situation

    Company A

    Company B

    Cash flow prior to the removal of tariffs

    10

    8

    Cash flow following the removal of tariffs

    40

    1

    1. What is the likely impact of these events on average cash balances held by each company? (Hint: Start out simply and just consider if cash holdings increase or decrease. Then, consider if they move in proportion to the annual cash flow. This relates to economies of scale in cash holdings.)

  1. How would your answer to a) above change if the interest rate subsequently decreases from 5% to 4%?

  2. Suppose Company B is a mining company that operates out of Broome and banks with Trust Us Bank (TUB). Due to cost cutting, TUB closes a large number of its rural branches, including that in Broome. The effect of this has been to make withdrawing money twice as difficult for the bank’s rural customers, including Company B. What would be the effect of this on the average cash balances held by Company B prior to the removal of the import tariffs?

Hint: Use the Baumol-Tobin model to calculate the elasticity of money demand with respect to income, interest rates and the cost of going to a bank. Interpret the income elasticity as the elasticity with respect to the company’s cash flow. Use these elasticities to calculate the consequence for money demand of a one-percent change in each of the variables. It may be helpful to use the following rules of powers: For u>0 and v>0, consider the function


This can be expressed as

and it follows that

Remember also that for

which is the elasticity of x with respect to z, or the percentage change in x following a one-percent change in z.

Tutorial 5: Central banking. Week beginning Monday 11th April

References:

* Issing, O. (2005). “Communication, Transparency, Accountability: Monetary Policy in the Twenty-First Century.” Federal Reserve Bank of St. Louis Review March/April: 65-83

* Mishkin, F. S. (2000). “What Should Central Banks Do?” Federal Reserve Bank of St Louis Review November/December 1-13.

Extract from the Reserve Bank Act 1959:



“It is the duty of the Reserve Bank Board… to ensure that the monetary and banking policy of the Bank is directed to the greatest advantage of the people of Australia and that the powers of the Bank … are exercised in such a manner as, in the opinion of the Reserve Bank Board, will best contribute to:

  1. the stability of the currency of Australia;

  2. the maintenance of full employment in Australia; and

  3. the economic prosperity and welfare of the people of Australia.”

Questions

  1. What is the composition of the RBA Board? Who appoints Board members? Given this, do you think that the Reserve Bank of Australia can be described as ‘instrument independent’?
    (See http://www.rba.gov.au/AboutTheRBA/rba_board.html)

  2. The following cartoon and letter to the editor are both from the Australian Financial Review of 5th November 2007. This was shortly before the Federal election in which the then-ruling Coalition lost office. Peter Costello was Treasurer and broadly speaking, had political responsibility for all matters related to the economy, including policy. Does the cartoon imply that the Reserve Bank of Australia was independent? Is correspondent David Blackhall really trying to argue that because higher interest rates have no measurable impact on the economy, the RBA may as well raise them?





  1. In the following table provides information regarding the transparency practices of leading central banks around the world:

Transparency Practice

Follower of practice

Issues a media release following all Monetary Policy meetings, including those which result in rates remaining unchanged

Reserve Bank of Australia, Bank of Canada, Bank of Japan, Federal Reserve (US)

Publishes the minutes of all Monetary Policy meetings

Reserve Bank of Australia, Federal Reserve (US), Bank of England, Bank of Japan

Publishes the voting details of individual Board members.

Bank of Japan, Bank of England, Federal Reserve (US)

Holds a press conference directly after all Monetary Policy Meetings.

European Central Bank, Bank of Japan

Source: Derived from Issing (2005).
Why is transparency and communication important for central banks? What mechanisms are in place to ensure that the RBA is transparent and accountable? With reference to the above table, how does the RBA compare with other central banks around the world regarding transparency? What would you recommend?

(See http://www.aph.gov.au/house/committee/efpa/rba2005_2/report/chapter1.pdf)



  1. How do we assess the performance of a central bank? Given this, how would assess the performance of the RBA over the last decade?

  2. It has been argued that inflation targeting – as an explicit nominal anchor - will lead to larger output fluctuations. What does Mishkin (2000) say about this argument? Has the performance of the world’s major economies been consistent with this argument?

Tutorial 6: Measuring inflation. Week beginning Monday 18th April

Reference:

* Clements, K.W. (2006). “Notes on Measuring Inflation.” Unpublished notes, Business School, University of Western Australia.



Questions

The first six of the following questions refer to Clements (2006) and Table 1 from that source is reproduced below.

1. The right-hand side of equation (5) defines the two-year inflation rate. Use the data of Table 1 to compute this rate for the period 1999 to 2001; ensure that it is 15.38 percent, as indicated by the entry for 2001 in column 4 of Table 1.

2. Use equation (7) to compute the average annual rate of inflation from 1999 to 2001; ensure this is 7.42 percent.

3. From column 3 of Table 1, and percent. Thus, the arithmetic average of these two rates is

This is close, but not exactly equal, to the entry in column 5 of Table 1 for 2001 of 7.42 percent for the average annual inflation rate. Why the difference? [Hint: Look at the discussion around equation (10)].

4. Use the data in column 2 of Table 1 to compute the ten-year rate of inflation and the corresponding annual average rate. How close is the latter to 6.35 percent, the average of the 9 one-year rates, given at the bottom of column 3 of Table 1?

5. The price level in 2005 is 170. Suppose the price level increases by 6.35% per annum from this year forth. What was the price level in 2006? By what year will the price level have tripled?

6. [Harder] Sketch an algebraic proof that the average rate of inflation is less volatile than the one-year rate.

7. Use the Reserve Bank of Australia’s Annual Inflation Calculator at http://www.rba.gov.au/calculator/ to answer the following:

a) Calculate the annual rate of inflation in each year of the decade of the 1990s.

b) Calculate the average annual rate of inflation for the 1990s.

c) Use these data to verify the first member of equation (11), the exact relation. Also compute the approximation given as the second member of equation (11). How close is the approximation?

8. In 1970, the cost of an ounce of gold was about $A30. If this price increased at the CPI rate of inflation, what would the cost be today? How does this compare to the annual cost in today? What do you conclude from this comparison and what are the implications for the Australian gold mining industry?

9. Today it costs about $14 to go to a movie. If movie admission prices moved in line with the CPI, what would this have cost in 1901? What if there were no movie theatres in 1901? More generally, what can be said about the measurement of inflation when new goods appear, and when the quality of existing goods improves significantly?

TABLE 1

THE PRICE LEVEL AND INFLATION









Rate of Inflation

Year

Price

Index


One-year

Two-year

Annual

average


(1)

(2)

(3)

(4)

(5)

1996

100










1997

110

10.00







1998

115

4.55

15.00

7.24

1999

130

13.04

18.18

8.71

2000

135

3.85

17.39

8.35

2001

150

11.11

15.38

7.42

2002

140

-6.67

3.70

1.84

2003

160

14.29

6.67

3.28

2004

180

12.50

28.57

13.39

2005

170

-5.56

6.25

3.08
















Average




6.35

13.89

6.66

Source: Clements (2006).

Tutorial 7: The quantity theory of money. Week beginning Monday May 2nd

Reference:

* Fisher, I. (1913). The Purchasing Power of Money. New York, Macmillan. Pp 21-24.



Questions

1. The quantity theory equation is where M is the money stock, V is velocity of circulation, P is the price level and T is the volume of transactions. Rewrite this equation as where Under what conditions is the price level proportional to money?

2. Are all increases in the money supply inflationary?

3. What would be the effect on the quantity theory equation of the development of a new financial asset which acted as a good substitute for money (consider both the long run and short run effects)? What would be the effect if the money supply simultaneously increased by 50 percent?

4. Central banks, including the RBA, customarily refer to monetary policy in terms of interest rates despite the fact that they don’t control interest rates directly. How does this work?

5. Many central banks are now inflation targeters. Would it be preferable for them to target the rate of growth of the money supply instead?



Tutorial 8: Interest rates. Week beginning Monday May 9th

References:

* Monnet, C. and W. E. Weber (2001) “Money and Interest Rates.” Federal Reserve Bank of Minneapolis Quarterly Review 25: 2-13.

* Carlstrom, C. and T. Fuerst (2003) “The Taylor Rule: A Guidepost for Monetary Policy?” Federal Reserve Bank of Cleveland Economic Commentary.

Questions


  1. What does the Fisher equation imply about the relationship between money supply changes and interest rate changes? What empirical evidence do Monnet and Weber find to support this view?

2. Explain the liquidity effect view. What evidence is there to support this view?

3. Are the two views conflicting? How do Monnet and Weber reconcile them?

4. Does the relationship between money supply and interest rates change if the central bank targets interest rates instead of money supply?

5. The Taylor rule is

(1)

where i is the Federal Funds Rate (nominal); is inflation; y is growth in real GDP; and is potential growth. These four variables are all expressed in terms of percent p. a.

a) Interpret this rule.

b) In what sense does the Taylor rule mean that the central bank “leans against the wind”? Is this a desirable feature of monetary policy?

c) In the third term of the right-hand side of equation (1), inflation is measured as a deviation from the value 2. Why?

d) If the central bank uses this rule, what happens to the ex post real interest rate, when inflation rises?

e) Growth and inflation are equally weighed in equation (1), which implies that they are, in some sense, directly comparable. Is it reasonable to argue that (a) below-trend growth and (b) inflation above 2 percent are equivalent for the purposes of managing the economy?

6. Suppose inflation is at 2 percent, GDP growth is at its long-run value, and the central bank follows the Taylor rule. What is the nominal interest rate? Suppose inflation increases to 3 percent while growth remains unchanged. What is the new interest rate? Why does the interest rate increase by more than the inflation rate?

7. Suppose the Reserve Bank of Australia adopted the Taylor rule. As this rule could be automated, would it mean substantial costs savings as many staff of the Bank, and possibly its Directors, would no longer be required to closely monitor the performance of the economy to provide advice on setting interest rates?
Tutorial 9: Discussion of quiz. Week beginning Monday May 16th

Tutorial 10: International monetary economics. Week beginning Monday May 23rd

References:

* Clements, K. Y. Lan and S. P. Seah (forthcoming). “The Big Mac Index Two Decades On: An Evaluation of Burgernomics.” International Journal of Finance and Economics (2010) DOI:10.1002/jife.432.

* Frenkel, J. A. and M. Mussa (1980). “The Efficiency of Foreign Exchange Markets and Measures of Turbulence.” American Economic Review 70: 374-81.

* The Economist (2009). “Cheesed Off.” July 18.



Questions

1. In Figure 1 below is a frequency distribution of daily changes over the last three decades in the Australian exchange rate, defined as the US dollar cost of one Australian.

a) The mean change in the exchange rate is zero. What does that imply for forecasting future currency value?


  1. In of cases, the daily absolute change in the rate exceeds 2 US cents. Is this a “large number”? [Hint: (i) What is the implied annual percentage change? (ii) Read Frenkel and Mussa (1980).]

Figure 1

Distribution of Australian-US Dollar Daily Changes

(12/12/1983-01/03/2010)

3.34%


2.47%

Mean = 0


SD = 0.0106

Min = -0.1083

Max = 0.1031

Source: RBA

Figures 2-5 below are from, or based on, Clements, Lan and Seah (forthcoming). It is not necessary to read this paper, but you are welcome to do so.

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