macroeconomics.doc

Inflation is a sustained rise in most prices in the economy. RBA usually uses Taylor-rule as a method to measure target rate of inflation in the economy. In Australia, RBA usually maintain the low inflation rate between 2% to 3% per year.1) Do you think 2.5 is a sensible choice for the target rate of inflation? Explain.To find the column of deviations, it needs to apply the formula Deviation of inflation from the target= Inflation rate Target rate (2.5%). From the table 1, it is clear to see that the target rate of inflation is 2.5% which is a sensible choice in most previous time periods. The reason is that most deviations of inflation from the target rate are close to zero which means the market under controlling well. Additionally, this target rate is not a sensible choice as the market is trading badly under global financial crisis which results the inflation rate out of control. This can be reinforced through the section of deviations of inflation from the target rate in the table as deviations are greater than one in the period from the March of 2008 to the June of 2009. Under a global slowdown, the inflation rate target should be adjusted accordingly.2) Do output gap and deviations of inflation from the target tend to move together over time? What happened to inflation and the output gap during the GFC?From the diagram 2.1, the graph expressed that the two series associated with output gap and deviations of inflation from the target were tend to move together over time. Diagram 2.1Diagram 2.2In the global financial crisis, both inflation and output gap decreased sharply. The inflation pressures in GFC were quite moderate because real GDP had a huge reduction in this period. During the GFC, fall in the stock market resulted a fall in wealth. For worsening outlook for business investment, companies cut the exogenous component of consumption as well as investment and further caused a massive reduction in real GDP. Eventually, the output gap was decreasing significantly because of the global financial problem.3) How well you think the Taylor-rule tracks the actual value of the cash rate set by the RBA? Taylor-rule measures two important variables including the output gap and inflation rate in economic policy.Diagram 3.1From the diagram 3.1 and table 2, it clearly expresses that the Taylor-rule tracks the actual value of the cash rate set by the RBA well in most previous years. The Taylor rule indicates that for a given inflation rate target, the nominal cash rate will be lower than the real cash rate if YY*(output gap is positive - expansionary gap). In these circles, they show us that the real world economy does not follow the Taylor-rule all the time. In actual economy, it is just a reminder of the direction to the movement in the target cash rate rather than a definitive guide to estimate the exact changes in the target cash rate. 4) Discuss the various reasons why the above Taylor-rule may not provide a complete description of RBA behaviour. In particular, you should consider the effects of forward-looking behaviour by the RBA and whether factors other than inflation and the output gap may influence the RBAs monetary policy decisions.Taylor rule is a reaction function that describes how the Reserve Bank has historically responded to economic conditions in setting the real cash rate. For a given recessionary gap and a given level of inflation, setting the real cash rate will be lower than the Taylor rule suggests. The Taylor-rule does not provide a complete description of RBA behaviour. The Taylor-rule is simple but not a perfect tool for RBA to forecast the future economic market as it uses the historical data and ignores the risks in the market. This rule cannot estimate long-term RBA cash rate as the historical output gap and level of inflation always change in different periods. Diagram 4.1For instance, monetary policy should accommodate the shock in GFC and therefore RBA allow the inflation above its target band for a sustained period which was from 2008 to 2009. In comparison, RBA responded less to inflation before 2008. This could be shown directly in the diagram that RBA real cash rate had not changed too much from 2003 to 2008. These can be shown through diagram 4.1 which tell us that RBA does not use the Taylor-rule as a whole tool.There are many factors other than inflation and the output gap that might influence the RBAs monetary policy decisions. RBAs monetary policy decisions involve the setting of various types of interest rate in the money market, controlling low inflation and achieving sustainable growth.Firstly, unemployment rate can affect the RBAs monetary policy decisions. In economic booms, the unemployment rate is lower and people will plan their medium term future with confidence. RBA will change their monetary policy decisions such as changing the saving interest rate. Secondly, exchange rate can also influence the RBAs monetary policy decisions. This involves the holding of foreign government bonds to be sold when foreign exchange is needed and purchased when foreign residents wish to purchase Australian currency to maintain the desired exchange rate. At the same time, the exchange rate shows the market power of purchasing foreign goods. RBA will adjust monetary policy to meet the market demand and supply. Thirdly, the RBAs monetary policy decisions can be influenced by the housing price. The slowdown for the growth rate of housing price will cause less people willing to buy houses. RBA will change monetary policy such as reducing real interest rate in order to reducing the pressure of loan for buying houses. Fourthly, RBAs monetary policy decisions will be affected by the government budget as well. The government budget could be deficit and surplus at each financial year. RBA will modulate monetary policy decision to maintain the balance of the market in a country.AppendixTable 1Date Output Gap Inflation DeviationsMar-1995-0.56542.33-0.1700 Jun-1995-0.64502.740.2400 Sep-1995-0.46163.100.6000 Dec-1995-0.60353.240.7400 Mar-1996-0.35363.130.6300 Jun-1996-0.55072.820.3200 Sep-1996-0.45612.33-0.1700 Dec-1996-0.50932.26-0.2400 Mar-1997-0.61862.47-0.0300 Jun-1997-0.01642.12-0.3800 Sep-1997-0.31451.82-0.6800 Dec-1997-0.03901.85-0.6500 Mar-19980.08621.60-0.9000 Jun-1998-0.00531.87-0.6300 Sep-19980.31101.93-0.5700 Dec-19980.50151.68-0.8200 Mar-19990.46131.71-0.7900 Jun-19990.33451.55-0.9500 Sep-19990.31292.05-0.4500 Dec-19990.59712.26-0.2400 Mar-20000.66662.47-0.0300 Jun-20000.56452.660.1600 Sep-20000.29432.42-0.0800 Dec-2000-0.08712.40-0.1000 Mar-20010.03512.600.1000 Jun-2001-0.08792.990.4900 Sep-2001-0.00123.150.6500 Dec-20010.11793.430.9300 Mar-20020.08813.120.6200 Jun-20020.35872.800.3000 Sep-20020.41172.760.2600 Dec-20020.44912.680.1800 Mar-20030.24172.860.3600 Jun-20030.32042.750.2500 Sep-20030.43742.750.2500 Dec-20030.43562.500.0000 Mar-20040.32732.41-0.0900 Jun-20040.21422.46-0.0400 Sep-20040.20302.38-0.1200 Dec-20040.14702.650.1500 Mar-20050.19152.560.0600 Jun-2005-0.01932.600.1000 Sep-20050.13892.580.0800 Dec-20050.08012.33-0.1700 Mar-2006-0.07782.580.0800 Jun-2006-0.16182.780.2800 Sep-2006-0.17182.850.3500 Dec-20060.06382.920.4200 Mar-20070.43052.710.2100 Jun-20070.59172.760.2600 Sep-20070.43202.930.4300 Dec-20070.34993.470.9700 Mar-20080.19354.081.5800 Jun-20080.12924.311.8100 Sep-2008-0.09694.652.1500 Dec-2008-0.63294.161.6600 Mar-2009-0.69393.911.4100 Jun-2009-0.68093.601.1000 Sep-2009-0.90033.190.6900 Dec-2009-0.85293.150.6500 Mar-2010-0.91733.020.5200 Table 2:Date Output Gap Inflation RBA Cash Rate Nominal Cash RateMar-1995-0.56542.337.504.1796 Jun-1995-0.64502.747.504.7150 Sep-1995-0.46163.107.505.4384 Dec-1995-0.60353.247.505.5065 Mar-1996-0.35363.137.505.5914 Jun-1996-0.55072.827.504.9293 Sep-1996-0.45612.337.004.2889 Dec-1996-0.50932.266.184.1307 Mar-1997-0.61862.476.004.3364 Jun-1997-0.01642.125.504.4136 Sep-1997-0.31451.825.003.6655 Dec-1997-0.03901.855.003.9860 Mar-19980.08621.605.003.7362 Jun-1998-0.00531.875.004.0497 Sep-19980.31101.935.004.4560 Dec-19980.50151.684.764.2715 Mar-19990.46131.714.754.2763 Jun-19990.33451.554.753.9095 Sep-19990.31292.054.754.6379 Dec-19990.59712.265.005.2371 Mar-20000.66662.475.505.6216 Jun-20000.56452.666.005.8045 Sep-20000.29432.426.255.1743 Dec-2000-0.08712.406.254.7629 Mar-20010.03512.605.555.1851 Jun-2001-0.08792.995.005.6471 Sep-2001-0.00123.154.785.9738 Dec-20010.11793.434.286.5129 Mar-20020.08813.124.256.0181 Jun-20020.35872.804.725.8087 Sep-20020.41172.764.755.8017 Dec-20020.44912.684.755.7191 Mar-20030.24172.864.755.7817 Jun-20030.32042.754.755.6954 Sep-20030.43742.754.755.8124 Dec-20030.43562.505.235.4356 Mar-20040.32732.415.255.1923 Jun-20040.21422.465.255.1542 Sep-20040.20302.385.255.0230 Dec-20040.14702.655.255.3720 Mar-20050.19152.565.495.2815 Jun-2005-0.01932.605.505.1307 Sep-20050.13892.585.505.2589 Dec-20050.08012.335.504.8251 Mar-2006-0.07782.585.505.0422 Jun-2006-0.16182.785.755.2582 Sep-2006-0.17182.856.005.3532 Dec-20060.06382.926.255.6938 Mar-20070.43052.716.255.7455 Jun-20070.59172.766.255.9817 Sep-20070.43202.936.506.0770 Dec-20070.34993.476.756.8049 Mar-20080.19354.087.227.5635 Jun-20080.12924.317.257.8442 Sep-2008-0.09694.657.028.1281 Dec-2008-0.63294.164.356.8571 Mar-2009-0.69393.913.256.4211 Jun-2009-0.6809