ECO 2020 Semester 1 Assignment No. 2

Unless an extension has been granted, a penalty of 3 marks (out of 30) will be deducted per day for up to 7 calendar days, at which point any submission will not receive any marks.

Answer all of the five (5) questions. Not all answers need to be of the same length.

Marking criteria: For all questions, marks will be awarded according to:

• Application and analysis of appropriate economic models, including diagrammatic analysis where required;
• Clarity and coherence of explanations of economic mechanisms;
• Quality of writing and overall presentation.

Overview of this assignment.

This assignment requires you to analyse the Reserve Bank of Australia Statement on Monetary Policy, February 2025. The questions below require you to explain various statements and graphs in the RBA’s document in terms of the models, concepts and economic mechanisms that have been covered in this course, in particular Lectures 5 to 8 inclusive.

Consider the following comments :

Monetary policy has been restrictive and will remain so after this reduction in the cash rate. Some of the upside risks to inflation appear to have eased and there are signs that disinflation might be occurring a little more quickly than earlier expected.

• In what sense has monetary policy been ‘restrictive’ ?

Monetary policy can be restrictive, neutral or expansionary. When it is neutral, the interest rate is at the level that is neither increasing or decreasing equilibrium output. This is known as the neutral interest rate. In terms of our model, the LM curve does not shift. When monetary policy is restrictive, the interest rate above the neutral rate and is having a negative effect on equilibrium output. The LM shifts to the left.

• On what basis does the RBA claim that monetary policy “will remain so after this reduction in the cash rate”?

The RBA’s modelling indicates that even though the interest rate is lower it is still above the neutral rate (see graph 1.5, p. 10) and is therefore having a negative effect on equilibrium output.

• On what basis does the RBA claim that “some of the upside risks to inflation appear to have eased”?

Underlying inflation eased in the December quarter (p.21), as did the headline inflation rate. Factors contributing to this include lower growth in underlying demand for housing (p.21) and GDP growth remaining below potential growth over the year to the September quarter (p.22). On the latter point, GDP growth in the September quarter turned out to be below the RBA’s expectations (p.26). This was partly due to lower than expected export growth (p.26).

On the other hand, the labour market remains tight and in fact the unemployment rate edged lower in the December quarter (p.22). This would tend to increase the upside risks to inflation.

In balancing these opposing risks to inflation, the RBA has come to the conclusion that there has been a net reduction in inflation risk.

Consider the data in Graph 2.29 (page 39).

• What does this indicate about inflationary pressure over the past two years? Explain and illustrate with appropriate diagrams.

The output gap remains above zero (according to most estimates), which means that equilibrium output (where IS and LM intersect) is above the natural or full employment level of output, i.e. . This implies that aggregate demand is intersecting short run aggregate supply at . Students should show this on an AD-AS diagram which may be supported by showing the IS-LM diagram where the two curves intersect at . This in turn implies upward pressure on the price level which, given that the price level is always rising (inflation is occurring), implies that inflation pressure is keeping inflation above the RBA’s target.

• To what extent is this consistent with the data in Graph 2.27 (page 38)?

The data in Graph 2.27 and the associated discussion above indicate that the unemployment rate is below the natural rate: . This implies that as shown in Graph 2.29. To this extent the data and discussion are consistent.

However, Graph 2.29 (and the discussion) indicate that the output gap narrowed in the September quarter, which implies that Y decreased relative to . This suggests that tightness in the labour market should have eased, that is, the gap between : should have narrowed. But this does not seem to have occurred: “…estimates suggest that no further narrowing occurred in the second half of the year” (page 38, left hand column).

• Consider the following statement on page 51:

“We judge that the unemployment rate will increase a little further, before stabilising at 4¼ per cent; this is around ¼ percentage point lower than forecast in November.”

Evaluate this statement based on data and arguments presented in the full RBA Statement on Monetary Policy.

While an increase in the unemployment rate is consistent with the evidence given above (Q1, (iii)) and also with the declining output gap as explained above (Q2 (i)), it is not clear how this is consistent with the lack of evidence for a declining unemployment gap in the latter half of 2024 (above Q2 (ii)).

Indeed the statement on page 51 says : “… the unemployment rate declined a little in the December quarter and leading indicators suggest that the earlier easing in labour market conditions has largely stalled.”

Further, the RBA expects GDP growth to pick up over 2025 due to growth in private demand (page 53). It is not clear how that is consistent with an increase in the unemployment rate. 

The RBA does acknowledge that there are risks in the forecast that unemployment increase (Key risk #1, page 58).

Consider the discussion about labour productivity growth on page 55.

• What does this imply about any movement in the natural rate of unemployment and the long run aggregate supply curve over the next two years? Illustrate with appropriate diagrams.

Labour productivity growth is expected to pick up over the next two years which partly explains the expected decline in nominal unit labour costs (the other fact explaining the latter is the assumed steady wages growth).

Higher productivity implies a rightward shift in the LRAS curve. (Therefore higher growth in productivity implies a greater rightward shift in the LRAS each year.)

• What in turn does this apply about changes in the Phillips curve? Illustrate diagrammatically.

Higher productivity, for a given level of aggregate demand, implies an increase in the natural level of output, , and a reduction in the output gap . In turn, according to Okun’s law this implies a reduction in the unemployment gap, and therefore a downward shift in the Phillips curve: . To explain further, expanding this equation: . Hence a reduction in implies a lower level of π for an level of u and therefore a downward shift in the Phillips curve.

• Consider the data in Graph 2.24 and the associated discussion. Does this suggest any change in the short run Phillips curve between 2022 and 2025? Explain and illustrate diagrammatically.

Inflation expectations, Eπ, affect the vertical placement of the Phillips curve. An increase (decrease) in Eπ implies an upward (downward) shift in the Phillips curve according to the equation in part (ii) above. The discussion around Graph 2.24 indicates that Eπ has decreased since 2022 which implies a downward shift in the Phillips curve. Also, it appears that Eπ is now steady implying no shift in the Phillips curve at the present time.

Note: students should illustrate all of the above using AD-AS and Phillips curve diagrams.

Consider the data in Table 3.1, page 61.

• What does the data indicate about the likely change in the current account balance from June 2025 to June 2027? Provide detailed numerical information from the table to support your answer. Are any additional data required in order to draw a more precise conclusion?

There is insufficient data in Table 3.1 to make precise calculation about the change in the CAB. The CAB can be calculated in 3 ways:

• Exports minus imports plus net income earned from overseas
• Gross national product minus gross national expenditure
• National saving minus national expenditure.

Some data is given in the table but not quite enough. Nevertheless, we can infer the likely direction (“likely” is the term used in the question).

Start with definition in (a). From June 2025 to June 2027 growth in imports is forecast to be consistently above growth in exports, by quite a margin most of the time. This indicates a significant decline in the trade balance. Net income from overseas is always smaller than either exports or imports (although data not given in the table). So it is very unlikely that this would increase enough to outweigh the declining trade balance.

Consider definition (b). We have GDP but not GNP (because we don’t have net income earned from overseas). However, for the same reason as given above, we can infer the likely change in the CAB based on GDP instead of GNP. The growth in GNE is projected to be considerably higher than the growth in GDP. This reinforces the conclusion based on definition (a). It is highly likely that the CAB will decline based on these projections.

Consider definition (c). National saving consists of household saving, corporate saving and public sector saving. Of these we only have data on household saving. Corporate saving and public saving are large enough, relative to household saving, that we cannot infer reliably any change in national saving based only on household saving. We do have all required data on national investment: dwelling investment plus business investment. But this does not help us because of the missing data on national saving.

So based on (a) and (b) it is likely that the CAB will decline. To be more definitive we would need data on either net income earned overseas or corporate and public sector saving.

• Use the data in Table 3.1 to make a plausible assessment about the likely impact of the economy on the direction of change in the Australian Government’s budget balance from June 2025 to June 2027? You do not need to give a numerical forecast for the budget balance.

We can use the data to infer changes to the passive budget balance, which is that part of the budget that is due to transfer payments and taxes, both of which are sensitive to changes in output. If growth in output is increasing, transfer payments decrease (mainly because unemployment benefits decrease as unemployment decreases) and taxes increase (mainly personal income tax and company tax which increase as incomes increase). Hence strong growth tends to increase the budget balance due to these ‘passive’ effects.

The question therefore is whether the data in Table 3.1 shows growth in output increasing and unemployment decreasing, or the opposite, or in fact neither i.e. growth on a steady path and no change in unemployment.

GDP growth is expected to pick up modestly from 2.0% in June 2025 to a range from 2.2% to 2.4% over the period to June 2027. Also, real wages are expected to rise, since the growth in the wage price index is greater than the inflation rate. Both of these factors point to a likely increase in income tax revenue. The unemployment rate is forecast to be steady at 4.2% over the two year period. This suggests little or no increase in unemployment benefits as a share of GDP. These observations point to a likely increase in the passive budget balance. That is, the economy is likely to have a positive impact on the budget balance.

However, if we include the impact of the terms of trade in our “impact of the economy”, the above assessment is muddied. The terms of trade is expected to decline over the two year period. This implies declining profits of mining companies and hence declining corporate tax revenue which would have a negative effect on the budget balance.

In summary, the domestic economy is likely to have a positive effect on the budget balance but international factors (i.e. the terms of trade) are likely to have a negative effect. It is not reasonable to conclude with any confidence, based only on the data in the table, what the net effect would be

Also of course, this says nothing about the actual change in the full budget balance because we don’t know what discretionary budget measures will be over the two year period.

 

Consider the following statement and the associated discussion

“The Australian dollar has depreciated by 5 per cent against the US dollar since the November Statement and by 2 per cent on a trade-weighted basis.”

• Explain and illustrate diagrammatically the causes and effects of this and illustrate in terms of the open economy Mundell Fleming model as studied in our course this semester.

This is a challenging question and should be marked accordingly. For example, students do not have to mention every point below.

A key reason for this is the widening interest rate differential between the US and Australia. That is, US interest rates have increased relative to Australian interest rates. Hence US financial assets such as bonds have become more attractive relative to Australian bonds. The opportunity cost of holding money in Australian bank accounts has therefore increased, since the money could be used to buy US bonds. This shifts money demand curve (in Australia) to the left which shifts LM to the right.

In the Mundell-Fleming model, the LM is vertical and the exchange rate is on the vertical axis. A rightward shift in LM results in a depreciation in the exchange rate. The interest rate does not change since it is exogenously given by the world interest rate. The depreciation increases net exports which increases output and income.

There are several factors behind the increase in interest rates in the US relative to Australia which are mentioned at the bottom of the left hand column on page 13. 

1. higher productivity growth in the US. This increases investment in the US which shifts the IS curve (in the US) to the right. The US economy is not a small open economy like Australia. It is therefore not well-described by the M-F model. The closed economy model is better at explaining the effects of a rightward shift in the IS curve in the US. That is, it increases the interest rate in the US which therefore explains the interest differential with Australia.
2. higher terms of trade in the US. This increases expenditure on US exports which again shifts IS to the right and increases the interest rate which appreciates the US dollar
3. effect of US tariffs. This reduces export expenditure in other countries that are exporting to the US. This shifts IS to the left in those countries. In the case of Australia, the M-F model predicts that this depreciates the A$.

• Consider the following statement on page 14:

Chinese authorities have leant against the depreciation of the renminbi over recent months

Explain and illustrate the monetary effect of this action by the Chinese authorities, on the Chinese economy, using an IS-LM framework. In particular, explain and illustrate diagrammatically how this policy action is effectively a tightening of monetary policy in China.

China’s central bank, the People’s Bank of China (PBC), “leans against” a depreciation of the renminbi by buying the renminbi in the foreign exchange market using its reserves of foreign currency. Owners of bank deposits denominated in Renminbi withdraw deposits to pay for the foreign currency that the PBC is selling. This reduces the money supply in China.

The LM curve shifts to the left resulting in higher interest rates and a move up the IS curve. This results in less investment and consumption and therefore less aggregate demand. It therefore acts effectively as a tightening of monetary policy.

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