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ECON5004: Mathematical Modelling in Business Project - Economic Analysis - Report Writing Assessment Answer

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Internal Code: 1AGGEA Code: ECON5004

Economic Analysis Report Writing Assessment Answer

Assignment Task: 1. The problem: ECON5004 The recent behaviour of banks not able or willing to pass on interest rate reduction onto their loan products has created further uncertainty in the market. While this behaviour affects the effectiveness of monetary policy, banks maintain that higher interest rates are required to offset the uncertainty in the international money market. That is, domestic deposit accounts do not provide sufficient funds for banks to satisfy the demand of borrowing. As a result, banks need to borrow money from the international money market which costs are reflected on the higher interest rates. The objectives of this project are (i) to assess the suitability of a well known economic model for examining the economic impact of recent banks’ behaviour; and (ii) to propose an alternative model to examine the economic impact of this behaviour. This project has two parts. The first part is a proposal which contains three components:
  1. Background information. A general description of the problem and why it is important.
  2. An evaluation on the suitability of the well known IS/LM model for analysing this problem.
  3. A proposal on how the IS/LM can be modified to investigate this problem.
The second part of the project is the implementation of Component 3 above. The final report should contain:
  1. A detailed description of the model in both plain language and mathematics. This should include special features of the model and how they are different from the existing IS/LM type models.
  1. Economic analysis using the proposed model. This should, at the minimum, include an analysis on how the different interest rates (from the central bank and other private banks) affect economic growth. It should also provide some insights into the argument that a higher interest rate is required to offset the uncertainty associated with the international money market.
  2. Policy implication(s) in terms of monetary policy.
2. Some starting points: ECON5004 You can start by considering the following profit maximisation problem for banks: max r ?(r) = m(r + ?r) - S(1 + r) - C(r) (1) where S is the aggregate amount of deposit, m(r) is the revenue generated through banks’ loan products and C(r) is the cost of raising sufficient fund to satisfy the demand on loan. r is the banks’ interest rate on deposit and ?r is the spread between interest rate on loans and deposit. You may also wish to consider the following IS/LM model for the Economy: Y = C(Y,T) + G + I(r, r?) (2) MP = L(Y,r,r?) (3) where Y, C, M, P denote income, consumption, money supply and price level, respectively, and T, r, r? are the tax, interest rate the official interest rate put forward by the Reserve Bank of Australia, respectively. L(Y,r,r?) denotes the money demand function which depends on income, interest rate and the official interest rate. Note that in this model, there is no explicit assumption on the functional form of consumption, investment and money demand. Therefore, you will need to make appropriate assumptions on various functions and/or their derivatives. Do not assume linear functional form in your final report but consider unknown functional forms with restrictions on their derivatives. For example, a sensible assumption for the investment function may be I(r, r?) > 0 and Ir(r, r?) < 0 where Ir(r, r?) denotes the derivative of I(r, r?) with respect to r. Note: The only difference between this model and the standard IS/LM is the separation of interest rate into two different rates. This is a closed economy model (no international trade) and therefore missing the international money market and other aspects of capital mobility and trade. You will need to consider the importance of these components in your model. 3. Analysis: ECON5004 You may wish to consider the following when planning for your modeling strategy.
  • The necessary first and second order conditions for profit maximisation from the banks’ perspective. Hint: You can derive the first and second order conditions following the profit function as stated in equation (1) but you can also derive your own profit function for banks to make it more realistic.
  • The effects of monetary and fiscal policies on income, money demand and investment in the new model.
  • The impact of bank rates, r, on income, money demand and investment. How does it affect the effectiveness of the monetary policy?
Please state and justify the assumptions underlying the new model. All analysis must include detailed mathematical expositions. 4 Report format - ECON5004 The word limit of the proposal and the final report is 2500 words each. They should contain an executive summary that is no longer than one page. Both the proposal and the report should be written in plain language with all the mathematical details in the appendix. The word limit does not apply to the appendix. If the proposal or the report contains any simulation or computation, both numerical or algebraic, the results must be presented as a Jupiter or RMarkdown notebook for the purpose of reproducibility. You can submit your report electronically via Blackboard. Please refer to the unit outline for the due dates.
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