DPBS1150
Global Business Environments
ECONOMIC LENS (III):
SHORT-RUN FLUCTUATIONS AND
POLICY RESPONSES (continued)
Unit 7: Lecture 7B
Lecturer: Hui Thong
Lecture Overview
(Unit 7A and 7B)
• Develop a simple macroeconomic model of income and
expenditure with sticky prices.
• Analyse household consumption/savings decisions.
• Evaluate how household marginal propensity to consume
determines the aggregate expenditure multiplier
• Define the main forms and functions of money.
• Understand how prices depend on the supply of money.
• Explain how the central bank influences economic activity.
• Articulate key mechanisms and limitations of fiscal and monetary
policy
DPBS11502
The Role of Money and Monetary Policy
3
What is Money?
Many functions for money:
• Medium of exchange
• Used to exchange for goods and
services
• Unit of account
• Used to measure the economic
value of goods and services
• Store of value
• Used to hold wealth
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Many types of money:
• Commodity money
• Something with intrinsic value used
as money
• Gold, silver, rice, salt, beads,
feathers, cigarettes, shells, noodles
• Fiat money
• Money with no intrinsic value
Anything that is generally accepted in
exchange for goods or services.
What is Money?
• Money derives its value from the trust people place in it
• This trust can be lost if mismanaged
• For example: if too much paper money is printed and issued, value of
money will fall (high inflation/hyperinflation)
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Image: Reserve Bank of Australia Image: National Museum of American History, Smithsonian Institution
What is Inflation?
• An increase in the level of prices of the goods and services
that households typically buy over time.
• Measured as the rate of change of those prices
• Typically, prices rise over time
• Prices can also fall (called deflation)
DPBS11506 Source: RBA
Measuring Inflation
• Consumer Price Index (CPI) measures the changes in the
price of a typical basket of goods and services consumed
by households.
• Inflation rate is the percentage change in the price of this
basket over time.
• For example, if the inflation rate is 3%, a ‘basket’ of goods and
services that cost you $100 last year will cost you $103 this year.
DPBS11507
Inflation and the Business Cycle
DPBS11508
D
ur
in
g
an
e
xp
an
si
on
• consumers demand more
output (goods/services)
• businesses produce more
output to meet increased
demand,
• eventually reach productive
capacity (maximum level of
supply)
There will be more demand for
their output than output
available. This pulls prices up.
• consumers demand less
• businesses produce less
output
• businesses may lower
prices or offer discounts
to increase sales.
This leads to lower inflation
or deflation.
D
uring a contraction
Why is Inflation Important?
• A low, steady rate of inflation is good for the economy.
• It is important for the rate of inflation in an economy to be
managed.
• If inflation is too high, the currency loses its value.
• If inflation increases at a very rapid rate  hyperinflation
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Costs of Inflation
Costs of expected inflation:
• Indexing costs: have to incorporate inflation expectations into
contracts; adjusting the terms of contracts
• Menu costs: have to change prices more often
• Shoe-leather costs: additional time and effort that consumers
must spend managing their cash holdings; consumers must go to
bank more to avoid losing purchasing power often
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Costs of Inflation
Costs of unexpected inflation:
• Inconvenience: hard to plan budgets/financial decisions when
prices keep changing
• Relative price distortions: not all prices adjust simultaneously;
prices of some goods adjust more rapidly than others
• Uncertainty: businesses face difficulties in accurately forecasting
costs, revenues, and profits, making investment decisions more
challenging; can distort investment
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Sticky Prices
• An important assumption of the Keynesian model is that prices tend to
adjust slowly in response to changes in supply and demand, a
phenomenon called sticky prices.
• Prices in the short run do not adjust quickly or fully in response to
changes in supply and demand conditions.
• Prices tend to remain relatively rigid or sticky.
• The following video describes some reasons why one particular and very
important price – a worker’s wage – tends to be sticky. (<5 mins)
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Redistributive Effects of Inflation
Unexpected inflation
Losers:
• fixed income earners
• If prices rise rapidly, the purchasing power of their fixed income diminishes because
they cannot easily adjust their income to keep up with inflation.
• Lenders
• Inflation erodes the value of money over time, the interest rates on loans may not
adequately compensate lenders for the decreased value of the loan repayment.
Winners:
• Borrowers
• If prices increase, the real value of the money they owe decreases over time.
• Asset holders
• Asset prices often rise during inflationary periods, as investors seek to protect their
wealth by investing in tangible assets that tend to retain value in inflationary
environments.
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“Headline” vs. “Underlying” Inflation
Headline inflation: % change in the CPI.
• What we usually mean when we just say “inflation”.
Underlying inflation: An inflation measure that excludes items that have particularly
large price changes.
• Intended to exclude price changes due to temporary factors.
• For example, supply disruptions due to weather events; energy prices due to geopolitical events
Provides a clearer signal of the overall inflationary pressures in the economy.
Make more informed decisions regarding monetary policy and other economic
measures.
• Many possible measures of underlying inflation, for example
• Core CPI: CPI excluding volatile items
• Trimmed mean: removing a certain percentage of the highest and lowest price changes from a set
of individual price changes
DPBS115014
Average Money Growth and
Inflation in Western Hemisphere Developing Countries
DPBS115015 Reproduced from Krugman, Ostfeld, and Melitz (2014)
Hyperinflation
Rapid inflation (>100-fold per
year)
Notable examples:
• Germany (1922-1923)
• Greece (1941-1946)
• Brazil (1985-1994)
• Yugoslavia (1992-1994)
• Zimbabwe (2007-2008)
• Venezuela (2016-present)
DPBS115016
Source: Mankiw (2018)
Output and Inflation in The Short Run
Phillips curve: Short-run inflation depends on the output gap
• Difference between actual output and “potential” output
17 Output gap ( − ∗)U
ne
xp
ec
te
d
In
fla
tio
n
(
−


)
DPBS1150
potential output = the level of output
that can be sustained without generating
inflationary pressures
-1
0
1
2
3
4
5
6
7
Inflation Inflation (excl. volatile items) Inflation (trimmed mean)
Australian Inflation
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The Central Bank (RBA)
• Implements monetary policy
• Control its money supply
• Issues currency
• Does not hold deposits for, or lend money to, people and businesses
• Banker to the banks
• Banks hold accounts to settle debts owing to other banks.
• Banks short on cash can borrow from the central bank if they cannot borrow enough
from other banks.
• Banker to the government
• Regulates financial markets
• Australia’s central bank: The Reserve Bank of Australia (RBA)
DPBS115019
The Reserve Bank of Australia
DPBS115020
It is the duty of the Reserve Bank Board, within the limits of its powers,
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:
a. the stability of the currency of Australia;
b. the maintenance of full employment in Australia; and
c. the economic prosperity and welfare of the people of Australia.
Reserve Bank Act 1959
Measuring Inflation
DPBS115021
The Governor and the Treasurer have agreed that the
appropriate target for monetary policy in Australia is to
achieve an inflation rate of 2–3 per cent, on average,
over time.
What Does the Central Bank Do?
Two videos from the RBA will introduce you to the role that the
central bank plays in managing the economy.
• The first video introduces monetary policy and explains why it
involves interest rates. (<6 mins)
• The second video explains some of the key transmission
mechanisms of monetary policy – that is, how changes in interest
rates affect production and consumption decisions in the economy.
(<10 mins)
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The RBA’s Toolkit
The RBA has:
• Three goals: price stability, full employment, and economic
prosperity
• One major tool of monetary policy: cash rate target
The Interbank Overnight Cash Rate (Cash Rate)
• The interest rate on unsecured overnight loans between banks
• The (near) risk-free benchmark rate for the Australian economy
DPBS115023
Influencing Interest Rates (and Inflation)
• Central Bank:
• influences the economy by carrying out ‘monetary policy’
• sets the ‘cash rate’ – which influences the interest rates offered by
commercial banks to their customers
• Raising or lowering interest rates can stimulate or dampen
economic activity, if needed
 helping to achieve a low and steady inflation rate
DPBS115024
Smoothing the Business Cycle
If the economy is
expanding too quickly
• Central Bank is likely to
raise the cash rate.
• Commercial banks will raise
interest rates, making it
more expensive to borrow
money, and more attractive
to save money.
• People will tend to save
more and borrow/spend less.
DPBS115025
Smoothing the Business Cycle
If the economy is
growing too slowly
• Central Bank is likely to
lower the cash rate.
• Commercial banks will
lower interest rates,
making it cheaper to
borrow money.
• People will tend to save
less and borrow/spend
more.
DPBS115026
Money Supply and The Cash Rate
How does the RBA set the cash rate?
1. It announces the cash rate target. For example: = 0.75%.
2. It allows banks to borrow for + 0.25% and save for − 0.25%.
3. It conducts open market operations
• If < target, the RBA sells government bonds to banks, taking cash out of
the market.
• If > target, the RBA buys government bonds from banks, injecting new
cash into the market.
• So, to ↓ , ↑ the money supply; to ↑ , ↓ the money supply.
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The cash rate is the interest rate that banks pay to borrow funds from other banks in the money
market overnight.
Other (Nominal) Interest Rates
• Does your mortgage interest rate depend on the cash rate?
• Yes!
• The cash rate influences all other interest rates, including
mortgage and deposit rates.
• The cash rate is the bank’s opportunity cost of lending
money
• Lenders charge an interest rate that covers their lending costs &
earn a return on their funds plus compensation for risk
interest rate = risk free rate + risk premium
DPBS115028
Real vs Nominal interest rates
• Nominal Interest Rate ():
• stated or advertised interest rate on a loan or investment.
• represents the absolute rate at which money grows over a specific period
without considering the impact of inflation.
• For example, if you have a loan with a nominal interest rate of 5%, it means
that the lender will charge you 5% interest on the loan amount, regardless
of inflation.
• Real Interest Rate ()
• takes into account the effect of inflation on borrowing or lending.
• represents the rate of return adjusted for inflation  providing a more
accurate measure of the purchasing power of money.
• Real Interest Rate = Nominal Interest Rate – Inflation Rate
DPBS115029
The Fisher equation
= +
• If lenders expect high inflation, they will demand higher nominal interest
rates to compensate for the erosion of purchasing power over time.
• If prices are sticky
• Inflation will adjust slowly to changes in .
• The central bank can influence real interest rates.
• (Not to be confused with the definition: = + )
DPBS115030
Real interest rate Expected inflation
Actual (past) inflation
Nominal Interest Rate
Interest Rates and The Economy
• Household consumptions/savings
• Lower interest rates
⇒ less costly to borrow/spend today
• Increase in , (new housing)
• Business investment
• Lower interest rates
⇒ lower opportunity cost of new capital equipment
• Increase in
• Cash flow
• Lower mortgage rates, means more cash in pockets
to spend today
• Increase in (especially for hand-to-mouth
households)
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Interest Rates and The Economy
• Asset prices
• Lower interest rates tends to increase asset prices.
• Easier for (wealthy hand-to-mouth) consumers to get loans.
• Consumption smoothers feel richer and spend more today.
• Increases
• Exchange rates
• Lower interest rates tends cause the Australian dollar to depreciate.
• Australian goods and services are cheaper for foreigners.
• Increases , decreases
• Fiscal policy
• Lower interest rates⇒ government debt is less of a concern.
• Increases
DPBS115032
Why Macroeconomic Policy is Hard
• Monetary and fiscal policy are blunt
instruments (not precise or targeted to
specific sectors or individuals)
• There are many competing objectives but two
main tools.
• Data availability
• Not clear what is happening until after the fact.
• What is the “potential” output?
• Supply-side shocks.
• Short-run output-inflation tradeoff.
• Zero lower bound for nominal interest rates.
• Requires “unconventional” monetary policy.
DPBS115033
Re-Cap
• Introduced a simple Keynesian model of economic output in
the short run.
• Depends on the key concepts of
• Sticky prices and wages
• Marginal propensity to consume
• The expenditure multiplier
• Help understand how fiscal policy can help stabilise
economic fluctuations.
DPBS115034
Re-cap
• Introduced the economic lens
and international trade.
• Explored the recent history of
globalisation.
• Considered the reasons
countries trade.
• Evaluated the benefits and
costs of increased trade.
• Examined the empirical
evidence of the effects of
increased trade.
Application suggestions
• Assessment 2
 Inflation
 Interest rates
Government spending
Aggregate demand model
Other (you need to find out)
• Assessment 3
You should select the right
content to use
DPBS115035
• We will return to examine the Sustainability Lens.
 We look at the business context through the sustainability
lens.
 We consider the key elements of environmental sustainability
and social sustainability.
 Business and Sustainability:
 Systems thinking and unintended consequences
 Supply chain failure and complexity
Next Lens
DPBS1150 36