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Econ1102_Sample_Questions_guide - ECON1102 MACROECONOMICS 1...

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ECON1102 MACROECONOMICS 1 Session 2, 2010 Sample Final Exam Questions Guide to Answering the Questions What I provide below is some guidance on how to answer the question and what might be expected in an answer. Question 1 (10 marks) (a) Briefly explain the main factors that determine the demand for money. Use a model to show equilibrium in the money market and explain the effect of a financial innovation that leads to a fall in the demand for money. (4 marks) If you consider nominal money demand M then it depends - positively on the price level P - positively on the level of real income Y - negatively on the nominal interest rate (i) Money demand will also be influenced by financial and technological changes that affect the costs and benefits of holding money. Equilibrium in the Money Market requires us to consider the demand and supply of money. Below I use a model in which the money supply curve is assumed to be vertical. This would be the usual approach, but you could assume a horizontal money supply curve (see Figure 10.6, Chapter 10 in BOF). i Ms Md Md’ M In the above diagram the fall in money demand shifts the Md curve inwards and leads to a fall in the nominal interest rate. Note that there is no change in the level of the money stock. If you use a horizontal Ms curve, then the inward shift in Md does not change the nominal interest rate, but produces a fall in the level of the money stock.
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(b) Briefly outline the mechanisms used by the RBA to achieve its target for the overnight cash rate. (6 marks) There is some discussion of this issue on page 256-259 of BOF, but more detail is provided in Week 7 Lecture Notes. Banks are required to hold exchange settlement accounts ( ESA ) with the RBA that cannot be overdrawn. ESA provide a means by which banks - can clear any payments among themselves and - make/receive payments to/from the RBA and federal government. There is a specialised market where banks are able to trade ESA – the overnight cash market. The interest rate that clears this interbank market is the overnight cash rate and it this rate that the RBA chooses to target. To ensure the actual cash rate equals its target the RBA uses 3 mechanisms: 1. The RBA pays interest on funds held in ESA accounts at rate which is 0.25% below its cash rate target. If the cash rate target is 3.25% then it pays a rate equal to 3.25 – 0.25 = 3%. This will be a lower bound for cash rate. Banks will
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