ECON 1102 Week 8 post lecture

Lower r and households less s more borrowing for c

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Lower r and households: less S, more borrowing for C, more borrowing for housing Lower r and firms: More borrowing for investment Lower r and external sector: Depreciation of \$A => lower real exchange rate, increase in international competitiveness, increase demand for X, decrease demand for M 59

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60 cash rate other rates real interest rate spending ( I, C) appreciation \$A ( NX) output employment inflationary pressures
Higher r and households: more S, less borrowing for C, less borrowing for housing Higher r and firms: Less borrowing for investment Higher r and external sector: Appreciation of \$A => higher real exchange rate, decrease in international competitiveness, decrease demand for X, increase demand for M 61

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PAE = C + Ip + G + NX C = C + c [ Y T ] a r I p = I b r G = G NX = NX a = strength of real interest rate ( r ) on consumption ( C ) and b = strength of r on investment ( I p ) Set PAE = Y (demand = supply) and solve for Y e Y e = 1/[1- c ] x [ C + I + G + NX c T ( a + b)r ] 62 * Simple Keynesian model - exogenous taxes and exogenous imports multiplier exogenous expenditure
C = 640, I = 250, G = 300, NX = 20, T = 250, c = 0.8, a = 400, b = 600, r = 0.05 Y e = 1/[1- c ] x [ C + I + G + NX c T ( a + b) r ] = 1/[1-0.8]x[640+250+300+20-0.8x250-(400+600)x r ] = 5 x [1,010 1,000 r ] = 5 x [1,010 1,000 x 0.05 ] Y e = 4,800 63 Changing r will change Y e . Lower r => higher Y e , higher r => lower Y e .

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We know at r = 5%, Y e = 4,800, however Y* = 5,000 We have a recessionary gap of 200, by how much should r be reduced? Recall, Exogenous expenditure = (1,010 1,000 r ) … (Eq 1) With a recessionary output gap of 200, and a multiplier of 5, exogenous expenditure must rise by 40 From Eq 1 , each 1% reduction in r would increase exogenous expenditure by 10 A 4% reduction in r would increase exogenous expenditure by 40 r should fall from 5% to 1% 64
65 65 . 0 Y (= GDP) PAE (planned aggregate expenditure) PAE (r = 5%) 4,800 Y* = 5,000 PAE (r = 1%) A reduction in r shifts PAE upward

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We know at r = 5%, Y e = 4,800, however Y* = 4,600 We have an expansionary gap of 200, by how much should r be increased? Recall, Exogenous expenditure = (1,010 1,000 r ) … (Eq 2) With an expansionary output gap of 200, and a multiplier of 5, exogenous expenditure must fall by 40 From Eq 2 , each 1% increase in r would reduce exogenous expenditure by 10 A 4% increase in r would reduce exogenous expenditure by 40 r should increase from 5% to 9% 66
67 67 . 0 Y (= GDP) PAE (planned aggregate expenditure) PAE (r = 5%) 4,800 Y*= 4,600 PAE (r = 9%) An increase in r shifts PAE down

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The RBA attempts to stabilise the economy by manipulating the real interest rate in response to the ‘output gap’ and the inflation rate A policy reaction function tries to explain/predict by how much the RBA changes the cash rate when there are changes in the state of the economy (eg ‘output gap’, ‘inflation rate’) THE TAYLOR RULE has been developed to describe the behaviour of the US Federal Reserve r = 0.01 0.5 [( Y* - Y)/Y *] + 0.5 => Suggests Federal Reserve responds to both output gaps and rate of inflation 68
Example Using the TAYLOR RULE r = 0.01 0.5 [( Y* - Y)/Y *] + 0.5 a 1% increase in inflation ( ) leads to an increase in r of 0.5 x 0.1 = 0.005 (or 0.5 percentage points) Application to behaviour of RBA

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