Economics Challenge (2 Viewers)

[uwshm8]

Time Lags!!!!!!!!!

 

[imoO]

I have a simple question that is designed to be thought provoking....

Why is it that CPI inflation for the September quarter 2007 was only 1.9% (below the RBA's 2-3% inflation target), yet the RBA raised interest rates in November 2007, February 2008 and March 2008.

Wheras CPI inflation for the March quarter 2008 was 4.2% - the highest in 6.5 years - and economists are only predicting a 50/50 chance that interest rates will rise in May 2008. Surely if the RBA is serious about inflation targeting it would definately raise interest rates?

Secondly, if the economy was in recession but also had high inflation; would the RBA increase interest rates in order to subdue inflation?

1st question -

There is lag between when the RBA implements policies and actions and when the effect of these implementations are actually felt. Therefore the RBA has to constantly plan ahead, and make safety nets for the economy. The RBA raised interest rates in order TO KEEP INFLATION UNDER 2-3%, not to bring it down.

2nd question -
The RBA will do what it's members of the board decide to do, so there is no definite prediction on whether they will raise interest rates or not. If enough members of the board believe that the so called 'safety net' is place well enough, based on the statistics of the past few months, maybe they'll back off increasing interest rates for a month?

3rd question-
In my opinion, NO, the RBA should not raise interest rates. This is because we are in RECESSION, and although raising interest rates would be deemed the 'orthodox' method, I believe that interest rates should be kept the same in order to promote spending within the economy. Going back, what does recession mean? It means that there has been negative growth in GDP, or what we can also call, 'economic decline'.

Now, a drop is GDP, is caused by a drop in demand, correct? simple economics there

A drop in demand could possibly mean that not enough people are spending?

Therefore spending must be PROMOTED!! Look at how many economies are trying to promote spending now, especially in times like this financial crisis. Even Mr. Rudd handed out $1000 to the working class (the people most likely to spend it), in order to promote spending and to minimise the impact this economic crisis has on Australia.


I would like some feedback please ? At the end on the day, I am an economics STUDENT, and yeah...need to lean more I guess...

 

[gnrlies]

1st question -

There is lag between when the RBA implements policies and actions and when the effect of these implementations are actually felt. Therefore the RBA has to constantly plan ahead, and make safety nets for the economy. The RBA raised interest rates in order TO KEEP INFLATION UNDER 2-3%, not to bring it down.

yes this is correct. Lars Svensson of the ECB has termed this as "inflation forecast targeting" i.e., make sure that the forecast rate (in 12-18 months) is between the desired level

2nd question -
The RBA will do what it's members of the board decide to do, so there is no definite prediction on whether they will raise interest rates or not. If enough members of the board believe that the so called 'safety net' is place well enough, based on the statistics of the past few months, maybe they'll back off increasing interest rates for a month?

Well certainly the board is there to guide decision making but a vote is not taken. The governor and deputy governor do have the final say (although it is not expected that the board be ignored). In the case given, the specific reason is to do with the nature of inflation targeting, and it is actually very interesting to examine within the current economic climate.

We have seen a series of rate reductions over the last few months yet inflation is still relatively high (compared to recent years, but certainly not compared to historical levels or even other countries). So why did they reduce the rates? Well again it is about there being an anticipated fall in inflation (i.e. inflation forecasts are lower), but it is also because the RBA DOES care about the level of output.

When I asked this question last year I was trying to make a point that is rarely made, and that is that output is considered when making decisions. I wont go into the science of it (taylor rule's and output ratios), but every central bank has a threshold of how much 'pain' it can take with respect to output within the economy.

Usually the central bank changes its attitudes because initial one off supply shocks that cause inflation (such as oil / commodity prices) are sustained and can no longer be influenced by tight monetary policy. It is argued that central banks should respond to a supply shock just like any other kind of inflation (i.e. increase rates to lower inflation) but if it is sustained, the central bank can ease off as the public become used to the increasing prices and the ability of the central bank to reduce inflationary expectations has resolved itself (and you are left with a component that cannot be influenced). It is pointless trying to reduce global oil prices with monetary policy, however it can be beneficial to subdue the initial shock affecting the publics perception of prices.

3rd question-
In my opinion, NO, the RBA should not raise interest rates. This is because we are in RECESSION, and although raising interest rates would be deemed the 'orthodox' method, I believe that interest rates should be kept the same in order to promote spending within the economy. Going back, what does recession mean? It means that there has been negative growth in GDP, or what we can also call, 'economic decline'.

Now, a drop is GDP, is caused by a drop in demand, correct? simple economics there

A drop in demand could possibly mean that not enough people are spending?

Therefore spending must be PROMOTED!! Look at how many economies are trying to promote spending now, especially in times like this financial crisis. Even Mr. Rudd handed out $1000 to the working class (the people most likely to spend it), in order to promote spending and to minimise the impact this economic crisis has on Australia.


I would like some feedback please ? At the end on the day, I am an economics STUDENT, and yeah...need to lean more I guess...

Well actually higher interest rates during a recession is not the orthodox method. It is the other way around.

But the point of question is this:

we have inflation targeting whereby the RBA must maintain inflation between 2 and 3 per cent. The question is should they abandon these principles when there is a recession if there happens to be high inflation.

My opinion is no as it undermines the effectiveness of the policy. But as stated earlier, inflation targeting does not mean that output it stuffed under the carpet and ignored. The RBA will have a tolerance and I suspect it is willing to live with some higher than preferred inflation for the benefit of economic growth. Afterall there is some flexibility built into the policy by allowing the policy target to be achieved over the medium term (so if you average out inflation over say a 5 year period it should be around 2-3%).