Sample Final Exam Questions
The following are examples of the type of question that could be asked in Part B of the final exam.
Question 1 (10 marks)
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) Factors that determine demand for money include:
Nominal interest rate: Money demand is negatively related to i. This is because higher interest rates yield higher returns on investments, and as a result, people want to invest more money (rather than hold it) when the interest rate it high. When the interest rate is low, people have less incentive to invest and hence hold more cash on hand. Real output or GDP: Money demand is positively related to Y. This is because- by the principle of the circular flow of income- output directly relates to households’ income. With higher values of Y, households have higher income and hence can afford to consume more. In order to consume more, people have to have more money on hand, and hence when Y increases, the demand for money also increases. Price Level or CPI: When the prices of everyday goods go up, in order for households to keep purchasing these goods, they need to have more money on hand. This is why money demand is positively related to the price level. Changes in technology: for example, the introduction of credit cards and ATM’s have reduced the demand for money since people now can pay via credit card, or access the ATM quickly to retrieve money.
A fall in the demand for money as a result of financial innovation leads to a leftward shift in the money demand curve. This shift causes the interest level to drop; since money supply does not change (it is inelastic as we assume that the reserve bank can supply money at any level of interest rate).
Outline the mechanisms used by the RBA to achieve its target for the overnight cash rate. (6 marks) Banks are required to hold exchange settlement accounts with the RBA that cannot be overdrawn (must remain in credit). These accounts provide a means by which banks can have transactions with themselves, and also for making and receiving payments with the RBA and the federal government. The overnight cash market is used to borrow and lend money within 24h between the banks in order to manage their ESA’s. Banks with too low reserves borrow money at a given interest rate called the overnight cash rate. Banks with too high reserves lend their money on the overnight cash market. By monitoring the conditions in the cash market, the reserve bank is able to tailor its purchases and sales of financial assets so as to achieve a particular target rate. If the cash rate looks like it will be above the target, (as a result of shortage of cash in the system) the RBA would increase its purchases of financial assets (bonds) from the banks, so RBA credits the selling commercial banks’ exchange settlement account. This means that more cash is available in the bank reserves. This increase in bank reserves encourages banks to lend money on the overnight cash market, and so the cash rate falls as there is greater supply for the cash. If the cash rate looks like it will be below the target (as a result of excess cash in the market), the RBA would increase its sales of bonds to the banks. This means the fewer reserves are available to the banks, and hence banks have higher motivation to borrow funds. With a higher demand for the cash, the cash rate rises.
The RBA rarely buys and sells government bonds outright, but through Repurchase Agreements. Here, purchases and sales of securities are only for a certain period (e.g. a week), after which the transaction is reversed.
The RBA will always (1) pay an interest rate on funds deposited by banks in their ESA’s that is a fixed margin below the target...