Exam (elaborations)
ECS3701 EXAM PACK 2022
- Course
- ECS3701 - Monetary Economics
- Institution
- University Of South Africa
ECS3701 EXAM PACK 2022
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ECS3701 EXAM PACK, ECS3701
Oct/Nov 2017
1. Explain the following terms
i. Inflation targeting
Monetary policy strategy that involves public announcement of a medium-term
numerical target for inflation.
ii. Interest rate risk
The riskiness of earnings and returns that is associated with changes in interest rates
iii. Monetary Policy
Monetary policy can be defined as the measures taken by the monetary authorities to
influence the quantity of money or the rate of interest with a view to achieving stable
prices, full employment and economic growth. Monetary policy in South Africa is
conducted by the South African Reserve Bank
iv. Money
Money or money supply is defines as anything that is generally accepted in payment
for goods or services or in the repayment of debts. Money is linked to changes in
economic variables that affect all of us and are important to the health of the economy.
1.2 Differentiate between hierarchical and dual mandates of monetary policy
Hierarchical versus Dual Mandates
Hierarchical mandates is when an economic goal, such as price stability, is put first
and the say that as long as it is achieved other goals can be pursued.
Dual Mandate is when a central bank is required to achieve two co-equal objectives;
price stability and maximum employment (output stability)
1.3 Can monetary policy alleviate South Africa ‘s high unemployment problem?
Explain
The goals of employment and economic growth appear particularly important because
of the high unemployment rate, and the prevalence of poverty among large sections
of the population.
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,The SARB is under pressure to lower interest rates, particularly from the trade unions.
Many believe that the advantages of a low interest rate (perceived as higher
employment) far outweigh the problems of a low interest rate (a higher rate of inflation).
Monetary policy is an ineffective tool to achieve this goal. Several reasons can be put
forward in support of this view:
1. Structural unemployment occurs when there is a mismatch between the supply
of worker skills and the demand for skill required. Raising the skill level of workers
calls for structural solutions, such as a good school system and the development of
worker skills and entrepreneurship through education and training. Structural
problems of a long term nature are best solved by long term structural solutions. Short-
term solutions like lowering interest rates to solve the structural unemployment
problem are generally ineffective and often not sustainable.
2. The case for lower interest rates rests on the assumption it will lead to a higher level
of economic activity and employment. The problem is that this may lead to price
inflation, and the lack of price stability has negative effects on long term growth.
Although it is generally accepted that low interest rates do boost production in the short
term, Mishkin (2009) notes that in the long term, price stability actually supports the
other goals like economic growth. Thus, in the long term, there is no trade-off between
price stability and growth.
The impact of lower interest rates on aggregate demand is also much more certain
than its impact on employment. Theoretically lower interest rates increase disposable
income of households and increases borrowing. This increases aggregate demand,
that is, the capacity of consumers and firms to spend. The first problem is, however,
that when the increased spending is on imported goods (for example luxury goods and
machinery), then there is very little impact on the domestic economy, that is, on its
level of production.
3. Analysts point out that the South African production structure – which ultimately
affects employment, is not very sensitive to interest rates. Some industries sell in fixed
price markets (e.g. mining) which are not affected by interest rates.
4. Even if lower interest rates increase production, then it will not necessarily affect
employment. This is particularly applicable to unskilled and low skilled jobs which
is where the problem lies.
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, 5. Monetary policy controls the repo rate which is a short-term interest rate. Output
and employment will react to medium and long term interest rates. There are lags
before a lower interest rate impacts on the economy, 3-24 months, making it difficult
to asses the impact.
Low interest rates can also have adverse affects. Because higher interest rates are
likely to lead to lower inflation, this implies that lower interest rates might lead to higher
inflation. Lower interest rates might lead to a depreciation of the value of the Rand and
reduce the inflow of foreign currency which may cause the value of the Rand to
depreciate making imports expensive and lead to higher inflation.
Higher inflation has a number of adverse affects on the economy. It increases
uncertainty which complicates planning, it corrupts information which disrupts
markets, it leads to all sorts of unproductive activities trying to escape the adverse
effects of inflation, it causes an unfavourable redistribution of income, it reduces social
cohesion and leads to social unrest. Everybody can gain by low inflation, particularly
the mass of workers who are more likely to be adversely affected by inflation.
The best way to judge interest rates is to use the real interest rate (nominal interest
rate minus the inflation rate) because this is what motivates most economic agents. A
high nominal interest rate does not necessarily imply that the real interest rate is also
high.
The best contribution the SARB's monetary policy can make is to maintain price
stability and contain cyclical variation in production employment levels creating
favourable conditions for sustainable growth in income and employment.
Question 2
2.1 Name the two partial equilibrium approaches to the determination of interest
rates
❖ The bond supply and demand framework
❖ The liquidity preference framework
2.2 Mention the two ways in which the credit channel of the monetary
transmission mechanism affects the economy
❖ The monetary policy effect
❖ balance sheets of households and firms
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