Exam (elaborations)
ECS3701 EXAM PACK 2023.
- Course
- Monetary Economics
- Institution
- University Of South Africa
ECS3701 EXAM PACK 2023.
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ECS3701 EXAM PACK 2023[School]
[Course title]
, ECS3701
Oct/Nov 2023
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. Shortterm 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.
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, 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.
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
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