Introductory Macroeconomics, ECON10003

Semester 2, 2020

Solution to Tutorial 6

1. (a) The decision to guarantee deposits made it easier for banks to raise funds. There are a
few issues that are worth highlighting. When deposit insurance was introduced, there
was a significant amount of uncertainty in financial markets at this time. This included
uncertainty regarding the balance sheet position of major banks and as a result, uncer-
tainty regarding their future solvency. This uncertainty raised the cost of funding for
Australian banks - essentially banks were viewed as more risky. People seeking to invest
in Australian banks would require a higher rate of return to do so (that is, it raised the
risk premium). This was exacerbated by several other countries offering deposit insur-
ance for financial institutions based in those countries. This further increased the risk
associated with investing in Australian banks.
(b) There are really two key things to note:
• If it became difficult for banks to obtain funds for financial intermediation, we would
expect that it would be difficult for firms within the economy to finance investment.
This decline in investment would have implications upon the equilibrium level of
output and employment in the economy.
• The other thing to note is that the financial sector is responsible for allocating
resources to their most productive use. If financial intermediaries are unable to
raise funds, then firms may be constrained in their investment decisions.
2. There are a few points that I would like to stress:
(a) First, the monetary policy function is really an approximation of how central banks
behave. A key part of central bank behaviour would be to use discretion or judgement
in monetary policy. This discretion allows central bankers to set interest rates that may
vary from what is implied by a policy reaction function. The following points highlight
why judgement may be a useful aspect of monetary policy:
• Central banks use a lot more information than just the output gap and interest
rates in determining monetay policy. They would collect more detailed information
regarding the state of the domestic economy and they would also have more infor-
mation about the international economy and its expected future. This information
may be important in assessing the current state of the economy and what is the
appropriate policy stance.
• Policy reaction functions are set as being dependent upon unobserved variables. The
output gap, for example, is not something that a central banker or statistician can
go out and measure. It requires some judgement to estimate the output gap.
(b) Second, the above points imply that policy reaction functions are really an approximation
of the behaviour of how a central bank behaves. This does not necessarily mean that
the use of a policy reaction function is problematic. As long as the policy reaction
function is a relatively good approximation of reality, it may still be a useful element of
macroeconomic models that helps simplify reality and provides insights.
3. The AD Curve is downward sloping because as inflation rises, the central bank will raise
real interest rates to reduce aggregate demand. There are really two key aspects that will
determine the slope of the AD Curve.
• The first is the policy reaction function of the central bank - how rapidly will it raise
real interest rates as inflation becomes higher? Suppose the policy reaction function is

1
 very steep in (π, r) space. It implies an increase in inflation leads to a large increase in r.
Other things equal, this will cause a larger decrease in planned aggregate expenditure.
This implies that the AD curve will be relatively flat.
• The second is how responsive are households and firms to changes in the interest rate.
Suppose households and firms respond to higher interest rates by reducing planned
expenditure by a large amount. Other things equal, this implies that when inflation
increases, the real interest rate becomes larger, and households and firms reduce planned
aggregate expenditure by a greater amount. Hence the AD curve is flatter.
A diagram (Figure 1) explains how the policy reaction function relates to the slope of the
AD Curve: we start off at position A with π = π0 and output equal to Y0 . An increase in π
leads to an increase in the real interest rate. If the central bank reacts modestly to inflation
it raises interest rates to r1 shifting in the PAE curve in our upper panel by a small amount.
If it reacts strongly to inflation it raises interest rates to r2 > r1 shifting in the PAE curve
in our upper panel by a large amount. In the first case, output falls to Y1 which corresponds
to point B. In the second case output falls to Y2 < Y1 which corresponds to point C. We
could do a similar analysis holding the policy reaction function constant and considering a
setting where consumption and investment react strongly to changes in the real interest rate.
A diagram is provided in Figure 2.
Here we consider an increase in inflation from π0 to π1 . The increase in inflation leads to an
increase in real interest rates. There are two cases to consider. If households and firms react
to changes in real interest rate modestly, there is only a small decline in PAE. The economy
moves from Y0 to Y1 and from point A to point B. If households and firms react to changes
in the real interest rate stongly, there is a large reduction in PAE and the economy moves
from Y0 to Y2 . This leads to a flatter AD curve when consumption and investment are more
responsive to changes in the real interest rate.

2
 Output, PAE

PAE (r = r0, π = π0)

PAE (r = r1, π = π1)

A
PAE (r = r2, π = π1)

r2 > r1
B

Y2 Y1 Y0 Output

Inflation

C Β
π1

π0

AD Curve

Y2 Y1 Y0
Output

Figure 1: AD Curve as central bank policy varies response to inflation

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 Output, PAE

PAE (r = r0, π = π0)

PAE (r = r1, π = π1,

small response of
A c and i to r)
PAE (r = r1, π = π1,
large response of
c and i to r)
B

Y2 Y1 Y0 Output

Inflation

C Β
π1

A
π0
AD Curve
(large c and i response)

AD Curve
(small c and i response)

Y2 Y1 Y0
Output

Figure 2: AD Curve as responsiveness of investment and consumption spending to interest rates

varies.