Answers to Sample Questions 1 and 2 provided in Wk 12’s Lecture
Comments
Each of the five qualitative questions in the final exam has a total of 10 marks allocated. In
general, each relevant and accurate point made in response to the question attracts one
mark so, as a rough guide, aim for making at least 10 distinct points in support of your
answer.
Answers may vary in their approach but be equally valid so two seemingly different answers
may attract the same mark. That said, the points have to be relevant, coherent and logical.
A scatter gun approach whereby one writes as much as one can and counts the number of
separate points but isn’t coherent and/or logical won’t attract high marks and may even fail
to achieve a passing mark. Answers have to be clear and well explained to gain top marks.
Practice writing answers to tutorial questions and get your friends to review them to see if
they make sense. It’s common for people to “know” the answer but find it difficult to
express what they know clearly and succinctly in written form. This is why practice is
important.
Sample Question 1
In a news article “The inflation conundrum baffling central bankers” (AFR 23 Apr 2019)
Jerome Powell, the head of the powerful US Federal Reserve, was quoted saying: "We're
really 10 years deep in this expansion, and inflation is still not clearly meeting our target.
Low inflation one of the major challenges of our time".
The article went on to note that “persistently weak inflation is all the more exasperating
[i.e., annoying] for central bankers because it seems to fly in the face of reputable economic
theory. The US is now enjoying one of its longest economic expansions in history and its
unemployment rate is hovering near 50-year lows”.
Required:
Why do central bankers find it puzzling that inflation remains weak despite a long economic
expansion and low unemployment? (3 marks)
Low inflation typically results in low yields on government bonds. Do low yields on
government bonds imply money is “cheap”? Explain your answer. (7 marks)
Sample Answer:
Context (before answer)
I thought I’d seize the opportunity to provide some useful or at least interesting historical
context to this question which was included in a previous final exam.
The official cash interest rate is presently 3.85% and inflation is running at 6.8%. Central banks
in most developed economies aims for an official inflation target of between 2% and 3%. Why
is this the target range rather than, say, 0% inflation?
Page 1 of 6
It turns out there isn’t much theoretical support for the idea. It just happens to be the
inflation rate that New Zealand decided to adopt in 1990 and the rest of the world followed
its lead. You can read about it here. (As it happens, this isn’t the only significant world-leading
initiative that New Zealand can boast about. In 1893 it became the first self-governing
country to give women the vote. In terms of firsts, UWA was the first free university in the
British Empire but, as perhaps you’ve noticed, those days are gone. Not all initiatives are
permanent.)
The AFR report to which question 1 refers was published in April 2019, when the official cash
rate was 1.5% and had been at that level since August 2916 when it was lowered from 1.75%.
Annual inflation was then 1.3% Low inflation was common through most of the developed
world, including the US.
Given the present efforts by monetary authorities and governments to reduce inflation it
seems surreal to read that in April 2019, their biggest concern was that “inflation remains
stubbornly weak” and that Jerome Powell, the head of the US Federal Reserve, proclaimed
low inflation “is one of the major challenges of our time”. To understand why deflation is a
concern when it happens, see here for an explanation by Nobel prize winning economist Paul
Krugman.
As it happens, the benchmark cash interest rate in Australia fell even lower than 1.5% after
April 2019; it hit 0.1% in December 2020 and stayed at that level until April 2022. This was of
course during the pandemic when everyone was concerned that demand would fall off a cliff
and the economy would crash. It didn’t happen due to massive government stimulus but in
March 2021, during the thick of the pandemic, Philip Lowe, the Governor of the Reserve Bank
of Australia, made the fateful prediction that interest rates were unlikely to rise until 2024.
To quote from an AFR report headed “There’s no interest rate rise on the RBA’s horizon” on
10 March 2021, “wages growth consistent with the inflation target is unlikely before 2024. So
the cash rate will stay at the record low 0.1 per cent for the next three years, the RBA governor
says”.
Dr Lowe turned out to be wrong, of course. In May 2022, inflation returned strongly so the
RBA started the first of an unusually rapid sequence of interest rate increases that saw the
benchmark cash interest rate go from 0.10% to the 3.85% level we have now (i.e., one year
later).
How did Dr Lowe get it so wrong and why has he been so harshly criticised? To be fair to Dr
Lowe, and here I note that I find it puzzling and off-putting that so many commentators are
disinclined to cut him much slack, he made his prediction when demand appeared very
depressed indeed and wages were not growing at all. There seemed to be plenty of spare
production capacity to meet demand.
The war in Ukraine and the prolonged disruption in supply chains across the world as a result
of lock-downs reduced supply and caused demand to outstrip supply. My colleagues and I
had a recent discussion about inflation and the view amongst the economists in the group –
Page 2 of 6
or at least some of them since we rarely unanimously agree on anything 1 - is that the
disruption to supply chains caused by the Ukraine war and lockdowns resulted in inflationary
expectations being reignited. Before that (the thinking goes) it didn’t seem to matter how
much money supply increased, people expected inflation to remain low and so prices
remained low.
The answer to the question (ie, the kind of response we looked for in marking the exam).
Note the question is out of date and I did not discuss inflation in any depth this year so don’t
feel alarmed if you find that the concepts are new. I had discussed the issues in the year I
included the question in the final exam. In addition to the answer being intrinsically interesting
you might find the approach used a helpful guide, e.g., note the short, direct responses.
Why do central bankers find it puzzling that inflation remains weak despite a long
economic expansion and low unemployment? (3 marks)
Price inflation occurs when demand is greater than supply and/or the growth of money
supply is higher than the growth of supply of goods.
A long economic expansion and low employment is usually indicative of an economic nearing
or at full capacity of production and is usually associated with inflation. This has not
happened (at the time the question was written) which puzzles economists.
Low inflation typically results in low yields on government bonds. Do low yields on
government bonds imply money is “cheap”? Explain your answer. (7 marks)
Bond yields decline when demand is high (i.e., there is an inverse relationship between
demand for bonds and the yield on bonds).
Greater demand for government bonds occurs when investor are more than usually fearful
about the future and they therefore buy government bonds because the bonds are risk-free.
An increase in demand for risk-free securities as a result of greater risk aversion implies that
investors are less likely to invest in riskier projects and so entrepreneurs with risky projects
have to offer higher expected return to attract investors, i.e., money is not cheap for nongovernment bonds.
Sample Question 2
Finance academic, Jay Ritter, has written that “[i]t is widely believed that economic
growth is good for stock returns and economic forecasts are a staple of international asset
allocation decisions. But does economic growth benefit stockholders? This article argues
on both theoretical and empirical grounds that the answer is no”.
Sometimes we don’t even agree with ourselves. US president Harry Truman is reported to have asked to be
sent a one-handed economist because he was tired of the economists who said “on the one hand, this …” and
“on the other hand, that …”.
1
Page 3 of 6
Explain why economic growth does not necessarily benefit stockholders and provide at
least one empirical example discussed in the FINA3324 lectures that supports his
argument. (10 marks)
The gains from economic growth are shared between (a) suppliers of capital (ie, investors)
who receive profits, (b) workers, in the form of higher wages, and (c) customers, in the form
of cheaper and/or higher quality goods.
The share that each group receives depends on the extent of competition.
Fierce
competition amongst airlines has generally resulted in customers and workers (e.g., airline
pilots) capturing the major share of gains from the growth of the industry.
When there are low barriers to entry in an industry and substantial competition then the
supplier of capital will tend to earn low profits. Most of the benefit from growth will accrue
to customers and workers.
In the lecture, an example discussed that illustrated the above point was the video cassette
industry in Mt Newman in the north of Western Australia in the late nine-eighties. There was
huge demand to hire video-cassettes but fierce competition amongst the many competing
shops that rented video-cassettes meant that few of them made much money. The
customers benefited from cheaper prices.
Lecturer’s note: “stockholder” is the North American term for “shareholder”. In North
America, shares are referred to as stocks.
Page 4 of 6
The inflation conundrum baffling central bankers
Karen Maley Apr 23, 2019 Australian Financial Review
It's the dismal reality that both frustrates and confuses policy makers at the world's major
central banks: despite their best efforts over the past decade, inflation remains stubbornly weak.
Jerome Powell, the head of the powerful US Federal Reserve, voiced his exasperation with the
situation at a press conference last month. "We're really 10 years deep in this expansion, and
inflation is still not clearly meeting our target," he complained. Low inflation, he added, is "one
of the major challenges of our time".
Persistently weak inflation is all the more exasperating for central bankers because it seems to
fly in the face of reputable economic theory.
The US is now enjoying one of its longest economic expansions in history and its
unemployment rate is hovering near 50-year lows. According to conventional economics, the
tightening in the labour market should push wages higher, leading to upward pressure on prices.
And indeed this seemed to be what was happening in 2018, as inflation hit the Fed's 2 per cent
target after years of undershooting it. The uptick in inflation, combined with robust economic
growth, emboldened the Fed to raise interest rates four times last year.
But price pressures have been waning this year, and economists expect that the core US
inflation rate (which strips out volatile food and energy prices) will continue its downward
trajectory.
Core inflation, which rose 1.8 per cent in January from a year earlier, dipped to 1.6 per cent in
March. Many economists see it wilting further to 1.5 per cent in July.
Cause for rethink
Not surprisingly, this risk that inflation could falter further is causing Fed officials to reappraise
their approach to monetary policy.
Last month, the US central bank signalled that it was unlikely to raise interest rates this year
and could be nearly finished with the series of rate hikes they became more than three years
ago.
Since then, comments by top US central bank officials signal growing support for the idea that
the Fed should cut interest rates if inflation weakens, even if economic growth remains solid.
It's a dovish volte that Australia's central bank has so far resisted. Still, the minutes of the
Reserve Bank's board meeting this month indicate that the combination of tepid inflation and
weak wages growth make it very unlikely that local interest rates will rise any time soon.
And RBA deputy governor Guy Debelle has signalled that the RBA is keeping a very close
lookout for signs that the strength of the local jobs market is translating into a pick-up in wages
growth.
"This low rate of wages growth has been a major contributor to the rate of inflation remaining
a little below the inflation target in recent years," he said in a speech in Adelaide this month.
"For inflation to rise to be sustainably within the inflation target range of 2-3 per cent, we need
to see higher wages growth."
Difficult to stoke price rises
Top officials at the Fed and the RBA are acutely conscious of the risk that persistently sub-par
inflation could become entrenched.
Page 5 of 6
That's because inflation expectations – that is, how much businesses and consumers expect
prices to rise in future – have a strong influence on actual inflation. In turn, these inflation
expectations are heavily determined by their recent experience with inflation.
Japan's experience amply demonstrates the lesson that the longer ultra-low inflation is allowed
to persist, the more difficult it is to kindle rising prices.
After six years of the most aggressive and audacious monetary stimulus ever attempted by a
developed country, the Bank of Japan is still frustratingly short of achieving its 2 per cent
inflation objective.
Japan's consumer prices, excluding volatile food and energy, rose by 0.4 per cent year on year
in March, matching February's rise, even though the country's unemployment rate is hovering
at a 25-year low.
There is, of course, another conclusion that central bankers could draw from the BoJ's
experiment with radical monetary policy: their limited ability to counteract the deflationary
pressures unleashed by globalisation and rapid technological change.
But that's likely to be a lesson for another day.
Page 6 of 6