second policy reaction function refers B u s i n e s s F i n a n c e

1. The following addresses the impact of a change in the cash rate (the interest 

rate in the overnight cash market (OCM)) on the one year bond market. 

a) Assume that the RBA decreases the cash rate from 3% to 2.75%. 

i) What profit opportunities initially exist in the one year bond market after 

the RBA announces a decrease in the cash rate? What happens to the 

market price of bonds in the one year bond market? Illustrate using a 

diagram showing the demand and supply of bonds (i.e. the demand 

and supply of loans)? Assume, for simplicity that the interest rate in 

the OCM and the interest rate in the 1 year bond market are initially 

equal. (1 mark) 

ii) What is the impact on the market price of the following bonds arising 

from the decrease in the cash rate? Assume the following: Principal = 

$10m; Coupon rate = 3%; Market interest rate = Cash Rate = 2.75%. (1 

mark) 

b) Assume the RBA increases the cash rate from 3% to 3.25% 

ii) What profit opportunities initially exist in the one year bond market after 

the RBA announces an increase in the cash rate? What happens to the 

market prices of bonds in the one year bond market? Illustrate using a 

diagram showing the demand and supply of bonds (i.e. the demand 

and supply of loans)? Assume, for simplicity that the interest rate in the 

OCM and the interest rate in the 1 year bond market are initially equal. 

(1 mark) 

ii) What is the impact on the market price of the following bonds arising 

from the increase in the cash rate? Assume the following: 

Principal = $10m; Coupon rate = 3%; Market interest rate = Cash Rate 

= 3.25% (1 mark) 

3. Assume that a central bank in the past when determining the cash rate placed 

equal weight on the output gap and the inflation rate. Also assume that the 

long-run equilibrium interest rate in this country is 2% ( ̅ = 2%). 

a) What is this central bank’s policy reaction function? (1 mark) 

b) What would be the prediction for the real and nominal interest rates 

set by this central bank when: (1 mark) 

– Output Gap = 3% 

– Inflation (π) = 5% 

c) What would be the prediction for the real and nominal interest rates 

set by this central bank when: (1 mark) 

– Output Gap = -3% 

– Inflation (π) = -1% 

d) What would be the prediction for the real and nominal interest rates 

set by this central bank when: (The following situation is referred to 

as stagflation) (1 mark) 

– Output Gap = -2% 

– Inflation (π) = 5% 

e) Let’s assume that the nominal interest rate (i) = 5%. Will the central 

bank decrease or increase the nominal interest rate for each of the 

above scenarios? (1 mark) What is the direction of the impact of the change in the nominal interest rate on the output gap and the 

rate of inflation for each of the above scenarios? (1 mark) Is the 

economic situation improved by the change in the interest rate? (1 

mark)

4. A central bank (CB) is represented by 2 different policy reaction functions. 

The first policy reaction function represents this central bank’s behaviour 

during the 10 years prior to the Global Financial Crisis (GFC).1

 The second policy reaction function refers to the behaviour of the same central bank after the GFC (Assume that the central bank sets the interest rate at 0.25% lower at each level of inflation, believing that the risks of increased inflation are lower than prior to the GFC) 

a) Fill in the following table (1 mark) 

b) Graph the different policy reaction functions. (Don’t forget to include some of the interest rate-inflation numbers on the diagram). (1 mark) 

                        Policy Reaction Function 1(Period Prior GFC)  Policy Reaction Function 2 (Period After GFC) 

Inflation Rate     Interest Rate Set by CB                                   Interest Rate Set by CB 

1%                      3.00% 

2%                      3.25% 

3%                      3.50% 

4%                      3.75% 

5%                       4.00%