8 Macro AD AS W5

What is the RBA's main policy tool, and what is it

The cash rate - the interest rate on overnight loans between banks.

The RBA sets a target for the cash rate. Changes in it flow through to the rates households and firms actually pay, such as mortgage and business loan rates.

Why does the RBA publish an explicit inflation target

To anchor inflation expectations and make the RBA accountable

The RBA raises the cash rate. What is the chain of effects on inflation?

Borrowing falls, the exchange rate rises, net exports fall, AD falls, inflation falls

Why does the AD curve slope downward (inflation on the vertical axis)?

Higher inflation leads the RBA to raise the real interest rate, which lowers investment and output

Why does the short-run aggregate supply (SRAS) curve slope upward?

Higher output means lower unemployment (Okun's law), and lower unemployment pushes inflation up (Phillips curve)

Which pair correctly matches what shifts each curve?

AD: fiscal policy, investment demand, confidence, a change in the inflation target.

SRAS: inflation expectations and supply shocks

What is the quick test for telling a demand shock from a supply shock

Demand shocks move inflation and output in the same direction; supply shocks move them in opposite directions

Consumer confidence slumps. What happens in the short run?

AD shifts left; the economy moves down along SRAS, so output and inflation both fall

(Lower consumption at every level of inflation shifts AD left. SRAS doesn't move. Because confidence recovers, it's temporary, and AD shifts back to restore Y* at the original inflation rate.)

An energy price spike hits. What happens in the short run?

SRAS shifts up; the economy moves up along AD, so inflation rises and output falls

Higher costs raise inflation at every level of output, so SRAS shifts up. The RBA's reaction function then raises the real rate, so output falls: a movement along AD, not a shift. Inflation and output move opposite ways, which marks it as a supply shock.

The RBA lowers its inflation target. What happens in the short run and then the long run?

Short run- AD shifts left, so output and inflation fall. Long run- expectations fall, SRAS shifts down, and the economy returns to Y* at the new target

(A lower target means higher real rates at every level of inflation, so AD shifts left. SRAS doesn't move yet because expectations are anchored at the old rate. As expectations adjust, SRAS shifts down, and the long-run result is lower inflation with no permanent output loss.)

Why is the long-run aggregate supply (LRAS) curve vertical at Y*?

Because in the long run output returns to potential, with unemployment at its natural rate, whatever the inflation rate

(Expectations catch up with actual inflation in the long run, so the economy ends up at potential output Y* regardless of the inflation level.)

When is it a shift of a curve, and when is it a movement along a curve?

A shift happens when something other than inflation or output changes spending, costs or expectations; a movement along happens when inflation or output itself changes

Real Rate

A real interest rate is the interest rate after taking inflation out, so it measures the true cost of borrowing

real rate ≈ nominal rate − inflation

is the nominal rate adjusted for inflation, which is the true cost of borrowing in terms of purchasing power

Nominal Rate

is the rate you actually see: the RBA’s cash rate, or a mortgage rate. It’s the dollar return or cost of borrowing.