Answer to Question #222480 in Macroeconomics for Amanda Jozina

Question

he South African Reserve Bank (SARB) has, in an unprecedented move, reduced the repo rate from 6.75% to 3.75% in a very short period. Use an appropriate diagram to illustrate and explain the likely effects of reducing the repo rate on output and inflation in South Africa, assuming that the economy was initially operating at less than full employment

Answer 1

The transmission mechanism is used to illustrate this.

The first stage of the mechanism involves the impact of this change in the repo rate on other interest rates and asset prices. A change in repo rate (i.e. a reduction) is immediately transmitted to other short term money market rates. But these rates may not always move by the exact amount of the official rate (repo) change.

A decrease in repo rate is interpreted as indicating that the Monetary Policy Committee believes that the economy may be growing slowly than it was thought previously, lowering expectations of future growth and confidence in general. However, it is also possible that a rate of reduction of the repo rate would be interpreted as signaling that the monetary policy perceives the need to fasten growth in the economy to reach the inflation target and this will rise the expectation of future growth and confidence.

The final stage bases on the impact of the various channels of inflation. All being equal, the expansion in total demand will increase output relative to its potential level and this will thus speed up the rate at which price level in falls relative to its trend. It will also increase the rate of wages in the labor market. All these channels transmit the effect of a reduction in repo rate to ultimately higher output and inflation.