Bond traders are now pricing in a 76 per cent chance RBA cash rate cut by November after the latest stock market rout. Monday's meltdown on global markets has driven up the chances of another cash rate cut by the Reserve Bank of Australia, according to market pricing. The RBA has cut the cash rate twice this year, from 2.5 per cent to a record low 2 per cent, and now seems inclined to leave it there.

Economists, however say the markets are over-reacting. Despite the shortening market odds of another cash rate cut this year, economists have cautioned that the hit to Australia's real economy from the drop in share values this week will be too small to warrant another reduction. "While we remain more concerned than most about the Australian economy, we don't think that the recent sharp falls in equity prices will filter through into much weaker investment or consumption," chief economist for Australia Paul Dales wrote in a note on Tuesday.

While conceding that the real state of China's economy will determine Australia's outlook, he says the sharp sell-off in equities in Shanghai was also overdone. "The collapse in equity prices on the Shanghai market is unlikely to translate into much weaker real activity in China and the lagged effects of earlier policy loosening by the People's Bank should shore up economic growth," he said.
Nomura economists Rob Subbaraman and Michael Loo also argue.... "The trend growth slowdown in China has no doubt hurt the rest of Asia's exports, while the collapse in commodity prices has also reduced demand from other emerging markets for Asian exports," they wrote on Tuesday. "However, looking specifically at Asia (excluding Japan), our fundamental view is that growth is not about to collapse and financial crises are unlikely," they said.

This view is echoed by HSBC's chief China economist Qu Hongbin and greater China economist Julia Wang. They say Chinese authorities are a long way from exhausting monetary and fiscal policy measures to maintain growth rates around 7 per cent.

"The market is concerned about many things, but China running out of options is not one we should be worried about, in our view," they said. "As these anticipated easing measures are delivered, the economy should be on track for a modest recovery in the second half of 2015.

"We maintain our full-year GDP forecast at 7.1 per cent."

Questions:

1. Following the stock market fall in Australia, market traders believe that there is now an increased chance of an interest rate cut by the Reserve Bank.
Based on this view, explain the causal links between falling share prices and its possible effect on the real economy in Australia. In your discussion use the Aggregate Expenditure model to explain the potential implications of the falling share price effect on equilibrium output and employment. Also explain the equilibrating process to the new potential macroeconomic equilibrium.

2(a) Explain the rationale behind why the Reserve Bank might intervene and lower interest rates. Building upon the Aggregate Expenditure model used in part (a), show the potential effects on equilibrium output and employment if the Reserve Bank does lower interest rates.

2(b) The article also highlights that some economists believe that "markets are over-reacting". Briefly explain the reason for this view held by some economists and what they believe the Reserve Bank will do to interest rates.

3. With reference to the statement " While conceding that the real state of China's economy will determine Australia's outlook" - use the dynamic Aggregate Demand-Aggregate Supply model to explain the potential impact on equilibrium output and (un)employment in the medium term for Australia in the context where Chinese economic growth rates are slower than hoped for and co-existing with Australia experiencing some productivity growth during this period.