econ 1102 week 7 post lecture

Money, Private Banks and the RBA

Read Chapter 7

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Louise Zieme

[email protected]

Room: 465, Australian School of Business Building (ASB) East Wing

Phone No: 9385 9935

Consultation Hours: ◦ Monday 4-6pm

◦ Friday 1-2pm

Email is the best way to contact me.

MID SESSION EXAM QUESTIONS WILL BE RELEASED ON MOODLE IN WEEK 8

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mailto:[email protected]

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.

0 Y (= GDP)

PAE (planned aggregate expenditure)

PAE = C + IP + G + NX

IP

IP + G I P + G + NX

Y* Starting at potential output (Y*), a fall in

exogenous C, I, G, NX

will lead to a recessionary gap

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Recap Week 6: If we assume that the planned aggregate expenditure is given by the equation PAE = 960 + 0.8Y a 10-unit drop in exogenous expenditure would result in a _____________ in short-run equilibrium output.

A. 50-unit decline

B. 40-unit decline

C. 950-unit decline

D. 4-unit decline

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Recap Week 6: If we assume that the planned aggregate expenditure is given by the equation PAE = 960 + 0.8Y a 10-unit drop in exogenous expenditure would result in a _____________ in short-run equilibrium output.

A. 50-unit decline (MPC = 0.8 Simple Multiplier =

1/1-MPC)

1/0.2 = 5 , 5 X 10

B. 40-unit decline

C. 950-unit decline

D. 4-unit decline

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.

0 Y (= GDP)



IP

IP + G I P + G + NX

Ye Y*

Recessionary gap

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.

0 Y (= GDP)



IP

IP + G I P + G + NX

Y* Ye

Expansionary gap

The government expenditure multiplier is greater than the tax/transfers multiplier

Withdrawals – higher income taxes and imports – reduce the impact of the multipliers

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Recap Week 6: The short-run effect of equilibrium GDP of an equal change in government expenditure and net taxes is a definition of:

A. the balanced budget B. the balanced budget multiplier C. balanced GDP D. balanced growth

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Recap Week 6: The short-run effect of equilibrium GDP of an equal change in government expenditure and net taxes is a definition of:

A. the balanced budget B. the balanced budget multiplier C. balanced GDP D. balanced growth

Discretionary fiscal policy equated with structural changes in the budget

Automatic stabilisers drive cyclical changes In response to the GFC: observe a cyclical decline in the budget balance

(mostly due to decline in T) as automatic stabilisers work, and

a structural decline due to big discretionary increases in G and reductions in T

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Recap Week 6: Because of automatic stabilisers, when GDP fluctuates the:

A. government's budget remains in balance

B. government's deficit fluctuates directly with GDP

C. government's deficit fluctuates inversely with GDP

D. the economy will automatically go to full employment

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Recap Week 6: Because of automatic stabilisers, when GDP fluctuates the:

A. government's budget remains in balance

B. government's deficit fluctuates directly with GDP

C. government's deficit fluctuates inversely with GDP

D. the economy will automatically go to full employment

We can rearrange this equation with gross taxes on the left-hand side:

Gt + Qt – Tt + rBt – 1 = (Bt – Bt – 1)

◦ When the government runs a deficit budget, the left-hand

side is positive and we will be adding to the stock of public debt.

◦ When the government runs a surplus budget, the left-hand side is negative and the stock of debt will fall.

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Recap Week 6: One of the powerful arguments for why governments might avoid policies that accumulate a large public debt is:

A. prudent securities analysis

B. intergenerational equity

C. balanced budget multipliers

D. diversification of export markets

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Recap Week 6: One of the powerful arguments for why governments might avoid policies that accumulate a large public debt is:

A. prudent securities analysis

B. intergenerational equity

C. balanced budget multipliers

D. diversification of export markets

Can be Inflexible

◦ Generally only implemented in annual budget

◦ Time lag to policy implementation

Deficits and public debt

Expansionary Fiscal policy => budget deficits and debt

Impact on monetary conditions (real interest rate)

Demand (and supply) impacts

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Recap Week 6: It might be argued that fiscal policy is NOT often used today to stabilise the economy because:

A. it may have undesirable long-run effects on the supply side of the economy

B. it may have undesirable effects on the planned budget

surplus C. it may be ineffective in the long run D. it may have negative effects on monetary policy

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It might be argued that fiscal policy is NOT often used today to stabilise the economy because:

A. it may have undesirable long-run effects on the supply side of the economy

B. it may have undesirable effects on the planned budget

surplus C. it may be ineffective in the long run D. it may have negative effects on monetary policy

The cumulative numbers for the two distributions are then compared to a perfectly equal distribution: ◦ The bottom 20% of the population would earn 20% of the

total income; the bottom 40% of the population earning 40% of the income, etc.

This line is drawn on the graph, and the Gini coefficient can be calculated as:

area between the line of equality and the Lorenz curve Gini = total area below the line of equality

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Recap Week 6: The Gini coefficient is a(n):

A. summary measure of the inflation rate

B. summary coefficient of the government's spending

C. summary measure of the government's fiscal policy performance

D. summary measure of income inequality

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Recap Week 6: The Gini coefficient is a(n):

A. summary measure of the inflation rate

B. summary coefficient of the government's spending

C. summary measure of the government's fiscal policy performance

D. summary measure of income inequality

1. Policies to stabilise the Business Cycle - Monetary Policy

2. The supply of money 3. Money and prices 4. The Reserve Bank of Australia

Read: Bernanke Chapter 7

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Fiscal Policy

(annual Budget sets out government’s fiscal policy intentions): ◦ Government expenditure ◦ Taxes (direct, indirect) ◦ Transfer payments

Monetary Policy

(monthly, Reserve Bank Board): ◦ Set monetary conditions -> interest rates, money supply

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.

0 Y (= GDP)



Ye Y*

Monetary Policy Reduce r (i) or increase Ms

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.

0 Y (= GDP)



Ye Y*

Monetary Policy Increase r (i) or reduce Ms

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interest rate (i)

money 0

MD

MS

Monetary policy set MS or i*

i *

Money is ..a commodity/token accepted as a means of payment because it fulfills 3 main functions:

◦ Medium of exchange

◦ Unit of account

◦ Store of value

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Good or asset whose primary purpose is to purchase

other goods. goods → money → goods Why not directly trade goods for goods? i.e. Barter Barter tends to be inefficient. If I want to buy a new computer I will have to find a

supplier who would be willing to accept a series of economics lectures in exchange

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For barter to occur: Person 1 wants to accept goods supplied by Person 2 Person 2 wants to accept goods supplied by Person 1 With a medium of exchange each person: Sells their goods for medium of exchange Uses medium of exchange to buy goods they want Significant reduction in costs of search

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Good that is used to compare the value of all other goods and services

Standard to use medium of exchange as the unit of account

In economics it gives meaning to term such as GDP, CPI

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Good or asset that serves as a means of holding (or transferring) wealth over time.

Many goods and assets can serve as a store of value (e.g. land, bonds, stocks) but do possess the medium of exchange or unit of account functions of money.

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How much money is there in the economy?

several alternative definitions of money which vary in how broadly money is defined:

1. Currency: notes and coins on issue (excluding holdings of currency by banks).

2. M1: currency plus current deposits held by banks. [Current deposits are money held in cheque and savings accounts].

3. M3: M1 plus all bank deposits of the private non-bank sector.

4. Broad money: M3 plus deposits held by non banks.

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How much money is there in the economy? several alternative definitions of money which vary in how broadly

money is defined:

1. Currency: notes and coins on issue (excluding holdings of currency by banks). Notes and coins held by households and businesses

2. M1: currency plus current deposits of households and businesses held by banks. [Current deposits are money held in cheque and savings accounts].

3. M3: M1 plus all bank deposits of the private non-bank sector. (currency + bank deposits of households and businesses in cheque and savings accounts + all other bank deposits held by households and businesses e.g. term deposits)

4. Broad money: M3 plus deposits of households and businesses held by non banks (building societies, credit unions).

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Measures of Money Aggregates for Australia

$ billion

June 2009 June 2013

Currency 45.5 54.9

M1 249.8 273.8

M3 1,182.2 1,567.4

Broad Money 1,257.0 1,573.8

Money supply (M3) consists of currency + bank deposits. amount of money also depends on the behaviour of commercial banks and their depositors

How banks influence money supply

Demand deposits (in banks) are redeemable in cash on demand. Banks retain a fraction of deposits as reserves (RESERVE RATIO = reserves/deposits).

The remainder they can lend out.

When Banks have excess reserves (actual reserve ratio exceeds desired ratio) they are able to make loans and therefore create money

=> Banks create money by making loans

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1. Policies to stabilise the Business Cycle - Monetary Policy

2. The supply of money 3. Money and prices 4. The Reserve Bank of Australia

Read: Bernanke Chapter 7

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Assets of Bank Liabilities of Bank

Reserves: $1,000 Deposits: $1,000

Total: $1,000 Total: $1,000

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The money supply increases by $1,000 – the initial deposit


Required Reserves: $100 (10% deposits)

Deposits: $1000

Excess Reserves: $900

Total: $ 1000 Total: $1000

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Reserves $1000 ($100 + new deposit)

Deposits: $1,000

Loans: $900 (Additional) Deposits: $900

Total : $ 1900 Total : $ 1900

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The money supply is now $1,900 (total bank deposits) the banks have created money. Since reserves/deposits = 1,000/1,900 = 52.6% ( > 10%) banks can make more loans …..


Reserves (10% deposits) $190 (Excess Reserves) $ 810

Deposits: $1,000

Loans: $900 (Additional) Deposits: $900

Total : $ 1900 Total : $ 1900

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The money supply is now $1,900 (total bank deposits) the banks have created money. Since reserves/deposits = 1,000/1,900 = 52.6% ( > 10%) banks can make more loans …..


Reserves: (10% deposits) $271 (Excess Reserves ) $729

Deposits: $1,000

Loans: $900 (Additional) Loans: $810

(Additional) Deposits: $900 (Additional) Deposits: $810

$2,710 $2,710

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etc……..


Reserves: $1,000 Initial Deposit: $1,000

Loans: $9,000 Subsequent Deposits: $9,000

Total assets: $10,000 Total liabilities: $10,000

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The money supply has increased by $10,000 10 x the initial deposit

Deposit Multiplier = 1 . = 1/.01 = 10

desired reserve/deposit ratio

(Final) Bank Deposits (change in Money Supply)

= Bank Reserves (Initial Deposit) x Deposit Multiplier = $1,000 x 10

= $10,000

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10%

Assumptions so far no currency, no government, closed economy


Reserves: $ 500 Loans: $ 4,500

Deposits: $500 Additional deposits: $ 4,500 Total Deposits: $ 5,000

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Money supply = currency held by public + bank deposits D money supply = $500 + Initial deposit x deposit multiplier = $500 + [$500 x 10] = $500 + $5000 (Total Deposits) = $5,500 Money supply influenced by currency, deposits, reserve ratio

1/(reserves/ deposits ratio)

$1,000 is deposited in a bank. The reserves to deposit ratio (the reserve ratio) is 5%. By how much does the money supply change?

Money supply = currency + bank deposits D money supply = D currency + D bank deposits = 0 + initial deposit x money multiplier = 0 + initial deposit x 1/reserve ratio = 0 + $1,000 x 1/0.05 = $1,000 x 20 = $20,000 What if $500 is kept as currency by households? D money supply = D currency + D bank deposits = 500 + 500 x 20 = $10,500

=

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The Quantity Theory of Money: in the long run, the amount of money circulating in the economy and the general level of prices are closely linked

M.V = P.Y

M = money supply

V = velocity of circulation

P = price level

Y = real GDP

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One of the functions of money is the unit of account. This means the prices of all other goods and services are measured in terms of money.

Prices of goods, services and financial assets in Australia are quoted in Australian dollars.

Large Flat White = $3.50

1 share in BHP-Billiton = $38.50

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How fast does a dollar circulate?

What is average value of transactions that a dollar can be used for (in a given period of time)?

Velocity ≡ Value of Transactions ≈ Nominal GDP Money Stock Money Stock

= P * Y M

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Velocity (V) = Value of transactions Money stock

= Nominal GDP Money stock

= P * Y M

Higher V the higher the speed at which money circulates

Example: Velocity of currency

In Dec Qtr 2008, currency was $130bill, nominal GDP was $1,089bill

=> V (currency) = nominal GDP/money stock (currency)

= $1,089bill/$130bill = 8.38

Similarly V (M1) = $1,089bill/$722.3bill = 1.51

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The definition of velocity can be re-arranged to give the quantity equation.

M.V = P. Y This states that the money stock times velocity equals nominal

GDP. Of course this must be true by definition. There is no

economics in the quantity equation. What we care about is the quantity theory. http://www.washingtonpost.com/blogs/wonkblog/wp/2012/08/

21/great-hyperinflation-episodes-in-history-and-what-they-tell-us-about-the-fed/

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http://www.washingtonpost.com/blogs/wonkblog/wp/2012/08/21/great-hyperinflation-episodes-in-history-and-what-they-tell-us-about-the-fed/


























D(M.V) = D(P.Y) M = money supply

V = velocity of circulation

P = price level

Y = real GDP

If real GDP (Y) is constant (in long run) and V is constant,

=> DM = DP

then x% increase in M => x% increase in the price level (P)

"Inflation is always & everywhere a monetary phenomenon." by Milton Friedman, Nobel prize winner 1976

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Figure 7.1 Countries with higher rates of growth in their money supplies also

tended to have higher rates of inflation between 1960 and 1990

Functions of the Reserve Bank of Australia (RBA)

Financial system stability

Conduct of monetary policy

Other monetary management tasks

◦ Banker to the Government

◦ Banker to banks

◦ Custodian of the country’s foreign currency

◦ Printer of currency

RBA – considered to be an ‘independent’ central bank

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The stability of the currency of Australia

The maintenance of full employment in Australia

The economic prosperity and welfare of the people of Australia

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RBA has an explicit inflation target (2-3 % per annum) In pursuing the goal of medium-term price stability,

both the Reserve Bank and the Government agree on the objective of keeping consumer price inflation between 2 and 3 per cent, on average, over the cycle. (2007)

First formal Policy Statement was in 1996. Has RBA achieved its target?

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Until mid 1980s: by targeting the growth of money supply

◦ Rationing lending (set reserve/deposits ratio), fixing interest rates, imposing credit controls

◦ Open market operations (OMO) – to influence bank reserves (and the monetary base)

Since mid 1980s: by setting the cash rate

◦ The interest rate that brings the supply and demand for overnight funds (exchange settlement funds) into equilibrium

◦ Uses open market operations (OMO) – to target the cash rate

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We know the RBA’s objectives, but how does it go about achieving them.

Has an announced target level for the cash rate (formally the overnight money market interest rate)

Implements monetary policy decisions via changes in the cash rate target

Current (April 2014) cash rate target is 2.5%

http://www.rba.gov.au/media-releases/2014/mr-14-05.html

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Banks hold accounts with the RBA called exchange settlement accounts (ESA). The funds held in these accounts are formally called exchange settlement funds, but are informally known as cash.

Rule:

Banks are not allowed to overdraw their ESA, i.e. they must always be in credit.

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Provide a means by which banks can clear any payments among themselves. If ANZ owes $20m to Westpac, then funds are simply transferred between their ESAs.

These types of interbank transfers will change the distribution of cash, but will not affect the overall level of cash in the system.

What happens if ANZ finds its level of cash holdings to be undesirably low?

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There is a specialised market where banks are able to trade cash. Overnight cash market

Borrowing and lending for periods up to 24 hours

ANZ could borrow cash from some other bank which might find itself with more than it wants to hold.

The interest rate that clears this interbank market is the overnight cash rate and it this rate that the RBA chooses to target.

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While the actions of the banks cannot change the level of cash in the system, the actions of the RBA can.

RBA can buy and sell bonds (typically government bonds) from/to the banks.

If the RBA buys bonds it pays for the bonds by crediting the bank’s ESA.

If the RBA sells bonds it receives payment by debiting the bank’s ESA.

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The action buying and selling bonds is known as Open Market Operations (OMO).

Open market operations provide a means by which the RBA can influence the overall level of cash (exchange settlement funds).

They also provide the means by which the RBA is able to ensure the overnight cash rate is equal to its target rate.

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If there is excess cash in the system so that there is pressure for the cash rate to fall below 2.5%, RBA will sell bonds and this will reduce the supply of cash.

If there is a shortage of cash in the system so that there is pressure for the cash rate to rise above 2.5%, RBA will buy bonds and this will increase the supply of cash.

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Monetary policy seeks to affect all interest rates in the economy, not just the overnight cash rate.

Longer term interest rates do tend to track the cash rate quite closely.

Interest rates decreasing on the overnight cash rate would attract longer-term loan money, which would tend to decrease the interest rate in those longer-term markets. Vice versa for an increase in interest rates.

At its monthly meeting the RBA board of governors decides what changes, if any, shall be made to the cash rate.

Financial markets follow these meetings with intense interest because the outcome immediately influences most interest rates and the bond, share and housing markets.

Having set the cash rate, the RBA conducts open market operations to achieve it.

Figure 7.2 Interest rates

econ 1102 week 7 post lecture

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