Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank

8–1Copyright 2005 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Macroeconomics by Bernanke, Olekalns, Frank

Chapter 8Money, Prices and the Reserve Bank

Copyright 2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank

8–2

Chapter 8: Money, Prices and the Reserve Bank

• Money and its uses• Commercial banks and the creation of money• Money and prices• The Reserve Bank of Australia

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8–3

Money and Its Uses

• Means of payment: avoids barter and promotes specialisation

• Unit of account• Store of value

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8–4

Unit of Account

• The cent piece is no longer a means of payment in Australia

• But cents remain a unit of account

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8–5

Measuring Money

• Currency: notes and coin• M1• M3• Broad money

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8–6

Composition of M1

• Currency held by the public• Current deposits held by the public in commercial

banks• When there are no excess reserves,

current deposits = reserves / [desired reserve-deposit ratio]

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8–7

Composition of M3

• M1 plus all other bank deposits• Although time deposits in banks cannot have

cheques written against them, they are quickly convertible into cash or current deposits, with an interest rate penalty

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8–8

Legal Tender

• Notes and coin are legal tender• Cheques and electronic payments are not legal

tender

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8–9

Current Deposits

• Not legal tender• But customarily acceptable• Part of M1

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8–10

Fractional Reserve Banking

• Demand deposits are redeemable in cash on demand

• So banks must hold cash reserves to meet this commitment

• But on any given day only a fraction of those deposits will be demanded

• So cash reserves are only a fraction of deposits

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8–11

The Reserve/Deposit Ratio

• High ratio gives safety but reduces the amount which can be lent for profit

• Low ratio increases potential profits but increases the probability of a run on the bank

• When actual reserve/deposit ratio exceeds desired ratio, banks lend cash

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8–12

Fragility of Banking System

• With fractional reserve banking, depositors’ loss of confidence can cause banks to fail by creating a run on the bank

• Spreads to other banks through ‘contagion’• This creates a role for a central bank with power to

print money• In emergency, RBA lends reserves to banks until

confidence is restored

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8–13

Loss of Confidence

• May have no basis in fact• Fed by rumour• Unpredictable• Existence of RBA makes it less likely

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8–14

Bank Balance Sheet

• Assets– cash (no interest)– short and long-term riskless government bonds (interest

bearing)– risky loans to customers (higher-interest bearing)

• Liabilities– demand deposits (zero or low interest)– term deposits (higher interest)

• Source of profit is the difference between lending and borrowing rates

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8–15

Other Bank Reserves

• Excessive cash is inconvenient• Most reserves held as electronic deposits in RBA• Totally safe, quickly convertible into cash• Zero interest payable• Short-term bonds may also be held as reserves if

quickly convertible to cash

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8–16

Bank Lending Creates Money

• Banks lend their excess reserves• Cash lent by a bank returns to the banking system

when that loan is spent by the borrower• This creates a deposit in the name of the person

who supplied goods and services to the borrower• The supply of money in the form of bank deposits

has increased

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8–17

The Velocity of Circulation (V)

• A given unit of money (M) can finance a greater value of transactions (PT ) the faster it circulates within a given period of time

• MV = PT: an identity which must be true• V = PT/M• Real GDP Y is proportional to all transactions,

where nominal GDP = PY • So V = PY/M

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8–18

The Quantity Equation

• Defining V = PY/M gives MV = PY• If V and Y are constant at full employment then we

have a theory of the price level • P = MV/Y• If V and Y are constant, then P depends only on M

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8–19

A Theory of the Inflation Rate

• P depends only on M, given the constant levels of V and Y

• Then the rate of growth of P is equal to the rate of growth of M, the money supply

• This is because, if V and Y are constant, their growth rates are zero

8–20

Inflation and Money Growth

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8–21

Controlling M – the RBA

• RBA is charged with maintaining full employment and the stability of the currency (acceptable rate of inflation)

• Its main policy tool is control of interest rates, which influence banks’ and people’s willingness to borrow, create money, and spend

• Interest rates and M are influenced by ‘open market operations’ in the bond market

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8–22

Open Market Operations

• Involve buying and selling short-term government bonds

• Selling bonds means bank reserves fall, as the buyers pay for them and draw on their bank deposits

• Buying bonds means bank reserves rise, as the RBA pays for them and the sellers deposit the proceeds in banks

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8–23

Changes in Interest Rates

• Any fall in bank reserves requires banks to borrow funds in the ‘overnight’ market – 24-hour loan market

• The ‘cash’ rate of interest on such loans rises• Any rise in bank reserves encourages banks to

supply funds to the ‘overnight’ market• The cash rate falls

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8–24

Flow-on Effects of Cash Rate

• A rise in the cash rate means that lenders demand a higher rate on bank deposits

• A rise in the deposit rate means that banks demand higher rates on bank loans

• A rise in the lending rate reduces the demand for bank loans and spending

8–25

Cash Rate and Interest Rates

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8–26

RBA Targets the Cash Rate

• 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

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8–27

Setting the Cash Rate

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