Economics for Management

GSB728

Topic 9:

Money and Interest Rates

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Note: This lecture note was prepared based on the teaching material provided

by the publisher of the textbook Principles of Economics.

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Learning Objectives1. The meaning and functions of money – What is

this thing called ‘money’?

2. The financial system in Australia – Where do banks and other financial institutions fit in?

3. The supply of money – How is it measured and what determines its size?

4. The demand for money – How much money do we want to hold at any one time?

5. Equilibrium – What effect does the demand and supply of money have on interest rates? 3

Money

• The functions of money:– Medium of exchange.

– Means of evaluation.

– Means of storing wealth.

• What should count as money?– Cash: Yes

– Goods: No

– Financial assets such as bank and credit union accounts, stock and shares: It depends how narrowly money is defined.

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Australia’s Financial System

• The role of the financial sector:

– Financial intermediaries serve to channel funds from depositors to borrowers.

– Financial intermediaries:

• Banks.

• Non-bank financial institutions (NBFIs).

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Shares of Australian Financial Institutions (March, 2012)

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Source: Reserve Bank of Australia (RBA) (2013).

*: Other includes Cash management trust, Common funds and Friendly societies.

Type of Institution Total Assets at March 2012 ($ Billions)

Banks 2,859

Building societies 22

Credit unions 50

Money market corporations 48

Finance companies 103

Securitisers 128

Insurance companies 383

Superannuation funds 1,162

Unit trusts 264

Other* 39

TOTAL 5,058

• Banks:

– Assets and liabilities:• Assets: loans; currency; deposits with the Reserve Bank

of Australia (RBA).

• Liabilities: deposits.

– Liquidity and profitability:• Liquidity: how easy an asset can be transformed into

cash without loss. Cash is perfectly liquid.

• Profitability: objective of the banks (lend money at a rate higher than the one paid to depositors).

• Liquidity and profitability move in opposite directions. 7

Australia’s Financial System (contd.)

• Non-bank financial intermediaries:

• Credit unions, building societies, finance companies.

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Australia’s Financial System (contd.)

– Functions:• Issues notes.

• Acts as a bank for banks.

• Acts as a lender of last resort to banks not NBFIs.

• Acting for the Federal government and States governments.

• Holds the official foreign currency reserves.

• Operates monetary policy:– Stability of currency.

– Maintenance of full employment.

– Economic prosperity and welfare of people in Australia.

The Reserve Bank of Australia

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The Supply of Money

• Measuring the money supply

– Monetary base:

• Notes, coins, deposits held by banks at the RBA.

– Broad money:

• Cash in circulation, bank deposits, deposits in NBFIs.

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Alternative Measures of the Money Supply (July, 2013)

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Source: Reserve Bank of Australia (RBA) (2013).

$ Billions

Currency 55

Plus current deposits with banks 219

Equals M1 274

Plus all other deposits at banks 1,294

Equals M3 1,567

Plus net borrowing from the private sector by NBFIs 6

Equals Broad Money 1,574

• Credit creation:– Expansion of the amount of bank deposits and

therefore the money supply.

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The Supply of Money (contd.)

Example of Credit Creation (I):Bank’s Original Balance Sheet

Source: Sloman et al. (2014).

Assets $Bn Liabilities $Bn

Balances with the Reserve Bank 10 Deposits 100

Advances 90

Total 100 Total 100

Example of Credit Creation (II):Initial Effect of an Additional Deposit of $10 Billion

Source: Sloman et al. (2014).

Assets $Bn Liabilities $Bn

Balances with the Reserve Bank (old) 10 Deposits (old) 100

Balances with the Reserve Bank (new) 10 Deposits (new) 10

Advances 90

Total 110 Total 110

Example of credit creation (III):The full effect of an additional deposit if $10 billion

Source: Sloman et al. (2014).

Assets $Bn Liabilities $Bn

Balances with the Reserve Bank (old) 10 Deposits (old) 100

Balances with the Reserve Bank (new) 10 Deposits (new: initial) 10

Advances (old) 90 Deposits (new: subsequent) 90

Advances 90

Total 200 Total 200

– The bank multiplier:• 1/L where L = liquidity ratio

– Banks’ liquidity ratio may vary:• Banks may choose a different liquidity ratio.• Customers may not want to take up the credit on offer.

– Banks may not operate a simple liquidity ratio.

– Some of the extra cash may be withdrawn from the banks.

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The Supply of Money (contd.)

• What is the relationship between the money supply and the rate of interest?

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The Supply of Money (contd.)

0

Rate

of i

nter

est

Quantity of money

MS

The Supply of Money Curve: (a) Exogenous Money Supply

Source: Sloman et al. (2014).18

0

Rate

of i

nter

est

Quantity of money

The Supply of Money Curve: (b) Endogenous Money Supply

MS

Source: Sloman et al. (2014).19

Exogenous and Endogenous Variables

• Models are composed by :– Exogenous variables: those that come outside of the

model.– Endogenous variables: those that a model tries to

explain.

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Source: Mankiw (2013).

The Demand for Money

• The motives for holding money:

– Transactions motive.

– Precautionary motive.

– Speculative motive.

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• Determinants of the size of the demand for money:

– Rate of interest (opportunity cost).

– Nominal GDP.

– Frequency with which people are paid.

– Financial innovations.

– Speculation about future return on assets.

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The Demand for Money (contd.)

0

Rate

of i

nter

est

MD

Quantity of money

The Demand Curve for Money

Source: Sloman et al. (2014).23

Equilibrium

• Equilibrium in the money market:

• Equilibrium interest rate.

• Where demand for money (Md) and supply of money (Ms) are equal.

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0

Rate

of i

nter

est

Md

Quantity of money

MS

re

Me

Equilibrium in the Money Market

Source: Sloman et al. (2014).25

• Full effect of changes in the money supply (Ms):

– Ms r (interest rates)

– r I, C

– I, C AD, GDP, inflation

– r exchange rate X, M

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Effects of an increase in Money Supply

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Relationships Among Money, Prices and Interest Rate

Source: Mankiw (2013).

References

Mankiw, N. G. (2013). Macroeconomics (8th ed.). New York: Worth.

Morales, L. E., Simons, P. and Valle de Souza, S. (2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business.

Reserve Bank of Australia (RBA) (2013). Statistics. Retrieved from http://www.rba.gov.au/.

Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson.

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