8–18–1 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Copyright  2005 McGraw-Hill Australia Pty Ltd PPTs t/a Principles of Macroeconomics by Bernanke, Olekalns, Frank Chapter 8 Money, Prices and the Reserve Bank

8–28–2 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–38–3 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Money and Its Uses Means of payment: avoids barter and promotes specialisation Unit of account Store of value

8–48–4 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Unit of Account The cent piece is no longer a means of payment in Australia But cents remain a unit of account

8–58–5 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Measuring Money Currency: notes and coin M1 M3 Broad money

8–68–6 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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]

8–78–7 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–88–8 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Legal Tender Notes and coin are legal tender Cheques and electronic payments are not legal tender

8–98–9 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Current Deposits Not legal tender But customarily acceptable Part of M1

8–10 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–11 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–12 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–13 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Loss of Confidence May have no basis in fact Fed by rumour Unpredictable Existence of RBA makes it less likely

8–14 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–15 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–16 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–17 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–18 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–19 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–21 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–22 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–23 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–24 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–26 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank 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

8–27 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Setting the Cash Rate Having set the cash rate, the RBA conducts open market operations to achieve it