1. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-1 Chapter 7 Money, prices and the Reserve Bank

2. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-2 Learning objectives 1.What are the three principal uses of money? 2.How does the government measure Australia’s money supply? 3.In what sense do commercial banks create money? 4.What is the relation between the money supply and the general level of prices? 5.What roles does the Reserve Bank play in the economy? 6.How can the Reserve Bank affect the level of interest rates in the economy?

3. Chapter organisation 7.1Money and its uses 7.2Commercial banks and the creation of money 7.3Money and prices 7.4The Reserve Bank of Australia Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-3

4. Money and its uses Money has three main uses: –Medium of exchange: avoids barter and promotes specialisation –Unit of account: the basic yardstick for measuring economic value –Store of value: a way of holding wealth Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-4

5. Measuring money Economists use several alternative definitions of money which vary in how broadly money is defined: –Currency: notes and coins on issue, less holdings of notes and coins by banks. –M1 is currency plus current deposits held by banks –M3 is M1 plus all bank deposits of the private non-bank sector. –Broad money is M3 plus borrowings from the private sector by non-bank depository corporations, less holdings of currency and deposits of non-bank depository corporations. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-5

6. Quantities of money, by definition Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-6 TABLE 7.1 Currency, M1, M3 and broad money in Australia, February 2010 ($ billion) Source: Reserve Bank of Australia (February 2010), Statistical Bulletin.

7. Chapter organisation 7.1Money and its uses 7.2Commercial banks and the creation of money 7.3Money and prices 7.4The Reserve Bank of Australia Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-7

8. Money supply What determines the amount of money in the economy? Money supply consists of currency and also bank deposits. –Therefore, the amount of money partly depends on the behaviour of commercial banks and their depositors. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-8

9. Example: Republic of Gorgonzola Assume a fictional country, the Republic of Gorgonzola, whose government has printed a total of one million guilders. –If all the currency of the economy is held in their banking system, and the banking system is simply a safe storage system, then the money supply of Gorgonzola is equal to one million guilders. –The banks’ consolidated balance sheet looks like this: Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-9

10. Bank reserves Bank reserves are assets held by banks to cover withdrawals from depositors and cheques written on their accounts. –Bank reserves are held by banks in their vaults. –They are not counted as part of the money supply. –Only deposits which can be used in transactions are part of the money supply. A 100% reserve banking system is when the banks hold all the money deposited in them. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-10

11. Fractional reserves In general, only a small part of the deposits are withdrawn or used by depositors at any time. Let’s assume the banks keep 10% as the reserve. –This means the remaining 90% of deposits can be loaned out and interest charged. Example: After 900 000 guilders of loans are made, the banks’ consolidated balance sheet will look like: Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-11

12. Fractional reserves (cont.) Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-12 Now the reserves to deposits ratio is 100 000/1 000 000 = 10% This 900 000 guilders now in the hands of Gorgonzola farmers is spent on the improvements they wanted to make. Those receiving the spending as income will deposit it in the bank.

13. Money creation After these deposits, the consolidated balance sheet is: The money supply is now 1 900 000 guilders. These loans have created new deposits = money. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-13

14. Money creation (cont.) Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-14 Reserves are now well above 10%, so further loans (of 810 000) can be made. Once again, these loaned guilders will end up as deposits in the banking system, and the consolidated balance sheet looks like:

15. Money creation (cont.) This process of excess reserves used to make loans, which are then deposited, which then cause excess reserves, will continue until reserves equal 10% of bank deposits. The final consolidated balance sheet looks like: The money supply = 10 000 000 guilders Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-15

16. Fractional banking system and money supply Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-16 Our fractional-reserve banking system has multiplied the money supply. Deposits expand through additional rounds of lending when the ratio of bank reserves to deposits exceeds the desired reserve-deposit ratio; and stops when it reaches it. Bank reserves Bank deposits = desired reserve–deposit ratio

17. The money supply with both currency and deposits If the people of Gorgonzola chose to hold 500 000 guilders as currency rather than as bank deposits, then: –money supply = currency held by public + bank deposits –we’ve just seen that: Money supply = 500 000 + 500 000 / 0.10 = 5 500 000 Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-17 Bank deposits = Bank reserves desired reserve–deposit ratio

18. Chapter organisation 7.1Money and its uses 7.2Commercial banks and the creation of money 7.3Money and prices 7.4The Reserve Bank of Australia Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-18

19. Money and prices The money supply is important because in the long run, there is a close link between the amount of money circulating in the economy and the general level of prices. A rapidly growing supply of money leads to quickly rising prices, i.e. inflation. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-19

20. Velocity Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-20 Velocity is defined as the value of transactions completed in a period of time divided by the stock of money required to make those transactions. Velocity is an important determinant of the price level in the economy. –The higher this ratio, the higher the speed at which money circulates. It is given by: value of transactions money stock Velocity = nominal GDP money stock =

21. Velocity (cont.) Let V stand for velocity and let M stand for the particular money stock being considered (e.g. M1 or broad money). Nominal GDP (a measure of the total value of transactions) equals the price level, P, times real GDP, y. Using this notation, we can write the definition of velocity as: Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-21 P x y M V =

22. Example: Velocity of money in Australia Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-22 In Australia, in the December quarter 2009, currency was $46.2 billion, M1 was $251.3 billion and nominal GDP $320.5 billion. Velocity for currency is given by: V =V = V =V = $320.5 billion $251.3 billion $320.5 billion $42.6 billion = 6.93 = 1.28

23. Money and inflation in the long run Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-23 The quantity equation describes the relationship between money and prices: M x V = p x y Assumptions: –If V depends on payment technologies and is approximately constant over the period of interest; and –Real output, y, is approximately constant during the period of interest, then: M x V = p x y Example: If M was to increase by 10%, there would be a corresponding increase in p of 10%.

24. Example: Inflation and money growth Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-24 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

25. Chapter organisation 7.1Money and its uses 7.2Commercial banks and the creation of money 7.3Money and prices 7.4The Reserve Bank of Australia Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-25

26. The Reserve Bank of Australia (RBA) The RBA is Australia’s central bank, and has two main responsibilities: 1.Maintaining stability of the currency, which is regarded as maintaining low inflation via monetary policy. 2.Oversight and regulation of financial markets. Monetary policy is now conducted by directly targeting interest rates. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-26

27. Open market operation (OMO) Open market operations are the buying and selling of financial assets such as short-term government bonds in order to affect the level of reserves in the commercial banks’ exchange settlement accounts. Exchange settlement accounts are accounts the commercial banks hold with the Reserve Bank so as to manage the flow of funds from transactions between them. If the RBA wants to raise the level of reserves, they will buy financial assets from the banks. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-27

28. Open market purchases The RBA paying for the assets raises the amount of the reserves in the exchange settlement accounts by the amount of the open market purchase. Exchange settlement accounts pay a low rate of interest. Any excess in those accounts encourages banks to supply funds to the overnight cash market, and the overnight cash interest rate will fall. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-28

29. Open market sales Similarly if the RBA wants to reduce the level of reserves, they will sell financial assets to the banks. Paying for the assets reduces the amount of the reserves in the exchange settlement accounts by the amount of the open market sale. Banks need adequate reserves in their exchange settlement accounts to transact between themselves. A reduction requires banks to borrow funds in the overnight cash market, and the overnight cash interest rate will rise. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-29

30. Flow-on effects of cash rate 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. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-30

31. 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. Having set the cash rate, the RBA conducts open market operations to achieve it. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-31

32. Overnight cash rate and other interest rates Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-32 Figure 7.2 Interest rates

33. Chapter organisation 7.1Money and its uses 7.2Commercial banks and the creation of money 7.3Money and prices 7.4The Reserve Bank of Australia Summary Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-33

34. Summary Money is used as a medium of exchange, unit of account and store of value. The reserve–deposit ratio is the key to money creation in a fractional banking system. In the long run, the quantity equation shows money supply is closely related to inflation. Open market operations are used to achieve the target cash rate in the overnight money market. Copyright  2011 McGraw-Hill Australia Pty Ltd PowerPoint slides to accompany Principles of Macroeconomics 3e by Bernanke, Olekalns and Frank 7-34