Money, Private Banks and the RBA

Read Chapter 7

Louise Zieme
L.Zieme@unsw.edu.au
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
2

PAE (planned aggregate expenditure)

PAE = C + IP + G + NX

I P + G + NX
IP + G
IP
Y*
Y (= GDP)
Starting at potential output (Y*), a fall in
exogenous C, I, G, NX
will lead to a recessionary gap

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
5

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
6

PAE (planned aggregate expenditure)

PAE = C + IP + G + NX

Ye

Y*

I P + G + NX
IP + G
IP
Y (= GDP)

Recessionary gap

PAE (planned aggregate expenditure)

PAE = C + IP + G + NX

I P + G + NX
IP + G
0

IP

Y*

Ye

Expansionary gap

Y (= GDP)
8

 The

government expenditure multiplier is greater

than the tax/transfers multiplier

Withdrawals

higher income taxes and imports

reduce the impact of the multipliers

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

10

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

11

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

12

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

13

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

14

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.

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

16

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

17

 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

18

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

19

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

20

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:
Gini =

area between the line of equality and the Lorenz curve

total area below the line of equality

22

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

23

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

24

1.

2.
3.
4.

Policies to stabilise the Business Cycle

- Monetary Policy
The supply of money
Money and prices
The Reserve Bank of Australia
Read: Bernanke Chapter 7

25

Fiscal Policy
(annual Budget sets out governments fiscal policy
intentions):

Government expenditure
Taxes (direct, indirect)
Transfer payments

Monetary Policy
(monthly, Reserve Bank Board):

Set monetary conditions -> interest rates, money supply

26

PAE (planned aggregate expenditure)

.

PAE = C + IP + G + NX

Monetary Policy
Reduce r (i) or increase Ms
0

Ye

Y*

Y (= GDP)
27

PAE (planned aggregate expenditure)

.

PAE = C + IP + G + NX

Monetary Policy
Increase r (i) or reduce Ms
0

Y*

Ye

Y (= GDP)
28

interest rate (i)

MS
Monetary policy set MS or i*

i*

MD
0
money
29

 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

30

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

31

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

32

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

33

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.

34

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.

35

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).

36

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

37

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
38

1.

2.
3.
4.

Policies to stabilise the Business Cycle

- Monetary Policy
The supply of money
Money and prices
The Reserve Bank of Australia
Read: Bernanke Chapter 7

39

Assets of Bank
Reserves:

Liabilities of Bank
$1,000

Total: $1,000

Deposits:

Total:

$1,000

$1,000

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

40

Assets of Bank

Liabilities of Bank

Required Reserves:
(10% deposits)

$100 Deposits:

Excess Reserves:

$900
Total: $ 1000

$1000

Total: $1000

41

Assets of Bank
Reserves
($100 + new deposit)
Loans:

Liabilities of Bank
$1000 Deposits:

$1,000

$900 (Additional) Deposits: $900

Total : $ 1900

Total :

$ 1900

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 ..
42

Assets of Bank

Liabilities of Bank

Reserves (10% deposits) $190 Deposits:

(Excess Reserves)
$ 810
Loans:

$1,000

$900 (Additional) Deposits: $900

Total : $ 1900

Total :

$ 1900

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 ..
43

Assets of Bank

Liabilities of Bank

Reserves: (10% deposits) $271 Deposits:

(Excess Reserves )
$729
Loans:
(Additional) Loans:

$1,000

$900 (Additional) Deposits: $900

$810 (Additional) Deposits: $810
$2,710

$2,710

etc..
44

Assets of Bank

Liabilities of Bank

Reserves:

$1,000

Initial Deposit:

Loans:

$9,000

Subsequent Deposits: $9,000

Total assets:

$10,000 Total liabilities:

$1,000

$10,000

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

45

10%

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

Assumptions so far
no currency, no government, closed economy
46

Assets of Bank
Reserves:
Loans:

Liabilities of Bank
$ 500
$ 4,500

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

Money supply = currency held by public + bank deposits

D money supply = $500 + Initial deposit x deposit multiplier
1/(reserves/
= $500 + [$500 x 10]
= $500 + $5000 (Total Deposits) deposits ratio)
= $5,500
Money supply influenced by currency, deposits, reserve ratio
47

$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
=

48

 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

49

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

50

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
51

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

52

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-theytell-us-about-the-fed/

53

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
54

55

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 countrys foreign currency
Printer of currency

RBA considered to be an independent central bank

57

 The

stability of the currency of Australia

The

maintenance of full employment in Australia

The

economic prosperity and welfare of the

people of Australia

58

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?

59

60

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

61

We know the RBAs 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-1405.html

62

63

64

65

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.

66

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?

67

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.

68

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 banks ESA.
If the RBA sells bonds it receives payment by debiting
the banks ESA.

69

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.
70

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.

71

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