Week 7

Lectures 13 & 14
Money, Prices and the Reserve Bank

Reference: Bernanke, Olekalns and Frank - Chapter 7

Key Issues
Financial system
What is money?
Private banks and money creation
Money and prices
Reserve Bank of Australia (RBA)
How the RBA sets a target value of the cash rate

Financial System
What happens to Saving?
Currency
Bank deposits
Stocks/shares/equities
Bonds
Other assets
Lenders
(Saver)

Financial System
{Intermediation}

Borrower
(Investor)
2

Asset Prices and Yields

The yield or return on a financial asset is inversely
related to the assets price.
Price(tomorrow) + Income
Return =
Price(today)
Other things equal:
Price(today) implies Return
3

Bonds
Principal = amount that is originally borrowed on the
bond
Term of bond = length of time before bond has to be
repaid (terms can range from 24 hours to 30 years)
Coupon payment = regular dollar payment of interest on
the bond
Coupon rate = Coupon Payment
Principal
4

Bonds (Example)
Principal (or face value) = $100
Term = 1 year
Coupon = $5 per year
Coupon rate = 5%

Bond Prices and Interest Rates

Bonds do not have to be held until maturity, but can be
bought and sold on the bond market.
What determines the price of a bond?
Consider a two year bond with a face value of $1000.
The annual coupon rate is 5%, implying there are two
annual coupon payments of $50.

A Timeline
5%
0
-1,000

1
50

2
50 + 1000

Bond price at 0, if market interest rates are 5% pa

A Timeline
5%
0
-1,000

1
50

2
50 + 1000

Bond price at 0, if market interest rates are 5% pa

Present-Value formula:
50
1,050
=
+
= 1,000
2
1.05 (1.05)
8

What if market interest rate rise? (At end of year 1)

5%
0
-1,000

10 %
1
50

2
50 + 1000

Bond price at end of year 1, if market interest rates rise

to 10% pa

What if market interest rate rise? (At end of year 1)

5%
0
-1,000

10 %
1
50

2
50 + 1000

Bond price at end of year 1, if market interest rates rise

to 10% pa
Present-Value formula:

1,050
=
= 954.5
1.10
10

Bond prices and interest rates are inversely related

If market interest rates had stayed at 5% then,
Bond Price = 1050/1.05 = 1000
but when they rise to 10%
Bond Price = 1050/1.10 = 954.5
The bond price falls.

11

What is Money?
Is Bitcoin Money?
https://theconversation.com/in-conversation-with-bitcoin-expert-and-nyu-professor-david-yermack-31048

12

Functional Definition of Money

Medium of exchange
Unit of account
Store of value

13

Medium of Exchange
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.

14

Double Coincidence of Wants

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

15

Unit of Account
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

16

Store of Value
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 not possess the medium of
exchange or unit of account functions of money.

17

Measuring Money
In modern economies money is provided by:
Government (currency notes and coin)
Banking system (deposits)

18

Standard Measures of Money for Australia

$ billion (end-June)
2009
2011
2014
Currency

45.5

48.1

58.0

M1

249.8

269.2

308.4

M3

1,182.2

1,345.5

1,663.6

Broad Money

1,257.0

1,385.7

1,670.2
19

Definitions of Money Measures

Currency = notes and coin on issue (less what is held by
RBA and banks)
M1 = Currency + Current deposits at banks
M3 = M1 + all other bank deposits of non-bank private
sector
Broad Money = M3 + borrowings from private sector by
non-bank depository corporations (less what these
non-banks hold with banks)
20

Banks as Creators of Money

Suppose central bank prints currency = $100m
This is distributed to households and firms
Rather than hold the currency, households and firms
deposit the entire $100m into the private banks.

21

Banking Systems Balance Sheet

Assets
Reserves = $100m

Liabilities
Deposits = $100m

100 Percent Reserve Banking

simple banking system
banks take deposits and hold the currency as reserves
banks earn income by charging fees
22

Bank Loans
Unnecessary for banks to hold all of their deposits in the
form of reserves
Some level of reserves is required to meet unexpected
withdrawals, but not 100 percent.
Banks can lend out their excess reserves to borrowers in
the form of bank loans.
Banks are now financial intermediaries.
23

Fractional Reserve Banking

Banks to decide to keep $10m as reserves and lend out
the other $90 million
Want to maintain a reserve-deposit ratio, R/D = 10%

24

Banking Systems Balance Sheet (100 percent reserve)

Assets
Reserves = $100m

Liabilities
Deposits = $100m

25

Banking Systems Balance Sheet (10 percent reserve)

Assets
Reserves = $10 m
Loans = $90m

Liabilities
Deposits = $100m

Where does the $90m lent to households and firms go?

Loans get re-deposited into banks

26

Banking Systems Balance Sheet (2)

Assets
Liabilities
Reserves = $10 m
Deposits
= $100m
+ $90m
+ $90m
Loans = $90m
Reserves = $100m

Deposits = $190m

R/D = 0.53. Much higher than desired

10% of $190m = $19m, so ($100m $19m) = $81m of
reserves can be used to make loans
27

Banks Make Additional Loans

Banking Systems Balance Sheet(3)
Assets
Liabilities
Reserves = $19 m
Deposits
= $100m
+ $90m
Loans = $90m
+ $81m

28

And they are Re-Deposited

Banking Systems Balance Sheet(3)
Assets
Liabilities
Reserves = $19 m
Deposits
= $100m
+ $ 81m
+ $90m
Loans = $90m
+ $81m
+ $81m
Notice that at the end of round 3, banking system still
has total reserves of $100m
Reserves = $100m
Deposits = $ 271m

R/D = 0.37 Too high, but falling.

29

What is the Money Supply?

Initial stock of money =$100m (currency = deposits)
After initial round of loans and re-deposits
Money supply = 100 + 90 = $190m
After second round
Money supply = 100 + 90 + 81 = $271m
Banking system is creating money (deposits)
30

Lets Bring the Process to a Close

What is the pattern?
Despite trying to reduce their reserves, the banking
system always finds it has reserves = $100m
However R/D ratio is declining (0.53, 0.37) towards its
desired ratio of 10%, due to increase in deposits
Lets solve for D in:

$100m/D = 0.10
D = $1,000m
31

Equilibrium in Banking System

Banking Systems Balance Sheet ()
Assets
Liabilities
Reserves = $100m
Deposits = $1,000m
Loans = $900m
Reserve-deposit ratio = 0.10
Money supply = $1,000m

32

Deposit Multiplier
Banks desired reserve-deposit ratio
Bank reserves = (desired) reserve-deposit ratio
Bank deposits

Deposits =

Reserves
(desired) reserve-deposit ratio
R
D
rd
33

Money Supply with Currency and Deposits

Money supply = currency held by public + bank deposits
R
M cu
rd

Suppose cu = $20m, R = $80, rd = 0.15

80
M 20
20 533.3 $553.3m
0.15

34

Money and Prices

One of the functions of money is the unit of account.
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 ($3.80)
1 share in BHP-Billiton = $38.50 ($38.64) ($32.65) ($36)
35

Velocity
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)?
Value of Transactions
Velocity

Nominal GDP

Money Stock

Money Stock

36

Velocity

Value of Transactions
Velocity

Nominal GDP

Money Stock

Money Stock

37

Question
On average approximately how many transactions is a
dollar of currency involved in over a year?
(a) 1
(b) 5
(c) 20
(d) 30
(e) 50

38

Question
On average approximately how many transactions is a
dollar of currency involved in over a year?
(a) 1
(b) 5
(c) 20
(d) 30
(e) 50

39

Velocity of Circulation in Australia

Nominal GDP in March quarter 2014 = $400 billion
Nominal GDP over 12 months to March quarter 2014 =
$1,586 billion
$ billion
(end-March 2014)
Currency
57.6
M1
295.8
M3
1,634.9
Broad Money 1,642.0

V
(qtr)
6.9
1.4
0.24
0.24

V
(annual)
27.5
5.4
0.97
0.97
40

Quantity Equation
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.

41

Quantity Theory (is what we care about)

The quantity theory makes two economic assumptions:
Velocity is constant, and
Output is constant
Quantity Equation

M V P Y

becomes
Quantity Theory

M V P Y
42

Quantity Theory of Prices

Quantity Theory

M V P Y

Re-write as

V
PM
Y
=

Price level is proportional to the money stock

Quantity theory states that changes in M cause
(proportional) changes in P.
43

Inflation and Money Growth

Re-write levels model
P M k

as one in growth rates

%P %M %k

Inflation rate = growth rate of money + growth of k

44

Inflation and Money Growth

%P %M %k

Assume:
%k 0

Remember k is ratio of constants

Let %P

%M
Inflation rate = growth rate of money
45

Empirical Evidence

46

Money Growth and Inflation in Australia 1950-83

30.0

25.0

% per year

20.0

15.0

10.0

5.0

0.0

1982

1980

1978

1976

1974

1972

1970

1968

1966

1964

1962

1960

1958

1956

1954

1952

1950
-5.0

M3 growth

Inflation

47

Question
What is Australias central bank?
(a) Treasury
(b) Fed
(c) RBA
(d) ECB
(e) RBNZ

48

Question
What is Australias central bank?
(a) Treasury
(b) Fed
(c) RBA
Reserve Bank of Australia
(d) ECB
(e) RBNZ

49

Question
According to the RBA Act of 1959 which of the following
is not a requirement of the RBA?
(a) Contribute to the stability of the currency
(b) Maintain a fixed exchange rate
(c) Maintenance of full employment
(d) Contribute to welfare and prosperity of Australians
(e) Maintenance of inflation between 2-3 percent per
annum

50

Question
According to the RBA Act of 1959 which of the following
is not a requirement of the RBA?
(a) Contribute to the stability of the currency
(b) Maintain a fixed exchange rate
(c) Maintenance of full employment
(d) Contribute to welfare and prosperity of Australians
(e) Maintenance of inflation between 2-3 percent per
annum
51

Reserve Bank of Australia (RBA)

Central Bank
responsible for operation of monetary policy
stability and efficiency of financial markets
promoting efficiency of payments system

52

Australias Framework for Monetary Policy

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?
53

-1.0

Mar-2014

Sep-2013

Mar-2013

Sep-2012

Mar-2012

Sep-2011

Mar-2011

Sep-2010

Mar-2010

Sep-2009

Mar-2009

Sep-2008

Mar-2008

Sep-2007

Mar-2007

Sep-2006

Mar-2006

Sep-2005

Mar-2005

Sep-2004

Mar-2004

Sep-2003

Mar-2003

Sep-2002

Mar-2002

Sep-2001

Mar-2001

Sep-2000

Mar-2000

Sep-1999

Mar-1999

Sep-1998

Mar-1998

Sep-1997

Mar-1997

Sep-1996

Mar-1996

Year-ended inflation rate

Headline Inflation and the RBAs Target Range

7.0

6.0

5.0

4.0

3.0

2.0

1.0

0.0

54

Question
What is the monetary policy instrument used by the RBA?
(a) The growth rate of the money supply
(b) Management of the exchange rate
(c) An interest rate target
(d) An inflation target
(e) A price level target

55

Question
What is the monetary policy instrument used by the RBA?
(a) The growth rate of the money supply
(b) Management of the exchange rate
(c) An interest rate target
cash rate
(d) An inflation target
(e) A price level target

Overnight interbank rate

56

RBAs Operating Procedures

Announces target value for the cash rate

Intervenes in cash market to ensure

Actual cash rate = Target cash rate
Current (since 4th Feb 2015) cash rate target is 2.25%
57

Jan-1990

Jan-2014

May-2013

Sep-2012

Jan-2012

May-2011

Sep-2010

Jan-2010

May-2009

Sep-2008

Jan-2008

May-2007

Sep-2006

Jan-2006

May-2005

Sep-2004

Jan-2004

May-2003

Sep-2002

Jan-2002

May-2001

Sep-2000

Jan-2000

May-1999

Sep-1998

Jan-1998

May-1997

Sep-1996

Jan-1996

May-1995

Sep-1994

Jan-1994

May-1993

Sep-1992

Jan-1992

May-1991

Sep-1990

Percent per-annum

RBAs Target for the Cash Rate (monthly)

18.00

16.00

14.00

12.00

10.00

8.00

6.00

4.00

2.00

0.00

58

How does the RBA achieve its Target for the Cash Rate?
1.

Exchange Settlement Accounts (ESA)/ Exchange

Settlement Funds (called cash)

2.

Banks borrow and lend cash on short-term basis.

There is a market for cash.

3.

RBA intervenes in cash market:

Sets interest rates at which it will borrow and lend
to banks
Conducts open market operations with banks
59

Role of Exchange Settlement Accounts and Exchange

Settlement Funds (or cash)
Banking Systems Balance Sheet
Assets
Liabilities
Reserves = $100m
Deposits = $1,000m
Loans = $900m
Banks hold reserves at RBA in exchange settlement
accounts (ESA).
Banks not allowed to overdraw their ESA
60

Role of ESAs
Banks use ESA to clear debts (or credits) with other
banks.
If ANZ owes $20m to Westpac, then funds are simply
transferred between their ESAs.
ANZ ESA (-$20m)
Westpac ESA (+$20)
Interbank transfers will change the distribution of cash,
but will not affect the overall level of cash in the system.
61

Overnight Cash Market

Suppose ANZ finds its level of cash holdings to be
undesirably low?
Overnight cash market
Specialised market where banks are able to trade
cash
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.

62

From Last Weeks lecture

Banks hold ESA with RBA
Use accounts to settle debts
Funds held in ESA are called cash
Banks borrow and lend cash in cash market
RBA target value for cash rate

63

Overnight Cash Market

What would cash market look like without any RBA

intervention?

64

Overnight Cash Market (without RBA intervention)

cash
rate

D
Cash (ES funds)
65

How the RBA Maintains its Cash Rate Target

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.
66

1. Open Market Operations

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.

67

Maintaining the Current Target Cash Rate = 2.5%.

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 to banks 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 from banks and this will
increase the supply of cash.

68

2. A Channel for the Cash Rate

There are two additional mechanisms used by the RBA
to help ensure it achieves its cash rate target.
Interest Rate on Reserves (IROR)
The RBA pays interest in funds held in ESA accounts
at rate which is 0.25% below its cash rate target. At
present it would be 2.5 0.25 = 2.25%. Lower
bound for cash rate.
69

A Channel for the Cash Rate

Re-discount rate
Banks can, at any time, borrow cash (using bonds as
security) from the RBA at a rate that is 0.25% above
the target cash rate (at present this would be
2.75%). Upper bound for cash rate

70

RBA announces a target value for cash rate as its policy

instrument. Cash rate shall be 2.5%.
cash
S
rate

D
ES funds (cash)
But actual cash rate is above 2.5 per cent!
71

RBA announces a target value for cash rate as its policy

instrument. Cash rate shall be 2.5%.
cash
S
rate

2.5
D
ES funds (cash)
But actual cash rate is above 2.5 per cent!
72

First. Bound the demand curve to lie in a narrow

channel around the target.
cash
rate

2.75
2.5
2.25

RBA lends
Interest on
Reserves
ES funds (cash)
73

Demand curve is truncated. (Why?)

cash
rate

2.75
2.5
2.25

RBA lends
Interest on
Reserves
ES funds (cash)

74

Second. RBA uses open-market-operations to adjust

supply of cash (ES funds) so that S = D.
cash
S
S
rate

2.75
2.5
2.25

RBA lends
Interest on
Reserves
ES funds (cash)

RBA buys bonds from Banks.

75

The Cash Rate and Longer Term Interest Rates

Under its current operating procedures the RBA has little
difficulty achieving its target for the cash rate.
However the cash market is highly specialised and the
cash rate is for very short-term borrowing and lending.
Not clear how the cash rate is relevant to the
consumption and investment decisions of households
and firms. Likely to be influenced by longer-term
interest rates
76

Movements in Longer-Term Rates Tend to be Linked to

the Cash Rate

77