Week 7

Lectures 13 & 14 Money, Prices and the Reserve Bank

Reference: Bernanke, Olekalns and Frank - Chapter 7 Key Issues Money and its uses Private banks and money creation Money and prices Reserve Bank of Australia Cash rate and exchange settlement funds

What is Money? Defined by its uses or its functions: Medium of exchange Unit of account Store of value

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. 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
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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 Significant reduction in costs of search
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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

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 possess the medium of exchange or unit of account functions of money.

Measuring Money In modern economies money is provided by: Government (currency notes and coin) Banking system (deposits) Standard Measures of Money for Australia $ billion (end-June 2009) Currency 45.5 M1 249.8 M3 1,182.2 Broad Money 1,257.0

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)
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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. Banking Systems Balance Sheet Assets Liabilities Reserves = $100m Deposits = $100m

100 Percent Reserve Banking This is a very simple banking system. Banks take deposits and place the currency in their vaults. These funds are called bank reserves. Like a safe-deposit facility. Banks could earn income by charging a fee for safeguarding and managing the currency. 100 percent reserve banking system.

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Bank Loans Banks decide that it is unnecessary 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. Some households and firms for demand additional currency and banks can lend out their excess reserves to these borrowers in the form of bank loans. Banks are now financial intermediaries.
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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% Banking Systems Balance Sheet(1) Assets Liabilities Reserves = $10m Deposits = $100m Loans = $90m Where does the $90m lent to households and firms go?
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Loans get Re-deposited into Banks Banking Systems Balance Sheet(2) Assets Liabilities Reserves = $10m 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
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Banks Make Additional Loans and they Re-Deposited Banking Systems Balance Sheet(3) Assets Liabilities Reserves = $19m 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.

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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)
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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 it does find its R/D ratio declining (0.53, 0.37) towards its desired ratio of 10%. Notice that it is the increase in deposits that is driving the ratio downwards. Lets solve for D in: $100m/D = 0.10 D = $1,000m
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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

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Deposit Multiplier Banks desired reserve-deposit ratio Bank reserves = (desired) reserve-deposit ratio Bank deposits or Deposits = Reserves (desired) reserve-deposit ratio
R D= rd
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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

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Money and Prices 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

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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)? Velocity Value of Transactions Money Stock
P Y V M
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Nominal GDP Money Stock

Velocity of Circulation in Australia Nominal GDP in March quarter 2009 = $330.33 billion Nominal GDP over 12 months to March quarter 2009 = $1,200.07 billion $ billion V V (end-March 2009) (qtr) (annual) Currency 44.4 7.4 27.0 M1 243.0 1.4 4.9 M3 1,148.4 0.29 1.04 Broad Money 1,228.7 0.27 0.98

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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. What we care about is the quantity theory.
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Quantity Theory The quantity theory makes two economic assumptions: Velocity is constant, and Output is constant Quantity Equation becomes Quantity Theory
M V = P Y
M V P Y

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Quantity Theory of Prices Quantity Theory

M V = P Y V P = M = M k Y

Re-write as

Price level is proportional to the money stock Quantity theory states that changes in M cause (proportional) changes in P.

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Inflation and Money Growth Re-write levels model

P = M k

as one in growth rates

%P = %M + %k

assume %k = 0 and let = %P

= %M
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Empirical Evidence

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Money Growth and Inflation in Australia 1950-83

30.0 25.0

20.0

% per year

15.0

10.0

5.0

0.0

1950
-5.0

1952

1954

1956

1958

1960

1962

M3 growth

1964

1966

1968

1970

Inflation

1972

1974

1976

1978

1980

1982
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Reserve Bank of Australia (RBA) Central Bank responsible for operation of monetary policy stability and efficiency of financial markets RBA Act 1959: RBAs operations should contribute to: (a) the stability of the currency of Australia; (b) the maintenance of full employment in Australia; and the economic prosperity and welfare of the people of (c) Australia.

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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?

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Year-ended % change
-1.0 0.0 1.0 2.0 3.0 4.0 5.0 6.0 7.0

Mar-96 Mar-97 Mar-98 Mar-99 Mar-00 Mar-01 Mar-02 Mar-03 Mar-04 Mar-05 Mar-06 Mar-07 Mar-08 Mar-09
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Headline Inflation and the RBAs Target Range

RBAs Operating Procedures 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 (since 5th May) cash rate target is 4.5%

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% per annum
10.00 12.00 14.00 16.00 18.00 0.00 2.00 4.00 6.00 8.00

Jan-90 Jan-91 Jan-92 Jan-93 Jan-94 Jan-95 Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09

RBAs Target for the Cash Rate

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Institutional Arrangements 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.

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Role of ESAs 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?

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Overnight Cash Market 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.
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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.

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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.

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Maintaining the Current Target Cash Rate = 4.5%. If there is excess cash in the system so that there is pressure for the cash rate to fall below 4.5%, 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 4.5%, RBA will buy bonds and this will increase the supply of cash.

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Some Technicalities In its OMO the RBA rarely buys and sells government securities outright. Rather it uses repurchase agreements (repos). Here purchases and sales of securities are only for a certain period (say a week), after which the original transaction is reversed. Government spending and private sector tax payments also have an effect on the overall level of exchange settlement funds. Such effects are largely predictable and easily offset by the RBA through its OMO.

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A Channel for the Cash Rate There are two further mechanisms used by the RBA it is cash rate target. 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 4.5 0.25 = 4.25%. Lower bound for cash rate. Banks can, at any time, borrow cash from the RBA at a rate that is 0.25% above the target cash rate (at present this would be 4.75%). Upper bound for cash rate
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Target Cash Rate is Bounded Cash Rate 4.75 4.5 4.25

Qty of cash

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Banks Demand for Cash At any interest above 4.75 banks have zero demand for a stock of cash, since they can always get what they require from the RBA for 4.75%. At any interest rate below 4.25 banks will demand an infinite amount of cash, since they can always earn 4.25% from their exchange settlement accounts. Between 4.75 and 4.25 we just assume banks demand for cash is negatively related to the cash rate.

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Demand for Cash and the Target Cash Rate Cash Rate 4.75 4.5 4.25

Qty of cash

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RBA uses its OMO to Ensure the Quantity of Cash Equals Demand at its Target Cash Rate 4.75 4.5 4.25 Qty of Cash (determined by OMO)

Qty of cash

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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
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Movements in Longer-Term Rates Tend to be Linked to the Cash Rate

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