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MAE203, T1, 2016

Lecture 8, week 8

Topic 5
Monetary System and Monetary Policy

Chapters 11 and 12
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Chapter 11
Monetary System
Money, Banks and
the Reserve Bank of
Australia

somchaij/Shutterstock

Learning objectives
1. Define money and discuss its functions.
2. Discuss the definitions of the money supply used in
Australia today.
3. Explain how financial institutions create money.
4. Discuss the role of the Reserve Bank of Australia.
5. Overview the quantity theory of money and use it to
explain how high rates of inflation can occur.

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Burmas people turn to gold for


savings

If a countrys government creates too much money, this can lead


to very high rates of inflation and economic collapse. The rapid
inflation in Burma (Union of Myanmar) has led to some people
resorting to other forms of money which keep their value, such
as gold.
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LEARNING OBJECTIVE 1

What is money and why do we


need it?
Money: Assets that people are generally willing to
accept in exchange for goods and services or for
payment of debts.
Asset: Anything of value owned by a person or firm.

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LEARNING OBJECTIVE 1

What is money and why do we


need it?
Barter and the invention of money
Barter is the exchange of goods or services for other
goods or services.
Barter requires a double coincidence of wants.
Commodity money: A good used as money that
also has value independent of its use as money.
Money makes exchange easier thereby allowing for
specialisation and higher productivity.
6

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Making

the

Connection 11.1

Money in a World War II


prisoner of war camp

During World War II


cigarettes were used
as money in some
prisoner of war
camps.

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LEARNING OBJECTIVE 1

What is money and why do we


need it?
The functions of money

1.

Medium of exchange.

2.

Unit of account.

3.

Store of value.

4.

Standard of deferred payment.

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LEARNING OBJECTIVE 1

What is money and why do we


need it?
What can serve as money?

There are five criteria that make a good suitable


to use as a medium of exchange.

1. The good must be acceptable to most people.


2. It should be of a standardised quality.
3. It should be durable.
4. It should be valuable relative to its weight so
that it can be easily transported.
5. It should be divisible.
9

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LEARNING OBJECTIVE 1

What is money and why do we


need it?
What can serve as money? cont.
Commodity money meets the criteria for a medium
of exchange, but has the problem that its value
depends on its quality.
e.g. gold is a medium of exchange but its value
depends on its purity.

Fiat money: Money, such as paper currency, that is


authorised by a central bank or government body and
that does not have to be exchanged by the central
bank for gold or some other commodity money.
10

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LEARNING OBJECTIVE 2

How do we measure money today?

11

Currency: Notes and coins held by the private


non-bank sector.

M1: The narrowest definition of the money supply


which is comprised of currency plus the value of all
demand deposits with banks.

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LEARNING OBJECTIVE 2

How do we measure money today?

12

Demand deposits: Also called current deposits,


these are deposits in financial institutions that are
transferable by cheque, by debit cards at EFTPOS
terminals and through electronic transfer between
accounts.

They are called demand deposits because they are


available on demand, and are repayable in notes
and coins.

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LEARNING OBJECTIVE 2

How do we measure money today?


Broader definitions of money
M3: M1, plus all other deposits of the private nonbank sector with domestic and foreign-owned banks
operating in Australia.
Includes certificates of deposit, term deposits and
deposits with banks from building societies, credit
unions and other authorised deposit-taking
institutions.

13

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LEARNING OBJECTIVE 2

How do we measure money today?


Broader definitions of money, cont.
Broad Money: M3, plus deposits into non-bank
deposit-taking institutions minus holdings of
currency and deposits of non-bank depository
corporations.
Non-bank depository corporations include finance
companies, money market corporations and cash
management trusts.

14

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

Measuring the money supply, Australia, March 2014: Figure 11.1

Source: Created from Reserve Bank of Australia (2014), Monetary Aggregates, Table D03 at <www.rba.gov.au>, viewed 16 May 2014.

15

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LEARNING OBJECTIVE 2

How do we measure money today?


Credit
Credit: Loans, advances and bills provided to the
private non-bank sector (individuals and firms) by all
financial intermediaries.
Credit is not a form of money, but is now used by
the Reserve Bank of Australia (RBA) as a main
measure of monetary movements in Australia.

16

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LEARNING OBJECTIVE 2

How do we measure money today?


Credit, cont.
Australia, March 2014: Total credit was
$2237.9 billion.
Total credit comprised:
Owner-occupier housing loans: $905 billion.
Investment housing loans: $445.1 billion.
Other personal loans: $141.8 billion, of which credit
cards comprised $49.8 billion.
Business loans: $746 billion.
17

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LEARNING OBJECTIVE 3

How do financial institutions


create money?
Bank balance sheets
Reserves: Deposits that a bank keeps as cash in its
vault or on deposit with the Reserve Bank of
Australia.
Reserve ratio (RR): A banks ratio of reserves to
deposits.
Excess reserves: Reserves above the normal ratio of
reserves to deposits.
A loan is an asset to a bank and a deposit is a
liability to a bank.
18

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Balance sheet for Save-IT Bank: Figure 11.2


Liabilities and shareholders
equity ($ millions)

Assets ($ millions)
Reserves

50 000

Loans

240 000 Short-term borrowing

Deposits with other banks


Securities
Buildings and equipment

5 000 Long-term debt


100 000
5 000

Other assets

110 000

Total assets

510 000

19

Deposits

Other liabilities
000
Total liabilities
Shareholders equity
Total liabilities and
shareholders equity

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300 000
60 000
50 000
40
450 000
60 000
510 000

LEARNING OBJECTIVE 3

How do financial institutions


create money?
Using T-accounts to show how a bank can create
money

20

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LEARNING OBJECTIVE 3

How do financial institutions


create money?
Using T-accounts to show how a bank can create
money, cont.
Assume Save-IT lends $900 (it is keeping 10% of
the deposit in reserve), which is spent, and the
recipient of the funds deposits them with Thrifty
Bank. Thrifty Banks reserves increase by $900.
The money supply has now increased by $900.

21

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 3

How do financial institutions


create money?
Using T-accounts to show how a bank can create
money, cont.

22

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 3

How do financial institutions


create money?
Using T-accounts to show how a bank can create
money, cont.

23

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LEARNING OBJECTIVE 3

How do financial institutions


create money?
Using T-accounts to show how a bank can create
money, cont.
Thrifty Bank lends $810 of the $900. By making an
$810 loan, Thrifty Bank has increased both its loans
and its deposits by $810.

24

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Using T-accounts to show how a bank can create money

25

Bank

Increase in demand account


deposits

Save-IT

$1000

Thrifty

900 (= 0.9 x $1000)

Third Bank

810 (= 0.9 x $900)

Fourth Bank

729 (= 0.9 x $810)

Total change in
demand account
deposits

$10 000

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LEARNING OBJECTIVE 3

How do financial institutions


create money?
The simple deposit multiplier
Simple deposit multiplier: The ratio of the amount
of deposits created by banks to the amount of new
reserves.

1
Simple deposit multiplier
RR

26

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LEARNING OBJECTIVE 3

How do financial institutions


create money?
The simple deposit multiplier versus the realworld deposit multiplier
The real-world deposit multiplier is smaller than the
simple deposit multiplier because:
banks may hold excess reserves.
people do not deposit all their money.
Households and firms keep roughly constant the
amount they hold in currency relative to the
value of their savings account balances.
27

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LEARNING OBJECTIVE 4

The Reserve Bank of Australia


The Reserve Bank of Australia
Reserve Bank of Australia (RBA): The central
bank of Australia.
The RBA has two major roles:
1.To maintain the financial integrity and stability of the
Australian financial system.
2.To implement monetary policy.
Monetary policy: The actions taken by the Reserve
Bank of Australia to manage interest rates in the
pursuit of macroeconomic goals.
28

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LEARNING OBJECTIVE 4

The Reserve Bank of Australia


How the RBA manages financial liquidity and
interest rates
Cash rate: The interest rate on loans in the
overnight money market.
Open market operations (OMOs): The RBA
purchasing or selling financial instruments such as
Commonwealth Government Securities and private
bonds and securities, either by outright purchase or
sale, or by the use of repurchase agreements
.

29

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LEARNING OBJECTIVE 4

The Reserve Bank of Australia


How the RBA manages financial liquidity and
interest rates, cont.
Repurchase agreement: The RBA offers to buy (or
sell) Commonwealth Government Securities and other
eligible financial instruments from banks or other
authorised financial dealers, provided the same banks
or dealers are prepared to repurchase (or resell) them
at a future date, often in a few days time, at a price
agreed at the outset.

30

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LEARNING OBJECTIVE 4

The Reserve Bank of Australia


How the RBA manages financial liquidity and
interest rates, cont.
The majority of RBA intervention in financial markets
is to sterilise, or offset, daily liquidity deficits and
surpluses, to keep interest rates stable.
To change interest rates, the RBA may not offset an
overnight surplus or shortage of funds in the financial
system, or the RBA may engage in OMOs.

31

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LEARNING OBJECTIVE 4

The Reserve Bank of Australia


Exchange rate management
The value of the Australian dollar is determined by
the interaction of the demand for and supply of the
Australian dollar in international currency markets.
However, the RBA very occasionally intervenes by
buying and/or selling Australian dollars.
The RBA also manages Australias foreign currency
and bonds, and gold reserves.

32

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LEARNING OBJECTIVE 5

The quantity theory of money


Connecting money and prices: The equation of
exchange
The connection between the quantity of money and
the price level is expressed in the following equation,
formalised by economist Irving Fisher.

M xV P xY
M = money supply; V = velocity of money
P = price level; Y = real GDP

33

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LEARNING OBJECTIVE 5

The quantity theory of money


Connecting money and prices: The equation of
exchange, cont.
Velocity of money: The average number of times
each dollar in the money supply is used to purchase
goods and services which are included in GDP.

P xY
V
M

34

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LEARNING OBJECTIVE 5

The quantity theory of money


The quantity theory explanation of inflation

The equation of exchange is transformed to:


Growth rate of money supply + growth rate of velocity
= growth rate of the price level (or inflation rate) +
growth rate of real GDP (or economic growth rate).

Which can be rearranged as:


Inflation rate = growth rate of money supply + growth
rate of velocity economic growth rate.

35

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LEARNING OBJECTIVE 5

The quantity theory of money


The quantity theory explanation of inflation, cont.
Irving Fisher was incorrect in stating that V is
constant.
Quantity theory of money predictions do not hold true
from year to year.
However, in the long run, the quantity theory
provides useful insights:

36

Inflation results from the money supply growing at


a faster rate than the economic growth rate.
Correlation and causation?

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LEARNING OBJECTIVE 5

The quantity theory of money


High rates of inflation

37

Hyperinflation is caused by central banks


increasing the money supply at a rate far in excess
of the economic growth rate.

Governments in some developing countries can


have difficulty in selling bonds to the public to fund
budget deficits, so they force their central banks to
buy the bondsthis can be very inflationary.

Germany (1922 - 1923), Turkey (1999 2006),


Zimbabwe (2004 2008)

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Making

the

Connection 11.3

The German hyperinflation


of the early 1920s

During the post-WWI


hyperinflation of the
1920s, people in
Germany used paper
currency to light their
stoves.

38

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Making
the

Connection 11.2

Coca-Cola dries up as the


Zimbabwe currency no longer
serves as money

People in Africa buy more


than 36 billion bottles of
Coca-Cola a year. In 2008,
Zimbabwe ran out of locally
produced Coke for the first
time in at least 40 years.
Because they could not
obtain US dollars, local Coke
bottlers were not able to
import from the United
States the concentrated
syrup used to make Coke.
39

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An inside look
An Australasian currency?
There could be
considerable advantages
to having a single
currency common to
Australia and New
Zealandbut opponents
point to the lack of the
ability to control domestic
monetary policy and
therefore interest rates
and inflation.

40

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Chapter 12
Monetary Policy

PowerPoint to accompany:

somchaij/Shutterstock

Learning objectives
1. Define monetary policy and describe the main goals of
monetary policy in Australia.
2. Describe how the Reserve Bank of Australia affects
interest rates.
3. Use the dynamic aggregate demand and aggregate
supply model to show the effects of monetary policy on
real GDP and the price level.
4. Discuss the Reserve Bank of Australias use of monetary
policy to target inflation.
5. Assess the arguments for and against the independence
of the Reserve Bank of Australia.
42

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Interest rates affect house prices


Home buyers are among the
hardest hit when the RBA
increases interest rates. The
eight successive interest rate
rises between 2005 and 2008
caused average mortgage
repayments to rise
significantly, reducing home
purchase affordability and
leading to a fall in house
prices in some areas.
During the economic contraction that followed the global financial
crisis, interest rates were lowered and remained at historical lows
in 2014. This increased the demand for mortgages and housing,
pushing up house prices and reducing affordability.
43

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LEARNING OBJECTIVE 1

What is monetary policy?


Monetary policy: The actions taken by the Reserve
Bank of Australia to manage interest rates in the
pursuit of macroeconomic goals.

The goals of monetary policy


1. Full employment of the labour force.
2. Stability of the Australian currency.
3. Economic prosperity and welfare for the people of
Australia.

44

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LEARNING OBJECTIVE 1

What is monetary policy?


The goals of monetary policy, cont.
Since 1993 the Reserve Bank of Australia (RBA) has
focused monetary policy mainly on achieving price
stability.
Inflation targeting: Conducting monetary policy so
as to commit the central bank to achieving a publicly
announced level of inflation.
The RBAs target inflation rate is between 2% and
3% per annum, on average over the business cycle.
45

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

The rate of inflation, Australia (actual and trend) 1993


2014: Figure 12.1

46

Source: Reserve Bank of Australia (2014), Measures of consumer price inflation, Table G01, at <www.rba.gov.au>, viewed 18 May 2014.
Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 2

The demand for and supply of


money
The demand for money
The money demand curve is downward sloping to
show the inverse relationship between the interest
rate on financial assets and the quantity of money
demanded.
The interest rate on financial assets is the
opportunity cost of holding money.
Low interest rates reduce the opportunity cost of
holding money.
High interest rates increase the opportunity cost of
holding money.
47

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The demand for money: Figure 12.2


Interest
rate, i
1. A
decrease in
the interest
rate

2. causes an
increase in the
quantity of money
demanded.

7%
6%

Money demand, MD
0
48

$250

300

Quantity of money, M
(billions of dollars)

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Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 2

The demand for and supply of


money
Shifts in the money demand curve

Changes in variables other than the interest rate


cause the money demand curve to shift.

The two most important variables that shift the


money demand curve are:
1. Real GDP.
2. The price level.

49

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Shifts in the demand for money: Figure 12.3


Interest
rate, i

An increase in real
GDP or an
increase in the
price level will shift
money demand to
the right.

A decrease in
real GDP or
a decrease in
the price
level will shift
money
demand to
the left.

MD2
MD3
0
50

MD1
Quantity of money, M
(billions of dollars)

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Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 2

The demand for and supply of


money
How the RBA manages the supply of cash
Recall from Chapter 11: The RBA uses open market
operations to sterilise liquidity changes in the
financial system, in order to keep the interest rate
the same.
Open market operations (OMOs): The RBA
purchasing or selling financial instruments such as
Commonwealth Government Securities and private
bonds and securities, either by outright purchase or
sale, or by the use of repurchase agreements.
51

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Open market operations

52

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LEARNING OBJECTIVE 2

The demand for and supply of


money
How the RBA manages the supply of cash, cont.
Repurchase agreements are widely used by the RBA
in its OMOs.
Cash rate: The interest rate on loans in the
overnight money market.
The cash rate is determined by the interaction of
demand for and supply of funds in the overnight
money market.
53

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LEARNING OBJECTIVE 2

The demand for and supply of


money
How the RBA manages the supply of cash, cont.
The majority of RBA intervention in financial markets
is to sterilise, or offset, daily liquidity deficits and
surpluses, to keep interest rates stable.
To change the cash rate, the RBA may not offset an
overnight surplus or shortage of funds in the financial
system, or the RBA may engage in OMOs to create a
shortage or surplus of funds.
A change in the cash rate typically flows through the
financial system impacting all interest rates.
54

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Short-term interest rates, Australia, 1985-2013: Figure 12.4

55

Source: Reserve Bank of Australia (2014), About Monetary Policy, Graph 2 at <www.rba.gov. au>, viewed 24 January 2014. Reserve Bank of Australia,
20012010. All rights reserved.
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2015 Pearson
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divisionofofPearson
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Ltd)
9781486010233/Hubbard/Macroeconomics
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LEARNING OBJECTIVE 2

The demand for and supply of


money
How the RBA manages the supply of cash, cont.
Exchange settlement accounts (ESAs): Accounts
held with the RBA by banks and other financial
institutions to enable the overnight transfer of funds
(cash) between financial institutions, and between the
RBA and financial institutions.
ESAs enable real-time gross settlement (RTGS) through
the RBA information and transfer system (RITS).
Balances held in ESAs are called exchange settlement
funds.
56

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LEARNING OBJECTIVE 2

The demand for and supply of


money
How the RBA manages the supply of cash, cont.
To reduce the cash rate, the RBA publicly announces
that it intends to do so.
The RBA will then either:
not sterilise an overnight surplus, or
offer to buy back repurchase agreements, or make
outright purchases of bonds.

When the RBA pays for the bonds, this increases


cash reserves held by financial institutions and the
rate of interest will fall.
57

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LEARNING OBJECTIVE 2

The demand for and supply of


money
How the RBA manages the supply of cash, cont.
To increase the cash rate, the RBA publicly
announces that it intends to do so.
The RBA will then either:
not sterilise an overnight shortage, or
use reverse repurchase agreements or carry out the
outright sale of bonds.

When the RBA receives payment for the bonds, this


reduces cash reserves held by financial institutions
and the rate of interest will rise.
58

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LEARNING OBJECTIVE 2

The demand for and supply of


money
Equilibrium in the money market
The RBA will use monetary policy to keep interest
rates at its target rate.
Therefore the money supply curve is a horizontal
line at the current interest rate.

59

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Interest rate targeting: Figure 12.5A


Interest rate
(per cent per
year)

Money
supply, MS

7%

MD
0
60

$900

Quantity of money
(billions of dollars)

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LEARNING OBJECTIVE 2

The demand for and supply of


money
Equilibrium in the money market, cont.
In the 1970s and 1980s, the RBA used to use
monetary targeting.
Monetary targeting: Conducting monetary policy
to control the size and rate of growth of the money
supply.
Therefore the money supply was exogenously
determined by the RBA, and the money supply curve
was therefore vertical.
The RBA no longer uses monetary targeting, and
instead uses interest rate targeting.
61

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Monetary targeting: Figure 12.5B


Interest rate
(per cent per
year)

Money
supply, MS1

MS2

7%

1. When the
RBA increases
the money
supply from MS1
to MS2

6%

2. the
equilibrium
interest
rate falls.

MD
0

62

$900

950

Quantity of money
(billions of dollars)

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Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 2

The demand for and supply of


money
A tale of two interest rates
The loanable funds model (see Chapter 5) is
concerned with the long-term real rate of interest.
In the money market model, the focus is on the
short-term nominal rate of interest.
When conducting monetary policy, it is the shortterm nominal interest rate that is most affected by
increases and decreases in liquidity.
Often (but not always) there is a close connection
between movements in the short-term nominal
interest rate and the long-term real interest rate.
63

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LEARNING OBJECTIVE 3

Monetary policy and economic


activity
How interest rates affect aggregate demand
Changes in interest rates will not affect government
purchases, but they will affect the other three
components of aggregate demand:
1. Consumption.
2. Investment.
3. Net exports.

64

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LEARNING OBJECTIVE 3

Monetary policy and economic


activity
The effects of monetary policy on real GDP and the
price level
Over time, potential GDP increases and the LRAS
curve shifts to the right.
The factors shifting the LRAS also shift the SRAS curve
to the right, as firms will now be supplying more goods
and services.
During most years, aggregate demand also increases,
and the curve shifts to the right.
65

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LEARNING OBJECTIVE 3

Monetary policy and economic


activity
The effects of monetary policy on real GDP and the
price level, cont.
Sometimes, aggregate demand may not increase
enough to keep the economy at potential GDP.
Expansionary monetary policy may be used during
periods of economic contraction or recession.
The RBA may use expansionary monetary policy to
increase aggregate demand by more than it would
have increased without policy.
66

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LEARNING OBJECTIVE 3

Monetary policy and economic


activity
The effects of monetary policy on real GDP and the
price level, cont.
Expansionary monetary policy: The use of
monetary policy by the RBA to decrease interest rates
to increase real GDP.
The RBA decreases the cash rate.
This decrease typically flows through to decreases in
interest rates through the entire economy.

67

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LEARNING OBJECTIVE 3

Monetary policy and economic


activity
The effects of monetary policy on real GDP and the
price level, cont.
Lower interest rates may encourage investment,
increase net exports, and may increase consumer
spending. Real GDP and the price level will rise.
The dynamic aggregate demand and aggregate supply
model is used to illustrate expansionary monetary
policy.

68

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

Expansionary monetary policy: Figure 12.6


Price level
Expansionary
monetary
policy causes
the AD curve
to shift further
to the right.

LRAS1

LRAS2
SRAS1
SRAS2

103

102
100

B
AD2(with policy)
AD2(without
policy)

AD1
0
69

$1000

1075 1100

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

Real GDP (billions


of dollars)

Making

the

Connection 12.1

Too low for zero: A cash rate of


almost zero in the United States

The Federal Reserve in the United States pushed interest rates


almost to zero during and after the global financial crisis.

70

Source: Created from Federal Reserve (2014), Selected interest rates, Table H.15, Federal Reserve Statistical Release, at <www.federalreserve.gov>, viewed 23 January 2014.
Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 3

Monetary policy and economic


activity
Can the RBA eliminate contractions and recessions?
Keeping a contraction or recession milder than it would
otherwise have been is usually the best the RBA can do.
There may be a recognition laga delay before the
RBA recognises that a contraction is imminent.
The longest time lag with monetary policy is the
impact lagthe time taken for monetary policy to affect
real GDP.
71

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LEARNING OBJECTIVE 3

Monetary policy and economic


activity
Using monetary policy to fight inflation
Sometimes, aggregate demand may be increasing too
fast, leading to inflation, and the economy may be in
equilibrium beyond potential GDP.
Contractionary monetary policy is used during periods
of high or rising inflation rates.
The RBA uses contractionary monetary policy to slow
the rate of increase of aggregate demand to less than
it would have increased without policy.
72

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LEARNING OBJECTIVE 3

Monetary policy and economic


activity
Using monetary policy to fight inflation, cont.
Contractionary monetary policy: The use of
monetary policy by the RBA to increase interest rates
to reduce inflation.
The RBA increases the cash rate.
This increase typically flows through to increases in
interest rates through the entire economy.

73

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 3

Monetary policy and economic


activity
Using monetary policy to fight inflation, cont.
Higher interest rates may reduce new investment
growth, decrease net exports, and may reduce the
growth rate of consumer spending. The slower
growth in aggregate demand may reduce the
inflation rate.

74

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

Contractionary monetary policy: Figure 12.7


Price level
Contractionary
monetary policy
causes the AD
curve to shift to
the right by less
104
than it would
have without
103
policy.

100

LRAS1

LRAS2
SRAS1
SRAS2

B
A

AD2(without policy
AD2(with policy)
0
75

AD1
930

1000 1030

Real GDP (billions


of dollars)

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 3

Monetary policy and economic


activity
Is monetary policy always effective and fair?
Time lags may reduce the ability of monetary policy
to impact on the economy at the appropriate time.
Over the past two decades the RBA has largely been
successful in anticipating inflation and understanding the
lags.

As banks and financial institutions are not required to


pass on cash rate changes, the effectiveness of
monetary policy can be reduced.
In recent years, banks in Australia have not always
passed on to customers the full amount of an interest
rate reduction.
76

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LEARNING OBJECTIVE 3

Monetary policy and economic


activity
Is monetary policy always effective and fair? cont.
Monetary policy is more effective at reducing the rate
of inflation during an economic boom than it is at
stimulating aggregate demand during a contraction
or recession.
Businesses will be unwilling to borrow if the
economic outlook is not good.
Banks may also be reluctant to make loans, as
occurred in some countries following the 2007-2008
global financial crisis.
77

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LEARNING OBJECTIVE 3

Monetary policy and economic


activity
Is monetary policy always effective and fair? cont.
Monetary policy is a blunt instrument and does not
affect all people or industries equally.
With contractionary monetary policy:
Savers can benefit and increase their spending.
Borrowers (individuals and businesses) face higher
interest repayments on loans.
Low income earners are often marginal borrowers, and
may be at a higher risk of loan defaults.

With expansionary monetary policy borrowers benefit


more than savers.
78

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Making

the

Connection 12.2

Why does the share market care


about monetary policy?

The share market


reacts when the
RBA implements
policy to either
raise or lower
interest rates.

79

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

Expansionary and contractionary monetary policy: Figure 12.8


(a) An expansionary policy
Reserve
Bank Board
decreases
the cash
rate

Other
interest
rates fall

Investment,
consumption
and net
exports
increase

The AD
curve shifts
to the right
by more
than it
otherwise
would have

(b) A contractionary policy


Reserve
Bank Board
increases
the cash
rate
80

Other
interest
rates rise

Investment,
consumption
and net
exports
decrease

The AD
curve shifts
to the right
by less
than it
otherwise
would have

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

Real GDP
and the
price level
rise by
more than
they would
have
without
policy
Real GDP
and the
price level
rise by less
than they
would have
without
policy

LEARNING OBJECTIVE 4

Should the RBA target inflation?


Arguments in favour of inflation targeting:
1. In the long run there is no impact of monetary
policy on potential GDP.
2. Having an explicit inflation target makes it easier
for firms and households to form expectations of
future inflation, thereby improving planning and
efficiency.
3. Monetary policy is less subject to a change in
emphasis, particularly when members of the
Reserve Bank Board change.
4. An inflation target provides a measure of the RBAs
performance.
81

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LEARNING OBJECTIVE 4

Should the RBA target inflation?


Arguments against inflation targeting:
1.The ability of the RBA to directly pursue its other
goals is limited.
2.An inflation target policy assumes that the RBA can
accurately forecast future inflation rates, which it
does not always do.
3.Making the RBA only accountable for inflation
targeting may make it less accountable for its other
policy goals, such as low unemployment, economic
growth or exchange rate management.
82

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Making

the

Connection 12.3

How does the RBA measure


inflation?

It is very important for the RBA to have an accurate


understanding of the current underlying rate of
inflation when it is implementing monetary policy.
Therefore in addition to
looking at the CPI, the RBA
also uses other measures
of consumer inflation.
Exclusion-based measures
Trimmed mean measure

83

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LEARNING OBJECTIVE 5

Is the independence of the Reserve


Bank of Australia a good idea?
The case for RBA independence

84

Avoids inflationary spending by the government of


the day, which may sell bonds to the central bank
to finance excessive spending.

Avoids the use of monetary policy to further other


political goals. For example, lowering interest rates
before an election.

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

LEARNING OBJECTIVE 5

Is the independence of the Reserve


Bank of Australia a good idea?
The case against RBA independence

85

An independent central bank is not directly


accountable to voters, and may implement
monetary policy against the wishes of the
electorate.

Too much economic power may be concentrated in


the hands of a single or small group of non-elected
peoplethose on the RBA Board.

Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e

An inside look
The Bank of England holds record low rates

Figure 1: The UK central bank reduced interest rates to close to


zero during and after the GFC.

86

Source: Created from Bank of England (2014), Annual


average official bank rate, Statistics, at
<www.bankofengland.co.uk>, viewed 23 January 2014.
Copyright 2015 Pearson Australia (a division of Pearson Australia Group Pty Ltd) 9781486010233/Hubbard/Macroeconomics 3/e