Chapter 11: Money, Banks and the Reserve Bank of Australia

Question 1

What are the functions of money?

Answer 1

1. It must act as a medium of exchange.
2. It must serve as a unit of account.
3. It must serve as a store of value.
4. It must offer a standard of deferred payment.

Question 2

Explain the following functions of money: medium of exchange

Answer 2

Money serves as a medium of exchange when sellers are willing to accept it in exchange for goods and services. An economy is more efficient when a single good is recognised as a medium of exchange.

Question 3

Explain the following functions of money: unit of account

Answer 3

In a barter system, each good has many prices. The function of money a unit of account, being a way of measuring value in the economy in terms of money.

Question 4

Explain the following functions of money: store of value

Answer 4

Money allows value to be stored easily: if you do not use your accumulate dollars to buy goods and services today, you can hold the rest to use in the future. Other assets also have – such as Telstra shares, government bonds, real estate or Renoir paintings – represents a store of value. However, the easy with which a given asset can be converted to a medium exchange does make money preferable (more liquid).

Question 5

Explain the following functions of money: standard of deferred payment

Answer 5

Money is useful because it can serve as a standard of deferred payment in borrowing and lending. Money can facilitate exchange at a given point in time by providing a medium of exchange and unit of account.

Question 6

What can serve as money?

Answer 6

1. The good must be acceptable to (usable by) most people
2. It should be a standardised quality so that any two units are identical
3. It should be durable so that value is not lost by spoilage
4. It should be valuable relative to its weight so that amounts large enough to be useful in trade can be easily transported
5. The medium of exchange should be divisible because different goods are valued differently

Question 7

How do we measure money today?

Answer 7

Economists have developed several different definitions of the money supply. Each definition includes a different groups of financial assets. The definitions range from narrow to broad and are based on how liquid the assets are.
This is the narrowest measure of money is currency. Then there is M1. Broader measures include other assets that can be easily converted to cash (being M3 and broad money).

Question 8

What is currency?

Answer 8

This is the narrowest measure of money. It includes notes and coins held by the private non-bank sector (individuals and firms).

Question 9

What is M1?

Answer 9

The narrowest definition of money supply which is composed of currency plus the value of all demand deposits with banks. Demand deposits = deposits in financial institutions that are transferable by debit cards at EFTPOS terminals, through electronic transfer between accounts and by cheque.

Question 10

What is M3?

Answer 10

M1 plus all other deposits of the private non-bank sector with domestic and foreign-owned banks operating in Australia. Specifically M3 also includes certificates of deposit, term deposits and deposits with banks from building societies, credit unions and other authorised deposit-taking institutions.

Question 11

What is broad money?

Answer 11

M3 plus deposits with non-bank deposit-taking institutions minus holdings of currency and deposits of non-bank depository corporations

Question 12

Explain figure 11.1: measuring the money supply

Answer 12

It is a pyramid with 4 levels:
Currency = top level, smallest
M1 = below and bigger than currency
M3 = bellow and bigger than M1
What is broad money = bottom level and biggest level

Question 13

What is credit?

Answer 13

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

Question 14

What are the key assets of a bank’s balance sheet?

Answer 14

Reserves, loans and holdings of securities (such as commonwealth government bonds).

Question 15

What are reserves?

Answer 15

Deposits that a bank keeps as cash in its vault (rather than loaned out or invested) or on deposit with the RBA. Most countries have a legal requirement that banks keep reserves.

Question 16

What are loans?

Answer 16

Banks make consumer loans to households and commercial loans to businesses. A loan is an asset to a bank because it represents a promise by the person taking out the loan to make certain specified payments to the bank. A bank’s reserves and its holdings of securities are also assets because they are things of value owned by the bank.

Question 17

How do you use T-accounts to show how a bank can create money?

Answer 17

It is easier to use a T-account then a balance sheet. A T-account is a stripped down version of a balance sheet that shows only how a transaction changes a bank’s balance sheet.
On the left of the T are the assets and on the right are the liabilities. The total value of all the entries on the right side must always be equal to the total value of all the entries on the left side.
Example:
Assets | Liabilities
______________________________________
Reserves +$1000 | Deposits +1000
Loans +$900 | Deposits +$900
An initial deposit of $1000 does not increase the money supply. Suppose banks keep 10% of deposits as reserves, banks do not earn interest on reserves, they have an incentive to loan out or buy securities with the other 90% = +$900 loan. By making this $900 loans, the bank has increased the money supply by $900. The initial $1000 deposited into a savings accounts has now been turned into $1900 in savings account deposits.

Question 18

What is the simple deposit multiplier?

Answer 18

The ratio of the amount of deposits created by banks to the amount of new reserves.
Simple deposit multiplier = 1/RR
RR = reserve ration
Change in demand account deposits = change in bank reserves x (1/RR)

Question 19

What is monetary policy?

Answer 19

The actions taken by the RBA to manage interest rates in the pursuit of macroeconomic objectives. In Australia, the primary goal of the RBA is to keep the inflation rate low, and more broadly to operate monetary policy to reduce economic fluctuations due to the business cycle or economic shocks.

Question 20

What is the aim of monetary policy in Australia?

Answer 20

To keep the rate of inflation between 2% and 3% per year on average, over time.

Question 21

How does the RBA manage financial liquidity and interest rates?

Answer 21

For the majority of time, involvement in the financial system revolves around altering daily liquidity in the financial system to keep interest rates unchanged, this daily altering is done through the overnight money market.

Question 22

Why does the overnight money market exist?

Answer 22

Every day there is a large volume of withdrawals from and injections into the financial system. This leads banks and other financial institutions to experience a shortage or a surplus of funds at the end of the day. If banks and other financial institutions experience a shortage of funds at the end of the day, funds have to be purchased overnight on the short-term money market. This increases the demand for overnight funds – known as cash.

Question 23

When happens when funds are purchased overnight on the short-term money market?

Answer 23

This increases demand for overnight funds – known as cash. According to the law of demand, this pushes up the price of overnight funds, which is the interest rate that financial institutions charge on loans or pay to borrow funds in the overnight money market, known as the cash rate.

Question 24

What is the cash rate?

Answer 24

The interest rate that financial institutions charge on loans or pay to borrow funds in the overnight money market. The cash rate is also the rate upon which all other interest rates are based.

Question 25

What would happen with the RBA intervention (through the OMM)?

Answer 25

Daily changes in liquidity would cause interest rates to fluctuate wildly and frequently.
E.g. bank reserves on the day each fortnight that the federal government pays its public sector wages and makes its social security payments: on these ‘pay days’, there is an increase in demand by the public for money which can cause banks to be in deficit at the end of the day. Without RBA intervention, the overnight cash rate would rise = increases in other interest rates.

Question 26

What are open market operations?

Answer 26

The RBA offsets the daily deficits or surpluses in liquidity in the financial system through the use of open market operations (AKA domestic market operations).
OMO involves 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.

Question 27

What are repurchase agreements?

Answer 27

The RBA’s offer to buy (or sell) commonwealth government securities an 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 agree at the outset.

Question 28

What can the RBA do in addition to its daily interventions?

Answer 28

If the RBA wishes to increase or decrease interest rates as part of its monetary policy objectives, it has to change liquidity levels actively in additions to its daily interventions.

Question 29

What is exchange rate management?

Answer 29

The RBA is also responsible for exchange rate management. The value of the Australian dollar relative to other currencies (the exchange rate) is usually determined by international market forces; that is, the demand and supply of AUD worldwide. However, occasionally the RBA intervenes in the market determination of the value of the Australian dollar in an attempt either to increase or decrease its value on international markets.

Question 30

How does the RBA increase the value of the AUD relative to other currencies?

Answer 30

A currency appreciation can take place by the RBA buying purchasing Australian dollars in foreign currency market to increase the demand for Australian dollars.

Question 31

How does the RBA decrease the value of the AUD relative to other currencies?

Answer 31

A currency depreciation can be achieved through the RBA increasing the supply of dollar on foreign currency markets by selling Australian dollars.

Question 32

Do RBA interventions always work?

Answer 32

No, and if they do work they may not be very successful if there are strong market forces operating to move the value of the currency in the opposite direction.

Question 33

What is the quantity theory of money?

Answer 33

A theory of the connection between money and prices that assumed that the velocity of money is constant.

Question 34

What is velocity of money?

Answer 34

The average number of times each dollar in the money supply is used o purchases goods and services that are included in GDP