Tutorial 9

Question 1

1. Money is a) an asset used as a medium of exchange b) equivalent to wealth c) equivalent to income d) backed by gold

Answer 1

a) an asset used as a medium of exchange

Question 2

2. Of the following assets, which is the most liquid? a) current deposit (e.g., deposit in a cheque account) b) term deposit c) a home d) rare coins

Answer 2

a) current deposit (e.g., deposit in a cheque account

Question 3

3. Under a fractional reserve banking system, commercial banks a) hold only a fraction of their deposits as reserves b) generally lend out a major proportion of their deposits c) can create money by lending out excess reserves d) all of the above are correct

Answer 3

d) all of the above are correct

Question 4

4. Bank runs a) are potentially a problem for all commercial banks since they only hold a fraction of deposits as reserves b) are only a problem for insolvent banks c) are of no concern to the Central Bank d) will not affect the money supply

Answer 4

a) are potentially a problem for all commercial banks since they only hold a fraction of deposits as reserves

Question 5

5. If the Central Bank sells government bonds to commercial banks, other things being equal, commercial banks’ reserves will _________ and interest rates will _________ a) increase, increase b) increase, decrease c) decrease, decrease d) decrease, increase

Answer 5

d) decrease, increase

Question 6

6. An expansionary monetary policy action __________ interest rates and shifts the aggregate demand curve to the __________ a) raises, right b) raises, left c) lowers, right d) lowers, left

Answer 6

c) lowers, right

Question 7

Fill in the blanks and cross out the inappropriate choices. If the RBA raises the cash rate, this is likely to result in a(n) ___________ in other interest rates. In turn, business fixed investment (e.g., new or expanded factories or equipment) and inventory investment will tend to ___________. Similarly, housing demand and purchases of durable consumer goods are likely to _____________. In short, real GDP growth will tend to be stronger/weaker, employment is likely to be stronger/weaker, and inflation will tend to rise/fall.

Answer 7

If the RBA raises the cash rate, this is likely to result in a(n) INCREASE in other interest rates. As a result, business fixed investment (e.g., new or expanded factories or equipment) and inventory investment will tend to DECREASE. Similarly, housing demand and purchases of durable consumer goods are likely to DECREASE. In short, real GDP growth will tend to be WEAKER, employment is likely to be WEAKER, and inflation will tend to FALL.

Question 8

For each of the following transactions, state what is the immediate effect on the money supply, as defined by M1. (Reminder: M1 = currency held by the private non-bank sector + current deposits held by the private non-bank sector at commercial banks) a) Alice deposits $1,000 in currency into her cheque account at the NAB (National Australia Bank).

Answer 8

Alice deposits $1,000 in currency into her cheque account at the NAB (National Australia Bank). M1 will be unchanged. [Why? The total, combined balance on cheque accounts held at commercial banks increases by $1,000, but the amount of currency held by the non-bank private sector also decreases by $1,000. Note also that the total level of cash reserves held by banks increases by $1,000. These reserves are not counted as part of the supply of money in circulation.]

Question 9

For each of the following transactions, state what is the immediate effect on the money supply, as defined by M1. (Reminder: M1 = currency held by the private non-bank sector + current deposits held by the private non-bank sector at commercial banks) b) The NAB sets aside $100 as reserves and lends Barry $900 by crediting his account with this sum of money.

Answer 9

The NAB sets aside $100 as reserves and lends Barry $900 by crediting his account with this sum of money. M1 will increase by $900. [Why? The combined balance on cheque accounts held at commercial banks increases by this amount. What about the $100 cash reserves held by the NAB? That is being held in reserve within the banking system and is not counted as part of M1. Besides, this amount ($100) was part of the $1,000 in cash reserves that the NAB received when Alice made her deposit, and the NAB is just holding on to it, so there is no change in the total level of bank reserves.]

Question 10

For each of the following transactions, state what is the immediate effect on the money supply, as defined by M1. (Reminder: M1 = currency held by the private non-bank sector + current deposits held by the private non-bank sector at commercial banks) c) Barry writes a cheque for $900 against his NAB account to pay Cathy (he is buying her old laptop computer) and Cathy deposits this sum into her account at the Commonwealth Bank.

Answer 10

Barry writes a cheque for $900 against his NAB account to pay Cathy (he is buying her old laptop computer) and Cathy deposits this sum into her account at the Commonwealth Bank. M1 will be unchanged. [Why? The combined balance on cheque accounts held at commercial banks is unchanged. While Barry’s account with the NAB decreases, Cathy’s account with the Commonwealth increases by the same amount. What about banks’ cash reserves? As explained above, bank reserves are not counted as part of M1. Besides, the total level of bank reserves does not change: although the NAB’s reserves decrease, the Commonwealth’s reserves increase by exactly the same amount.]

Question 11

For each of the following transactions, state what is the immediate effect on the money supply, as defined by M1. (Reminder: M1 = currency held by the private non-bank sector + current deposits held by the private non-bank sector at commercial banks) The Commonwealth Bank sets aside $90 as reserves and lends Dave $810 by crediting his account with this sum.

Answer 11

The Commonwealth Bank sets aside $90 as reserves and lends Dave $810 by crediting his account with this sum. M1 will increase by $810.

Question 12

Assume that the Reserve Bank of Australia considers the rate of inflation to be too high. What action would you expect it to take in response to this situation? Carefully explain how this action will affect the economy in the short run. Through what channels will these effects take place? Use diagrams where appropriate.

Answer 12

[You should recognise immediately that this question is about contractionary monetary policy. In a developed economy like Australia, that would probably be implemented via an open-market sale of securities. Note that the question asks you to explain the channels through which this action is translated into its effects.] [You should draw diagrams. Carefully label what you draw.] If the RBA views the inflation rate as too high, then it must be considering a contractionary action, which would dampen aggregate demand and employment, and reduce inflationary pressures. As an example, let’s consider the case where the RBA sells government bonds to commercial banks. In return, the RBA receives currency from these banks, or it can debit (reduce) their accounts held at the RBA. In either case, the total amount of cash reserves held by the commercial banks as a whole is reduced. [Commercial banks regard both currency, kept inside their tills and vaults, and deposits held at the RBA as “cash” reserves. The rate of interest that they charge each other for the overnight loan of such funds is called the “cash” interest rate.] Because there is a decrease in the amount of cash available within the commercial banking system, the cash interest rate rises. Other interest rates tend to follow. With less cash in reserve, banks tend to reduce their new lending and might call in some existing loans if possible. Other things being equal, this will reduce the money supply (as measured by M1, M3, or broad money) through a reversal of the deposit multiplier process. With the cost of borrowing being higher and the availability of credit being reduced, investors and households will tend to reduce expenditure on business investment, housing, and consumer durables. This means aggregate demand will fall at any given level of price; i.e. the AD curve will shift leftward as shown in the diagram. As a result, both real GDP and the price level will be lower than otherwise. The dampening effects on real GDP and inflation will be in line with what the RBA is trying to achieve. [In practice, the conduct of monetary policy is often made very difficult by time lags and by uncertainty regarding the state of the economy and the exact relationships between its components.]

Question 13

1. Paper money a) has no intrinsic value b) is used in a barter economy c) is valuable due to its general acceptance d) both (a) and (c) are correct

Answer 13

d) both (a) and (c) are correct

Question 14

2. The value of money a) increases when the level of prices rises b) increases when the price of bonds falls c) increases when the level of prices falls d) decreases when the level of prices falls

Answer 14

c) increases when the level of prices falls

Question 15

3. In an open-market purchase, the Central Bank typically: a) purchases government bonds from commercial banks, thereby decreasing the money supply b) purchases government bonds from commercial banks, thereby increasing the money supply c) increases the money supply by selling government bonds to commercial banks d) decreases the money supply by selling government bonds to commercial banks

Answer 15

b) purchases government bonds from commercial banks, thereby increasing the money supply

Question 16

4. A major argument against using monetary and fiscal policy for stabilisation purposes is that a) the effects of these policies on AD are totally unpredictable b) the effects of these policies on AD are too small c) these policies affect AD with a substantial and unpredictable lag d) both (b) and (c) are correct

Answer 16

c) these policies affect AD with a substantial and unpredictable lag

Question 17

Medium of exchange

Answer 17

is an object that is generally accepted in exchange for goods & services and is ‘liquid’

Question 18

Money

Answer 18

For “something’ to be termed “money” it has to perform at least these three functions:

1. Medium of exchange: is an object that is generally accepted in exchange for goods and services and is ‘liquid’
2. Unit of Account: an agreed measure for stating the prices of goods and services
3. Store of Value: any commodity or token that can be held and exchanged later for goods and services (so it must be non-perishable)

Question 19

Money supply measures: M1, M3, Broad money

Answer 19

Question 20

Fractional reserves

Answer 20

• In a normal period of time, bank deposits are approximately equal to withdrawals
• Banks need to keep only a fraction of their deposits as reserves to meet withdrawals demand
• They can lend excess reserves (what they don’t need to keep) and earn profits

Question 21

Deposit multiplier

Answer 21

Question 22

Monetary policy

Answer 22

In general, monetary policy involves the authorities (officials) making changes to money supply or the interest rates in order to in influence macroeconomic conditions

The RBA focuses mainly on changing interest rates (in particularly, the cash interest rate, explain below)

Since 1993, the primary objective of the RBA ‘s conduct of Monetary Policy has been to manage the inflation rate* as measured by *the consumer price index (CPI)

Other important objectives, according to RBA’s charter, include the “maintenance of full employment” in Australia

Question 23

Open market operations

Answer 23

The open market operation is a transaction in which the RBA buys or sells securities, mainly from banks ( these transactions take place in secondary markets, ie. the seller of securities bought these in the past, possibly from original issuers of assets)

Payments to or from the RBA will affect the quantity of overnight funds available to banks

Buy securities from the banks: increase suppl of overnight funds consequently the cash rate falls

Sell securities to the banks: decrease suppl of overnight funds consequently the cash rate rises

By engaging in open market operations, the RBA increases or decreases the supply of funds available to banks on an overnight basis. In turn these changes will affect the cash rate and, through it, other interest rates and components of AD

Question 24

The cash rate

Answer 24

RBA sets’the interest rate on overnight loans in the money market’

The relevant money market is the interbank market for overnight funds.

• Banks frequently need to borrow from each other
• Such interbank loans can be for various terms (lengths of time)
• The shortest term is overnight
• The interest rate that banks charge each other on overnight loans of funds is called the “cash” rate
• Why this name, ‘cash’? Because banks use the term ‘cash’ to describe funds that are available immediately upon being lent from one bank to other (no need to wait for clearance)
• In the USA the equivalent interest rate is called the Federal funds rate.

Question 25

If holding more reserves makes commercial banks less vulnerable to runs, why don’t they try to hold a lot more reserves than are usually held?

Answer 25

While holding more reserves would make commercial banks less vulnerable to runs, it would also make them less profitable, as reserves typically earn zero interest, or a relatively low interest rate. Banks need to strike an appropriate balance between profitability and prudence.

Question 26

Why do commercial banks keep accounts at the RBA? Why do they consider funds in these accounts “cash”? What is the cash rate? How can the RBA influence this rate?

Answer 26

The RBA acts as the banker of commercial banks. Commercial banks keep accounts at the RBA to facilitate payments between themselves: such payments can be made simply via credits and debits to these accounts. Commercial banks consider funds in these accounts “cash” because such funds can be used in making payments between themselves, and because they can serve as bank reserves, just like currency. The cash rate is the interest rate that banks charge each other for loans of cash on an overnight basis. (In the US this would be called the “Federal funds” rate.) By selling government securities to commercial banks and buying government securities from commercial banks, the RBA can vary the amount of cash reserves available within the commercial banking system. If the system’s total level of cash reserves falls, the cash rate will tend to rise, and vice versa.

Question 27

Suppose the RBA conducts an open market operation and buys government securities. How does this operation work, and what are its main effects on the economy?

Answer 27

(Appropriate diagrams would be useful) When the RBA buys government securities, it offers in return either currency (i.e. RBA money) or funds held in accounts kept at the RBA itself – as seen above, the latter is also regarded as “cash”. In either case, the commercial banking system now has more cash reserves than before. The cash interest rate falls, and this fall will tend to spread to other interest rates. As interest rates fall, investment and durable consumer spending will tend to increase. The AD curve shifts to the right. Both real GDP and the inflation rate rise.