Week 6 Flashcards
Money
Money is the set of assets in an economy that people regularly use to buy goods and services from other people.
What are the main functions of money
medium of exchange (means of payment)
unit of account
store of value
Medium of exchange
An item that buyers give to sellers when they want to purchase goods and services.
A medium of exchange is anything that is readily acceptable as payment.
Unit of account
A unit of account is the yardstick people use to post prices and record debts.
Store of value
A store of value is an item that people can use to transfer purchasing power from the present to the future.
Commodity money
Commodity money takes the form of a commodity with intrinsic value.
Examples: gold, silver, cigarettes.
Fiat money
Fiat money is used as money because of government decree.
It does not have intrinsic value.
Examples: coins, currency, cheques, deposits
zero-coupon bond of infinite maturity
Currency
Currency is the plastic notes and metal coins in the hands of the public.
Current deposits
Current deposits are balances in bank accounts that depositors can access on demand by using a debit card or writing a cheque.
Money supply
The money supply is the quantity of money available in the economy
Creation of money supply by the central bank AND the banking system
- the RBA (monopolistically)
- Open market operations - Money stock (M1-M3) through interactions between the CB, commercial banks and the public and the ‘multiplication’ process
money in the Australian economy
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Can banks also affect money supply?
Influencing the quantity of demand deposits
Reserves
Reserves are deposits that banks have received but have not loaned out.
fractional-reserve
In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest
Reserve ratio
Reserve ratio (R) is the fraction of deposits that banks hold as reserves
Money multiplication
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Money multiplier
The money multiplier is the amount of money the banking system generates with each dollar of reserves
The money multiplier is the reciprocal of the reserve ratio:
M = 1/R
Capital
The capital is the owners’ equity (part of their funding raised by issuing shares)
Leverage ratio
total assets/capital
Is the Multiplier Model Correct?
No.
Is the Multiplier Model useful?
Yes.
Is the Multiplier Model Correct? No. Is it Useful? Yes.
Above it is assumed that the initial step in the process of changing money supply is on the banks liabilities side
i.e. there are some changes in deposits which will affect money supply.
But can this be the other way round?
Can this be that a bank decides to give a loan, creates electronic money out of nothing, and THEN creates a deposit to the loan’s recipient?
If so, can this be a problem? Why? When?
RBA
The Reserve Bank of Australia (RBA) serves as the nation’s central bank since 1959.
It has two main functions:
The formulation and administration of monetary policy.
To maintain financial stability
What is the Reserve Bank Board?
responsible for the Bank’s monetary and banking policy.
What does the explicit inflation target do?
Accountability
The inflation target also anchors private sector inflation expectations.
Credibility
The inflation forecast targeting regime
If inflation is forecast to be:
above the target, monetary policy has to be tightened to move inflation down
contractionary policy
below the target, monetary policy should be eased
expansionary policy
Cash rate
The cash rate is the interest rate that financial institutions can earn on overnight loans of their currency or reserves (the short-term money market which financial institutions operate in).
The inflation targeting regime
The RBA now targets the cash rate (as its instrument) as a means of influencing the inflation rate.
When the cash rate rises, interest rates in the retail market rise. Likewise when the cash rate falls, interest rates fall. As changes in the cash rate flow through to interest rates, generally economic activity is affected
How does the Reserve Bank affect the cash rate?
open market operations
To increase the amount of cash in the economy, the RBA buys government securities from financial institutions.
To decrease the money supply, the RBA sells government securities to financial institutions.
open market operations
purchasing or selling Australian government securities
To increase the amount of cash in the economy, the RBA buys government securities from financial institutions.
Injecting cash into money markets
What then happens to the money supply?
To decrease the money supply, the RBA sells government securities to financial institutions.
withdrawing cash from the system
Problems in affecting the economy
The RBA has been able to control movements in the cash rate and thereby influence the cash market but its ability to control the money supply is not precise.
The RBA must wrestle with two problems that arise due to fractional-reserve banking
The RBA does not control the amount of money that households choose to hold as deposits in banks.
The RBA does not control the amount of money that bankers choose to lend.
