Week 6 Flowchart Flashcards
Money
The set of assets in an economy that people regularly use to buy goods and services from other people. Money includes cash, deposits and other types of assets, but not credit card (or cheques). In fact, if people use cheques instead of cash, money supply will increase as people no longer carry extra cash.
The 3 functions of money
Medium of exchange
Unit of account
Store of value
Medium of exchange
An item that buyers give to sellers when they want to purchase goods and services. Money is the most liquid asset available
Unit of account
The yardstick people use to post prices and record debts.
Store of value
An item that people can use to transfer purchasing power from the present to the future.
Money is not the best store of value (shares, bonds, real estate…). Value of money deteriorates when there are inflationary expectations.
Liquidity
The ease with which an asset can be converted into the economy’s medium of exchange.
Kinds of money
When money takes the form of a commodity with intrinsic value, it is called commodity money (e.g. gold.)
Flat money: Money without intrinsic value that is used as money because of government decree.
Monetary policy in Australia today
The RBA uses the cash rate to influence the level of economic activity rather than attempting to control the money supply. The RBA uses open-market operations to guarantee that its target rate is the equilibrium interest rate in the short-term money.
Cash rate
The interest that financial institutions can earn on overnight loans of their currency or reserves.
Open-market operations
The purchase and sale of Australian government securities by the RBA
Problems in controlling the money supply
Can not control the amount that bankers chose to lend.
Trade-off between inflation and unemployment in short-run
Bank runs
Can not control the amount of money that households choose to hold as deposits in banks.
Bank runs
Large numbers of depositors all try to withdraw their deposits at the same time
Banks and the money supply
100 per cent reserve banking
Fractional-reserve banking
100 per cent reserve banking
Reserves: Deposits that banks have received but have not lent out
In banks hold all deposits in reserve, banks don’t influence the supply of money.
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Fractional-reserve banking
A banking system in which banks hold only a fraction of deposits as reserves. Lend out a majority of their deposits thereby creating money.
Reserve ratio
Money multiplier
Reserve ratio
The fraction of deposits that banks hold as reserves.
The money multiplier
The amount of money the banking system generates with each dollar of reserves.
Fractional reserve ratio example
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When banks hold only a fraction of deposits in reserve, banks create money. While new money has been created so has debt. There is no new wealth created by the process. The process of money creation does not continue forever. It stops when the actual reserve-deposit ratio is equal to the desired reserve-deposit ratio.
Money in the Australian economy
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Money supply
The quantity of money available in the economy.
Currency
Current deposits
Currency
The plastic notes and metal coins in the hands of the public.
Current deposits
Balances in bank accounts that depositors can access on demand by using a debit card or writing a cheque.
Central Bank (or The Reserve Bank of Australia)
An institution designed to oversee the banking system and regulate the quantity of money in the economy.
Roles of the RBA
Monitor individual banks and ensure their stability
Act as a lender of last resort
Determine monetary policy
Monetary policy
The management by the central bank of liquidity conditions in the economy. Liquidity conditions refers to the price and availability of funding for the economy’s expenditure.
There is a _____:
a.short-run trade-off between prices and interest rates
b. long-run trade-off between inflation and unemployment
c. short-run trade-off between inflation and unemployment
d. short-run trade-off between inflation and the money supply
ANS: CThe Reserve Bank of Australia (RBA) can choose to pursue the goal of “inflationary pressures” via the use of raised interest rates in order to reduce Aggregate Expenditures (AE) in the economy or it may choose to pursue the goal of “unemployment” by reducing interest rates in order to stimulate/ increase aggregate expenditures.Because the goal of inflation implies the use of high interest rates whilst the goal of unemployment implies the use of low interest rates, both goals cannot be successfully pursued by the RBA simultaneously. Further, the pursuit of one goal moves the economy further away from the attainment of the other goal. Therefore, there is a trade of between inflation and unemployment as the pursuit of one objective leads to worsening problems with the other objective.
If the public switches from doing most of its shopping with currency to using cheques instead, and the Reserve Bank takes no action, the money supply will:
Increase
Cheques are a method of deferred payment where the exact amount is transferred out of the cheque
If a bank uses $80 of reserves to make a new loan when the reserve ratio is 25 per cent, then:
The level of wealth in the economy will not have changed
New loans lead to an expansion of the money supply. Changes in true wealth however are linked to changes in GDP per capita. That is, the level of goods and services that each average person is endowed with. Increases in the money supply alone, that is not accompanied by increases in GDP per capita do not represent a true change in the wealth of a nation.
A decrease in reserve requirements will likely result in banks:
A decrease in reserve requirements means that banks are now required to hold a smaller portion of deposits as required reserves. This means banks have more money available for creating loans. As banks create a larger number of loans, the money supply increases.
If you withdraw $100 from your bank, then:
the reserves of your bank will initially fall by $100
If banks choose to hold more excess reserves, then:
By holding more reserves, banks are implicitly making fewer loans so the money supply decreases.
Store of value deteriorates when
There are inflationary expectations.
Money in currency form loses value when there is inflation because stored money is a fixed amount of money that does not increase in line with inflation. Specifically, when the prices of goods and services increase, stored money is worth less because it now exchanges for (buys) a smaller quantity of goods and services.
