Chapter 11 Monetary policy and the financial system Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Learning Objectives Review the functions of money and the money supply in Australia. Explain the transactions demand and asset demand for money. Examine the institutional structure of the Australian financial system and the role of the Reserve Bank of Australia. Explain the money-creating abilities of the banking system and the monetary (or credit) multiplier. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Learning Objectives (cont.) Discuss the objectives of monetary policy and the route by which monetary policy affects the operation of the economy. Examine the balance sheet of the Reserve Bank of Australia, through which monetary policy is largely implemented. Analyse the techniques of monetary policy—the major instruments and how they function. Discuss the cause–effect chain through which monetary policy functions, and evaluate its effectiveness. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Functions of Money What is money? Anything that performs the function of money is money. Money is what money does. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Functions of Money (cont.) Money is a medium of exchange. Buying and selling goods and services. Money is a unit of account. Assisting measurement of relative worth of various goods, services and resources. Money serves as a store of value. A form in which to store wealth, due to its liquidity and convenience. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Supply of Money—Money Defined: M3 Three components: currency (coins and notes) current deposits in banks upon which cheques can be drawn non-current accounts such as savings. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Currency In Australia, token money has intrinsic value which is less than face value of the money is the coin and note component of the money supply. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Current Deposits Cheques enable the ownership of current deposits to be transferred. Cheques are generally acceptable as a medium of exchange. Cheques can be readily converted into currency. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Non-Current Deposits highly liquid financial assets can be readily converted into currency or current deposits new technologies (such as EFTPOS) important. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Broad Money M3 plus borrowings from the private sector of non-bank financial intermediaries (NBFIs) less holdings of currency and bank deposits by the NBFIs. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Credit Cards not money simply a convenient method of obtaining a short-term loan from the card-issuer facilitate the synchronisation of receipts and expenditures, reducing the demand for cash. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Monetary Base Composed of: currency held by the public currency held by the banks banks’ demand deposits with the RBA. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

What ‘Backs’ the Money Supply? money as debt value of money acceptability of money legal tender fiat money relative scarcity. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Demand for Money The demand for money is the demand for real money balance. Two reasons why people demand money: transactions demand (Dt) asset demand (Da). Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Transactions Demand (Dt ) The demand for money as a medium of exchange. Level depends on money GDP (not interest rates!). Money demand curve is vertical. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Assets Demand (Da ) The demand for money as financial assets and store of wealth. Level depends on interest rates. Down-sloping money demand curve. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Total Demand for Money (Dm ) Transactions demand and assets demand are added horizontally. Changes in interest rates lead to movement along the curve. Anything that changes money GDP leads to a shift in the money demand curve. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

+ = Demand for Money Transactions Demand, Dt Dt Asset Demand, Da Da Total Demand for Money, Dm Dm 10 7.5 5 2.5 10 7.5 5 2.5 10 7.5 5 2.5 Rate of interest, i (per cent) Rate of interest, i (per cent) Rate of interest, i (per cent) 0 50 100 150 200 250 300 0 50 100 150 200 250 300 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Amount of money demanded (billions of dollars) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Money Market The combination of the money demand and money supply determines the equilibrium interest rate. The interest rate represents the opportunity cost of holding money balances. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Equilibrium Interest Rate Sm 10 7.5 5 2.5 Dm Equilibrium Interest Rate ie Rate of interest, i (per cent) 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Interest Rate Differentials between Bond and Deposit Accounts Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Australian Financial System Consists of: the Reserve Bank of Australia (RBA) the banks financial intermediaries. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Reserve Bank of Australia (RBA) Responsibilities set out in the Reserve Bank Act 1959 Main functions: control of note issue banker to the banks exchange settlement accounts non-callable deposits banker to the government vital role in financing government deficits Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Reserve Bank of Australia (RBA) (cont.) Main functions (cont.): management of the international means of payment implementation of monetary policy. Other functions: regulation of the payment system membership of the board of the Australian Prudential Regulation Authority (APRA) membership of the Council of Financial Regulators. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

How Banks Create Money The focus of this section will be on explaining how banks create deposit money. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

A single bank in a banking system Transaction (1): The birth of a bank new owners sell $250 000 worth of shares in the bank Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

A single bank in a banking system (cont.) Transaction (2): Becoming a going concern acquisition of property and equipment Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

A single bank in a banking system (cont.) Transaction (3): Accepting deposits citizens and businesses deposit $100 000 change in composition not total supply of money Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

A single bank in a banking system (cont.) Transaction (4): Setting aside required reserves assume reserve ratio is 20% bank must keep $20 000 (required reserves) bank’s required reserve bank’s deposit liabilities Reserve ratio = Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

A single bank in a banking system (cont.) Bank decides to keep $ 110 000 (actual reserves), which is $90 000 more than required (excess reserves). Bank’s required reserves are 20% of $100 000. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

A single bank in a banking system (cont.) Transaction (5): Drawing a cheque A citizen who has substantial deposits in the bank draws a cheque for $50 000 to buy goods. The seller of the goods deposits the cheque in another bank. The banking system as a whole has not lost or gained. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

A single bank in a banking system (cont.) Transaction (5): Drawing a cheque (cont.) Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Creating Money Transaction (6): Granting a loan A company borrows $50 000 from the bank. Money is created. Balance sheet after loan is negotiated: Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Creating Money (cont.) Now, bank has no excess reserves. Balance sheet after cheque drawn on loan has been cancelled: Now, bank has no excess reserves. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Creating Money (cont.) Transaction (7): Buying government bonds Bank buys $50 000 of government bonds instead of lending $50 000. Money is created. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Banking System Multiple banks: multiple-deposit expansion. Money is created by a multiple of the banking system’s excess reserves. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Multiple-Deposit Expansion Assume initially: 20% reserve requirement Bank A Accepts a deposit for $100 does not alter money supply excess reserves of $80 a loan of $80 is negotiated. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Multiple-Deposit Expansion (cont.) Balance Sheet: Bank A Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Multiple-Deposit Expansion (cont.) Loan cheque of $80 is drawn on Bank A and deposited in Bank B Bank B Gains $80 in reserves and deposits Excess reserves of $64 Loans $64. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Multiple-Deposit Expansion (cont.) Bank B Loan cheque of $64 is drawn on Bank B and deposited in Bank C, and so on … Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Multiple Deposit Expansion Process Acquired reserves and deposits Required reserves Excess reserves New money created Bank A B C D E F G H I J K L M N Other banks $100.00 80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 21.97 $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 $80.00 64.00 51.20 40.96 32.77 26.22 20.98 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.57 Total amount of money created by the banking system $400.00 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Multiple-Deposit Expansion (cont.) Total banking system has created $400 How? Via the monetary multiplier where m is the monetary multiplier 1 reserve ratio monetary multiplier = 1 R m = Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Some Modifications Determining the required reserve ratio The Australian Prudential Regulation Authority (APRA) as a supervisory body. The prime assets ratio (PAR)—the proportion of the banks’ total liabilities that must be held in a highly liquid form. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Other Leakages Currency drains Loan may be paid in cash and remain in circulation Transfer of deposits to non-bank financial institutions Excess reserves Individual banks may choose to have larger reserves than required (say 25% instead of 20%) For the full multiplier effect to take place: Borrowers must be willing and able to utilise the loans Borrowing is likely to be low during a recession. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Objectives of Monetary Policy influencing interest rates and credit availability to stabilise real GDP, employment and the price level Fundamental objectives full employment non-inflationary level of total output The Reserve Bank of Australia has responsibility for managing monetary policy. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Cause-Effect Chain of Monetary Policy Cash rate interest rate charged by the RBA for exchange settlement account funds Other short-term interest rates the cash rate sets the cost of short-term funds for banks influences the rate at which banks are willing to lend Aggregate demand Availability of bank credit, which impacts on interest-sensitive spending (and therefore output, employment and prices), is impacted through monetary policy. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetary Policy and Aggregate Demand Easy money policy RBA reduces the cash rate, lowering the cost and increasing the availability of bank credit, to expand spending and real GDP. Tight money policy RBA increases the cash rate, increasing the cost of credit, reducing the availability of credit, to reduce spending in the economy and reduce inflationary pressures. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetary Policy and Investment Increases in interest rate reduce the viability of many investments and the quantity of investment spending falls. Increases in interest rate make the purchase of financial assets more attractive, in preference to making investment expenditures. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Balance Sheet of the RBA Assets: gold and foreign exchange government securities Liabilities: notes on issue non-callable deposits exchange settlement account (ESA) funds. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Changes in ESA Funds and Monetary Policy Funds flow to and from government accounts. Banks must maintain a positive balance in their ESAs with the RBA. If a bank’s ESA goes into deficit: it may borrow funds from other banks, or trade in either government securities or repurchase agreement (repo) Repos are agreements detailing the price, timing and conditions under which the banks and the RBA may exchange government securities. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Yield Curve The yield curve is a summary of the interest rates that apply at any given point in time to interest-bearing securities. Shows the link between the cash rate and other short-term interest rates. Changes in the cash rate change the cost of funds for banks, and change the cost of credit (loans) provided by the banks. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

The Yield curve June 2006 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Tools of Monetary Policy Two major tools used by the RBA to determine the cash rate: open market operations foreign exchange swaps and intervention in the foreign exchange market. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Open-Market Operations Buying and selling of Commonwealth government securities by the RBA in the cash or short-term money market. The objective of open-market operations (OMOs) is to ensure that the demand and supply of ESA funds are such that they are in balance at the target cash rate. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Open-Market Operations (cont.) Buying and selling of Commonwealth government securities by the RBA affects the cash rate. Cash rate provides an indication of the RBA’s monetary policy stance sustained increases in cash rate target level: tightening of monetary policy sustained decreases in cash rate target level: easing of monetary policy. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Open-Market Operations: Buying Securities Banks sell some of their securities. RBA pays for securities by increasing banks’ exchange settlement accounts (ESAs). ESAs form part of the banks’ prime assets ratio (PAR) requirement. Bank reserves increase causing the monetary base and the banks’ lending ability to increase. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Open-Market Operations: Selling Securities The RBA sells securities to the banks. Banks pay for securities by decreasing their exchange settlement accounts (ESAs). Bank reserves decrease causing the monetary base and the banks’ lending ability to decrease. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Foreign Exchange Swaps RBA may use foreign exchange swaps to supplement or substitute for OMOs. Foreign exchange market intervention—either selling or buying Australian dollars Purchase/sale of dollars is equivalent to purchase/sale of government securities, and has similar impact on banks’ ESA funds. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Rediscount Rate and Monetary Policy The rate at which the RBA buys or sells short-term securities under repurchase agreements. These can be used as a central tool of monetary policy. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Easy Monetary Policy Implemented when the economy is faced with the prospects of substantial unemployment or deflationary pressure. RBA announces its intention to reduce the cash rate. RBA acts to bring the ESA funds market into balance. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Tight Monetary Policy Enacted when the economy is facing significant inflationary pressures. RBA announces its intention to increase the target cash rate. ESA funds are brought into balance at this new target cash rate. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetary Policy and Equilibrium GDP Cause–Effect Chain of Monetary Policy: Money supply impacts on interest rates. Interest rates affect investment. Investment is a component of AD. Equilibrium GDP is changed. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Quantity of money demanded and supplied Monetary Policy and Equilibrium GDP (cont.) SF2 SF1 10 8 6 10 8 6 Investment demand Real rate of interest, i D1 Quantity of money demanded and supplied Amount of investment, i ASLR AS Tight Monetary Policy Price level P1 AD1 Real domestic output, GDP Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Quantity of money demanded and supplied Monetary Policy and Equilibrium GDP (cont.) SF2 SF1 10 8 6 10 8 6 Investment demand Real rate of interest, i D1 Quantity of money demanded and supplied Amount of investment, i ASLR AS Tight Monetary Policy Price level P1 AD1 AD2 Real domestic output, GDP Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetary Policy and Equilibrium GDP (cont.) Refinements and Feedback Effects Policy effectiveness depends on shape of the demand for money curve shape of the investment demand curve Feedback effects Reductions in GDP tend to reduce business profits, causing business to reduce investment. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Monetary Policy and the Open Economy Net Export Effect Changes in interest rate affect the value of the exchange rate under floating exchange rate. An increase in interest rate appreciates the currency, resulting in lower net exports. A decrease in interest rate leads to currency depreciation and a rise in net exports. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Shortcomings of Monetary Policy cyclical asymmetry conflict with Treasury goals cost-push inflation investment insensitivity Some question how sensitive investment actually is. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Strengths of Monetary Policy Flexible and speedy to implement, relative to fiscal policy. Politically acceptable, due to its broad impact. Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal

Next Chapter: Economic resources and the labour market Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Economic Principles 2e, by Jackson, McIver & Bajada By Muni Perumal