Money, Banks and the Reserve Bank of Australia Chapter 15 Money, Banks and the Reserve Bank of Australia

Learning Objectives Define money and discuss its functions. Discuss the definitions of the money supply used in Australia today. Explain how financial institutions create money. Overview the financial system in Australia and discuss the role of the Reserve Bank of Australia.

Petrol dries up as Zimbabwe currency crashes The Zimbabwe example illustrates the importance of confidence and trust in the domestic currency for the viability of the entire economy.

What is money and why do we need it? LEARNING OBJECTIVE 1 What is money and why do we need it? Money: Assets that people are generally willing to accept in exchange for goods and services or for payment of debts. Asset: Anything of value owned by a person or firm.

What is money and why do we need it? LEARNING OBJECTIVE 1 What is money and why do we need it? Barter and the invention of money. Barter is the exchange of goods or services for other goods or services. Barter requires a double coincidence of wants. Commodity money: A good used as money that also has value independent of its use as money.

Money in a World War II prisoner of war camp. MAKING THE CONNECTION 15.1 Money in a World War II prisoner of war camp. During World War II cigarettes were used as money in some prisoner of war camps.

What is money and why do we need it? LEARNING OBJECTIVE 1 What is money and why do we need it? Money makes exchange easier thereby allowing for specialisation and higher productivity. The functions of money. Medium of exchange. Unit of account. Store of value. Standard of deferred payment.

What is money and why do we need it? LEARNING OBJECTIVE 1 What is money and why do we need it? What can serve as money? There are five criteria that make a good suitable to use as a medium of exchange. The good must be acceptable to most traders. It should be a standardised quality. It should be durable. It should be valuable relative to its weight so that it can be easily transported. It should be divisible.

What is money and why do we need it? LEARNING OBJECTIVE 1 What is money and why do we need it? What can serve as money? Commodity money meets the criteria for a medium of exchange, but has the problem that its value depends on its quality. Eg: Gold is a medium of exchange but its value depends on its purity. Fiat money: Money, such as paper currency, that is authorised by a central bank or government body and that does not have to be exchanged by the central bank for gold or some other commodity money.

Money without a government? The strange case of the Iraqi dinar. MAKING THE CONNECTION 15.2 Money without a government? The strange case of the Iraqi dinar. Many Iraqis continued to use currency with Saddam’s picture on it, even after he was forced from power.

How do we measure money today? LEARNING OBJECTIVE 2 How do we measure money today? Currency: Notes and coins held by the public less holdings of coins and notes held by the banks and the Reserve Bank of Australia (RBA). The RBA is Australia’s central bank. M1: The narrowest definition of the money supply which includes all the paper money and coins that are in circulation – meaning what is not held by the banks or the state and federal governments – plus the value of all demand deposits with banks.

How do we measure money today? LEARNING OBJECTIVE 2 How do we measure money today? Demand deposits: Also called current deposits, these are deposits in financial institutions that are transferable by cheque, by debit cards at EFTPOS terminals and through electronic transfer between accounts. They are called demand deposits because they are available on demand, and are repayable in notes and coins.

How do we measure money today? LEARNING OBJECTIVE 2 How do we measure money today? Broader definitions of money. M3: M1, plus all other deposits with domestic and foreign owned banks operating in Australia. Includes certificates of deposit, term deposits and deposits with banks from building societies, credit unions and other authorised deposit-taking institutions.

How do we measure money today? LEARNING OBJECTIVE 2 How do we measure money today? Broader definitions of money. Broad Money: M3, plus deposits into non- bank deposit-taking institutions less holdings of currency and deposits of non- bank depository corporations, such as finance companies, money market corporations and cash management trusts.

Please insert Figure 15.1 from page 489. Measuring the money supply, Australia, January 2009: Figure 15.1 Please insert Figure 15.1 from page 489. Figure 15.1: Measuring the money supply in Australia. Source: Reserve Bank of Australia (2009), ‘Monetary aggregates’, Table D03, viewed 22 March 2009, at <www.rba.gov.au> The Reserve Bank of Australia uses several different measures of the money supply. In the pyramid, each measure includes the assets of the measure above it, as well as additional assets. Source: Reserve Bank of Australia (2009), ‘Monetary aggregates’, Table D03, viewed 22 March 2009, at <www.rba.gov.au> Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

How do we measure money today? LEARNING OBJECTIVE 2 How do we measure money today? Credit: Credit is not a form of money, but is now used by the RBA as a main measure of monetary movements in Australia. Credit: Loans, advances and bills provided to the private non-financial sector (individuals and firms) by all financial intermediaries.

How do we measure money today? LEARNING OBJECTIVE 2 How do we measure money today? Australia, January 2009: Total credit was $1 912.0 billion. Total credit comprised: Housing loans: $999.4 billion. Other personal loans: $145.0 billion, of which credit cards comprised $44.6 billion. Business loans: $767.8 billion. Source: Reserve Bank of Australia (2009), ‘Monetary aggregates’, Table D03, viewed 22 March 2009, at <www.rba.gov.au> . Source: Reserve Bank of Australia (2009), ‘Monetary aggregates’, Table D03, viewed 22 March 2009, at <www.rba.gov.au>

How do financial institutions create money? LEARNING OBJECTIVE 3 How do financial institutions create money? Bank balance sheets Reserves: Deposits that a bank keeps as cash in its vault or on deposit with the Reserve Bank of Australia. Reserve Ratio: A bank’s ratio of reserves to deposits. Excess Reserves: Reserves above the normal ratio of reserves to deposits. A loan is an asset to a bank and a deposit is a liability to a bank.

Balance sheet for Save-IT Bank: Figure 15.2 Figure 15.2: Balance sheet for Save-IT Bank. The items on a bank’s balance sheet of greatest economic importance are its reserves, loans and deposits. Notice that the difference between the value of Save-IT’s total assets and its total liabilities is equal to its shareholders’ equity. As a consequence, the left side of the balance sheet always equals the right side. Note: Some entries have been combined to simplify the balance sheet. Hubbard, Garnett, Lewis and O’Brien: Essentials of Economics © 2010 Pearson Australia

How do financial institutions create money? LEARNING OBJECTIVE 3 How do financial institutions create money? Using T-accounts to show how a bank can create money. If you deposit $1000 into your savings account at Save-IT Bank, this increases Save-IT’s assets and liabilities by the same amount.

How do financial institutions create money? LEARNING OBJECTIVE 3 How do financial institutions create money? Using T-accounts to show how a bank can create money. Assume Save-IT lends $900 (it is keeping 10% of the deposit in reserve), which is spent, and the recipient of the funds deposits them with Thrifty Bank. Thrifty Bank’s reserves increase by $900. The money supply has now increased by $900.

How do financial institutions create money? LEARNING OBJECTIVE 3 How do financial institutions create money? Using T-accounts to show how a bank can create money. Thrifty Bank lends $810 of the $900. By making an $810 loan, Thrifty Bank has increased both its loans and its deposits by $810.

How do financial institutions create money? LEARNING OBJECTIVE 3 How do financial institutions create money? Using T-accounts to show how a bank can create money.

How do financial institutions create money? LEARNING OBJECTIVE 3 How do financial institutions create money? The simple deposit multiplier. This is the ratio of the amount of deposits created by banks to the amount of new reserves.

How financial institutions create money LEARNING OBJECTIVE 3 How financial institutions create money Suppose Colin deposits $1000 into ABC Bank. Assume ABC Bank has no excess reserves at the time of this deposit, and the bank’s reserve ratio is 0.10. a) Use a T-account to show the initial impact of Colin’s deposit on the bank’s balance sheet, and the impact of ABC Bank lending the maximum amount if can from this loan.

How financial institutions create money LEARNING OBJECTIVE 3 How financial institutions create money Now suppose Collette borrows this amount from ABC Bank to buy a surfboard from the Wave Surf Company. Wave Surf then deposits the entire amount in XYZ Bank. (a) Show the effect of this transaction using a T-account for XYZ bank. (b) What is the maximum increase in deposits that can result from Colin’s initial deposit? What is the increase in the money supply?

How financial institutions create money LEARNING OBJECTIVE 3 How financial institutions create money STEP 1: Review the material. The problem is about how financial institutions create money, so you may wish to revise the section in the text book: ‘How do financial institutions create money?’. STEP 2: Answer (a) Follow the description of T-accounts in the text book.

How financial institutions create money LEARNING OBJECTIVE 3 How financial institutions create money The T-account for ABC Bank

How financial institutions create money LEARNING OBJECTIVE 3 How financial institutions create money STEP 3: Answer (b) by showing the deposit into XYZ bank of the full amount lent out by ABC bank ($900). XYZ bank must keep 10% of the $900 ($90) and can lend out the remaining $810. XYZ T-Account

How financial institutions create money LEARNING OBJECTIVE 3 How financial institutions create money STEP 4: Answer (c) by using the following equation to find the total increase in deposits:

How financial institutions create money LEARNING OBJECTIVE 3 How financial institutions create money The change in deposits is equal to Colin’s initial deposit of $1,000 and the deposit multiplier is 1 divided by 0.1, or 10, hence:

How financial institutions create money LEARNING OBJECTIVE 3 How financial institutions create money STEP 5: To find the change in the money supply we need to subtract Colin’s initial deposit from the $10 000, as this represents money taken out of circulation. The change in the money supply is therefore: $10 000 - $1 000 = $9 000

An overview of the financial system LEARNING OBJECTIVE 4 An overview of the financial system The financial system channels funds from savers to borrowers and channels returns on borrowed funds back to savers. Financial markets include the share market and the bond market. Financial intermediaries act as go-betweens for borrowers and lenders, and include banks and non-bank intermediaries (NBFIs) (such as credit unions, building societies, managed funds, superannuation funds and insurance companies).

An overview of the financial system LEARNING OBJECTIVE 4 An overview of the financial system In addition to matching borrowers with lenders, the financial system provides three key services for savers and borrowers: Risk sharing. Liquidity – the ease with which financial securities (shares, bonds) can be exchanged for cash. Information.

An overview of the financial system LEARNING OBJECTIVE 4 An overview of the financial system The Reserve Bank of Australia. The RBA has two major roles: To maintain the financial integrity and stability of the Australian financial system. To implement monetary policy. Monetary policy: The actions the RBA takes to manage the availability of cash on the overnight money market and hence interest rates to pursue economic objectives.

An overview of the financial system LEARNING OBJECTIVE 4 An overview of the financial system How the RBA manages financial liquidity and interest rates Cash rate: The overnight money market interest rate. Open Market Operations (OMOs): The RBA purchasing or selling short-dated financial instruments such as Commonwealth Government Securities (CGS) and private bonds and securities, either by outright purchase or sale or by the use of repurchase agreements.

An overview of the financial system LEARNING OBJECTIVE 4 An overview of the financial system How the RBA manages financial liquidity and interest rates Repurchase Agreements: The RBA offers to buy (or sell) CGS and 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 agreed at the outset.

An overview of the financial system LEARNING OBJECTIVE 4 An overview of the financial system How the RBA manages financial liquidity and interest rates The majority of RBA intervention in financial markets is to sterilise, or offset, daily liquidity deficits and surpluses, to keep interest rates stable. To change interest rates, the RBA may not offset an overnight surplus or shortage of funds in the financial system, or the RBA may engage in OMOs.

An overview of the financial system LEARNING OBJECTIVE 4 An overview of the financial system Exchange rate management The value of the Australian dollar is determined by the interaction of demand and supply of the Australian dollar on international currency markets. However, the RBA occasionally intervenes. The RBA also manages Australia’s foreign currency and bonds, and gold reserves.

An Inside Look One Currency for Australia and New Zealand?

Key Terms Asset Broad money Cash rate Commodity money Credit Currency Demand deposits Fiat Money M1 M3 Monetary Policy Money Open market operations Repurchase agreement Reserve Bank of Australia Reserves Simple deposit multiplier

Get Thinking! How much time do you spend in the Express Lane at your local supermarket waiting for the customers in front of you to buy milk with their credit cards? Has Australia really become a paperless economy? It turns out we still rely much more on cash to pay for goods and services than casual observation would suggest. The big difference is in how we withdraw our cash. Discuss the changes that have occurred over time in how people access their cash, and whether or not these changes have increased transaction efficiency.

Check Your Knowledge Q1. A double coincidence of wants refers to: a. When a good that is used as money also has value independent of its use as money. b. The fact that for barter trade to take place between two people, each person must want what the other has. c. The idea that a barter economy is more efficient than a monetary economy. d. The idea that a monetary economy is more common than a barter economy.

Check Your Knowledge Q1. A double coincidence of wants refers to: a. When a good that is used as money also has value independent of its use as money. b. The fact that for barter trade to take place between two people, each person must want what the other has. c. The idea that a barter economy is more efficient than a monetary economy. d. The idea that a monetary economy is more common than a barter economy.

Check Your Knowledge Q2. If prisoners of war use cigarettes as money, then the cigarettes are: a. Token money. b. Fiduciary money. c. Fiat money. d. Commodity money.

Check Your Knowledge Q2. If prisoners of war use cigarettes as money, then the cigarettes are: a. Token money. b. Fiduciary money. c. Fiat money. d. Commodity money.

Check Your Knowledge Q3. Money serves as a unit of account when: a. Sellers are willing to accept it in exchange for goods or services. b. It can be easily stored and used for transactions in the future. c. Prices of goods and services are stated in the monetary unit. d. All of the above are correct.

Check Your Knowledge Q3. Money serves as a unit of account when: a. Sellers are willing to accept it in exchange for goods or services. b. It can be easily stored and used for transactions in the future. c. Prices of goods and services are stated in the monetary unit. d. All of the above are correct.