1. ECO1000 Economics
Semester One, 2004
Lecture 8

2. Answer to a Good Question
What is the natural rate of unemployment in Australia?
According to Groenwald et al, Australian Econ. Papers, 2000:
Australia’s natural rate rose sharply from 6% in the late 1970s to 8% and remained at or around 8% until the late 1990s.
Australia’s actual rate of unemployment has been both above and below the natural rate at various times in this twenty-year period.

3. Outline or Plan of Today’s Lecture
Material Covered: Module Five
Reading: Text Chapters 12 and 13 Plus Hakes and Parry Chapters 12 and 13
Topics Considered: Money and Prices

4. Purpose or Objectives of the Lecture
You will learn about:
The Monetary System (including trading banks and the central bank)
Inflation (in more detail)
The Economics that Underlies the Development of Macroeconomic Policies

5. THE MONETARY SYSTEM
Money

6. An Overview of Money
Money is the set of assets in the economy that people regularly use to buy goods and services from other people.
Money has three functions in the economy.
Medium of exchange
Unit of account
Store of value

7. Liquidity
Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.
Examples in order of declining liquidity are:
Money in a savings account
Money in a term deposit
A house

8. The Kinds of Money
Commodity money takes the form of a commodity with intrinsic value.
Examples: Gold, silver, cigarettes
Fiat money is used as money because of government decree.
It does not have intrinsic value.
Examples: Coins, currency, cheque deposits

9. Money in the Australian Economy
The main types of money in Australia are:
Currency is the paper bills and coins in the hands of the public; and
Current deposits are balances in bank accounts that depositors can access on demand by using a debit card or writing a cheque.
There is $30b of currency in the Australian economy ($1500 for every man, woman and child).
Obviously some people are holding a lot of currency for some reason (tax evasion, crime proceeds etc.)

10. The Money Supply
The money supply is the quantity of money available in the economy.
The money supply is partly* determined by the actions of the Reserve Bank of Australia and by the banking system.
*Some macroeconomic theories are based on the assumption that the central bank fully determines supply.

11. Commercial Banks and The Money Supply
Reserves are deposits that banks have received but have not loaned out.
In a fractional reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

12. Money ‘Creation’
The money supply is affected by the amount deposited in banks and the amount that banks loan.
Deposits into a bank are recorded as both assets and liabilities.
Loans become an asset to the bank.

13. Money Creation First State Bank Assets Liabilities
Reserves
$20.00
Loans
$180.00
Deposits
$200.00
Total Assets
Total Liabilities
This T-Account illustrates a bank that accepts deposits, keeps a portion as reserves, and lends out the rest.

14. Reserves Reserves are kept to ensure the bank has some liquidity
The reserve ratio
Proportion of money held as reserves (eg 10%)
Concern about a ‘run’ on deposits
The required reserve ratio
Proportion of money that banks are required, by the government, to hold
No longer a requirement in Australia

15. The Money Multiplier
When one bank lends money, that money is generally deposited into another bank.
Payments for goods, services or investments
Repayment of debts
This creates more deposits and more reserves to be lent out.
The money multiplier is the amount of money the banking system generates with each dollar of reserves.

16. The Money Multiplier First State Bank Second State Bank Assets
Liabilities
First State Bank
Reserves
$10.00
Loans
$90.00
Deposits
$100.00
Total Assets
Total Liabilities
Assets
Liabilities
Second State Bank
Reserves
$9.00
Loans
$81.00
Deposits
$90.00
Total Assets
Total Liabilities

17. Money Supply = $190.00! The Money Multiplier First State Bank
Assets
Liabilities
First State Bank
Reserves
$10.00
Loans
$90.00
Deposits
$100.00
Total Assets
Total Liabilities
Assets
Liabilities
Second State Bank
Reserves
$9.00
Loans
$81.00
Deposits
$90.00
Total Assets
Total Liabilities
Money Supply = $190.00!

18. The Money Multiplier
How much money is eventually created in this economy?
Original deposit
= $
First State lending
= $ [=0.9 x $100.00]
Second State lending
= $ [=0.9 x $90.00]
Third State lending
etc.
= $ [=0.9 x $81.00]
etc.
Total money supply
= $1,000 (from the original $100)

19. The Money Multiplier M = 1/R
The money multiplier is the reciprocal of the reserve ratio.
M = 1/R
With a reserve requirement, R = 10% or 1/10,
The multiplier is 10 (as in the previous example)
So we multiply the $ deposit by 10 to get the total created money supply of $ If the R = 3% or 1/30, our money multiplier = 30.

20. MONETARY POLICY IN AUSTRALIA
The Role of the RBA

21. Monetary Policy and the RBA
Monetary policy is controlled by the Reserve Bank of Australia.
Monetary policy is aimed at:
Maintaining a stable currency
Maintaining full employment
Ensuring the economic prosperity and welfare of the Australian people
(see rba.gov.au)

22. Monetary Policy in Australia Today
Monetary policy is set so as to achieve an inflation rate of 2-3 per cent on average.
The application of the inflation target is seen as a mechanism whereby discipline is maintained in monetary policy decision-making.
The inflation target also anchors private sector inflation expectations.

23. The Inflation Targeting Regime
If inflation is forecast to be:
above the target: monetary policy has to be tightened to move inflation down.
below the target: monetary policy can be expansionary so as to promote as strong a growth in output as possible.
Monetary policy is put into action by the RBA’s control of the cash rate.

24. The Inflation Targeting Regime
The cash rate is the interest rate charged on loans in the cash market (the short-term money market which financial institutions operate in).
The Reserve Bank's ability to set a cash rate stems from its control over the supply of funds which banks use to settle transactions among themselves.
These are called exchange settlement funds.

25. The Inflation Targeting Regime
If the Reserve Bank supplies more exchange settlement funds than the commercial banks wish to hold, the banks will lend more in the cash market, resulting in a cash rate fall (and vice versa)
When the cash rate rises, interest rates in the retail market rise. Likewise when the cash rate falls the interest rate falls.
As changes in the cash rate flow through to interest rates generally, economic activity is affected.

26. Problems in Controlling the Money Supply
Although the RBA can control movements in the cash rate and thereby influence the cash market, its ability to control the overall money supply is not precise.
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.

27. INFLATION: ITS CAUSES AND COSTS
Rising Prices

28. Inflation in Australia

29. Inflation Defined Inflation is an increase in the overall price level.
It is a continuous, not once-off, increase in prices.
It means an increase in the average of prices and not just significant increases in the price of a few goods.
Deflation is a decreasing average prices (very rare)
Hyperinflation refers to very high rates of inflation (eg Germany 1930s or Russia early to mid-90s)

30. Inflation: Historical Aspects
Over the past fifty years, prices have risen on average about 5 percent per year.
In Australia in the 1970s prices rose by 11 percent per year.
In Australia from 1990 to 2000 prices rose at an average rate of about 2 percent per year.

31. Inflation and Money Supply and Demand
The price level has a close relationship with the supply and demand for money.
As we shall see, the price level adjusts to the equate money supply and demand.

32. Money Supply
The money supply is a policy variable that is affected by the RBA’s control of the cash market.
* We assume in this model that the RBA has total control of the money supply.

33. Money Demand
Money demand has several determinants, including interest rates and the average level of prices in the economy.
People hold money because it is the medium of exchange.
The amount of money people choose to hold depends on the prices of goods and services.

34. Money Supply and Money Demand
In the long run, the overall level of prices adjusts to the level at which the demand for money equals the supply.
This can be depicted geometrically using a rather interesting graph.

35. Money Supply & Demand Value of Money Price Level MS1 1 (High) 1 (Low)
3/4
1.33 A
1/2 2
1/4 4
Money
demand
(High)
(Low) M1
Quantity of money

36. The Effects of Monetary Injection
Suppose the RBA injects money into the economy by lowering the cash rate:
The supply of money curve shifts to the right.
The equilibrium value of money decreases.
The equilibrium price level increases.

37. The Effects of Monetary Injection
Value of
Money
Price
Level
MS1
MS2 1
(High) 1
(Low)
1. An increase in the money supply...
3/4
1.33
2....decreases the value of money ...
3. and
increases
the price
level. A
1/2 2 B
1/4 4
Money
demand
(High)
(Low) M1 M1
Quantity of money

39. QUANTITY THEORY

40. The Quantity Theory of Money
How the price level is determined and why it might change over time is called the quantity theory of money. This theory has two main arguments:
The quantity of money available in the economy determines the value of money.
The primary cause of inflation is the growth in the quantity of money.

41. Velocity
The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

42. V = (P x Y)/M Velocity Equation Y = the quantity of output
Where: V = velocity
P = the price level
Y = the quantity of output
M = the quantity of money

43. Example
If 10 bookcases are produced in a year and they sell for $1 each and the quantity of money is two $1.00 coins then:
($1 x 10)/$2 = 5
For $10 worth of spending to take place, the two $1.00 dollar coins must change hands 5 times in the year.

44. Velocity and the Quantity Equation
Rewriting the equation gives the quantity equation.
M x V = P x Y
This equation relates the quantity of money to the nominal value of output (P x Y).

45. Foundations of the Quantity Theory of Money
The velocity of money is relatively stable over time.
When the RBA changes the quantity of money, it causes proportionate changes in the nominal value of output.
Because money is neutral, money does not affect real output.
Changes in the money supply that induce parallel changes in the nominal value of output are also reflected in changes in the price level.
When the RBA increases the money supply rapidly, the result is a high rate of inflation.

46. PROBLEMS CAUSED BY INFLATION AND RELATED ISSUES

47. The Inflation Tax
When the government raises revenue by printing money, it is said to levy an inflation tax.
An inflation tax is like a tax on everyone who holds money.
The inflation ends when the government institutes fiscal reforms such as cuts in government spending.

48. The Costs of Inflation Shoeleather costs Menu costs
Relative price variability
Tax distortions
Confusion and inconvenience
Arbitrary redistribution of wealth

49. Shoe-Leather Costs
Shoe-leather costs are the resources wasted when inflation encourages people to reduce their money holdings.
Inflation reduces the real value of money, so people have an incentive to minimise their cash holdings.
Less cash requires more frequent trips to the bank to withdraw money from interest-bearing accounts.
Extra trips to the bank take time away from productive activities.

50. Menu Costs Menu costs are the costs of changing prices.
During inflationary times, it is necessary to update price lists and other posted prices.
This is a resource-consuming process that takes away from other productive activities.

51. Relative-Price Variability
Inflation distorts relative prices.
Consumer decisions are distorted, and markets are less able to allocate resources to their best use.

52. Inflation-Induced Tax Distortion
Inflation exaggerates the size of capital gains and increases the tax burden on this type of income.
With progressive taxation, capital gains are taxed more heavily.

53. Inflation-Induced Tax Distortion
The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation.
The after-tax real interest rate falls, making saving less attractive.

54. Confusion and Inconvenience
With rising prices, it is more difficult to compare real revenues, costs, and profits over time.

55. Arbitrary Redistribution of Wealth
Unanticipated inflation redistributes wealth between debtors and creditors.
This may result in wealth transfers that would not otherwise be acceptable.

56. A Note on the Fisher Effect
Named after Irving Fisher, the Fisher effect suggests that:
Real interest rate = nominal - inflation
Since money supply does not influence any real variable, an increase in the money supply leads to an increase in the inflation rate and the nominal interest rate (in order to leave the real rate unchanged).

57. Concluding Remarks
Money supply and demand are important macroeconomic variables
The relationship between money and the price level is critical.
Since inflation has various costs and causes problems, the RBA attempts to keep inflation under control.

58. In Light of the Objectives of this Lecture…
We now know about:
Money
Inflation
The Reserve Bank and Trading Banks
Monetary policy

59. Next Week Material Covered: Module Six
Reading: Text and Hakes and Parry Chapters 14 and 15
Topics: The Open Economy

60. THE END