1. 9–19–1 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 9 The Reserve Bank and the Economy

2. 9–29–2 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Chapter 9: The Reserve Bank and the Economy The Reserve Bank, interest rates and the money supply The supply of money and money market applications How the Reserve Bank affects nominal interest rates Implications of interest rate targeting for the supply of money The effects of the Reserve Bank’s actions on the economy The Reserve Bank’s policy reaction function Monetary policy making: art or science?

3. 9–39–3 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Personal Demand for Money The anticipated value of my transactions – this depends on my income The rate of interest – because money bears no interest, holding money means I incur the opportunity cost of interest forgone on other financial assets Higher interest rates mean lower demand for money

4. 9–49–4 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Macroeconomic Money Demand Nominal interest rate (i) [on the vertical axis] Real income or output (Y) affects the total volume of transactions in the economy The price level (P): the higher the price level, the more dollars are needed to finance a given volume of transactions

5. 9–59–5 The Money Demand Curve

6. 9–69–6 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Shifts in Money Demand Curve An increase in real income shifts the curve to the right because there is a greater volume of transactions and more money demanded at each interest rate A rise in the price level shifts the curve to the right because more money is needed to finance a given volume of transactions (The introduction of the GST raised the price level) Seasonal factors, such as spending for Christmas

7. 9–79–7 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Supply of Money & Equilibrium Money supply determined by the RBA Does not depend on interest rates So money supply curve is vertical with respect to interest rates Equilibrium interest rate occurs where money demand and supply curves intersect

8. 9–89–8 Money Market Equilibrium

9. 9–99–9 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Bonds Are IOUs issued by borrowers Borrower promises to pay annual interest as well as principal on maturity – the maturity value Borrowers supply bonds Lenders demand bonds

10. 9–10 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Coupon Rate of Interest The coupon rate of interest is the dollar amount of annual interest promised as a percentage of the principal amount borrowed Term of bond raises coupon rates Credit risk of borrower (bond issuer) raises coupon rates

11. 9–11 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Market Price of a One-Year Bond How much would you pay now for a risk-free bond promising you a principal repayment of $1000 and a coupon of $50, both in one year’s time, a total maturity value of $1050? It depends on current (not historical) market interest rates

12. 9–12 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Bond Price (cont.) If current interest rates on similar securities such as bank deposits are 5%, you would pay $1000 because $1000 deposited at 5% would grow to $1000(1.05) = $1050 But if current interest rates are 6%, you would pay only $990.57 because at 6% a smaller amount is needed to grow to $990.57(1.06) = $1050 And if current interest rates are 4%, you would pay more – $1009.62 – because at 4% this higher amount would be needed to grow to $1009.62(1.04) = $1050

13. 9–13 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Bond Price (cont.) Paying these prices means you earn market interest rates on the bond If market interest rates are 5%, you will pay 1050/1.05 = $1000; gain of $50 = 5% If market interest rates are 6%, you will pay 1050/1.06 = $990.57; gain of $59.43 = 6% If market interest rates are 4%, you will pay 1050/1.04 = $1009.62; gain of $40.38 = 4%

14. 9–14 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Interest Rates and Bond Prices Bond prices are inversely related to market interest rates When market interest rates rise (fall), the prices of existing bonds fall (rise) Conversely, when bond prices rise (fall), it means that market interest rates have fallen (risen)

15. 9–15 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Market Price of a One-Year Bond Suppose a bond has a maturity value of MV in one year’s time. What is its market value now – its present value (PV)? In one year’s time this PV will grow to a maturity value of PV(1 + i), where i is the current market interest rate. So MV = PV(1 + i) It follows that PV = MV/(1 + i)

16. 9–16 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Bond Prices & Market Rates If we know the maturity value (MV) of a bond and its current market price (PV), what is the implied interest rate? If PV = MV/(1 + i) then i = [MV/PV] – 1

17. 9–17 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Money Market Equilibrium Suppose the demand for money exceeds the supply … People will sell some of their bonds Bond prices will fall Market interest rates will rise The rise in interest rates reduces the quantity of money which is demanded: shift along curve Demand for money now equals supply, and bond prices and interest rates are stable

18. 9–18 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank RBA Influences the Cash Rate When the RBA sells government bonds, money is taken out of the money market as these bonds are paid for The interest rate on 24-hour or overnight loans rises

19. 9–19 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank A Rise in the Cash Rate Spreads Lenders have a choice between lending in the overnight market at the cash rate, and lending for a longer term, such as 90 days, at higher rates Borrowers face similar choices When the cash rate rises, lenders demand higher rates in the 90-day market while borrowers offer higher rates in that market

20. 9–20 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The 90-Day Bill Market The demand for 90-day securities by lenders shifts to the left The supply of 90-day securities offered by borrowers shifts to the right The price of 90-day securities falls and the rate of interest rises

21. 9–21 Rise in Cash Rate Spreads

22. 9–22 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Targeting Interest Rates If the RBA targets the cash rate, it can only achieve this by setting the money supply consistent with this target The money demand curve tells us the demand for money at the target interest rate So the RBA has to set the money supply equal to this level of demand in order to achieve the target If there is a change (shift) in the demand for money, the interest target can only be maintained if the supply of money is also allowed to change

23. 9–23 Interest Rate Target of 5%

24. 9–24 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The GST and Money Demand When the GST was introduced, the price level rose This increased the demand for money Demand for money shifted to the right The RBA could only maintain its interest rate target by increasing the supply of money in line with the demand

25. 9–25 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Targeting the Money Supply If the RBA targeted the money supply, instead of the interest rate, it would have to accept the interest rate at which the demand for money is equal to that target supply

26. 9–26 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Nominal vs Real Interest Rates The RBA controls the nominal interest rate The real interest rate is the nominal rate minus the inflation rate The inflation rate is ‘sticky’ in the short run because it depends on inflation expectations of workers and employers So in the short run, the RBA controls real rates through control of nominal rates In the long run, the RBA has less control because real rates are determined by the supply and demand for saving

27. 9–27 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank How Monetary Policy Works A rise in interest rates reduces consumption and investment spending because it raises the cost of borrowing, and the attraction of lending own funds rather than investing them in investment projects It may also encourage saving Conversely, a fall in interest rates has the reverse effects

28. 9–28 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank Equilibrium GDP When Spending is Real Interest Rate (r) Sensitive C = C + c[Y –T ] – ar I p = I – br G = G NX = NX (Where bars signify exogenous spending) PAE = sum of these components of spending Set PAE = Y (demand = supply) and solve for Y e Y e = [C + I + G + NX – c T – ar – br]/[1 – c]

29. 9–29 Recession is Fought by Lowering r

30. 9–30 Inflation is Fought by Raising r

31. 9–31 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank RBA’s Policy Reaction Function The RBA is concerned with cyclical unemployment and the inflation rate When GDP is close to potential, the emphasis is on the acceptable ‘core’ inflation rate, in the region of 2–3% The policy reaction function tries to explain/predict by how much the RBA raises the cash rate when the core inflation rate exceeds the target by 1%

32. 9–32 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank The Taylor Rule In theory, the RBA responds to the ‘output gap’ (the difference between GDP and potential) and to the inflation rate A rise in the output gap will lead the RBA to raise nominal and real interest rates A rise in the inflation rate will lead the RBA to raise nominal and real interest rates: that is, nominal interest rates will be raised by more than the rise in the inflation rate

33. 9–33 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank By How Much? If GDP exceeds potential by 1%, by how much will interest rates be raised? If inflation rises by 1%, by how much will interest rates be raised? This is difficult to predict because it depends on the respective weights or importance which the RBA attaches to these undesirable outcomes

34. 9–34 Hypothetical Reaction Function

35. 9–35 Copyright  2005 McGraw-Hill Australia Pty Ltd PowerPoint® Slides t/a Principles of Macroeconomics by Bernanke, Olekalns and Frank RBA May Be Proactive The RBA may be proactive rather than reactive, and may raise the cash rate to forestall an expected, unacceptable but unquantified rise in the inflation rate to prevent it from eventuating The RBA may also threaten to raise interest rates to forestall higher expected inflation, not actually raising them if the threat is believed and has the desired effect Central banking, like any form of leadership and crowd control, is not an exact science

36. 9–36 Recent History of Cash Rates