2. The Monetary and Financial
System (Chapter 15)
• Before we study Monetary Policy, it is
important to understand about money,
money supply, interest rates and how
the financial system operates.
2
3. Monetary and financial system: Key CONCEPTS
•
•
•
•
•
•
What makes money ‘money’?
Other desirable properties of money
The demand for money
Four money-supply definitions
The equilibrium interest rate
How changing money supply affects interest
rates, prices, output and employment
• A modern financial system
3
4. WHAT MAKES MONEY ‘MONEY’?
• Exchange can take place using a trading system
known as barter – direct exchange of one good for
another.
• Barter requires double coincidence of wants.
• The use of money simplifies and facilitates market
transactions.
4
5. THE THREE FUNCTIONS OF MONEY
Money is
anything that
serves as:
a medium of
exchange
a unit of
account
a store of
value.
Money has been:
metals, shells,
stones &
cigarettes
It needs to
serves the
three
functions
5
Credit cards are
not money – by
themselves, they
do not carry out
the three
functions of
money.
6. THE THREE FUNCTIONS OF MONEY (CONT.)
• Medium of exchange – the primary function of
money: to be widely accepted in exchange for
goods and services.
• Unit of account – the function of money to
provide a common measurement of the relative
value of goods and services.
• Store of value – the ability of money to hold
value over time.
6
7. THE DEMAND FOR MONEY
• Money itself provides no return, so people
and business who hold cash or cheque
account balances incur an opportunity cost
(foregone interest or profits from the money
held).
• There are three motives for holding money.
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8. MOTIVES FOR HOLDING MONEY
• The transactions demand for money
– the stock of money people hold to make everyday
predictable expenses like making purchases or
paying bills.
• The precautionary demand for money
– the stock of money people hold to pay for
unpredictable expenses like unforeseen events.
• The speculative demand for money
– the stock of money people hold to take advantage of
expected future price changes in the price of stocks,
bonds or other non-money financial assets
8
9. OVERALL DEMAND FOR MONEY
• This shows the overall quantity of money that people
want to hold at different interest rates, ceteris
paribus.
• Other things being equal, there is an inverse
relationship between the quantity of money
demanded and the interest rate.
• The interest rate is the price of money.
9
10. FOUR MONEY-SUPPLY DEFINITIONS
• There are four different (arbitrary) definitions of money
supply in Australia:
Monetary
Base
M1
M3
Broad
Money.
• These account for how people hold their money in cash
and notes, and in deposits at banks and non-bank institutions.
• The widest definition of money published by the Reserve Bank
of Australia (RBA). Broad money is defined as currency plus ADI
deposits from the non-AFI private sector, plus other short-term
liquid AFI liabilities held by the non-AFI private sector.
10
11. THE EQUILIBRIUM INTEREST RATE
• The money demand curve (MD) is a graphical
representation of the inverse relationship
between interest rates and money demand.
• The supply of money curve is independent of
the interest rate.
11
13. Bond Price
Term
Interest Rate
Interest Paid
Dm > Sm
Sb > Db
Bond Price
Interest Paid
Interest Rate
$100
10 years
5.00%
$5
Sell Bonds
Bond Price Falls
$90
$5
5.56%
14. Actions by the Central Bank affects
The Interest Rate
• Changing the cash rate is action taken by
the nation’s central bank to influence:
–
–
–
–
the monetary base (money supply)
interest rates (lending and saving)
economic activity (circular flow)
price levels (inflation).
14
15. INCREASING THE MONEY SUPPLY
• This creates a surplus of money at the prevailing
interest rate.
• This is called expansionary monetary policy.
• People seek to invest this money in interest-bearing
bonds, which drives their price higher and the interest
rate lower.
• Thus the imbalance between money supply and
demand disappears.
15
16. Increasing Money Supply
The RBA decides on expansionary monetary
policy, in which case they increase the money
supply and interest rates fall.
16
17. Bond Price
Term
Interest Rate
Interest Paid
Dm < Sm
Sb < Db
Bond Price
Interest Paid
Interest Rate
$100
10 years
5.00%
$5
Buy Bonds
Bond Price Rise
$110
$5
4.55%
18. DECREASING THE MONEY SUPPLY
• This creates a shortage of money at the prevailing
interest rate.
• This is called contractionary monetary policy.
• People seek to sell interest-bearing bonds, which
drives their price lower and the interest rate
higher.
• Thus the imbalance between money supply and
demand disappears.
18
19. Decreasing Money Supply
The RBA decides on contractionary monetary policy, in
which case it lowers the money supply and the interest
rate rises.
19
20. How Changing Money Supply affects
Prices, Output And Employment
• The monetary policy transmission mechanism shows how
monetary policy is transmitted through the economy,
affecting prices, output and employment.
20
21. How Increasing Money Supply Affects Prices, Output
And Employment
• With Increased money supply and lower
interest rates :
– consumers are more willing to spend
– businesses are more willing to spend on plant,
structures and equipment.
21
22. THE AUSTRALIAN FINANCIAL SYSTEM
• The Reserve Bank of Australia (RBA) is
Australia’s central bank.
• The RBA is responsible for financial system
stability, the financial payments system and
banking services to the financial sector and
the government.
• The RBA Board determines monetary policy
in Australia.
22
23. THE BANKING SYSTEM
• Each bank conducts an exchange settlement account
(ESA) with the RBA in order to conduct its business with
other banks and financial institutions, the RBA and the
government.
• Exchange settlement accounts must have a positive
balance at the end of each trading day to ensure
settlements of accounts can be made.
• “An account held at the Reserve Bank of Australia by
financial institutions to settle financial obligations
arising from the clearing of payments.” RBA
23
24. THE BANKING SYSTEM (CONT.)
• The banks must also maintain minimum liquidity
requirements to meet short term requirements from
depositors and creditors.
• They must also maintain capital adequacy
requirements as reassurance to depositors that their
funds are safe.
24
25. THE BANKING SYSTEM AND
CREATING MONEY
• Fractional Reserve Banking is a system whereby banks
must keep only a percentage of their deposits on
reserve to meet day to day liquidity needs.
• The rest can be loaned to borrowers. This creates new
deposits which can be used for lending. This is credit
creation (the monetary multiplier).
25
26. THE MONEY MARKET
• The short-term money market (STMM) allows banks,
non-bank institutions, merchant banks, insurance
companies, etc. to invest or borrow for short periods,
usually in treasury notes or commercial bills.
• Treasury notes - Commonwealth Government
Securities with a short term to maturity, issued at a
discount to their face value with the difference (or
discount) representing the return on the note. They
are used primarily to meet the Government's need
for within-year finance. (RBA)
26
27. Key Concepts to be Learnt in relation to
Monetary Policy
• The goals of monetary policy and two views of the
monetary policy transmission mechanism
• The appropriate role for monetary policy: the rules
versus discretion debate
• Monetary targeting; Australia, 1976–85
• Modern monetary policy implementation: the case of
Australia
• Linking the RBA operation of monetary policy to the
AD–AS framework
27
28. What Is Monetary Policy?
• Australia’s central bank (Reserve Bank of
Australia; RBA) has responsibility for the
determination and implementation of monetary
policy.
• Monetary policy: The actions taken by the
Central Bank (Reserve Bank of Australia; RBA) to
affect interest rates in order to keep inflation low
and stable.
28
29. THE GOALS OF MONETARY POLICY
• The Goals of Monetary policy in Australia:
– Low and stable inflation rate: with inflation low
and stable, it is predicted that economic
growth will be higher and unemployment
lower in the long term.
– Full employment of the Labour Force
– Stability of the Australian currency.
– Economic prosperity and welfare for the people of
Australia.
29
30. Monetary Policy in Australia
• Monetary policy in Australia is conducted in a transparent and
forward-looking manner.
• Transparency is achieved through regular public commentary
by the RBA Governor, and means that the RBA is accountable
for its actions.
• The forward-looking nature of monetary policy means the RBA
pays close attention to leading indicators (i.e. housing
approvals) to try to prevent inflation rising (rather than trying
to reduce inflation after it has already risen).
30
31. THE KEYNESIAN VIEW OF MONETARY POLICY
Changes in monetary policy affect interest rates, which
affects consumer expenditure and investment
demand.
This affects AD, resulting in changes to real output,
employment and prices.
31
32. THE MONETARIST’S VIEW OF MONETARY POLICY
Changes in money supply directly affect changes in
AD, and therefore changes in real output,
employment and prices.
32
33. THE EQUATION OF EXCHANGE
• This is an accounting identity that states that the money
supply times the velocity of money equals total spending.
MV = PQ
• Where:
• M = money supply
• V = velocity of circulation (the average number of times per period
•
•
a $ of the money supply is spent on final goods and services)
P = the price level
Q = quantity of output
33
34. THE QUANTITY THEORY
OF MONEY
• Classical economists believe that V and Q in are
fairly constant and
• changes in the price level (inflation) are directly
related to changes in the quantity of money.
• M.V = P.Q
• Therefore, an increase in money supply causes
prices to rise (inflationary)
34
35. MODERN MONETARISM
• Evidence today suggests Velocity is not constant.
• The economy is not always at full employment.
• Thus, although Money Supply and Price level are
correlated, they do not change proportionally.
• If well below full employment, and increase in M
will result in an increase in nominal GPD
• If near full employment, and increase in M will
increase prices rather than GDP.
35
36. THE ROLE FOR MONETARY POLICY:
THE RULES VS. DISCRETION DEBATE
• Monetary policy has powerful effects on the
macro economy.
• Keynesians would prefer the central bank to retain
considerable discretion to adjust monetary policy.
• Monetarists prefer pre-announced and widely
publicised rules, especially one for pre-set targets
for money supply growth.
36
37. COUNTERCYCLICAL
MACROECONOMIC POLICY
• Macroeconomic policy aims to smooth
fluctuations in the business cycle.
• The RBA aims to adjust monetary policy in a
timely way so the impacts of the policy will be
felt at the right time in the business cycle.
• This is difficult to do due to time lags.
37
38. TIME LAGS
• These are delays associated with
implementing countercyclical policy:
– information lags
– policy determination lags
– policy effectiveness lags.
• The length of time associated with some of
these lags can be long and highly variable
• Caution: the market is self-correcting and
intervention could be disruptive by the time
policy takes effect
38
40. MODERN MONETARY POLICY IMPLEMENTATION
IN AUSTRALIA
• The RBA (since 1996) has an official inflation target of 2–3
per cent per annum.
• The RBA adjusts the overnight cash rate, which influences
all other interest rates.
• The RBA announces its cash rate target, then uses openmarket operations to maintain that rate (buy and sell
government securities).
• securities - A financial instrument which represents a
claim over real assets or a future income stream. Such
instruments are usually tradeable. Examples of securities
include bonds, bills of exchange, promissory notes,
certificates of deposit and shares.
40
41. Cash Rate
• The Cash Rate is the interest rate on overnight loans
between financial institutions including the RBA.
• Determined by the interaction of demand for and supply
of funds in the overnight funds market.
• Open Market Operations (OMOs) can also be used to
change the cash rate.
• A change in the cash rate typically flows through the
financial system impacting all interest rates.
41
42. Open Market Operations
• Open market consist of the RBA buying and selling
Commonwealth government securities from the private
sector - usually other banks – for cash.
• RBA simply electronically debit or credit the Exchange
Settlement Account (ESA) of other banks.
• ESAs are accounts held with RBA by other banks and
financial institutions.
42
45. Monetary policy decisions
are expressed in terms of
a target for the cash rate,
which is the overnight
money market interest
rate. A media release is
issued at 2.30 pm after
each Reserve Bank Board
meeting, with the Board's
decision taking effect the
following day
Effective Date
2 May 2012
7 Dec 2011
2 Nov 2011
3 Nov 2010
5 May 2010
7 Apr 2010
3 Mar 2010
2 Dec 2009
4 Nov 2009
7 Oct 2009
8 Apr 2009
4 Feb 2009
3 Dec 2008
5 Nov 2008
8 Oct 2008
3 Sep 2008
5 Mar 2008
6 Feb 2008
7 Nov 2007
8 Aug 2007
Change in cash rate
Percentage points
-0.50
-0.25
-0.25
+0.25
+0.25
+0.25
+0.25
+0.25
+0.25
+0.25
-0.25
-1.00
-1.00
-0.75
-1.00
-0.25
+0.25
+0.25
+0.25
+0.25
New cash rate target
Per cent
3.75
4.25
4.50
4.75
4.50
4.25
4.00
3.75
3.50
3.25
3.00
3.25
4.25
5.25
6.00
7.00
7.25
7.00
6.75
6.50
46. Monetary Policy Transparency
• The RBA Board meets on the first Tuesday of
the month (except January).
• The Board determines interest rate policy.
• The decision is announced to the media and on
the Bank’s website at 2.30 p.m.
• OMOs commence the morning following any
change in policy.
46
47. Expansionary Monetary Policy
• Aim: To provide an economic stimulus when
the economy is in recession.
• Expansionary Monetary Policy aims to
increase real GDP and to reduce the level of
unemployment.
47
48. Expansionary Monetary Policy Transmission
•The RBA uses OMOs to buy back Commonwealth
government securities (bonds).
•This will increase money supply and decrease
the cash rate
• A decrease in the cash rate will decrease other
market interest rates.
48
49. Expansionary Monetary Policy Transmission
(Continued)
•A decrease in interest interest rates will increase both
investment and interest-sensitive consumption.
•The decrease in interest rates will also decrease the
exchange rate value of the dollar ($ depreciates). This will
increase net exports.
•Thus, decrease in interest rates will increase aggregate
demand (AD), real GDP and the price level, and reduce
the level of unemployment.
49
50. Using Expansionary Monetary Policy to Increase
Aggregate Demand
LAS
125
Price level
(GDP deflator, 2003/04 = 100)
Increase in AD
raises price level
and increases
real GDP...
AD1
AD0
SAS
B
108
105
A
95
Full Employment
0
850
900
950
1,000
Real GDP (billions of 2003/04 dollars)
50
51. RBA Operation of Contractionary Monetary Policy
• If the RBA believes that inflation is at the top of
its acceptable range and will persist:
– it would react by increasing the cash rate (often in a
series of small, monthly steps). This increases
interest rates in the economy.
• Aim: To slow down the economy when the
inflation is higher than target and keep
increasing.
51
52. CONTRACTIONARY MONETARY POLICY
• Contractionary monetary policy causes a decrease in
total spending ( aggregate demand).
• This will lead to a reduction in output (real GDP), and
employment (i.e. the level of economic activity).
• The reduction in aggregate demand will also tend to
reduce the rate at which prices have been rising (price
level decreases).
52
53. Contractionary Monetary Policy Transmission
RBA uses OMOs to sell securities; Money supply decreases
Cash rate increases; All interest rates in the economy increase
Investment and interest-sensitive consumption decrease.
Increase in interest rate will increase the exchange rate value of
the dollar ($ appreciates). This leads to a reduction of net
exports.
These result in decrease in real GDP and the price level, but
increase the level of unemployment.
53
54. Using Contractionary Monetary Policy to Decrease
Aggregate Demand
LAS
Price level
(GDP deflator, 2003/04 = 100)
125
Decrease in AD
decreases price level
and decreases
real GDP...
AD0
AD1
110
105
SAS
A
B
95
Full Employment
0
800 850 900
950
1,000
Real GDP (billions of 2003/04 dollars)
54
55. Further Reading
The RBA and the then newly elected Labor
Government issued a “Statement on the Conduct
of Monetary Policy” in December 2007. Find and
read this document which records the relationship
between the Australian Government and the RBA
at:
http://www.rba.gov.au
55
56. Summary
• Goals of Monetary policy
• RBA and the implementation of modern monetary
policy in Australia
• Inflation targeting
• Cash rate
• Open market operations
• Expansionary monetary policy and its effects on real
GDP and price level
• Contractionary monetary policy and its effects on
real GDP and price level
56
57. Feedback
• Write down the most difficult concepts in
today’s lecture that you need further
assistance with?
• What were the most important ideas
discussed in today’s lecture?
57
58. Self-review Questions
• Compare and contrast Keynesian and Monetarist views of
monetary policy.
• What is monetary policy and what are the goals of modern
monetary policy of Australia?
• How does the RBA conduct open market operations to
decrease the cash rate? To increase the cash rate?
• Using diagrams, explain the effects of expansionary monetary
policy and contractionary monetary policy.
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