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ECO1000Economics
Semester One, 2004Lecture 8
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.
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
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
THE MONETARY SYSTEMTHE MONETARY SYSTEM
Money
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
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
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
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.)
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.
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.
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.
Money Creation
This T-Account illustrates a bank that accepts deposits, keeps a portion as reserves, and lends out the rest.
Assets Liabilities
First State Bank
Reserves$20.00
Loans$180.00
Deposits$200.00
Total Assets$200.00
Total Liabilities$200.00
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
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.
The Money Multiplier
Assets Liabilities
First State Bank
Reserves$10.00
Loans$90.00
Deposits$100.00
Total Assets$100.00
Total Liabilities$100.00
Assets Liabilities
Second State Bank
Reserves$9.00
Loans$81.00
Deposits$90.00
Total Assets$90.00
Total Liabilities$90.00
The Money Multiplier
Assets Liabilities
First State Bank
Reserves$10.00
Loans$90.00
Deposits$100.00
Total Assets$100.00
Total Liabilities$100.00
Assets Liabilities
Second State Bank
Reserves$9.00
Loans$81.00
Deposits$90.00
Total Assets$90.00
Total Liabilities$90.00
Money Supply = $190.00!
The Money Multiplier
How much money is eventually created in this economy?
Original deposit = $ 100.00First State lending = $ 90.00 [=0.9 x $100.00]Second State lending = $ 81.00 [=0.9 x $90.00]Third State lending etc. etc.
= $ 72.90 [=0.9 x $81.00]etc.etc.
Total money supply = $1,000 (from the original $100)
The Money Multiplier
The money multiplier is the reciprocal of the reserve ratio.
M = 1/RWith a reserve requirement, R = 10% or 1/10,The multiplier is 10 (as in the previous example)So we multiply the $100.00 deposit by 10 to get the total created money supply of $1000.00. If the R = 3% or 1/30, our money multiplier = 30.
MONETARY POLICY IN AUSTRALIA
The Role of the RBA
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)
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.
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.
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.
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.
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.
INFLATION: ITS CAUSES AND COSTS
Rising Prices
Inflation in Australia
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)
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.
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.
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.
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.
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.
Money Supply and Money Demand
Money Supply & Demand
Quantity of money
Value ofMoney
Price Level
A
Moneydemand
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
M1
MS1
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.
The Effects of Monetary Injection
Quantity of money
Value ofMoney
Price Level
A
B
Moneydemand
0
1
(Low)
(High)
(High)
(Low)
1/2
1/4
3/4
1
1.33
2
4
M1
MS1
M1
MS2
2....decreases the value of money ... 3. and
increasesthe pricelevel.
1. An increase in the money supply...
QUANTITY THEORY
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.
Velocity
The velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.
Velocity Equation
V = (P x Y)/M
Where: V = velocity
P = the price levelY = the quantity of outputM = the quantity of money
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.
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).
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.
PROBLEMS CAUSED BY INFLATION AND RELATED ISSUES
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.
The Costs of Inflation
Shoeleather costs Menu costs Relative price variability Tax distortions Confusion and inconvenience Arbitrary redistribution of wealth
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.
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.
Relative-Price Variability
Inflation distorts relative prices. Consumer decisions are distorted,
and markets are less able to allocate resources to their best use.
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.
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.
Confusion and Inconvenience
With rising prices, it is more difficult to compare real revenues, costs, and profits over time.
Arbitrary Redistribution of Wealth
Unanticipated inflation redistributes wealth between debtors and creditors.
This may result in wealth transfers that would not otherwise be acceptable.
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).
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.
In Light of the Objectives of this Lecture…
We now know about: Money Inflation The Reserve Bank and Trading Banks Monetary policy
Next Week
Material Covered: Module Six Reading: Text and Hakes and Parry
Chapters 14 and 15 Topics: The Open Economy
THE END
