Money, Prices and the Reserve Bank

Chapter 7: Money, Prices and the Reserve Bank.

• Monetary policy, the name given to the central banks policies that affect the rate of interest in the economy. Interest rate changes are believed to be an effective way of influencing planned aggregate expenditure and so impact on the economy’s equilibrium level of GDP.

The financial system and the allocation of saving to productive uses:

• A well-functioning financial system improves the allocation of saving in two distinct ways;

• System provides information to savers where highest returns are possible.
• Financial markets help savers to share the risks of individual investment projects.

• The three key components of the financial system;

• The banking system: The banking system consists of commercial banks that accept deposits from individuals and businesses and use those deposits to make loans – “financial intermediaries”, firms that extend credit to borrowers using funds raised from savers.
• A Bond is a legal promise to repay a debt. These repayments typically consist of two parts. First, the principle amount, which is the amount originally, lent, is paid at some specific date in the future (maturation date). Second, the owner of the bond called the bondholder, receives regular interest or coupon payments until the bond’s maturation date. Bond prices and interest rates are inversely related (bond price x 1.06 = $1050).
• A share of stock (or equity) is a claim to partial ownership of a firm. First shareholders receive regular payments called dividend for each share of stock they own. Second, shareholders receive returns in the form of capital gains when the price of the their stock increases. (stock price x 1.06 = $81.00).

Bond markets, stock markets and the allocation of savings:

• Corporations that are planning a capital investment but do not want to borrow from the bank have two other options; issue new bonds or issue new shares in itself.
• The ongoing search by savers and their financial advisors for high returns leads the bond and stock markets to direct funds to the uses that appear most likely to be productive.
• Savers reluctant to take large risk, therefore diversification is the practice of spreading ones wealth over a variety of different financial investments to reduce overall risk.

Money and its uses:

• Money is any asset that can be used in making purchases. Money has three principal uses:

• Medium of exchange: when it is used to purchase goods and services – crucial functions.
• Unit of account: money is the basic yardstick for measuring economic value.
• Store of value: money is a way of holding wealth.

• Measuring money:

• Currency: notes and coins on issue less holdings of notes and coins by all banks.
• M1: currency plus current deposits with banks.
• M3: M1 plus all deposits of the private non-bank sector.
• Broad money: M3 plus borrowing from private sector by non0bank depository corporations less holding of currency and deposits of non-bank depository corporations.

Commercial banks and the creation of money:

• In modern economies the money supply consists not only of currency but also of deposit balances held by the public in commercial that is, private banks.
• Cash or similar assets held by banks are called bank reserves (reserves of cash kept by banks to meet their customers demands to withdraw deposits.
• 100% reserve banking: all bank deposits are kept in the form of cash reserves.

• The reserve-deposit ratio, which is bank reserves divided by deposits is now equal to 100000/1 million (when loans of 900000 are made), 10%. A banking system in which banks hold fewer reserves than deposits, so that the reserve-deposit ratio is less the 100% is called fractional-reserve banking system.

[pic 1]

[pic 2]

Money and prices

• A major reason that the supply of money is important is that, in the long run, the amount of money circulating in an economy and the general level of prices are closely linked.
• Velocity is a measure of the speed at which money circulates. It is defined as the value of transactions completed in a period of time divided by the stock of money required to make those transactions. Higher ratios – faster typical dollar circulating.
• Let V = velocity, M = particular money stock being considers (e.g. M1 or broad money), P = nominal GDP and y = real GDP.

[pic 3]

• Definition of velocity to see how money and prices are related in the long run. Quantity equation an identity that states the nominal value of expenditure in the economy must be equivalent to the stock of money multiplied by its velocity of circulation.

[pic 4]

• According to the quantity equation a 10% increase in the money supply, M, should cause a 10% increase in the price level P that is an inflation of 10%.
• Thus high rates of money growth will tend to be associated with high rates of inflation and with no associated change in real output.

THE RESERVE BANK OF AUSTRALIA

• The reserve bank is Australia’s central bank and has two main responsibilities. First, it is responsible for monetary policy, which these days means that the reserve bank influence the level of interest rates in the economy. Second, the reserve bank bears important responsibility for the oversight and regulation of the financial markets.
• The emphasis now is on reserve bank interventions in the financial market, designed to affect the general level of interest rates in the economy.
• To begin, the reserve bank affects the supply of reserves which Australia’s commercial banks hold in special account, known as exchange settlement accounts, with the reserve bank. The reserve bank achieves this through its open market operations.
• Suppose the reserve bank wants to raise the level of bank reserves. To accomplish this, the reserve bank buys financial assets, usually from private banks. The reserve bank using newly printed money, therefore the reserves of the commercial banking system will increase by the amount equal to the value of the assets. The reserve banks purchase of government bonds, leading to an increase in bank reserves, is called open-market purchase.
• Suppose the reserve bank wants to lower the level of bank reserves , it sells some of the financial assets that it holds usually to banks. This leads to a transfer of reserves from the commercial bank to reserve bank. The sale of financial assets by the reserve bank for the purpose of reducing bank reserves is called an open-market sale. 
• Open market operations is both open market sale purchase and sale.
• Exchange settlement accounts are kept by commercial banks with the reserve bank that are used by the banks to settle their obligations with each other. These accounts pay relative low interest, therefore incentive for commercial banks not to keep more reserves than needed to fulfill obligation with other banks. Need for exchange settlement reserves fluctuate daily with the level of business their customers are transacting in.
• Management of commercial banks exchange settlement accounts is done through the overnight cash market (its function is to facilitate borrowing and lending for periods of 24 hours or less). Commercial banks fearing their exchange settlement accounts are running to low may borrow fund from the overnight cash market and the interest rate on that loan is called the overnight cash rate.  Banks who have excess exchange settle balances can lend that money on the overnight cash market.
• By carefully monitoring conditions in the cash market the reserve bank is able to tailor its purchase and sales of financial assets so as to achieve a particular target for the cash rate.

• E.g. cash rate looks above reserve banks target rate. Reserve bank increases its purchase of assets. Commercial banks will now have an incentive to lend out surplus funds in the overnight cash market – making it easier for borrowers to negotiate a lower cash rate. End result lower overnight cash interest rate.
• E.g. cash rate looks below reserve banks target rate. Reserve bank will sell financial assets. Therefore commercial banks exchange settle accounts decrease, in order to prevent them from becoming to lower they borrow funds in the overnight cash markets. Increase in demand for borrowed funds increases the overnight cash rate.

• Monetary policy seeks to affect all interest rates in the economy not just the overnight cash rate. For open-market operations to have the desired economy wide effect on interest rates there must be some link between the cash rate and other rates of interest.
• The relationship that exists between these interest rates, and the fact that the reserve bank can target the overnight cash rate through the effect of open market operations on banks exchange settlement accounts, means that in changing the cash rate the reserve bank is also able to affect other rates of interest as well. It is through this mechanism that the reserve bank is able to influence the level of planned aggregate spending in the economy.

Chapter 8: The reserve bank and the economy.

The reserve bank, interest rates and monetary policy

• A 90-day commercial bill is a bond supplied by firms seeking funds for three months (supply and demand of 90-day bills.
• When the price of these bills is high, which corresponds to a low interest rate, firms are likely to issue an increased quantity of bills, since the cost of borrowing when the interest rate is low is also relatively low. Hence positively sloped supply of 90-day bills schedule and the demand curve summaries the decisions made by those willing to lend money. When price is high (interest rate is low ) fewer funds lent than when the price is low (interest rate is high).
• In the instance that these bills are priced below the equilibrium price, given the inverse relation between bond price and interest rate, this situation reveals the bills are in excess of its equilibrium. People are willing to lend to firms more than they wish to borrow. Resulting in the price at which these bills are traded will be bid upwards. Until reaching equilibrium.
• Further more suppose the market for 90-day bills is in equilibrium and the reserve bank takes steps to increase overnight cash rate. The higher interest will cause some firms to borrow short-term funds to revise their financing plans and move to longer-maturity loans. The supply of the 90-day bills will shift right. However some lender will leave the 90-day bill market to seek higher returns in overnight cash market, causing the demand curve to shift left. The end result is a lower equilibrium price and higher interest rate.
• The reserve banks move to increase the overnight cash rate has spilled over and caused the 90-day bills rate to increase. Once the 90-day bill rate increase we would expect that the 180-day bill rate would follow suit.

Implication of change in monetary policy for the money supply