econ1102 week 7

Week 7 Lectures 13 & 14

Money, Prices and the Reserve Bank Reference: Bernanke, Olekalns and Frank - Chapter 7 Key Issues

Financial system

What is money?

Private banks and money creation

Money and prices

Reserve Bank of Australia (RBA)

How the RBA sets a target value of the cash rate

Financial System What happens to Saving?

Currency

Bank deposits

Stocks/shares/equities

Other assets Lenders Financial System Borrower (Saver) {Intermediation} (Investor)

Asset Prices and Yields The yield or return on a financial asset is inversely related to the asset’s price. Price(tomorrow) + Income

Return = Price(today) Other things equal: Price(today) implies Return

Bonds Principal = amount that is originally borrowed on the bond Term of bond = length of time before bond has to be repaid (terms can range from 24 hours to 30 years) Coupon payment = regular dollar payment of interest on the bond Coupon rate = Coupon Payment Principal

Bonds (Example) Principal (or face value) = $100 Term = 1 year Coupon = $5 per year Coupon rate = 5%

Bond Prices and Interest Rates Bonds do not have to be held until maturity, but can be bought and sold on the bond market. What determines the price of a bond?

Consider a two year bond with a face value of $1000.

The annual coupon rate is 5%, implying there are two annual coupon payments of $50.

A Timeline 5% 0 1 2 -1,000 50 50 + 1000 Bond price at 0, if market interest rates are 5% pa

A Timeline 5% 0 1 2 -1,000 50 50 + 1000 Bond price at 0, if market interest rates are 5% pa Present-Value formula:

𝑃𝑉 = 50

(1.05)2= 1,000

What if market interest rate rise? (At end of year 1) 5% 10 % 0 1 2 -1,000 50 50 + 1000 Bond price at end of year 1, if market interest rates rise to 10% pa

What if market interest rate rise? (At end of year 1) 5% 10 % 0 1 2 -1,000 50 50 + 1000 Bond price at end of year 1, if market interest rates rise to 10% pa Present-Value formula:

𝑃𝑉 = 1,050

1.10= 954.5

Bond prices and interest rates are inversely related If market interest rates had stayed at 5% then,

Bond Price = 1050/1.05 = 1000 but when they rise to 10%

Bond Price = 1050/1.10 = 954.5 The bond price falls.

What is Money? Is Bitcoin Money? https://theconversation.com/in-conversation-with-bitcoin-expert-and-nyu-professor-david-yermack-31048

Functional Definition of Money

Medium of exchange

Unit of account

Store of value

Medium of Exchange

Good or asset whose primary purpose is to purchase other goods.

goods → money → goods Why not directly trade goods for goods? i.e. Barter Barter tends to be inefficient.

Double Coincidence of Wants For barter to occur:

Person 1 wants to accept goods supplied by Person 2

Person 2 wants to accept goods supplied by Person 1 With a medium of exchange each person:

Sells their goods for medium of exchange

Uses medium of exchange to buy goods they want

Unit of Account Good that is used to compare the value of all other goods and services Standard to use medium of exchange as the unit of account

Store of Value Good or asset that serves as a means of holding (or transferring) wealth over time. Many goods and assets can serve as a store of value (e.g. land, bonds, stocks) but do not possess the medium of exchange or unit of account functions of money.

Measuring Money In modern economies money is provided by:

Government (currency – notes and coin)

Banking system (deposits)

Standard Measures of Money for Australia $ billion (end-June)

2009 2011 2014 Currency 45.5 48.1 58.0 M1 249.8 269.2 308.4 M3 1,182.2 1,345.5 1,663.6 Broad Money 1,257.0 1,385.7 1,670.2

Definitions of Money Measures Currency = notes and coin on issue (less what is held by

RBA and banks) M1 = Currency + Current deposits at banks M3 = M1 + all other bank deposits of non-bank private sector Broad Money = M3 + borrowings from private sector by non-bank depository corporations (less what these non-banks hold with banks)

Banks as Creators of Money Suppose central bank prints currency = $100m This is distributed to households and firms Rather than hold the currency, households and firms deposit the entire $100m into the private banks.

Banking Systems’ Balance Sheet

Assets Liabilities Reserves = $100m Deposits = $100m 100 Percent Reserve Banking

simple banking system

banks take deposits and hold the currency as reserves

banks earn income by charging fees

Bank Loans Unnecessary for banks to hold all of their deposits in the form of reserves Some level of reserves is required to meet unexpected withdrawals, but not 100 percent. Banks can lend out their excess reserves to borrowers in the form of bank loans. Banks are now financial intermediaries.

Fractional Reserve Banking Banks to decide to keep $10m as reserves and lend out the other $90 million Want to maintain a reserve-deposit ratio, R/D = 10%

Banking Systems’ Balance Sheet (100 percent reserve)

Assets Liabilities Reserves = $100m Deposits = $100m

Banking Systems’ Balance Sheet (10 percent reserve)

Assets Liabilities Reserves = $10 m Deposits = $100m Loans = $90m Where does the $90m lent to households and firms go?

Loans get re-deposited into banks

Banking Systems’ Balance Sheet (2) Assets Liabilities

Reserves = $10 m Deposits = $100m + $90m + $90m

Loans = $90m Reserves = $100m Deposits = $190m R/D = 0.53. Much higher than desired 10% of $190m = $19m, so ($100m – $19m) = $81m of reserves can be used to make loans

Banks Make Additional Loans Banking Systems’ Balance Sheet(3)

Assets Liabilities Reserves = $19 m Deposits = $100m

+ $90m Loans = $90m + $81m

And they are Re-Deposited Banking Systems’ Balance Sheet(3)

Assets Liabilities Reserves = $19 m Deposits = $100m

+ $ 81m + $90m Loans = $90m + $81m + $81m Notice that at the end of round 3, banking system still has total reserves of $100m Reserves = $100m Deposits = $ 271m R/D = 0.37 Too high, but falling.

What is the Money Supply? Initial stock of money =$100m (currency = deposits) After initial round of loans and re-deposits Money supply = 100 + 90 = $190m After second round Money supply = 100 + 90 + 81 = $271m Banking system is creating money (deposits)

Let’s Bring the Process to a Close What is the pattern? Despite trying to reduce their reserves, the banking system always finds it has reserves = $100m However R/D ratio is declining (0.53, 0.37) towards its desired ratio of 10%, due to increase in deposits Let’s solve for D in: $100m/D = 0.10 D = $1,000m

Equilibrium in Banking System

Banking Systems’ Balance Sheet (∞) Assets Liabilities

Reserves = $100m Deposits = $1,000m Loans = $900m Reserve-deposit ratio = 0.10 Money supply = $1,000m

Deposit Multiplier Banks’ desired reserve-deposit ratio Bank reserves = (desired) reserve-deposit ratio Bank deposits Reserves Deposits = (desired) reserve-deposit ratio

Money Supply with Currency and Deposits Money supply = currency held by public + bank deposits

Suppose cu = $20m, R = $80, rd = 0.15

mM 3.553$3.5332015.0

Money and Prices One of the functions of money is the unit of account. The prices of all other goods and services are measured in terms of money. Prices of goods, services and financial assets in Australia are quoted in Australian dollars. Large Flat White = $3.50 ($3.80) 1 share in BHP-Billiton = $38.50 ($38.64) ($32.65) ($36)

Velocity How fast does a dollar circulate? What is average value of transactions that a dollar can be used for (in a given period of time)? Value of Transactions Nominal GDP Velocity ≡ ≈ Money Stock Money Stock

Velocity Value of Transactions Nominal GDP Velocity ≡ ≈ Money Stock Money Stock

𝑉 ≡𝑃 × 𝑌

Question On average approximately how many transactions is a dollar of currency involved in over a year?

(a) 1 (b) 5 (c) 20 (d) 30 (e) 50

Question On average approximately how many transactions is a dollar of currency involved in over a year?

(a) 1 (b) 5 (c) 20 (d) 30 (e) 50

Velocity of Circulation in Australia Nominal GDP in March quarter 2014 = $400 billion Nominal GDP over 12 months to March quarter 2014 = $1,586 billion

$ billion V V (end-March 2014) (qtr) (annual) Currency 57.6 6.9 27.5 M1 295.8 1.4 5.4 M3 1,634.9 0.24 0.97 Broad Money 1,642.0 0.24 0.97

Quantity Equation The definition of velocity can be re-arranged to give the quantity equation.

YPVM This states that the money stock times velocity equals nominal GDP. Of course this must be true by definition. There is no economics in the quantity equation.

Quantity Theory (is what we care about) The quantity theory makes two economic assumptions:

Velocity is constant, and

Output is constant

Quantity Equation YPVM becomes

Quantity Theory YPVM

Quantity Theory of Prices

Quantity Theory YPVM

Re-write as Y

𝑃 = 𝑘 × 𝑀 Price level is proportional to the money stock Quantity theory states that changes in M cause (proportional) changes in P.

Inflation and Money Growth Re-write levels model

kMP as one in growth rates

kMP %%%

Inflation rate = growth rate of money + growth of k

Inflation and Money Growth

kMP %%% Assume:

0% k Remember k is ratio of constants

Let P%

Inflation rate = growth rate of money

Empirical Evidence

Money Growth and Inflation in Australia 1950-83

M3 growth Inflation

Question What is Australia’s central bank?

(a) Treasury (b) Fed (c) RBA (d) ECB (e) RBNZ

Question What is Australia’s central bank?

(a) Treasury (b) Fed (c) RBA Reserve Bank of Australia (d) ECB (e) RBNZ

Question According to the RBA Act of 1959 which of the following is not a requirement of the RBA?

(a) Contribute to the stability of the currency (b) Maintain a fixed exchange rate (c) Maintenance of full employment (d) Contribute to welfare and prosperity of Australians (e) Maintenance of inflation between 2-3 percent per

Question According to the RBA Act of 1959 which of the following is not a requirement of the RBA?

(a) Contribute to the stability of the currency (b) Maintain a fixed exchange rate (c) Maintenance of full employment (d) Contribute to welfare and prosperity of Australians (e) Maintenance of inflation between 2-3 percent per

Reserve Bank of Australia (RBA) Central Bank

responsible for operation of monetary policy

stability and efficiency of financial markets

promoting efficiency of payments system

Australia’s Framework for Monetary Policy RBA has an explicit inflation target (2-3 % per annum) In pursuing the goal of medium-term price stability, both the Reserve Bank and the Government agree on the objective of keeping consumer price inflation between 2 and 3 per cent, on average, over the cycle. (2007) First formal Policy Statement was in 1996. Has RBA achieved its target?

Headline Inflation and the RBA’s Target Range

Question What is the monetary policy instrument used by the RBA?

(a) The growth rate of the money supply (b) Management of the exchange rate (c) An interest rate target (d) An inflation target (e) A price level target

Question What is the monetary policy instrument used by the RBA?

(a) The growth rate of the money supply (b) Management of the exchange rate (c) An interest rate target cash rate (d) An inflation target (e) A price level target

Overnight interbank rate

RBA’s Operating Procedures

Announces target value for the cash rate

Intervenes in cash market to ensure Actual cash rate = Target cash rate

Current (since 4th Feb 2015) cash rate target is 2.25%

RBA’s Target for the Cash Rate (monthly)

18.00Ja

How does the RBA achieve its Target for the Cash Rate? 1. Exchange Settlement Accounts (ESA)/ Exchange

Settlement Funds (called cash) 2. Banks borrow and lend cash on short-term basis.

There is a market for cash. 3. RBA intervenes in cash market:

Sets interest rates at which it will borrow and lend to banks

Conducts open market operations with banks

Role of Exchange Settlement Accounts and Exchange Settlement Funds (or cash)

Banking Systems’ Balance Sheet Assets Liabilities

Reserves = $100m Deposits = $1,000m Loans = $900m Banks hold reserves at RBA in exchange settlement accounts (ESA). Banks not allowed to overdraw their ESA

Role of ESAs Banks use ESA to clear debts (or credits) with other banks. If ANZ owes $20m to Westpac, then funds are simply transferred between their ESAs.

ANZ ESA (-$20m)

Westpac ESA (+$20) Interbank transfers will change the distribution of cash, but will not affect the overall level of cash in the system.

Overnight Cash Market Suppose ANZ finds its level of cash holdings to be undesirably low? Overnight cash market

Specialised market where banks are able to trade cash

Borrowing and lending for periods up to 24 hours

ANZ could borrow cash from some other bank which might find itself with more than it wants to hold.

From Last Week’s lecture

Banks hold ESA with RBA

Use accounts to settle debts

Funds held in ESA are called “cash”

Banks borrow and lend cash in cash market

RBA target value for cash rate

Overnight Cash Market

What would cash market look like without any RBA intervention?

Overnight Cash Market (without RBA intervention) cash S rate D Cash (ES funds)

How the RBA Maintains its Cash Rate Target While the actions of the banks cannot change the level of cash in the system, the actions of the RBA can. RBA can buy and sell bonds (typically government bonds) from/to the banks.

If the RBA buys bonds it pays for the bonds by crediting the bank’s ESA.

If the RBA sells bonds it receives payment by debiting the bank’s ESA.

1. Open Market Operations The action buying and selling bonds is known as Open Market Operations (OMO). Open market operations provide a means by which the RBA can influence the overall level of cash (exchange settlement funds). They also provide the means by which the RBA is able to ensure the overnight cash rate is equal to its target rate.

Maintaining the Current Target Cash Rate = 2.5%.

If there is excess cash in the system so that there is pressure for the cash rate to fall below 2.5%, RBA will sell bonds – to banks – and this will reduce the supply of cash.

If there is a shortage of cash in the system so that there is pressure for the cash rate to rise above 2.5%, RBA will buy bonds – from banks – and this will increase the supply of cash.

2. A Channel for the Cash Rate

There are two additional mechanisms used by the RBA to help ensure it achieves its cash rate target. Interest Rate on Reserves (IROR)

The RBA pays interest in funds held in ESA accounts at rate which is 0.25% below its cash rate target. At present it would be 2.5 – 0.25 = 2.25%. Lower bound for cash rate.

A Channel for the Cash Rate Re-discount rate

Banks can, at any time, borrow cash (using bonds as security) from the RBA at a rate that is 0.25% above the target cash rate (at present this would be 2.75%). Upper bound for cash rate

RBA announces a target value for cash rate as its policy instrument. Cash rate shall be 2.5%. cash S rate D ES funds (cash) But actual cash rate is above 2.5 per cent!

RBA announces a target value for cash rate as its policy instrument. Cash rate shall be 2.5%. cash S rate 2.5 D ES funds (cash) But actual cash rate is above 2.5 per cent!

First. Bound the demand curve to lie in a narrow channel around the target. cash S rate 2.75 RBA lends 2.5 2.25 Interest on Reserves ES funds (cash)

Demand curve is truncated. (Why?) cash S rate 2.75 RBA lends 2.5 2.25 Interest on Reserves ES funds (cash)

Second. RBA uses open-market-operations to adjust supply of cash (ES funds) so that S = D. cash S S’ rate 2.75 RBA lends 2.5 2.25 Interest on Reserves ES funds (cash) RBA buys bonds from Banks.

The Cash Rate and Longer Term Interest Rates Under its current operating procedures the RBA has little difficulty achieving its target for the cash rate. However the cash market is highly specialised and the cash rate is for very short-term borrowing and lending. Not clear how the cash rate is relevant to the consumption and investment decisions of households and firms. Likely to be influenced by longer-term interest rates

Movements in Longer-Term Rates Tend to be Linked to the Cash Rate

econ1102 week 7

bond market

year bond

bond term of bond

bond prices

goods money goods

bond coupon rate

bond price falls

year coupon rate

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