econ 1000: macro: mod 6 part 2, lecture 10

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Econ 1000: macro: mod 6 part 2, lecture 10

C. L. Mattoli

(C) Red Hill Capital Corp., Delaware, USA 2008

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Learning Objectives Use the concepts of money demand and

money supply to explain the determination of interest rates in an economy

Explain the effect of monetary policy on interest rates, prices, output and employment

Describe the Australian financial system as an example of a typical financial system in the 21st century.


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Intro A well developed economy needs a well-

developed financial system. The primary foundation of a financial

system is money. Money makes ease of all transactions,

allowing an automatic increase in economic activity over a barter economy.

Money has features and consequences, which we shall look at in this section.


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Intro With money in a modern economy comes

banks, a head bank and money control. In the end, money allows ease of

transactions, including ordinary consumer transactions and investment, and facilitating the flow of funds from those who have excess, savers, and those who need money, businesses (and some consumers).

Later we shall look at how money affects things in the economy, including employment, output, and spending, using the aggregate supply/demand model.


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Properties of Money


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Tintin meets Linlin Tintin who is a fisherman has discovered

Linlin on the other side of her island. Linlin grows tomatoes, and in order for

Tintin and Linlin to sell their one good to each other, they must agree upon a tomato-fish exchange rate.

That type of system for engaging in transactions in economic activity is known as barter.


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Tintin meets Linlin In a barter system, much time is wasted.

We have to spend time coming up with tomato-potato, fishnets-for-eggs, and many other individual exchange rates.

Then, we have to devote time and energy to finding all of the various trading partners who are willing to exchange what we need for what we have. That is know is coincidence of needs.


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Tintin meets Linlin Moreover, even those exchange rates

will vary, for example, if Tintin’s fish is judged to be a much higher quality than Tony’s. Then, there will be even more exchange rates in the economy, bogging it down even more.

The next natural step is to agree upon some durable standard intermediary good that can serve as a universal medium of exchange: money.


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3 Functions: 1) Medium of Exchange Money must serve 3 functions, in order to

be money.. As a medium of exchange, it must be

widely accepted for goods and services. For thousands of years, gold and silver

were used as the standard intermediary good/medium of exchange. Gold was more popular than silver because it was about 20 times more valuable (20 times less weight to carry in your pocket).


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3 Functions: 1) Medium of Exchange With things, like gold, cigarettes, or

sea shells, as a medium of exchange, people are using something that has intrinsic value, on its own, more or less.

Paper money began by being backed by real assets, like gold and silver, held in reserve by a country’s central bank.


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3 Functions: 1) Medium of Exchange Today, that is no longer true. Today,

money is generalized purchasing power. Which everybody has valued, more or less, and people can count on its acceptance throughout the economy.

While that is true in the short run, money can gain or lose value based on inflation and its supply versus the economy.


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3 Functions: 2) Unit of Account How do HH and business compare their

incomes to expenses? How does a government keep track of

tax revenues collected? How can we compare the money value

of GDP to those of other countries? In those situations, we need to use money

as a unit of account.


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3 Functions: 2) Unit of Account As a unit of account, money is used as a

common denominator in computing and comparing the relative values of all goods and services.

Then, we can figure that one carrot is worth 2 potatoes, if a carrot is $2 and potatoes are $1 each.

In Australia, the basic unit of money is the dollar, as it is in HK and the USA. It has different names in different countries and regions, like the Euro in Europe, the ringgit in Malaysia, the yen in Japan, and the Yuan in China.


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3 Functions: 3) Store of value We use money as a means of exchange

and as a unit of account, for which we rely on its value.

Given that we want to keep money, now, to pay for expenses, later, then, money must retain value.

Store of value is the ability of our money to retain value over time.

Gold was good for that, but, for example, corn would not be because it will rot and lose is its value.


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3 Functions: 3) Store of value It is useful for transforming present income

into present and future purchases. The key property of money, in this regard,

is also its complete liquidity. Money is immediately convertible into goods and services.

Other assets, like bonds, stock, and real estate that are also stores of value are not as liquid as is needed for something to be useful as money.


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Plastic Money? People sometimes refer to credit and debit

cards as plastic money, but are they really money?

Credit cards are knocked out immediately because they are not a store of value but are actually sinks, not sources, of net worth.

Even though they are widely accepted, it is because of a guarantee by the credit company to pay. They might not pay.

Finally, the credit card account is an account with the unit of account in dollars.


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Plastic Money? Neither do debit cards satisfy any of the three

functions of money. The only difference is that debit cards are not means of borrowing money but instead are means of accessing money held in a bank account more easily

Both credit and debit cards represent an alternative to checks, which are payment instructions to transfer money between banks.

They improve the efficiency and capacity of doing transactions.


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Other Desirable Properties Beyond those 3 basic requirements, there are

other tests for money to pass. Money must have a certain level of scarcity.

Dirt and sand are much too available, while Diamonds might be too scarce.

It must be plentiful enough to handle the normal volume of transactions in an economy but not so plentiful as to make it worthless.

Counterfeiting threatens scarcity. Thus, the making of money must be done in such a way as to make counterfeiting more difficult.


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Other Desirable Properties Next, it should be portable and divisible. Diamonds might be more portable than gold,

but gold is more easily divisible. For example, pieces of eight were actually cut pieces of a certain gold coin from several hundred years ago in the west. Paper money in various denominations makes for easy divisibility.

Gold has one pure quality, also, while diamonds and beaver skin quality might vary.


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Behind money

Money in the form of precious metals or other tangible goods are examples of commodity money.

Commodity money has market value in its end uses, like gold for jewelry.

Later, paper money was backed by gold and silver.


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Behind money

Since the 1970’s paper money is no longer backed by assets but is what is called fiat money.

Thus, money does not have to have intrinsic value. Fiat money is issued by central banks of countries. It is deemed by law to be legal tender that should be accepted for all debts, private and public.


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Demand for Money


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Intro People want to hold money for various

reasons, and that creates a demand for money.

People want liquidity in the form of actual cash or cash balances in checking demand accounts at banks.

Indeed, there is an opportunity cost of holding money, since inflation will erode the buying power of money.

Three general reasons are sited for money demand.


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Transactions motive

First, there is a transactions motive for wanting to hold a certain stock of money.

That is so that people and businesses can run their everyday lives, buying things that they need and paying bills that have come due.


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Transactions motive

These transactions are fairly predictable, and the balances of money that are and will be needed at given times are easy to budget.

Poor predictions will lead to possible losses when HH’s must liquidate less liquid assets to get more money. Businesses could be in default of loans without money to make payments on debt.


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Precautionary Motive Because life is not predictable, it is wise, in

many cases, to have an extra reserve of money to meet with the unexpected.

That is the precautionary motive for holding even more money than for predictable transactions. It is money saved for a rainy day.

A HH’s heating/cooling unit might unexpectedly need repair; similarly, for a machine at a business plant. By holding a precautionary balance of money, people will not sacrifice paying their predictable bills on time.


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Speculative Motive

The third layer of money demand is also for the unpredictable, but, this time, unexpected opportunities.

First of all, you might keep money and forego interest, now, because you expect interest rates to rise in the near future.

So, better expected future investment opportunities are one reason.


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Speculative Motive

Also, a supplier might stop by, one day, with your regular order and offer a large discount on any extra purchases you make on the spot.

Holding speculative cash, waiting for prices of other assets, like bonds, stock or real estate, to fall is the main factor in this type of money demand.


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Overall demand The three motives combine to create an

overall demand for money in an economy at any particular time.

Basically, interest rates (rates of return) are at the center of all three motives, so we can conclude that the demand for money is determined by interest rates, ceteris paribus.


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Overall demand Note: there are many interest rates, but we

talk of the interest rate, in economics. That is because we are referring to the general level of those interest rates in the economy.

All interest rates are related and will move more or less together over time.

When rates are down, people will feel less of a need to park funds in interest bearing accounts.


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Overall demand

When rates are up, people will be motivated to put their money in interest earning assets, and they will demand less cash.

Thus, there is an inverse relationship between money demand and the interest rate.


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Overall demand

There is also a relationship between income and the need for cash. As people make more money, they spend more, and need more for their daily affairs. The same is true for business.

In this course, we shall emphasize only the interest rate relationship.


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Definitions of Supply


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Intro We understand what money should be and

why people want to have it. Next, we must discuss the various definitions of money supply that are used in modern economies.

the specific ones that are used in Australia are: money base, M1, M3 and broad money.

Most modern economies will have similar definitions of money supply, but there are additional definitions of money supply.


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The Monetary Base

The starting point for money supply, in Australia is the monetary base.

It consists of all cash and coins in circulation plus funds held by banks in accounts of the reserve bank of Australia (RBA).


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The Monetary Base Both of these components are under

control of the RBA, and we shall learn, in due course, how the RBA manages and controls money supply and why it does so.

This base is used for transactions in the economy, including banks’ accounts at the RBA, which are used for exchange among banks to settle payments held at one bank paid to payees at others.


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M1 and M3 M1 is defined as all currency in the hands of

the public plus all balances in demand checking accounts at banks.

Thus, M1 includes more than the monetary base. It is much more liquid than broader definitions of supply

If we add all other bank deposits of the non-bank public, we arrive at M3.

Thus, M3 includes savings deposits of various sorts.

Those types of accounts are interest-earning (interest-bearing) accounts.


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Broad Money Definition At the top of this telescoping definition of money

supply is broad money. Broad money adds the public’s deposits at

non-bank financial institutions (NBFI’s) less the currency and bank deposits held by them.

NBFI’s include institutions like credit unions and building societies that also take depositor’s money but are not part of the RBA system of actual banks.

These are the final category of financial assets included in definition of money supply.


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The makeup of supply In recent years, the percentage of components

making up money are:

1. Currency comprises about 20 percent of M1. It is a small part of overall money and is necessary, mostly, for small transactions.

2. Checking account deposits, which are electronic book entries at banks, accounted for about 80% of M1.

3. Then, M1 is only around 20% of M3.

4. NBFI deposits were about 10% of broad money.(C) Red Hill Capital Corp.,

Delaware, USA 2008

Changing base The RBA has assets and liabilities. In fact paper money is a liability of the

RBA. Assets include foreign currency and

gold, for example. The RBA can create money by buying

securities or foreign currencies from banks.

(C) Red Hill Capital Corp., Delaware, USA 2008 40

Changing base When money comes out of the RBA to pay

for things, like buying securities from banks, there is more money put into circulation.

Similarly, when the RBA sells to banks, it takes money out of circulation.

Since the RBA is banker for the government, if taxes are paid to the federal government, money goes out of circulation.

(C) Red Hill Capital Corp., Delaware, USA 2008 41

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Break time

Please take a 10 minute break.


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The Equilibrium Interest Rate


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Intro On an abstract level, we are ready to

consider the money market and the determination of the interest rate from the interaction of the supply and demand for money.

In the figure on the next slide, we show the inverse relationship between interest rates and the demand for money.

For supply, we assume that the RBA has used the various tools available to it to fix the supply, no matter what the interest rate.

The equilibrium interest rate will be at the intersection of the 2 curves.


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MS meets MD & causal chains

Shortage

Surplus

Excess Money Demand

ExcessMoney Supply

People buy bonds

PeopleSell

Bonds

Bond priceFalls

Rates rise

Bond pricesUp

Rates fall

MD MS


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Excess quantity demanded Suppose that interest rates were lower than

the equilibrium rate. Then, people would try to liquidate bonds to

raise cash, but as bonds are sold, prices go down, and rates will increase until MD is at the intersection with available supply.

To understand how that works, consider a bond of Copper Company paying 4% interest per year and final principal of the loan of $1,000 in 2 years.


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Excess quantity demanded If people start selling bonds, the supply for

sale increases versus demand, which results in the price going down.

When the price goes down, the effective rate of return goes up, as there are 4% per year interest payments plus a gain on sale between the price paid and the $1,000 redemption value of the bond.

As price falls, a point is reached where the supply gets bought up, equilibrium exists in the money market, and therefore there is no further pressure on interest rates.


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Excess in the quantity of money supplied Assume the interest rate is above the

equilibrium rate. Then, there will be an excess in money

supplied versus demand. People are holding more money than they

need. Thus, people will try to invest the excess

money in bonds. The price of bonds will be bid up, meaning

interest rates will fall. Notice the inverse relationship between bond

prices and interest rates.


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The Affects of Money Policy


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Monetary policy & interest rates Assuming a fixed schedule of

demand, then, money policy will determine the interest rate.

Central banks can change the supply of money through various means, like printing more money or taking money out of supply.


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Monetary policy & interest rates

This power of the RBA to alter supply will, then, change the equilibrium interest rate.

Collateral effects of changes in rates will happen to output, employment, and prices.

Thus, the central bank can affect the monetary bases, interest rates, the general level of prices, economic output, and employment through its monetary policy.


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Expansionary money policy

An expansionary monetary policy will cause interest rates to fall. The supply curve will push out, the equilibrium money quantity will increase and the price of money (interest rates) will decrease.

The excess of money is put to work by holders by buying bonds.


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Expansionary money policy

As the price of bonds is bid up, interest rates (also called bond yields for bonds) are bid down.

As the interest rate is bid down, the opportunity cost appears less threatening to people, and equilibrium in money holdings obtains.


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Tight money policy If the RBA decides to decrease supply, the

situation will be the reverse. There will be less money than people want

to hold, so they will sell bonds to raise cash, the interest rate will go up, and a new equilibrium in holdings will obtain.

In selling bonds, the prices will go down, the effective interest rate will increase, and a final equilibrium will occur at a lower quantity of money at a higher price (interest rate) level.


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Money policy, prices, output and employment Monetary policy affects interest rates, which,

in turn, affect macroeconomic variables. This is known as the monetary policy

transmission mechanism. It looks at how changes in money policy can

affect supply and be transmitted through the economy to affect major economic variables.

Changes in supply cause changes in interest rates which affects investment, which affects aggregate demand, which affects output, employment, and prices.


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The Causal Chain

Change inMoneyPolicy

Change inMoney Supply

Change inInterestRates

Change inInvestment

Change inAggregate

Demand

Change inPrice, GDP,Employment


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Monetary Policy & AD-AS model When interest rates fall, businesses will, in

general, find investment more attractive. HH will also be more willing to invest in

housing, also a part of I in AD. I is inversely related to interest rates. The rise in I is manifest in a shift in the AD

curve, as a non-price level determinant of demand.

The rise against fixed AS will cause an increase in output at a higher price and with higher employment, assuming that AS is in the neo-classical range.


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Graphical ChainsMS Investment vs. Rates

Real GDP vs. Price level


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The Australian Financial System


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Intro To have paper money means to have a central

bank to print it and manage it. That is the RBA, the central bank in Australia.

After that, the central bank must have a system of banks through which it can funnel money through the economy.

In addition to that basic part of the financial system, there are other financial institutions and markets that comprise the whole financial system.


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The RBA The RBA was created in 1959, and its

powers and responsibilities are given in the Reserve Bank Act of 1959, the Banking Act of 1959, and the Financial Corporations Act of 1974.

The first act gave the RBA the responsibility to maintain stability of the currency (fight inflation) and full employment to promote welfare and prosperity.


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The RBA The second act charged it with maintaining

the integrity of the banking system, and gave it power to regulate interest rates, lending, and portfolio structure.

The next step, more recently, was to move much of the regulation of financial institutions to APRA, the Australian Prudential Regulation Authority. Financial markets are under control of the Australian Securities and Investments Commission (ASIC).


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The RBA The RBA is governed by a board. In 1996,

the board and the Treasurer of Australia agreed to give the RBA freedom to conduct monetary policy as it sees fit to keep inflation in the target rate of the agreement, 2-3% on the CPI inflation scale.

So, current duties include stability of the system, standing behind the payment system, monetary policy to limit inflation.


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The RBA The RBA also acts as banker to the

government, other banks, and financial organizations.

As banker for the government, it issues commonwealth government securities, deposits the proceeds in to the government’s account and pays its bills.

Government securities are considered to be riskless because the government can be counted on for eventual payment.


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The origin of banks

In medieval times in Europe, since gold was heavy to carry around, people began depositing gold with goldsmiths.

Goldsmiths sat on their benches with ledgers to record deposits and withdrawals, and the word bank comes from the Italian word for bench: banco.


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The origin of banks Their receipts to customers for deposits, in

turn, became the first paper money, and these receipts were used in exchange for G&S.

In addition, goldsmiths discovered that there was always a certain level of gold deposits that was much more than needed to handle everyday withdrawals, so they began to also lend out gold and charge interest, issuing loans for more gold than they actually held in their vaults.

They became the first fractional reserve banking system


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The Banking System Banks are counted on not to fail, but their

failure is not underwritten by the RBA. Banks are part of the RBA’s network. They

take deposits and maintain a portfolio of loans.

Each bank maintains an exchange settlement account (ESA) at the RBA to settle transactions which involve accounts at different banks, with the government, and with certain other financial institutions.


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The Banking System

Banks must maintain a positive daily balance in ESA’s, high standards of liquidity management, and meet hurdle rates for capital (net assets) adequacy.

ESA’s play a central role in settling transactions in a modern economy.


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The Banking System Liquidity is necessary since many of

the deposits are demand deposits which can be withdrawn anytime, on demand, while loans made by banks are longer term and fixed in maturity.

Capital adequacy is to ensure that unexpected losses can be covered by equity, which percentage is determined versus risk-adjusted assets.


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The creativity of banking. Even though banks, like their predecessors,

the goldsmiths, hold only a fraction of their deposits in the vaults and at the RBA, they can create money.

For example, suppose there is just one bank in an economy, and it has deposits of $100,000.

Based on experience, it decides that prudent liquidity management for dealing with expected net withdrawals is 10%, and that it will lend out money to customers.


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The creativity of banking. What the bank does is makes $900,000 in loans,

and the $100,000 in deposits becomes 10% of assets of $1 million in loans and deposits.

It does that by simply making an entry of $900,000 into new accounts, like checking or savings.

That process is called credit creation. Then, those deposits are in the bank from the

borrowers, and the bank has real deposits of $1 million.


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The creativity of banking. Thus, the amount of money in the system

has increased 10-fold, the reciprocal of the reserve ratio. That is called the money multiplier.

In the real world, not all of the money will flow back to the one bank but will end up distributed among banks in the system.

This is an important aspect in creation of the money supply in the real world.


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The short-term money market There are a number of markets in

Australia that lend large amounts of money for periods up to a year.

These could be direct loans or money for the issuance of a financial instrument.

Collectively, we refer to these interrelated markets as the short-term money market (STMM).


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The short-term money market They have additional importance in that

they are where the RBA carries out its monetary policy implementation and from where that is transmitted to the rest of the economy.

This market is a so-called dealer OTC (over the counter) network market as opposed to the stock market, which is at a physical exchange, housed in one building.


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The short-term money market In the next chapter, we shall explore how

the RBA buys and sells government securities to banks to increase or decrease the money in circulation.

The market is made up of banks and other financial institutions, large commercial and industrial companies, brokers, and individuals with large sums of money to invest. Minimum investment is $100,000.


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The short-term money market Securities in this market are usually

discount securities. Discount securities are sold at less than

face value, where face value is the amount of the obligation when due.

Then, the difference between what you pay and what you get at redemption is an effective interest return on your investment. No formal interest is paid


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The short-term money market The 2 most commonly traded securities in

the market are commercial bills, corporate loans for less than a year, BAB’s (bank accepted bills), which are commercial bills that are guaranteed by a bank, and T-notes, Government short-term notes.

The 2 most important functions served by any financial market is to redistribute savings to the highest yield and to redistribute risk to those more willing to bear it.


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The stock market The Australian Stock Exchange (ASX) is

where shares of stock, a security representing equity (ownership) of a corporation, of major Australian and international companies are traded (exchanged) in Australia.

A company whose shares are listed on the exchange is called a public corporation because its shares are held by the general public.


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The stock market Shares traded (bought and sold) on the

exchange are already-issued “used” shares. Trading is motivated by liquidity requirements of people versus perceived opportunities for return on investment.

When a company sells its shares to the public for the first time (initial public offering, IPO), they are said to be going public.


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The stock market That is done in what is called the

primary market, not the exchange, but after going public, the company can apply for listing its shares for trading in the secondary market, and the ASX is a secondary stock trading market.

People decide what prices to pay for stock based on expected future profits versus other market opportunities and risks.


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Foreign exchange market

Because of international business transactions and travel, thousands of people daily trade Australian currency versus the currencies of other countries.

This is the foreign exchange (FOREX) market, and it is a worldwide, 24-hour a day dealer network market, dominated by international banks.


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Foreign exchange market

A buyer of Australian crocodiles, in Siberia, needs to make payment with AUD, so he must convert his Russian Rubles to Australian dollars (AUD).

An investor in South America might want to buy Australian investments and needs to convert her Brazilian Reals into AUD.


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Financial Futures markets The functions of financial markets are: 1) to

hook up supply and demand for financial assets, 2) to allow liquidity management (limiting opportunity cost, while allowing ease of conversion), and management of risk.

The additional markets are specifically about risk management.

Financial futures derived from the concept of forward and future contract for ordinary commodities, like corn and pig bellies.


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Financial Futures markets

A forward contract calls for delivery of a certain amount of something at a certain price on a given future day.

A future is a standardized exchange-traded forward contract. The term forward contract is usually reserved for tailor-made OTC contracts.

Examples are as follows, a European buyer of Australian copper might need AUD 3 months from now, not now.


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Financial Futures markets Thus, he might buy AUD forwards or

futures on AUD instead of investing his money in AUD, now, and tying it up for 3 months or instead of risking the change of exchange rates between now and then.

Futures are not traded for all currencies. Another financial future in Australia is the

BAB future. It entitles the buyer to delivery of $1 million BAB’s in some future month (standardized and limited by the exchange).


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Financial Futures markets One can sell a BAB future to cover

the risk of interest rates rising in the future. If rates rise, the value of BAB’s will fall, and you will make a profit on the drop in prices.

There are even futures on stock markets and some to cover many other types of risks.


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Options markets Options are the next level of risk

management in the financial and asset markets.

With a future, you can completely eliminate risk. If I know that I will have 5000 barrels of oil in my hands in 3 months, and I sell a future for 5000 barrels of oil for delivery in 3 months at a price of $60/bbl, I have no more price risk.


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Options markets However, futures and forwards take away

the risk but allow no benefit if things go in a favorable direction by the time the future.

For example, suppose you sold oil at $60 3 months into the future because you were worried that prices might drop to $50 three months from now.

If instead at the end of 3 months, the price of oil is $75, then, you will have lost an opportunity to profit.


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Options markets Options offer risk protection but allow for

benefits. A future contract obligates delivery and

acceptance of delivery in the future. An option contract is the right but not the

obligation of the optionee to call for delivery or sale of something in the future.

There are 2 types calls, which are the right to buy in the future, and puts, rights to sell in the future.


Ask Yourself1. Why is gold a better form of money than

silver? Why would diamonds not be a good form of money?

2. What, exactly, in your own words, does “a coincidence of needs” mean?

3. Why could goldsmiths get away with lending out more gold than they actually had in their vaults? How was money created in gold depository receipts of the goldsmiths?

90(C) Red Hill Capital Corp.,

Delaware, USA 2008

Ask Yourself

4. If you own a call option to buy stock at $40, and at expiration of the option contract, the stock is selling in the market at $39, what is the call option contract worth?

5. Explain how selling a future contract on a bond will protect you against a rise in interest rates.

6. Can you explain the 3 reasons for demanding to hold cash?


Delaware, USA 2008

Ask Yourself

7. Can you explain both the necessary and the additional desirable properties of something for it to be usable as money?

8. If a person makes a tax payment to the government, does the money base increase, decrease or stay the same? Why?

9. What are the purposes of all of the different types of financial markets that we have discussed, in a few simple, insightful words?


Delaware, USA 2008

93

Homework

Chapter 15: Problems 1-13 MC 1-11


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Next week

Monetary policy, chapter 16


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END


econ 1000: macro: mod 6 part 2, lecture 10

Documents

mattolic red hill capital

money control

money supply

introwith money

concepts of money demand

individual exchange

barter system

barter economy