Chapter 9 Money and interest

1. ‘The Price of money’ = 3 % p.a.!!! Chapter 9Money and interest

2. Lecture plan • The functions of money • Measures of money • M1, M2 and M3 • Broad money • Credit • Changes in the money supply • Primary and secondary sources • Factors affecting interest rates • Nominal and real rates • Relationship between Australian and overseas interest rates

3. The Functions of Money • A medium of exchange • A measure of value • A store of wealth • Key factor: the rate of inflation influences people’s attitudes towards saving/spending • A standard for deferred payments • Lending/borrowing by nations, governments, individuals

4. The Money Supply • Measures the volume of money in the economy. • There are several measures of the money supply • M1 and M3 • Broad Money • Credit to the private sector by the financial intermediaries

5. M1, M3 M1 and M3 M1: notes and coins in the hands of the public + Current accounts held with banks (cheque accounts) M3:notes and coins held by the public + All bank sector deposits (including term and fixed deposits)

6. Broad Money (BMY) and Credit • BMY =M3 +Deposits lodged with non-bank financial institutions (NBFIs) less Holdings of currency and bank deposits by NBFIs • Credit to the private sector by financial intermediaries = all outstanding bills endorsed and accepted by banks, plus loans and advances by those financial intermediaries whose deposit liabilities are included in broad money

7. Australian money supply, by main component, June 2003, A$ billion Source: Adapted from Reserve Bank Bulletin, July 2003, Table D3.

8. Changes in the Money Supply 1. Primary sources • Governmental transactions • ‘Printing money’ • Borrowing from abroad and using funds in Australia • International transactions • RBA intervention in the foreign exchange market 2. Secondary sources • Credit creation depending on the credit multiplier (the reciprocal of the reserve asset ratio)

9. Interest Rates • Compensation to the lender for giving up ‘liquidity’ • The cost to the borrower for gaining the opportunity to make purchases or investments • The annual rate of return on the market price of the security • Ratio between dollars paid per year and dollars borrowed

10. Factors Affecting Interest Rates • The degree of risk involved • ‘Risk premiums’ • The maturity term • Usually directly proportional with term • Degree of liquidity of assets • Inversely proportional • Administrative costs • Inflation

11. Real and Nominal Interest Rates • Interest rates are affected by both the demand for and supply of money • The nominal interest rate: the face value rate paid to the lender, or by the borrower • The real interest rate: the nominal rate adjusted for inflation

12. Relationship Between Interest Rates in Australia and Overseas • Heavy influence of overseas interest rates because of Australia’s high international indebtedness • Nominal interest rates in Australia tend to be higher than in the United States and Japan • Degree of risk in lending to Australia • The relative inflation rate in Australia compared to overseas