ECO1000 Economics

1. ECO1000Economics Semester One, 2004 Lecture 8

2. 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.

3. 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

4. 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

5. THE MONETARY SYSTEM Money

6. 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

7. 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

8. The Kinds of Money • Commodity moneytakes the form of a commodity with intrinsic value. • Examples: Gold, silver, cigarettes • Fiat moneyis used as money because of government decree. • It does not have intrinsic value. • Examples: Coins, currency, cheque deposits

9. 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 depositsare 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.)

10. 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.

11. 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.

12. 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.

13. This T-Account illustrates a bank that accepts deposits, keeps a portion as reserves, and lends out the rest. First State Bank Assets Liabilities Reserves $20.00 Loans $180.00 Deposits $200.00 Total Assets $200.00 Total Liabilities $200.00 Money Creation

14. 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

15. 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 multiplieris the amount of money the banking system generates with each dollar of reserves.

16. First State Bank Second State Bank Assets Liabilities Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $100.00 Total Liabilities $100.00 Total Assets $90.00 Total Liabilities $90.00 The Money Multiplier

17. First State Bank Second State Bank Assets Liabilities Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $100.00 Total Liabilities $100.00 Total Assets $90.00 Total Liabilities $90.00 The Money Multiplier Money Supply = $190.00!

18. The Money Multiplier • How much money is eventually created in this economy? Original deposit = $ 100.00 First 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)

19. The Money Multiplier • The money multiplier is the reciprocal of the reserve ratio. M = 1/R With 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.

20. MONETARY POLICY IN AUSTRALIA The Role of the RBA

21. 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)

22. 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.

23. 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.

24. 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.

25. 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.

26. 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.

27. INFLATION: ITS CAUSES AND COSTS Rising Prices

28. Inflation in Australia

29. 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. • Deflationis a decreasing average prices (very rare) • Hyperinflationrefers to very high rates of inflation (eg Germany 1930s or Russia early to mid-90s)

30. 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.

31. 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.

32. Money Supply • The money supplyis 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.

33. Money Demand • Money demandhas 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.

34. Money Supply and Money Demand • 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.

35. Value of Price Money Level Money demand Quantity of money Money Supply & Demand MS1 1 1 (High) (Low) 3/4 1.33 A 2 1/2 1/4 4 (High) (Low) 0 M1

36. 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.

37. Value of Price Money Level 3. and increases the price level. Money demand Quantity of money The Effects of Monetary Injection MS1 MS2 1 1 (High) (Low) 1. An increase in the money supply... 3/4 1.33 2....decreases the value of money ... A 2 1/2 B 1/4 4 (High) (Low) 0 M1 M1

39. QUANTITY THEORY

40. 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.

41. Velocity • The velocity of moneyrefers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

42. Velocity Equation V = (P x Y)/M Where: V = velocity P = the price level Y = the quantity of output M = the quantity of money

43. 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.

44. 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).

45. 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.

46. PROBLEMS CAUSED BY INFLATION AND RELATED ISSUES

47. 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.

48. The Costs of Inflation • Shoeleather costs • Menu costs • Relative price variability • Tax distortions • Confusion and inconvenience • Arbitrary redistribution of wealth

49. 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.

50. 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.