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

1. Econ 1000: macro: mod 6 part 2, lecture 10 C. L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008

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

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

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

5. Properties of Money (C) Red Hill Capital Corp., Delaware, USA 2008

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

22. Demand for Money (C) Red Hill Capital Corp., Delaware, USA 2008

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

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

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

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

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

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

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

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

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

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

33. Definitions of Supply (C) Red Hill Capital Corp., Delaware, USA 2008

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

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

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

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

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

39. The makeup of supply • In recent years, the percentage of components making up money are: • Currency comprises about 20 percent of M1. It is a small part of overall money and is necessary, mostly, for small transactions. • Checking account deposits, which are electronic book entries at banks, accounted for about 80% of M1. • Then, M1 is only around 20% of M3. • NBFI deposits were about 10% of broad money. (C) Red Hill Capital Corp., Delaware, USA 2008

40. 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

41. 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

42. Break time • Please take a 10 minute break. (C) Red Hill Capital Corp., Delaware, USA 2008

43. The Equilibrium Interest Rate (C) Red Hill Capital Corp., Delaware, USA 2008

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

45. MS meets MD & causal chains Excess Money Demand People Sell Bonds Bond price Falls Rates rise Excess Money Supply People buy bonds Bond prices Up Rates fall Surplus MS MD Shortage (C) Red Hill Capital Corp., Delaware, USA 2008

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

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

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

49. The Affects of Money Policy (C) Red Hill Capital Corp., Delaware, USA 2008

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