Download PPT chapter 11 - McGraw Hill Higher Education

Chapter 11
Monetary policy and the
financial system
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
11- 1
Learning objectives
1. Review the functions of money and the money
supply in Australia.
2. Explain the transactions demand and asset
demand for money.
3. Examine the institutional structure of the
Australian financial system and the role of the
Reserve Bank of Australia.
4. Explain the money-creating abilities of the banking
system and the monetary (or credit) multiplier.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
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11- 2
Learning objectives (cont.)
5. Discuss the objectives of monetary policy and the
route by which monetary policy affects the operation
of the economy.
6. Examine the balance sheet of the Reserve Bank of
Australia, through which monetary policy is largely
implemented.
7. Analyse the techniques of monetary policy—the
major instruments and how they function.
8. Discuss the cause–effect chain through which
monetary policy functions, and evaluate its
effectiveness.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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11- 3
The functions of money
What is money?
• Anything that performs the function of money is
money.
• Money is what money does.
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11- 4
The functions of money (cont.)
• Money is a medium of exchange.
– Buying and selling goods and services
• Money is a unit of account.
– Assisting measurement of relative worth of various
goods, services and resources
• Money serves as a store of value.
– A form in which to store wealth, due to its liquidity
and convenience
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11- 5
The supply of money—money
defined: M3
Three components:
• currency (coins and notes)
• current deposits in banks upon which cheques can
be drawn
• non-current accounts such as savings.
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11- 6
Currency
• In Australia, token money:
– has intrinsic value which is less than face value of the
money
– is the coin and note component of the money supply.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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11- 7
Current deposits
• Cheques enable the ownership of current deposits
to be transferred.
• Cheques are generally acceptable as a medium of
exchange.
• Cheques can be readily converted into currency.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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11- 8
Non-current deposits
• Highly liquid financial assets
• Can be readily converted into currency or current
deposits
• New technologies (such as EFTPOS) important
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11- 9
Broad money
• M3 plus borrowings from the private sector of
non-bank financial intermediaries (NBFIs) less
holdings of currency and bank deposits by the
NBFIs.
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11- 10
Credit cards
• Not money
• Simply a convenient method of obtaining a
short-term loan from the card-issuer
• Facilitate the synchronisation of receipts and
expenditures, reducing the demand for cash
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11- 11
The monetary base
Composed of:
• currency held by the public
• currency held by the banks
• banks’ demand deposits with the RBA.
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11- 12
What ‘backs’ the money supply?
• Money as debt
• Value of money
– Acceptability of money
– Legal tender
 Fiat money
– Relative scarcity
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11- 13
Demand for money
• The demand for money is the demand for real money
balances.
Two reasons why people demand money:
• transactions demand (Dt)
• asset demand (Da).
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11- 14
Transactions demand (Dt )
• The demand for money as a medium of exchange
• Level depends on money GDP (not interest rates!)
• Money demand curve is vertical
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11- 15
Assets demand (Da )
• The demand for money as financial assets and
store of wealth
• Level depends on interest rates
• Down-sloping money demand curve
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11- 16
Total demand for money (Dm )
• Transactions demand and assets demand are
added horizontally.
• Changes in interest rates lead to movement along
the curve.
• Anything that changes money GDP leads to a shift
in the money demand curve.
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11- 17
Demand for money (cont.)
Transactions
demand, Dt
+
Asset
demand, Da
=
Total demand
for money, Dm
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11- 18
The money market
• The combination of the money demand and money
supply determines the equilibrium interest rate.
• The interest rate represents the opportunity cost of
holding money balances.
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11- 19
Equilibrium interest rate
Rate of interest, i (per cent)
Sm
10
7.5
Equilibrium
interest rate
ie 5
Dm
2.5
0
0
50
100
150
200
250
300
Amount of money demanded
(billions of dollars)
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11- 20
Interest rate differentials between
bond and deposit accounts
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11- 21
The Australian financial system
Consists of:
• the Reserve Bank of Australia (RBA)
• the banks
• financial intermediaries.
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The Reserve Bank of Australia
(RBA)
• Responsibilities set out in the Reserve Bank Act 1959
• Main functions
– Control of note issue
– Banker to the banks
 Exchange settlement accounts
 Non-callable deposits
– Banker to the government
 Vital role in financing government deficits
– Management of the international means of
payment
– Implementation of monetary policy
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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11- 23
The Reserve Bank of Australia
(RBA) (cont.)
• Other functions:
– regulation of the payment system
– membership of the board of the Australian
Prudential Regulation Authority (APRA)
– membership of the Council of Financial
Regulators.
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11- 24
How banks create money
The focus of this section will be on
explaining how banks create deposit
money.
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A single bank in a banking
system
• Transaction (1): The birth of a bank
– New owners sell $250 000 worth of shares in the
bank.
Balance sheet 1
Assets
$
Cash
250 000
Liabilities & net worth
$
Capital stock
250 000
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A single bank in a banking
system (cont.)
• Transaction (2): Becoming a going concern
– Acquisition of property and equipment
Balance sheet 2
Assets
$
Cash
Property
Liabilities & net worth
$
10 000 Capital stock
240 000
250 000
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A single bank in a banking
system (cont.)
• Transaction (3): Accepting deposits
– Citizens and businesses deposit $100 000.
– Change in composition not total supply of money
Balance sheet 3
Assets
Liabilities & net worth
$
$
Cash
110 000 Deposits
100 000
Property 240 000 Capital stock
250 000
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11- 28
A single bank in a banking
system (cont.)
• Transaction (4): Setting aside required reserves
– Assume reserve ratio is 20%
– Bank must keep $20 000 (required reserves).
bank’s required reserve
Reserve ratio =
bank’s deposit liabilities
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A single bank in a banking
system (cont.)
•
Transaction (4): Setting aside required reserves (cont.)
– Bank decides to keep $ 110 000 (actual reserves),
which is $90 000 more than required (excess reserves).
– Bank’s required reserves are 20% of $100 000.
Balance sheet 4
Assets
Liabilities & net worth
$
$
Cash
0 Deposits
100 000
Reserves 110 000 Capital stock
250 000
Property 240 000
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11- 30
A single bank in a banking
system (cont.)
• Transaction (5): Drawing a cheque
– A citizen who has substantial deposits in the bank
draws a cheque for $50 000 to buy goods.
– The seller of the goods deposits the cheque in
another bank.
– The banking system as a whole has not lost or
gained.
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A single bank in a banking
system (cont.)
Transaction (5): Drawing a cheque (cont.)
Balance sheet 5
Assets
$
Reserves 60 000
Property 240 000
Liabilities & net worth
$
Deposits
50 000
Capital stock 250 000
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11- 32
Creating money
• Transaction (6): Granting a loan
– A company borrows $50 000 from the bank.
– Money is created.
– Balance sheet after loan is negotiated:
Balance sheet 6(a)
Assets
Liabilities & net worth
$
$
Reserves 60 000 Deposits
100 000
Loans
50 000 Capital stock
250 000
Property 240 000
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11- 33
Creating money (cont.)
Balance sheet after cheque drawn on loan has been
collected:
Balance sheet 6(b)
Assets
Liabilities & net worth
$
$
Reserves 10 000 Deposits
50 000
Loans
50 000 Capital stock
250 000
Property 240 000
Now, bank has no excess reserves.
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Creating money (cont.)
• Transaction (7): Buying government bonds
– Bank buys $50 000 of government bonds instead
of lending $50 000.
– Money is created.
Balance sheet 7
Assets
Liabilities & net worth
$
$
Reserves 60 000 Deposits
100 000
Bonds
50 000 Capital stock
250 000
Property 240 000
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11- 35
The banking system
• Multiple banks: multiple-deposit expansion
• Money is created by a multiple of the banking
system’s excess reserves.
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11- 36
Multiple-deposit expansion
• Assume initially: 20% reserve requirement
• Bank A
– Accepts a deposit for $100
 Does not alter money supply
 Excess reserves of $80
– A loan of $80 is negotiated.
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Multiple-deposit expansion (cont.)
• Balance sheet: Bank A
• Loan cheque of $80 is drawn on Bank A and
deposited in Bank B.
Balance sheet 8
Assets
$
Reserves +100
–80
Loans
+80
Liabilities & net worth
$
Current deposits
+100
+80
–80
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Multiple-deposit expansion (cont.)
• Bank B gains $80 in reserves and deposits.
– Excess reserves of $64
– Loans $64
Balance sheet 9
Assets
$
Reserves
–80
–64
Loans
+64
Liabilities & net worth
$
Current deposits
+80
+64
–64
• Loan cheque of $64 is drawn on Bank B and deposited in
Bank C, and so on …(summarised in following table).
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Multiple deposit expansion process
Bank
Acquired reserves
and deposits
Required
reserves
Excess
reserves
New money
created
$80.00
A
$100.00
$20.00
$80.00
64.00
B
80.00
16.00
64.00
51.20
C
64.00
12.80
51.20
40.96
D
51.20
10.24
40.96
32.77
E
40.96
8.19
32.77
26.22
F
32.77
6.55
26.22
20.98
G
26.22
5.24
20.98
16.78
H
20.98
4.20
16.78
13.42
I
16.78
3.36
13.42
10.74
J
13.42
2.68
10.74
8.59
K
10.74
2.15
8.59
6.87
L
8.59
1.72
6.87
5.50
M
6.87
1.37
5.50
4.40
N
5.50
1.10
4.40
17.57
Other banks
21.97
4.40
17.57
Total amount of money created by the banking system $400.00
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Multiple-deposit expansion (cont.)
• Total banking system has created $400.
• How?
– Via the monetary multiplier
monetary multiplier
1
=
reserve ratio
m =
1
R
where m is the monetary multiplier
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11- 41
Some modifications
Determining the required reserve ratio
• The Australian Prudential Regulation Authority
(APRA), as a supervisory body, sets banks’ liquidity
requirements:
– Liquidity as defined by the prime assets ratio (PAR)—
the proportion of the banks’ total liabilities that must
be held in a highly liquid form
– Capital adequacy requires that banks hold enough
shareholders’ funds plus reserves to cover losses.
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Potential leakages other than
required reserves
• Currency drains
– Loan may be paid in cash and remain in circulation.
• Transfer of deposits to non-bank financial institutions
• Excess reserves
– Individual banks may choose to have a ‘safety margin’
so that reserves are larger than required (say 25%
instead of 20%).
• For the full multiplier effect to take place:
– Borrowers must be willing and able to utilise the loans.
– Borrowing is likely to be low during a recession.
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Objectives of monetary policy
• Monetary policy
– Influencing interest rates and credit availability to
stabilise real GDP, employment and the price level
• Fundamental objectives
– Full employment
– Non-inflationary level of total output
• The Reserve Bank of Australia has responsibility
for managing monetary policy.
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Cause-effect chain of monetary
policy
• Cash rate
– Interest rate charged by the RBA for exchange
settlement account funds
• Other short-term interest rates
– The cash rate sets the cost of short-term funds for
banks.
– Influences the rate at which banks are willing to lend
Aggregate demand
• Availability of bank credit, which impacts on
interest-sensitive spending (and therefore output,
employment and prices), is impacted through
monetary policy.
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Monetary policy and aggregate
demand
• Easy money policy
– RBA reduces the cash rate, lowering the cost and
increasing the availability of bank credit, to
expand spending and real GDP.
• Tight money policy
– RBA increases the cash rate, increasing the cost
of credit, reducing the availability of credit, to
reduce spending in the economy and reduce
inflationary pressures.
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Monetary policy and investment
• Increases in interest rate reduce the viability of
many investment projects and the quantity of
investment spending falls.
• Increases in interest rate make the purchase of
financial assets more attractive, in preference to
making investment expenditures.
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Balance sheet of the RBA
• Assets
– Gold and foreign exchange
– Government securities
• Liabilities
– Notes on issue
– Exchange settlement account (ESA) funds
– Deposits of government and instrumentalities
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Changes in ESA funds and
monetary policy
• Funds flow to and from government accounts.
• Banks must maintain a positive balance in their
ESAs with the RBA.
• If a bank’s ESA goes into deficit:
– it may borrow funds from other banks, or
– trade in either government securities or repurchase
agreement (repo).
 Repos are agreements detailing the price, timing and
conditions under which the banks and the RBA may
exchange government securities.
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Yield curve
• The yield curve is a summary of the interest rates
that apply at any given point in time to interest-bearing
securities.
• Shows the link between the cash rate and other
short-term interest rates
• Changes in the cash rate change the cost of funds for
banks, and change the cost of credit (loans) provided
by the banks.
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11- 50
The yield curve June 2010
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Tools of monetary policy
• Two major tools used by the RBA to determine the
cash rate:
– open market operations
– foreign exchange swaps and intervention in the
foreign exchange market.
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Open-market operations
• Buying and selling of Commonwealth government
securities by the RBA in the cash or short-term
money market.
• The objective of open-market operations (OMOs)
is to ensure that the demand and supply of ESA
funds are such that they are in balance at the target
cash rate.
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Open-market operations (cont.)
• Buying and selling of Commonwealth government
securities by the RBA affects the cash rate.
• Cash rate provides an indication of the RBA’s
monetary policy stance:
– sustained increases in cash rate target level—
tightening of monetary policy
– sustained decreases in cash rate target level—
easing of monetary policy.
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Open-market operations:
buying securities
• Banks sell some of their securities.
• RBA pays for securities by increasing banks’
exchange settlement accounts (ESAs).
– ESAs form part of the banks’ prime assets ratio
(PAR) requirement.
• Bank reserves increase:
– causing the monetary base and the banks’ lending
ability to increase.
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Open-market operations:
selling securities
• The RBA sells securities to the banks.
• Banks pay for securities by decreasing their
exchange settlement accounts (ESAs).
• Bank reserves decrease:
– causing the monetary base and the banks’
lending ability to decrease.
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Foreign exchange swaps
• RBA may use foreign exchange swaps to
supplement or substitute for OMOs.
• Foreign exchange market intervention—either
selling or buying Australian dollars
– Purchase/sale of dollars is equivalent to
purchase/sale of government securities, and has
similar impact on banks’ ESA funds.
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Rediscount rate and monetary
policy
• The rate at which the RBA buys or sells short-term
securities under repurchase agreements
• These can be used as a central tool of monetary
policy.
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Easy monetary policy
• Implemented when the economy is faced with the
prospects of substantial unemployment or
deflationary pressure.
• RBA announces its intention to reduce the cash rate.
• RBA acts to bring the ESA funds market into balance
at the new target cash rate.
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Tight monetary policy
• Enacted when the economy is facing significant
inflationary pressures.
• RBA announces its intention to increase the target
cash rate.
• ESA funds are brought into balance at this new
target cash rate.
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Monetary policy and equilibrium
GDP
Cause–effect chain of monetary policy:
• money supply impacts on interest rates
• interest rates affect investment
• investment is a component of AD
• equilibrium GDP is changed.
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Real rate of interest, i
Monetary policy and equilibrium
GDP (cont.)
SF2
10
SF1
10
8
8
6
6
Price level
D1
0
0
Quantity of money demanded and supplied
ASLR AS
Investment
demand
Amount of investment, i
Tight monetary
policy
P1
AD1
Real domestic output, GDP
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Real rate of interest, i
Monetary policy and equilibrium
GDP (cont.)
SF2
10
SF1
10
8
8
6
6
Price level
D1
0
0
Quantity of money demanded and supplied
ASLR
AS
Investment
demand
Amount of investment, I
Tight monetary
policy
P1
AD1
AD2
Real domestic output, GDP
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Monetary policy and equilibrium
GDP (cont.)
Refinements and feedback effects
• Policy effectiveness depends on:
– shape of the demand for money curve
– shape of the investment demand curve.
• Feedback effects
– Reductions in GDP tend to reduce business profits,
causing business to reduce investment.
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Monetary policy and the open
economy
• Net export effect
– Changes in interest rate affect the value of the
exchange rate under floating exchange rate.
 An increase in interest rate appreciates the currency,
resulting in lower net exports.
 A decrease in interest rate leads to currency
depreciation and a rise in net exports.
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
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Shortcomings of monetary policy
•
•
•
•
Cyclical asymmetry
Conflict with Treasury goals
Cost-push inflation
Investment insensitivity
– Some question how sensitive investment actually is
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Slides prepared by George Bredon
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Strengths of monetary policy
• Flexible and speedy to implement, relative to fiscal
policy
• Politically acceptable, due to its broad impact
Copyright © 2012 McGraw-Hill Australia Pty Ltd
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Slides prepared by George Bredon
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Next chapter
Economic resources
and the labour market
Copyright © 2012 McGraw-Hill Australia Pty Ltd
PowerPoint presentation to accompany Economic Principles 3e, by Jackson, McIver, Wilson & Bajada
Slides prepared by George Bredon
11- 68