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

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
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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
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A well developed economy needs a welldeveloped 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
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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
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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
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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
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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
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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
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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
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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
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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
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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?
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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?
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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 nonbank 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
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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
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3.
4.
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.
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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.
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Changing base
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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.
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Break time
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Please take a 10 minute break.
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The Equilibrium Interest Rate
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Intro
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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
Excess
Money
Demand
People
Sell
Bonds
Excess
Money
Supply
People
buy
bonds
Bond price
Falls
Rates rise
Bond prices
Up
Rates fall
Surplus
MD
MS
Shortage
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Excess quantity demanded
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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
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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
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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
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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
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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
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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
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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
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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 in
Money
Policy
Change in
Price, GDP,
Employment
Change in
Money
Supply
Change in
Aggregate
Demand
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Change in
Interest
Rates
Change in
Investment
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Monetary Policy & AD-AS model
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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 Chains
MS
Investment vs. Rates
Real GDP vs. Price level
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The Australian Financial System
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Intro
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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
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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
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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
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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
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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
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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
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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.
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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.

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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

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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

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
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 exchangetraded 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

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
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.
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Ask Yourself
1.
2.
3.
Why is gold a better form of money than
silver? Why would diamonds not be a
good form of money?
What, exactly, in your own words, does “a
coincidence of needs” mean?
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?
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Ask Yourself
4.
5.
6.
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?
Explain how selling a future contract on a
bond will protect you against a rise in
interest rates.
Can you explain the 3 reasons for
demanding to hold cash?
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Ask Yourself
7.
8.
9.
Can you explain both the necessary and the
additional desirable properties of something
for it to be usable as money?
If a person makes a tax payment to the
government, does the money base increase,
decrease or stay the same? Why?
What are the purposes of all of the different
types of financial markets that we have
discussed, in a few simple, insightful words?
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Homework



Chapter 15:
Problems 1-13
MC 1-11
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Next week

Monetary policy, chapter 16
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END
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