01- Introduction to financial

system
Content
 5 sector circular flow model
 Financial system
o Financial market
o Financial institutions
 Direct financing & indirect financing
 Function of financial

Circular Flow of Income

Sources of income
 Land  rent
 Labor  wages & salaries
 Capital  interest
 Entrepreneurship  profits
Net export = export – import

Disposable income = income – Net tax

= income – (tax – transfer payment)

Financial institution are there to facility

The 5 sector model consist of households, business firms, govt, rest of the world & financial institutions.
The circular flow depicts how income/money is distributed among 5 sectors in the economy. Resources
are anything that can be used to satisfy human needs & wants. Economic resources can be classified as
land, labor, Capital & entrepreneurship.

When considering the households & firms. Households provide resources (labor) to firms & in return firms
provide households with income. Firms also provide households with goods & services in return
households expense from their income to purchase the goods & services.

When households save their privet income in financial institutions, The financial institutions are able to
contribute loans/invest on firms.

The government collect taxes from firms & households in addition to spending/govt purchases with firms.
The resulting income of households (income – Net tax) is called the disposable income. The government
also barrow loans from different financial institution such as Sovereign bonds, treasury bills etc.. The
government may also conduct transfer payment through trust, NFP organizations to benefit households
with a lower disposable income.

Households interact with the rest of the world by purchasing goods & services from abroad (imports). How
firms interact with the rest of the world is through gathering exports provided by the rest of the world.
Financial too can barrow cash from abroad from the rest of the world. If incase there is a shortage of
money within the financial institution.

Leakages  any withdrawals from the income flow (savings, tax & imports)
Injections  any input into the income flow (investment, govt spending & export)

Financial system
Matching principle

For the Financial market instruments, the Matching principle indicates in the money market, short term
assets, should be funded with, short term liabilities & the for the capital markets, long terms assets, should
be funded with long term liabilities.

Ex :

Money market 1 year loan with 1 year assets the org buys
Capital market  more than 1 year loan, assets that are been used for more than 1 year

Primary market

• All financial claims have primary markets.

• Funds are obtained by the issuer [i.e., DSU] to raise funds to purchase goods, services or assets by:
• Businesses (via company shares or debentures)
• Governments (via Treasury notes or bonds)
• Individuals (via mortgage)
• Facilitated by underwriting groups (e.g., investment banks) who set a beginning price range for a given
security
• Also, oversee its sale directly to investors.

Secondary market

• Secondary markets are where previously issued financial claims are exchanged among investors.
• No new funds are raised.
• Transfer of ownership.
• Supply and demand set price of the security.

Most important function:

• Provision of additional liquidity to financial instruments via the trading of existing securities.

Money market

• Short-term securities are issued (primary market) and traded (secondary market)
• Securities are highly liquid:
• Term to maturity of one year or less (usually 90 days or less)
• Highly standardised form
• Deep secondary market
• Low expected return but also low degree of risk
• Large denominations (over $1 million)
• No specific infrastructure or trading place (OTC)

Money markets serve several functions:

• Financing trade
• Financing industry
• Profitable investment
• Self-sufficiency of commercial banks
• Assists central banks
• Most important function is it allows financial institutions to undertake liquidity management.
 • Does this by managing mismatches that occur between cash payments and cash receipts.

Capital market

• Longer term securities are issued and traded with original term-to-maturity in excess of one year.
– Equity (stock) market
– Corporate debt market
– Government debt market
• Participants include individuals, business, government and overseas sectors.
– Offer higher returns than money markets.

Equity market

• New issues of shares are initial public offering (IPO).

• Investment banking firm typically acts as the underwriter.
• The seller receives the proceeds of the IPO and investors receive the shares.
• Any trade after the security’s primary issue is a secondary market transaction.
• Increases the willingness of investors in primary markets

Debt market

• Usually in the form of bonds, but it may include notes, bills, etc.
• Primary goal is to provide long-term funding for public and private expenditures.
• Adhere to the matching principle
• Typically, government bond markets are very important due to their size and liquidity.

Financial institutions

They act as an intermediary, in the financial system consisting of banks, credit unions, insurance
companies, pension funds, mutual funds & finance companies. Who are providing financial services to
economic unit.

Direct Vs Indirect financing

Financial markets perform the most important role of, channeling funds from people who have surplus
funds (revenue > expenditure), to people who have a deficit (revenue< expenditure) In need of money in
the economy.

People with surplus money –> SSU (surplus saving unit)

People with less money  DSU (deficit spending unit)

Funds Funds
SSU Financial market DSU

Financial claim issued by DSU

In direct financing, funds are obtained through, primary market by the direct relationship with fund
supplier (SSU) is called Direct Financing.

In order to borrow money from SSU, DSU will issue a financial claim which against SSU’s money at a future
date. It has different names such as financial instruments, financial securities, financial claims & IOU (I Owe
You).

It’s a liability to the borrower of funds (DSU), & simultaneously an asset to the supplier of funds (SSU).

Financial claims can be in different formats such as stock & bonds. However, they’re written promises with
3 characteristics.
 To pay a specific sum of money (principal)
 Plus, the interest for the privilege of borrowing money
 There is a period of time (maturity of the loan)

Example for Direct Financing.

Company X needs $100 million to buy a new machinery, selling long term bonds with 15-year maturity.

SSU DSU
Assets Liabilities Assets Liabilities
- Money to DSU + Money from SSU + Direct claims sold
+ Direct claims to SSU
bought from DSU

Direct Financing

Advantages
• Avoids costs of intermediation
• Allows the borrower to diversify funding sources
• Enhances firm reputation

Disadvantages
• Matching of preferences
• Liquidity and marketability of a security
• Search and transaction costs
• Assessment of risk, especially default risk
• Limitations create a role for financial intermediation.

Indirect Financing
In indirect financing, a financial institution or an intermediary stand between DSU & SSU. It makes the
financial claim more attractive to both DSU & SSU.

In this method, there are 2 separate contractual agreements. One between DSU & financial institution
(Direct Claim) & the other with between SSU & financial institution (Indirect Claim)

Agreement 2 Agreement 1

Certificate of deposit (CD) Principle + interest

Indirect Claim Direct Claim

SSU Financial Institution DSU

One of the main differences between direct & indirect financing is that, in direct financing the financial
claim that, transfer from DSU to SSU, the form of the claim will remain unchanged.

However, in the indirect financing, the financial institution can tailor mate more attractive, financial claims
to meet the need of the customer.
Since SSU has no expertise knowledge to transact in the financial market, They proffered indirect
financially through institutions .

SSU Financial Intermediary DSU

Assets Liabilities Assets Liabilities Assets Liabilities
- Money to + Money + Indirect + Money + Direct
financial from SSU claim to from claims to
intermediary SSU financial financial
intermediar intermediar
+ Indirect - Money to y y
claim from DSU
financial
intermediary + Direct
claim from
DSU

Main Benefits of Financial Intermediation / Indirect financing

Asset transformation
 All the financial intermediaries namely collect funds through deposits which is a liability for them &
the main business is converting these deposits into loans, which is an asset to them. This process of
transforming deposits to loans is called Asset transformation.

Denomination divisibility
  Typical households don’t have enough cash to invest in direct markets, where minimum
transactions are often $1 million. Financial intermediation facilitates direct investment to
households by offering financial claims with smaller denominations. (from $1 – millions of dollars)
 They do this by, pooling funds, of many individuals & invest them in direct securities of varying
sizes. If not, fanatical institutions households would have to accumulate large sums of money
before they invest.
 During this process households, would earn 0 income & great opportunity cost. Therefore, they’ll
be demotivated to save & invest.

Currency transformation
 In financial intermediaries’ financial claims can be bought in 1 currency & sold in another currency.

Maturity flexibility
 Financial institutions are able to create financial claims with a wider range of maturities (from 1 day
to more than 30 days). Mostly the claim for SSU is shorter, because they prefer, shorter maturities
& with DSU, fairly long-term maturity as they prefer longer term maturity.

Liquidity
 Financial institution produces, financial claims which are mostly liquid. This is because, most of the
times consumers prefer to hold more liquid assets (assets that can be readily convertible to money)

Role of financial System

 To facilitate the flow of funds

This is the role of financial system, which facilitates direct financing through financial markets &
indirect financing through financial institutions.
(Explainboth direct & indirect financing markets)

 To provide ways of dealing with incentive problems

Asymmetric information

This occurs when buyers & seller don’t have access to the same information. This
happens where the seller has more information than the buyer.

In financial truncations a Asymmetric information refers to the fact that issuer of the
security (DSU). Know better than investor (SSU) about the credit quality of the
financial claim, been issued.

This problem is much lower for large public cooperation because lot of information is
readily available.

01. Adverse selection


This occurs before a transaction takes place. When lack of information is
available & the loan is granted without proper additional information
gathering, leading to market failures.

Since gathering additional information isn’t free loan pricing becomes much
more important & difficult.

02. Moral Hazard

 
This occurs after a transaction taken is place. When lack of available
information, once the loan is granted due to behaviour of the barrower is
different than agreed, there will be chance that the barrower will default.

Therefore, financial institutions should be experts in information contribution. This is usually larger
for individuals & small businesses. & as a result they typically find, it more economical to access the
credit markets, using the services financial institutions.

 To facilitate financial market efficiency

01. Allocational efficiency

It’s a form of economic efficiency that implies the funds will be allocated to
their highest value use. (the funds couldn’t not have been allocated in any
other way that would’ve made society better off.)

This is important as it promotes investment, In the projects offering the

highest rate of return. & that households, invest in direct or indirect financial
claims offering the highest yields for given level of risk.

02. Informational efficiency


This relates to the ability of investors to obtain accurate information about the
Information relative values of different financial claims or securities. In an informationally
efficient market security’s prices the best indicators of relative value cuz,
financial prices reflect all relevant information about the securities.

This is important because, it allows investors to determine which investment are

the most valuable & ensures that the financial markets are allocation ally
efficient too. That is because, investors can get the information they require to
make the intelligent investment decisions
Fees, commissions
03. Operational efficiency

This is important because, if transaction cost are higher fewer financial
transactions will take place & a greater number of valuable investment projects
will be passed out, therefore higher transaction cost will prevent investors from
in investing all desirable projects. If the investment projects are forgone
unemployment will be higher & economic growth declines

Transaction cost –->

They’re all types fees & commissions paid when buying & selling financial claims such
as search cost, cost of security exchange commission (SEC registration cost), time &
hassle of financial transactions.

04. Financial system provides the means to transfer & manage risk

Since financial claims are associated with risk, it facilitates SSU’s with proper risk
management strategies such as, securitization & derivative products.
Securitization includes packing up homogeneous assets & selling them to a 3 rd
party. Also derivative securities include futures, forwards, options & swaps.
 05. Payment system


Bank’s bank
account handled The payment
by the Reserve
system is the
bank of
Australian mechanism by
which funds are
transferred from
one party to the
other party.

This can be in-between different financial

market participants such as consumers,
businesses etc…

The Australian payment system handles

their transactions in accordance with the
size, whether they are high value or low
value. This determines a given transaction is
settled in real time or batch processed after
the net position of each institution in th e system is calculated at the end of each business day.

High value payment:

These are settled individually & cannot be reversed, each elidable financial
institution holds & ESA account (Exchange Settlement Account) with Reserve
Bank of Australia (RBA) within RITS (Reserve bank information & transfer
system).therefore funds are transferred to and from ESA accounts in order to
settle transitions in the payment system. The settlement will be on RTGS
basis (Real-time Gross Settlement cant be achieved crediting & debiting of
ESA’s held at RBA access through RITS. The balance of ESA represents bank
reserves. As the funds are settled at the same time as the payment details is
transferred settlement rise is law (yield  return of an investment)

Low value payment

These are retail payments which are settled on net settlement basis.

This is batch processes after the net position of each institution in the system
at the end of business day

 To provide the means to transfer and manage risk

 To provide the mechanism to settle transactions (i.e., payments system)

 02 - Theories of the
Demand for Money
3 primary functions of money

1. Medium of Exchange
• It’s the most liquid part of wealth. Which can be most readily exchanged for goods &
services. An item that buyers give to sellers when they purchase goods and services (i.e.,
facilitate transaction).
2. Unit of Account
• Money has a agreed value, to evaluate cost of goods & services, assest & liabilities. An agreed 3.

3. Store of Value
 its 1 form of assets that can store value over time. Land & gold are also used to store wealth.
Money can also be saved & retrieved it holds its value over time.

Fisher’s Quantity theory of money

Money demand refers to the desire for holding financial assets in the form of money. If you hold your
wealth in the form of money it gives you the advantage of liquidity. However, holding money gives you no
interest (dis-adv), also its loses purchasing power during inflation (Dis-adv). This indicates that there is a
trade-off between liquidity advantage & interest advantage.

Fisher’s quantity theory of money stresses the connection between changers in the economy’s money
stop. & Changers in the general price level.

M*V=P*T

Quantity of money Velocity  avg time a $ is General Aggregate out of the

(economy’s money stop) spend per year Price level economy (GDP)

The important concept in the Fisher’s theory is the velocity of money. It is calculated by

V = total spending / quantity of money

Or
The theory assumed that the:
01. velocity is fairly constant in the short run.
 Velocity is affected by the technology (rapidity of transportation of goods & services & nature of banking
system). Which changers very slowly over time.

02. Transactions/aggregate income is also constant in the short-run

Here we assume that the output will be at full employment level

Since both V & T are constant, if money supply doubles, price levels must also double. Therefore, quantity of money
is proportionate to the change of price level.

Due to this money demand becomes a function of income.

Activity

i. What was the motive that informed Fisher’s money demand?

ii. What was the main factor influencing money demand?
iii. What is the role of interest rates under Fisher?
iv. What does Fisher say about the velocity of money?

1. Motive the theory in this case is transaction demand for money

2. Income
3. It has not discussed about the interest rate
4. According to the theory, its assumed fairly constant in the short run

Under the velocity its no longer constant therefore the fisher’s theory in no longer valid.

Keynes’ Liquidity Preference Theory

• Keynes (1936) developed his theory of money demand:

– abandoned classical view that velocity was constant
– identified a link between money and interest rates.

• Individuals hold money for three motives:

– Transactions Motive
– Precautionary Motive
– Speculative Motive

(i) Transactions Motive (income)

• Individuals are assumed to hold money because it is a medium of exchange.
• Demand for money is determined primarily by the level of people’s transactions.
• Transactions were proportional to income:
– As income rises, people undertake more transactions and will hold more money.
(ii) Precautionary Motive (income)
• Individuals also hold money for unexpected needs and emergencies (i.e. different type of
transaction).
• Hence, demand for precautionary money balances is proportional to income.
– As income rises, people hold more money for potential emergency transactions.

(iii) Speculative Motive (interest)

• This motive is the money demand for investment purposes.
• Most important contribution of Kayne’s to the theory of money Demand
• Accordingly, Kayne’s assumed 2 assets where people can store wealth such as
• Money (expected return is zero)
• Bonds (expected return through interest & there is risk associated with it)

Q.
What is relationship between interest rate & bond prices?

Case1 :
Assume you have a bond which has a price $1000 & the current interest rate is 10% per annum.
Calculate the expected return at the end of 1sy year (yield)

$1000*10% = $100

Assume the interest is increased to 15% your return or loss when selling the bond

X*15% = $100
X = $100/15%
X = $666.67

A capital loss of = $1000 - $666.67 = $333.33

Interest rate increases : Bond Price decreases  (-) relationship

Therefore, speculative demand for money will decrease

There is a (-) relationships between interest rate & speculative demand for money
Velocity under Kayne’s Theory

Starting from a position of equilibrium in the money & bonds markets & anticipated increase in the supply
of money, causes interest rate to fall & money demand to increase. Therefore, when interest rate
increases people will hold low real money balances at a given level of income, then velocity increases
because people convert more bonds to cash.

(+) relationship, as interest rate increases there’s a capital loss. To avoid the capital loss people, sell the
bonds, as a result more money circulating in the economy.

Micro Theory of Keynes’s LPF (Liquidity Preference theory)

To decide whether to keep or hold bonds convert to cash agents must compare the interest
rate payable on bonds with the risk of capital loss of holding them. This requires a decision
regarding likely future bond price.

Keynes assumed that every person at any time holds a view of the likely interest rate in the. Economy
that is the interest rate he or she regarded as “normal interest rate”.

If the current interest rate is < normal interest.
Rate
Agents would anticipate a RISE in the interest rate.
Therefore, at a LOWER interest rate, bond prices
will fall and people will switch from bonds to
money & money demand will increase. (People will
sell bonds)
If the current interest rate is > normal interest.
Rate
Agents would anticipate a FALL in the interest rate.
Therefore, at a HIGHER interest rate, bond prices
will INCREASES people will switch from MONEY to
BONDS & money demand will DECREASE. (People
will buy bonds)

Therefore normal interest rate will show the interest of people switching between bonds & cash
Criticisms of LPT
 Keynes assumed that if the interest rate is likely to rise (and the bonds processes fall) causes a
switch between bonds to cash entirely & visa versa. It is clearly unrealistic at micro level because
the rational level dictated a portfolio of diversification & the holding of a mixture of bonds & cash.

Baumol-Tobin (B-T) Transaction demand / Inventory theoretic model

In this model they’ve considered that the balances set aside for transaction purposes are
held temporary in the form of securities & it can be converted easily into money when
needed to purchase goods & services. However, in this conversion processes bonds to
money & money to bonds there is a “transaction cost” (fees, commission, transportation
etc…) which also affected money demand. When transaction cost is high it reduces the
demand for bonds or securities, this will increase the demand for money.

In Keynes LPF the opportunity cost of holding money for transaction purposes aren’t recognised. Here it
says that when keeping money for transaction purposes when the interest increases therefore holding
money for te transaction purposes will decrease. Therefore, the transaction demand for money inversely
related to the interest rate.

As a summary BT transaction model means holding money for transaction purposes is positively related to
the transaction cost & negatively related to Interest rate.

B-T Precautionary Demand

Here it says that there is an opportunity cost of holding money for precautionary purposes. When interest
rate is high then opportunity cost of holding money for precautionary purposes will be high & therefore
money demand for precautionary purpose will be low.

As a summary for precautionary purpose the money demand will negatively related to the interest rate.

B-T Speculative Demand

Hence limit its speculative demand to only money and bonds, but B-T model assume a portfolio a portfolio
approach. This means that individuals have a mix of assets in the portfolio & their choice between money
& bonds is depends on expected return trade-off & the degree of risk associated with the total portfolio of
bonds & money.

Money = 0 return & 0 Risk

Bond = high risk & high return

Therefore, in portfolio approach of money & bonds its possible to reduce risk by having low risk low return
assets or high risk high return assets. Individuals can choose a mix of theses 2 types of assets based on risk
& expected return trade off.
Freidman’s modern quantity theory of money

Freidman (1956) applied the “assets demand theory” to identify factors influencing money demand. He
didn’t specify as Keynes did any particular motive for holding money. He viewed money as a durable good
yielding a flow of non-observable services. He also assumed that money competes with other assets, such
as bonds, stocks & physical goods.
(Money is considered as a durable product)

It where money has to compete with these assets in individual’s portfolio. Therefore, the demand for
money should be a function of
1. The resources available for individuals (their wealth)
2. Expected return of other assets relative to expected return on money
 03- Money Supply and Money
Creation
Measurement of money

• No single correct measure of money circulation exists.

• Narrow measures:
– Typically includes currency in circulation and demand deposits (e.g.) cash, coins and balances
held in checking and savings accounts.
• Broad measures:
– Typically refers to the total amount of monetary assets available in an economy at a specific
time.

Monetary Aggregates

01. Money base is currency plus deposits of banks with the RBA, and other private
non-bank deposits with the RBA.
02. M1 is currency plus bank current deposits from the private non-bank sector.
03. M3 is M1 plus all other ADI deposits from the private non-ADI sector.
04. Broad money is M3 plus other short-term liquid AFI (i.e., all financial
intermediaries) liabilities held by the private sector except those held by other
AFIs.

Exogenous Money Creation: FRB(Fractional Reserve Bamking)

Banks hold a fraction of their deposits as reserves

• Required reserves represent the minimum amount of funds a bank must hold in its cash vault or
deposit with the central bank against certain liabilities (e.g. deposit).
• NB: Australian banks have no required reserve requirements.
• Excess reserves are the cash reserves beyond Requirement reserve
• Total reserves is the fraction of a bank’s total deposits that are held in reserves. (Required + Excess
reserves)

Money supply equation

When the bank is creating a loan, a simultaneous deposit is created
That means a new deposit is created resulting a money supply of $1800

As a result of creating a simultaneous deposit due to the loan

Money multiplier equation

There’re 2 types of money multiplier

 Simple money multiplier
 True money multiplier

1. Simple money multiplier

1. If initial money was deposited into the bank via currency in circulation then the total amount of money
created is:
$1,000 currency; SMM: 1/0.2 = 5
Initial deposit of $1,000 creates $800 of new money * 5 = $4,000 creation of money (Increase in MS)

2. If initial money was deposited into the bank via RBA purchase of bonds then the total amount of money
created is:
$1,000 purchase of bonds by RBA; SMM: 1/0.2 = 5
Initial creation of money is $1,000 * 5 = $5,000 creation of money (Increase in MS
2. True money multiplier
When using normal supply equation

Currency deposit ratio is the amount of currency that people hold as a proportion of aggregate
deposits.

• The ‘true’ money multiplier formula reflects the fact that:

– People do hold currency; and
– Banks do hold excess reserves (i.e., currency drain occurs).

• Thus:
Banking system is limited in the amount of money it creates through fractional
reserve banking.
Total composition

1st bank = $1000

Loan ($750) = $500
= $250
New loan = $360  $2110

Using simple multiplier

Loan 1 = 1/ r = 1/0.2  $750/0.5 – $750 $3750

True money multiplier

M = (1+ c)/ (rr +e+c) = (1+0)/0.2+0.05 +0) = 4

Example

Q.
Suppose the currency deposit ratio is 40%, the reserve requirement is 10% and the excess reserve ratio is
0.5%

• The ‘true’ money multiplier is

 – m = (1+c)/(rr+e+c)
– m = (1+0.4)/(0.1 + 0.005 + 0.4) = 2.77
– A one dollar increase in the monetary base will lead to a $2.77 increase in the money supply
– Note that if c = e = 0, then the money multiplier would have been 10. (simple money
multiplier)

• Accounting for currency and excess reserves is clearly important.

Q.
Assume c = 0.25, e = 0.001, and rr = 0.10. Compute the ‘true’ money multiplier:
– m = (1+c)/(rr+e+c)
– m = (1+0.25)/(0.1+0.001+0.25) = 3.56

Q.
The Central Bank decides to increase rr to 20%. What happens to the money multiplier (and the money
supply as a result?)
– m = 1.25/0.451 = 2.77
– A smaller multiplier means that banks create less money through lending and therefore the
money supply will fall.
– Thus, the ‘true’ money multiplier and the money supply are negatively related to rr.
– This also applies to e (i.e., excess reserves).

Assume: c = 0.2, rr = 0.25, and e = 0.05

– m = (1+c)/(rr+e+c)
– m = (1+0.2)/(0.25+0.05+0.2) = 1.2/0.5 = 2.4

Now suppose c rises to 0.3, while all other variables remain constant
– m = (1+0.3)/(0.25+0.05+0.3) = 1.3/0.6 = 2.17

Increasing the amount of currency people hold as a fraction of their deposits causes the money supply to
fall.
– Money is being taken out of the banking system where it could have been used to make
loans.
– Thus, the ‘true’ money multiplier and the money supply are negatively related to c.
Exogeneous money creation

Central Bank and the Banking System

• Although money creation occurs mostly via bank lending, the system is exogenous as long as the
extent to which a bank is able to lend money still depends on the central bank.
– (e.g.) Lending activity is limited via increase in required reserves.

Commercial Banks ability to create money depends on:

• Depositors
• The size of the reserve ratio
• The amount of excess reserves
• Currency deposit ratio
• Demand for credit
• Banks (depository institutions) willingness to lend

Endogenous Money creation

Three main types of money:

(i) currency.
(ii) bank deposits; and
(iii) central bank reserves.

Each represents an IOU from one sector of the economy to another.

Approx. 97% of money in circulation comprise bank deposits.

Key contention:

Traditional bank deposits include transaction accounts, savings accounts, term deposits, etc.

However, banks also create deposits via the act of making new loans.
• (e.g.) When a bank makes a loan it simultaneously creates a matching deposit in the
borrower’s bank account for the size of the loan… At this instant, new money is created.
• NB: Currency is created by the RBA

Endogenous money creation via additional loans*

Consumer/Firms
• New deposits increases assets of consumer/companies.
• New loan increases their liabilities.
• New broad money is created.

Commercial banks
• New deposit to customer is a liability.
• New loan to the customer is an asset.

Central bank (RBA)

• New broad money is created without any change in central
bank money or ‘base money’.
• Reserves are a consideration after the fact… however they
do not directly constrain bank lending.
Endogenous theory contrasts with exogenous theory by reordering the sequence of money creation.
• Endogenous: Loans make deposits then banks consider reserves afterwards
• Exogenous: Deposits are placed in banks, then reserves are put aside followed by making
loans.

what about the money multiplier then?

• A hypothesis about the nature of money can be derived from the money multiplier model:

Hypothesis:
1. The creation of credit money should
happen after the creation of central bank
money.
• Empirical studies:
• Kydland and Prescott (1990):
US data from 1954 to 1989.
• Levrero and Deleidi (2017):
US data from 1959-2016.
Empirical conclusion:
 For exogenous to be correct, monetary base
(i.e., fiat money injection) needs to occur
before credit money (i.e., making loans) as
per diagram.
 Empirical studies have found no evidence to
support this.
 Instead, studies show that credit money
occurred before changes to the monetary
base (where changes occurred about a year
later).

Central Bank and the Banking System

• Banks have the power to create money via loans based on demand for credit.
• If insufficient reserves, banks will still make loans and replenish reserves later by borrowing them
from other banks or the central bank.
• Central bank cannot control the money supply.

Commercial Banks ability to create money depends on:

• Demand for credit
• Banks (depository institutions) willingness to lend

Limits on Endogenous Creation

 Market forces constrain lending (firms, consumers and banks)

 Need to mitigate risks associated with lending
 Regulatory policy
 Monetary policy (cash rate impacts cost of borrowing)
 04 - Determination and Term
Structure of Interest Rates
Loanable Funds Theory

In macroeconomic texts, there’re theories of interest rates determination. Which explains the interest rate
based on demand & supply of money.

However, in the loanable funds theory the interest rate is determined by the supply & demand of
“Loanable funds”

What are loanable funds?

The funds that are available within the financial system for lending. Therefore, the interest rate is
determined when loanable fund demand = loanable fund supply.

Increasing the demand for loanable funds will increase the interest rate (visa versa) . The supply of
loanable funds decreases the interest rate will increase (visa versa)
1. Demand for loanable funds

The demand for loanable funds consists of 2 components

1. Business sector demand for loanable funds
2. Government sector loanable funds

01. Business sector demand for loanable funds


This is, mainly to finance short term working capital requirement & long term capital requirements.
This has a negative relationship with interest rate (when the interest rate is high, the demand for
loanable funds is low)

02. Government sector loanable funds


When there is a budget deficit, the government must fund their annual budget, through the
government barrowings through the financial market. They also have to fund daily liquidity shortfalls
such as pension payments & so on through borrowings. However, this is independent from the market
interest rate. Therefore, has a perfectly inelastic demand curve.

To get the total loanable demand curve, we need ad both Business sector demand for loanable funds
& Government sector loanable funds
2. Supply for loanable funds

Loanable fund supply is coming from 3 principal sources

1. Savings of household sector (S)
 when the interest rate is high the saver will be motivated to save more & therefore, the
supply of loanable funds based on savings is positively slow. However, the emphatical
studies show that there is no strong relationship between interest rate & savings.
Concluding we can draw the supply curve for the loanable funds based on savings as a
steeper curve.

2. Changes in money supply (M)


As money supply is perfectly inelastic the changers, to money supply will be represented asa
parallel line to the savings curve.
 3. Dishoarding (D)

The term “Hoarding” is the proportion of total savings in economy held as currency. If
hoarding occurs the money will not be available in the banking system. When interest rate
rises there is a incanting for those individuals who are holding cash to deposit those in a
bank account. This will reduce currency holding & dishoarding occurs.

When dishoarding occurs more funds are available within the financial system.

Equilibrium/ equilibrium interest rate

According to the loanable funds theory the interest rate is determined based on demand
for loanable funds & supply for loanable funds.
Term Structure of Interest Rates

The relationship between interest rates or bond yields and different terms or maturities.
• also known as a yield curve and it plays a central role in an economy.

Yield is the total rate of return on an investment, comprising interest received and any capital gain (or
loss).

Characteristics;

1. Yields for different bond maturities tends to move together over time (i.e., same
direction).
2. Yields on short-term bonds are more volatile than yields on long-term bonds.
3. Long term bond yields tend to be higher than short-term bond yields (i.e., yield
curves are typically upward sloping).

*The shape and the slope of the yield curve represent the term structure of interest rate

The yield curve the relationship between return on any investment & the time for maturity.

The shape of yield curve

01. Normal/positive yield curve

 this shows that the longer-term interest rate are greater than shorter term interest rates
02. Inverse/negative yield curve
 this shows that the longer-term interest are lower than the shorter term interest rates

03. humped yield curve

 the yield curve changers overtime from normal to inverse

04. Flat yield curve

 the eyelid curve shows that the shorter-term interest rates are very close long-term rates
*Term Structure of interest rate

1. Expectations Theory

Assumptions;
 large number of investors with similar expectations about value of future short-term rates.
 no transactions costs
 investors aim to maximise returns
 bonds as perfect substitutes (this notion assumes away inflation and interest rate risk).

According to this, there’re 2 types interest rates

i. Current short-term interest rate
ii. Expected future short term interest rate

Are being used to explain the shape & slop of the yield curve. The theory also explains that
the long-term interest rate will be equal to average of current short-term interest rate & the
expected future short-term interest rate

Example: Suppose one-year rates over the next five years are: 5%; 6%; 7%; 8%; and 9% per
annum.
 The interest rate on the two-year bond is:
5% + 6% / 2 = 5.5%
 The interest rate on the five-year bond is:
5% + 6% + 7% + 8% + 9%/ 5 = 7%
 Thus, interest rates for one to five year bonds are:
5%; 5.5%; 6%; 6.5%; and 7% … these essentially form your yield curve.

Q.
Assume if a bank is offering a 1-year short-term deposit with a rate of 4.25% per annum. & a
2-year term deposit with a rate of 4.75% per annum. What is the expected future short-
term interest rate?

Long-term interest rate = (Current interest rate + expected future interest rate)/ 2
0.0475 = (o.0425 + x) / 2
(2*0.0475) – 0.0425 = x
X = 0.0525 or 5.25%
Shape & slope of the yield curve

If the short-term expected rate is < long term rate the graph would be a negative yield
curve.

2. Segmented Market Theory


Assumption
 Markets for different maturity bonds are completely segmented.
 Investors will operate within some preferred maturity range.
 Investors are motivated by reducing the risk of their portfolios.
 Longer term bond maturities have different inflation and interest rate risks than
short term bond maturities (i.e., no perfect substitutes).

Investors operate in a preferred maturity range between risk taking behaviour. And they’re
motivated by reducing the risk of the portfolio.

Ex:
Assume that the central increase the supply of treasury bills, with 1 year maturity.
Everything else being constant the when the supply increases the price of the bond will fall
& the yield will increase. This will only felt at the short term end. And make the yield curve
inverse. No change to long term yield curve.
 Matching principle
• Short-term assets should be funded with short-term (money market) liabilities.
• Longer term assets should be funded with equity or longer term (capital market)
liabilities.
• Shape and slope of the yield curve
– Determined by the relative demand and supply conditions of securities that exist
along the maturity spectrum.

• Different maturity bonds are completely segmented (i.e., different asset classes).
• Thus:
• Changes in supply and demand in one maturity spectrum should not impact
expected returns on bonds with other maturities.
• This is known as a discontinuity of the yield curve (see next slide).

• Lower inflation and interest rate risk for shorter term bonds means yields on longer term bond
maturities will generally be higher.
– This explains why yield curve is usually upward sloping (characteristic 3).
• Segmentation theory cannot explain
– why short- and long-term yields move together; and
– why short-term yields are more volatile (characteristics 1 and 2).

3. Liquidity Premium Theory


Assumptions
i. Bonds of different maturities are substitutes but not perfect substitutes.
ii. Investors prefer successive shorter term instruments to invest in due to:
i. Greater liquidity
ii. Lower inflation and interest rate risk in short term investments.

Shape and slope of curve is explained by:

• Current short-term interest rate and expectations about future short-term interest
rates, along with compensation for holding a longer term bond.
• This compensation is called a ‘liquidity premium’.

Ex;
One-year rates over the next five years are: 5%; 6%; 7%; 8%; and 9% per annum. Suppose
investors’ preferences for holding short term bonds gives us the following liquidity
premiums for one to five year bonds respectively: 0%; 0.25%; 0.50%; 0.75%; and 1.0%

The interest rate on the two-year bond is:

[5% + 6% / 2] + 0.25% = 5.75%
The interest rate on the five-year bond is:
[5% + 6% + 7% + 8% + 9%/ 5] + 1.0% = 8%
Thus, interest rates for one to five year bonds are:
5%; 5.75%; 6.5%; 7.25%; and 8% … these essentially form your yield curve.
 In conclusion

• Liquidity premium theory can explain the three characteristics.

• It explains characteristics one and two since, like expectations theory, long term rates are
essentially tied to expected future short term rates.
• Satisfies characteristic three since the liquidity premium increases with time to maturity
(i.e., compensation increases with longer bond durations).
• Hence, the yield curve should normally slope upwards

Risk Structure of Interest Rates

• The relationship among interest rates on bonds with the same term to maturity.
• Default risk is the risk that the borrower (i.e. issuer) will fail to meet its interest payment
obligations.
• Investors will require compensation for bearing the extra default risk.

Term to maturity high the risk is high

Financial institutions
• Movements in interest rates directly impact net interest margins.
• (e.g.) Institutions will restructure asset portfolios along with liability commitments.
• (e.g.) Institutions will set their pricing of their borrowing and lending products based on
expected future movement in interest rates.
 05 - Monetary Policy
Implementation
The RBA formulates and implements monetary policy.
– Conducted in a transparent manner to reduce uncertainty.

The main goal of monetary policy has been revised to focus on inflation.
– Inflation targets of 2–3 per cent, on average, over the medium term.

At this target range:

– Inflation preserves the value of money.
– Encourages strong and sustainable growth in the economy over the longer term.

According to Reserve Bank Act 0f 1959, Australian monetary policy has 3 objectives
i. Stability of Australian currency
ii. Full employment of the labour force
iii. Economic prosperity & welfare for the people of Australia

Cash Rate

Monetary policy decisions involve setting the cash rate

– Cash rate is the interest rate on unsecured loans overnight loans between banks.

The cash rate cannot be changed by transactions between financial institutions.

Only transfers between the RBA and a bank can affect the cash rate.
– A change in the cash rate indirectly influences the term structure of interest rates in the
whole economy.

Q
Assume there are 4 major banks A, B, C & D in the Australian banking system. They maintain their ESA
accounts wit RBA . Assume the following transactions have been taken place within the day,

Bank D has to pay $80 to bank B & $100 bank A to bank B, Bank C should pay $200 to bank A, and Bank B
should pay $70 to bank C.

*show the ESA accounts