Macroeconomics1:

LECTURE 7
The monetary system

LEARNING OBJECTIVES
In this chapter you will:
consider what money is and what functions
money has in the economy
learn about the Reserve Bank of Australia
examine how the banking system influences the
amount of money in the economy
see what tools the Reserve Bank of Australia
uses to influence liquidity conditions in the
economy.

The meaning of money

Money is the set of assets in an economy that
people regularly use to buy goods and services
from other people.
Money has three functions in the economy:
medium of exchange
unit of account
store of value.

The functions of money

Medium of exchange
A medium of exchange is anything that is readily
acceptable as payment.

Unit of account
A unit of account is the yardstick people use to post
prices and record debts.

The functions of money

Store of value
A store of value is an item that people can use to
transfer purchasing power from the present to the
future.

Liquidity
Liquidity is the ease with which an asset can be
converted into the economys medium of exchange.

Kinds of money
Commodity money takes the form of a
commodity with intrinsic value.
Examples: gold, silver, cigarettes

Fiat money is used as money because of

government decree. It does not have intrinsic
value.
Examples: coins, currency, cheque deposits

MONEY IN THE AUSTRALIAN

ECONOMY

The Reserve Bank of Australia

The Reserve Bank of Australia (RBA) serves
as the nations central bank. Its two main
functions:
the formulation and administration of monetary
policy
to maintain financial stability, including stability of
the payments system.

The RBA was created in 1959. Prior to that,

central banking powers were held in the
Commonwealth Bank of Australia.

Organisation of the RBA

The Reserve Bank Board is responsible for
the Banks monetary and banking policy.
Decisions regarding the setting of monetary
policy are made by the Reserve Bank Board
at its monthly meeting.
Changes in the stance of monetary policy are
communicated to the Treasurer and then the
public through a statement from the bank.

Changes in the RBAs role

Prudential supervision of banks has shifted to
the Australian Prudential Regulation Authority
(APRA).
The RBAs key role is to determine monetary
policy.
The RBAs charter:
contribute to the stability of the currency , the
maintenance of full employment; and the economic
prosperity and welfare of the people of Australia

The main contribution is control inflation:

Target of 23 per cent.

State Bank of Vietnam

The State Bank of Vietnam defines its principal roles as:

Promoting monetary stability and formulating monetary
policy.
Promoting institutions stability and supervising financial
institutions.
Providing banking facilities and recommending economics
policies to the government.
Providing banking facilities for the financial institutions.
Managing the countrys international reserves.
Printing and issuing banknotes.
Supervising all commercial banks activities in Vietnam.
Lending state money to the commercial banks.
Issuing government bonds, organising bond auctions.
Being in charge of other roles in monetary management and
foreign exchange rates.
Slide 11

Monetary Policy
Central banks in most developed economies
usually describe their aims in terms of the
pursuit of non-inflationary growth.
Today, theres a consensus that price stability
should be the overriding objective of
monetary policy.
External Balance Goal: Maintain the
exchange rate within a particular band.
Internal Balance Goal: Maintain the
inflation rate within Slide
a particular
band.
12

External Balance
When there is an increase in the demand for the
Dong; the market exchange rate strengthens and
the exchange rate moves to the lower end of the
established band, the Authority sells VND to banks
and/or buys government securities from banks.
The money base (supply) will increase, pushing
down Vietnamese dollar interest rates. Lower
domestic interest rates relative to foreign interest
rates restrain capital inflows into the nation,
encouraging outflows.
Supply of foreign currency (FX) decreases and
demand for foreign currency increases, weakening
13
the currency to restore Slide
stability.

Internal Balance

Goal: Maintain the inflation rate within a

particular band.
Sale and purchase of government securities
changes bank reserves and thus their ability to
extend credit, thus changing the money supply
and the interest rate.
The Monetary Authority targets interest rates by
affecting system liquidity.
Monetary policy influences the size of bank
reserves. This influences:
The size of the money supply.
The interest rate and the availability of credit.
Investment spending, interest-sensitive
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consumption
spending
thusandoutput,
employment
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Open Market Operations

Monetary Authority actions designed to
change interest rates by changing system
liquidity to change the cost of credit and thus
economic activity and the price level.
Easy Money: Authority announces its decision
to reduce interest rates it buys government
securities to maintain the lower interest rates;
expanding the money supply and reducing the
cost of credit.
Tight Money: Authority announces its
decision to increase interest rates it sells
government securities to maintain the higher
interest rates; reducing the money supply and
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15

Banks and the money supply

Banks can influence the quantity of demand
deposits in the economy and therefore the
money supply.
Reserves are deposits that banks have
received but have not loaned out.
In a fractional-reserve banking system,
banks hold a fraction of the money deposited
as reserves and lend out the rest.
Reserve ratio is the fraction of deposits that
banks hold as reserves.

Money creation with fractionalreserve banking

The money supply is affected by the amount
deposited in banks and the amount that banks
loan.
Deposits into a bank are recorded as both assets
and liabilities.
Loans become an asset to the bank.

Money creation with fractionalreserve banking

This T-Account shows a bank that accepts
deposits, keeps a portion as reserves and
lends out the rest. It assumes a reserve ratio
of 10 per cent.

Money creation with fractionalreserve banking

When one bank loans money, that money is
generally deposited into another bank.
This creates more deposits and more
reserves to be lent out.

Money creation with fractionalreserve banking

When a bank makes a loan from its reserves,
the money supply increases.
The money multiplier is the amount of money
the banking system generates with each
dollar of reserves.

The money multiplier

First State Bank
Assets

Liabilities

Reserves
$10.00

Deposits
$100.00

Loans
$90.00
Total assets
$100.00

Second
Bank
Assets State
Liabilities
Reserves
$9.00

Deposits
$90.00

Loans
$81.00
Total liabilities
$100.00

Total assets
$90.00

Total liabilities
$90.00

Money supply = $190.00!

The money multiplier

The money multiplier is the reciprocal of the
reserve ratio:
M = 1/R
With a reserve requirement, R = 20 per cent or
1/5, the multiplier is 5.

The money multiplier

How much money is eventually created in this
economy?
Original deposit
= $ 100.00
First State lending
= $ 90.00 [=0.9 x $100.00]
Second State lending
= $ 81.00 [=0.9 x $90.00]
Third State lending
= $ 72.90 [=0.9 x $81.00]
etc.
etc.
etc.
etc.
Total money supply

= $1000.00

Bank capital and leverage

Financial resources that a bank gets from
issuing equity to its owners are known as bank
capital or owners equity.
Aside from capital, a bank uses resources from
deposits and debt to generate profit for its
owners.

Bank capital and leverage

The use of debt to supplement existing funds
for investment purposes is leverage.
The leverage ratio is the total bank assets to
bank capital.

Bank capital, leverage and the

financial crisis of 200809
In 2008 and 2009, many banks in the US fell
short of capital after they incurred heavy losses
on mortgage loans and securities backed by
mortgage loans.
The capital shortage induced banks to scale
back lending, leading to a credit crunch
thatcontributed to a severe downturn in
economic activity.

Bank capital, leverage and the

financial crisis of 200809
To address the problem, the US Treasury
along with the Federal Reserve injected
billions of dollars of public funds into the
banking system to increase the amount of
bank capital.

Monetary policy in Australia

In the past the RBA targeted the money
supply.
The RBA now targets the cash rate to
influence the level of economic activity.
The cash rate is the interest rate that financial
institutions can earn in the overnight market for
cash.
The cash rate is the benchmark for other interest
rates in the economy.

Monetary policy in Australia

Each bank keeps deposits with the RBA to
facilitate transactions with other banks and
the government.
These are deposits are called exchange
settlement (ES) accounts.
This market is the overnight money market.
These deposits earn interest just below the cash
rate or banks can borrow in this market at interest
rates just above the cash rate.

Open-market operations
The main way in which the RBA targets the
cash rate is through open-market operations.
An open-market operations is the purchasing or
selling Australian government securities.
If there is an excess supply of funds in the
overnight money market at the cash rate, the RBA
withdraws funds by selling government securities.
It takes cash from the banks ES account, thus
reducing cash in the market.

Open-market operations
If there is an excess demand of funds in the
overnight money market at the cash rate, the
RBA injects funds by buying government
securities.
This increases the cash in the overnight
money market.

Open-market operations
In practice, the RBA uses repurchase
agreements (repos) with commercial financial
institutions.

The Target cash rate and the

actual cash rate

Open-market operations
The cash rate is like a wholesale rate that
financial institutions charge each other for
borrowing and lending. They use this as the
basis for determining other interest rates.
As changes in the cash rate flow through to
other interest rates, generally economic
activity is affected.

Open-market operations
For example, if the economy is growing too
fast the RBA will announce a higher cash
rate.
The higher interest rate will deter some
borrowers and the demand for real goods
and services will fall.

Problems in controlling the money

supply
The RBA has been able to control
movements in the cash rate and thereby
influence the cash market, but its ability to
control the money supply is not precise.

Problems in controlling the money

supply
The RBA must wrestle with two problems that
arise due to fractional-reserve banking:
The RBA does not control the amount of money
that households choose to hold as deposits in
banks.
The RBA does not control the amount of money
that bankers choose to lend.

Summary
The term money refers to assets that people
regularly use to buy goods and services.
Money serves three functions in an economy:
as a medium of exchange, as a unit of
account and as a store of value.

Summary
The process of bank lending in a fractionalreserve system gives rise to a money
multiplier.
The Reserve Bank of Australia has control of
monetary policy in Australia.
The RBA uses open-market operations to
achieve a desired cash rate outcome.