(8) Money, Banks and RBA

Money

The asset generally accepted in exchange for goods and services or for payment of debts.

Functions of money

1. Medium of exchange

2. Unit of account

3. Store of value

4. Standard of deferred payment.

Barter

Exchange of goods/services for other goods/services

• Requires double coincidence of wants

Medium of exchange

Money eliminates the need for a double coincidence of wants in barter trade.

Unit of account

Money provides a common measure for valuing goods and services.

Store of value

Money can hold its purchasing power over time if inflation is low.

Standard of deferred payment

Money is accepted for settling debts due in the future.

Double coincidence of wants

The situation in barter where each trader must want what the other offers.

Commodity money

Money that has intrinsic value (e.g., gold coins).

Fiat money

Money that has value because the government declares it legal tender.

Liquidity

The ease with which an asset can be converted into cash.

M1

Notes and coins held by the public + demand/current deposits at banks.

• demand/current deposits - money kept in checking/current accounts that people can withdraw on demand

M3

M1 + other bank deposits such as term deposits.

Broad money

M3 + non-bank deposits (e.g., credit-union deposits).

Financial sector

Institutions that link savers and borrowers through financial markets.

Money creation

Occurs when banks lend part of their deposits; loans become new deposits elsewhere.

Reserve ratio

The proportion of deposits banks keep as reserves.

Money multiplier

Shows how initial deposits lead to a larger money supply; = 1 / reserve ratio.

Reserve Bank of Australia (RBA)

Australia’s central bank responsible for monetary policy and financial stability.

Monetary policy

Actions by the RBA to influence interest rates and the money supply.

Cash rate

The interest rate on overnight loans between banks; the RBA’s policy target.

Open-market operations

The RBA buying or selling government securities to change the cash rate.

Expansionary monetary policy

RBA lowers interest rates → increases spending and investment → AD rises.

Contractionary monetary policy

RBA raises interest rates → reduces spending → AD falls.

Goals of monetary policy

1. Stability of currency

2. Full employment

3. Economic prosperity and welfare.

Transmission mechanism

How changes in the cash rate affect borrowing, spending, and aggregate demand.

Inflation target

The RBA aims to keep inflation between 2 % and 3 % on average over time.

Q - A ‘double coincidence of wants’ refers to:

B) each person must want what the other has

Q - Money serves as a unit of account when:

C) prices are stated in money terms

Q - A car dealer sells you a car today, you pay later. This shows money as:

D) standard of deferred payment

Currency

cash (physical money) - notes and coins held by the private non-bank sector

Credit

Loans, advances, and bills provided to the private non-bank sector (individuals and firms) by all financial intermediaries

Reserves

Deposits that a bank keeps as cash in its vault or on deposit with the reserve bank of Australia

Simple Deposit Multiplier

Ratio of the amount of deposits created by banks to the amount of new reserves

1/RR

Real world deposit multiplier is smaller than the simple deposit multiplier because…

• banks may hold excess reserve

• people do not deposit all their money

Bank assets

What the bank OWNS or IS OWED

• Reserves

• Loans

• Deposits with other bank

• Securities

• Buildings/equipments

Bank Liabilities

What the bank owes to others

• Deposits (from customers)

• Borrowings (short-term)

• Long-term debt

• Equity (from shareholders)

Quantity Theory of Money

Money Supply (M) x Velocity of money (V) = Price level (P) x Real GDP (Y)

Inflation rate = growth rate of money supply - economic growth rate

States that the total amount of money spent equals the total goods of services sold

Explain high inflation using quantity theory of money

• If M grows faster than Y (economy output), too much money chases too few goods

• This leads to rising prices (inflation)

Hyperinflation

Caused by central banks increasing the money supply at a rate far in excess of the economic growth rate