Study Notes on Money and Monetary Policy

Medium of Exchange: Money facilitates transactions between buyers and sellers, eliminating the need for barter.
Unit of Account: It provides a common measure for valuing goods and services, allowing for easy comparison.
Store of Value: Money retains its value over time, enabling individuals to save for future purchases.

Measurement of Money:

M1: Includes cash and checking deposits, representing the most liquid forms of money.
M2: Encompasses M1 plus savings accounts and time deposits, providing a broader measure of the money supply.

Definition of Money: A medium of exchange that is generally accepted in transactions and for settling debts.
Primary Functions of Money:
- Medium of Exchange: Needs to be universally accepted to facilitate transactions.
- Characteristics: Ease of conversion and low cost, termed liquidity.
- Unit of Account: Provides a universal measure of value, allowing different goods and services to be compared easily.
- Store of Wealth: The most liquid form of wealth providing security against the risk of losses.
- Functions support standard measures of money, typically reflected in bank deposits and currency.

To measure how much money exists in the economy, it is necessary to define which assets qualify based on the functions of money.

Creation of Money:
- Money is created through credit or loans from banks.
- When a bank grants a loan, it provides credit to the borrower's account, thus creating new money at that moment (McLeay et al., p.16).
Process of Deposit Creation:
- Loans generated by banks return to the banking system as deposits, which are subsequently re-lent. This creates a cycle of deposit expansion.
- Limits to Creation:
- Fractional reserve nature of the banking system limits the amount of new money created.
- The willingness and ability of banks to make new loans.
- The ratio of money the public wishes to hold as currency.

Definition of Reserves: Primarily consist of exchange settlement accounts at the Reserve Bank of Australia (RBA).
The RBA typically accommodates the demand for reserves at a price they determine, showing the endogenous nature of money supply.
- That is, the evolution of deposit volume is influenced by the demand for loans and banks' willingness to meet that demand.

Demand for money can be understood as:
- Positive Function of Income: Increases in income lead to greater money holdings for financing transactions and precaution.
- Negative Function of the Rate of Interest: Higher interest rates reduce the amount of money held as an asset.
The money supply in this context is endogenous—adapting based on demand influenced by income and interest rates.

Monetary policy is mainly conducted through the setting of interest rates, affecting economic activity.
Key Actions by RBA:
- Influences the cash rate, which balances the supply and demand in the overnight interbank market.
- Uses exchange settlement funds (ESA) and determines rates paid on ESA balances and charged for ESA funding.
Interest Rate Corridor: This structure creates both a lower and upper limit for rates in the overnight market.

The cash market involves the interbank market for ESA funds. It includes mechanisms to establish rates for borrowing and lending between banks.
Target rate of interest ($ic T$) influences market dynamics profoundly, setting a baseline for other rates.
Changes in the target cash rate will directly affect the interest rates banks will charge and offer.

The interest rate reflects the return expected from holding a bond, which should be inversely related to bond pricing.
Present Value Calculation: The interest rate is the discount rate that equates to the bond's market price ($p_B$).

An increase in the cash rate makes overnight market less attractive than solutions offering longer maturities (n-day bonds).
- This results in increased supply of n-day bonds and decreased demand, causing n-day bond prices to fall and interest rates to rise.
General Implication: A rise in the cash rate should lead to a corresponding rise in general interest rates, but there are several qualifications:
- Term structure is influenced by both monetary policy and risk perceptions regarding longer-term financial assets.
- Changes in medium to long-term interest rates significantly affect aggregate demand, driving investment and consumer expenditures.

A monetary policy change can lead to adjustments in real medium and long-term interest rates, impacting demand.
The model suggests that a drop in interest rates ($r$) will lead to an increase in equilibrium GDP ($Y$).
Fluctuations in the expected levels of spending (
$Cd$ and $Ip$) are crucial for predicting economic outcomes in response to policy changes.