Money, Interest, and Financial Markets: Comprehensive Study Guide

Learning Outcomes and Core Principles

• Functions of Money: Understanding the role of money as a medium of exchange, a unit of account, and a store of value within a market economy.

• Theories of Inflation: Utilizing the classical theory of inflation and the Fisher effect to explain the relationship between money supply, price levels ($P$), and nominal interest rates.

• Fractional Reserve Banking: Analyzing the mechanics of how banks influence money supply through reserve ratios, asset purchasing (such as LSAP), discount rates, and the Official Cash Rate (OCR).

• Money Market Models: Demonstrating how supply and demand for money interact to determine interest rates.

• Loanable Funds Market: Explaining the coordination of saving and investment through financial markets.

The Functions and Definition of Money

• Medium of Exchange: Money acts as an intermediary to facilitate the purchase of goods and services, eliminating the need for a double coincidence of wants.

• Unit of Account: Money provides a standard measure for pricing goods, services, and debts (e.g., using dollars to price a car).

• Store of Value: Money allows individuals to store wealth for future use (e.g., holding paper money or bank deposits), although its effectiveness depends on price stability.

The Money Market Model

• Components of the Money Market:

  • Nominal Interest Rate ($i$): The price of holding money, represented on the vertical axis.

  • Quantity of Money ($M$): Represented on the horizontal axis.

  • Money Demand ($M_d$): Consists of Transaction Demand (money needed for daily purchases) and Saving Demand (preference for liquidity/cash over other assets).

  • Money Supply ($M_s$): Controlled by the central bank (RBNZ) and influenced by the banking system.

• Predicting Market Changes:

  • If the demand for money increases, the nominal interest rate will rise as people compete for a fixed supply of liquid assets.

  • If the supply of money increases, the nominal interest rate will fall as the surplus of liquidity drives down the cost of borrowing.

Fractional Reserve Banking and Money Creation

• The Banking Mechanism: Banks do not keep all deposits in vaults; they keep a fraction as reserves and lend the rest.

• Hypothetical Scenarios for Money Creation:

  • Initial Deposit: $\$1000$.

  • Case 1 (50% lending): If a bank lends out 50% ($\$500$) and that is re-deposited, and the bank continues to lend 50% of each subsequent deposit, the total money created is determined by the money multiplier formula: $\text{Total Money} = \frac{\text{Initial Deposit}}{\text{Reserve Ratio}}$. For a 50% reserve ratio, this is \1000 \times \frac{1}{0.5} = \$2000$.

  • Case 2 (80% lending): If the bank lends out 80% (meaning a 20% reserve ratio), the total money created would be \1000 \times \frac{1}{0.2} = \$5000$.

The Quantity Theory of Money

• The Equation of Exchange: $M \times V = P \times Y$

  • $M$: Money Supply

  • $V$: Velocity of Money (the rate at which money changes hands)

  • $P$: Price Level (Inflation factor)

  • $Y$: Real Output (Real GDP)

• Economic Implications:

  • Constant Velocity: If $V$ remains stable and $M$ increases, Nominal GDP ($P \times Y$) must increase.

  • Inflation ($P$) vs. Growth ($Y$): If $M$ grows faster than $Y$, the result is an increase in $P$, which is defined as inflation.

  • NZ Historical Example (2019-2020): Nominal GDP was stable, but Real GDP ($Y$) fell. According to the formula, if $V$ were constant, $M$ would have needed to stay stable or fall. However, during lockdown, $V$ typically decreases as people spend less frequently.

  • Velocity Fluctuations (US Federal Reserve Data): In 2020, $V$ fell from $1.45$ to $1.15$. To keep Nominal GDP stable during such a drop, $M$ must increase significantly. When $V$ recovered to $1.4$ in 2021 while $M$ remained high, Nominal GDP spiked, leading to rapid increases in $P$ (inflation).

Role of the Reserve Bank of New Zealand (RBNZ)

• Mandate: To maintain a sound and efficient financial system with a specific goal of keeping price levels stable (inflation target of $2-3\%$).

• Core Activities:

  • Managing inflation.

  • Regulating banks, insurers, and finance companies.

  • Issuing banknotes and coins.

  • Operating wholesale payment and settlement systems.

• Monetary Policy in Crisis (2020 Case):

  • Large Scale Asset Purchase (LSAP): Launched in March 2020, expanding to a maximum of $\$100B$ NZD by August 2020 to inject liquidity into the economy.

  • Money Creation Constraints: If banks hold 10% in reserve, $\$100B$ could theoretically create $\$1000B$. However, if people do not want to borrow and banks can only lend out 50%, the money creation is severely limited.

The Official Cash Rate (OCR) and Trading Banks

• Definition: The OCR is the interest rate set by the RBNZ. It influences all other interest rates in the economy.

• Trading Bank Responses to Market Interest Rates:

  • Higher market interest rates incentivize banks to decrease their cash-to-deposit ratio. They hold less cash reserves and issue a greater fraction of deposits as loans, increasing the money multiplier and the quantity of money supplied.

• Trading Bank Responses to OCR Changes:

  • When the RBNZ increases the OCR, banks are incentivized to hold larger settlement balances at the RBNZ because they earn more on those deposits and pay more to borrow overnight cash. Consequently, they make fewer loans, the money supply curve shifts leftwards, and market interest rates rise.

• Policy Lag: It takes a significant amount of time (often months or years) for changes in the OCR to fully impact inflation because it must filter through consumer behavior and business investment.

The Fisher Effect

• Concept: The nominal interest rate adjusts to reflect changes in expected inflation to maintain a consistent real interest rate.

• Formula: $\text{Nominal Interest Rate} = \text{Real Interest Rate} + \text{Expected Inflation}$

• Productivity Example: If a new technology increases productivity by $5\%$ (Real return) and inflation is expected to be $2\%$, the maximum nominal interest rate a business should pay for a loan is $7\%$.

• Real Return Example: If you buy a bond paying a $5\%$ nominal interest rate and inflation is $5\%$, your real return is $0\%$.

The Market for Loanable Funds

• Definition: This market coordinates national saving and investment through the Real Interest Rate.

• Supply: Comes from National Saving ($S = S_{\text{private}} + S_{\text{public}}$).

  • $S_{\text{private}} = Y - T - C$ (Income minus Taxes and Consumption).

  • $S_{\text{public}} = T - G$ (Tax revenue minus Government spending).

• Demand: Comes from Investment ($I$) by firms and households.

• Circular Flow Model:

  • $Y = C + I + G + NX$

  • Households receive income ($Y$), pay taxes ($T$), consume ($C$), and save the remainder ($S_{\text{private}}$).

• Equilibrium: The real interest rate adjusts to balance the quantity of funds supplied (savings) with the quantity demanded (investment).

Capital Flows and Financial Assets

• Risk-Adjusted Returns: In the long run, capital flows between different markets (banks, bonds, stocks) until returns are equalized based on risk.

  • Bank Deposits: Generally lowest risk (federally insured), hence lowest returns.

  • Bonds: Moderate risk (potential for bankruptcy/default), higher returns than banks.

  • Stocks: High volatility and risk, expected to provide higher average returns in the long run.

• Secondary Bond Markets:

  • Bond prices and interest rates have an inverse relationship.

  • Example: A bond pays $\$60/\text{year}$ (6% of $\$1000$). If market rates rise to 10%, a new investor only needs to spend $\$600$ to earn that same $\$60$. To sell your existing bond, you must lower the price to be competitive.

Questions & Discussion

• MCQ 1: Which is an example of money as a unit of account? Answer: A. Using dollars to price a car.

• MCQ 2: What happens if the government increases tax on interest income? Answer: C. The supply of loanable funds would shift to the left (saving becomes less attractive).

• MCQ 3: A higher interest rate induces people to: Answer: A. Save more; so the supply of loanable funds slopes upward.

• MCQ 4: When money facilitates purchases, it acts as: Answer: B. A medium of exchange.

• Discussion on OCR Timing: Why did RBNZ keep the OCR low when inflation hit 6% in Dec '21? This relates to the lag in data reporting and the fear of stifling economic recovery post-lockdown. The OCR impacts the $M$ component of $M \times V = P \times Y$.