Money Creation and Inflation

How is Money Created?

• Commercial banks create money through the fractional reserve banking model.

• Banks keep a fraction of deposits as reserves and loan out the rest.

  • The Reserve Bank can legislate the fraction that banks must keep.

• Money is created by receiving deposits and making loans through fractional reserve model.

• The change in the money supply $(\Delta MS)$ equals the deposit amount (D) multiplied by one over the reserve ratio (R): $(\Delta MS = D \cdot (1/R))$.

• The smaller the reserve ratio $(R)$, the larger the money supply.

Fractional Reserve Banking Model Example

• Deposit of $100$. Bank keeps $10$ (10%) as reserves and loans out $90$.

• This $90$ is deposited in another bank, which keeps 10% ($9$) as reserves and loans out $81$.

• This process continues, creating a multiple of the initial deposit.

• In this example, $100$ deposit can create $1,000 in money supply if the reserve ratio is 10%.

The Reserve Bank's Role

• The Reserve Bank ensures the monetary system's stability.

• It can change the reserve requirements for commercial banks.

• The Reserve Bank controls the official cash rate (OCR), influencing interest rates on loans.

• Banks borrow from the Reserve Bank to clear debts at the end of each day.

• A low OCR encourages lending, while a high OCR makes banks more cautious.

Why is Money Important?

Money facilitates transactions, allowing people to buy and sell goods and services.

It helps with saving and investment, enabling economic growth. Money affects inflation, influencing the cost of living.

It plays a role in employment rates, impacting job availability.

Money is crucial for a country's overall economic stability and growth.

The Consumer Price Index (CPI)

• The CPI measures the weighted average level of prices consumers pay for a fixed basket of goods and services.

• It is used to indicate what is happening in relation to things that one would typically buy.

• It reflects average household spending on various goods and services.

• The CPI helps determine the rate of inflation which can indicate the standard of living.

• Stats NZ collects data from supermarkets and online to determine the basket of goods costs and there are about 690 goods and services included in the basket.

CPI and Real Wages

• Changes in the CPI affect real wages, which is the nominal wage (W) divided by the price level (P):
  $Real\ Wage = \frac{W}{P}$

• If the price level (P) increases faster than nominal wages (W), real wages decrease.
  -Understanding the CPI is important for negotiating pay increases to maintain the standard of living.