Flashcards in Chapter Ten Deck (30):
What is the definition of money
Money is any commodity or token that is generally accepted as a means of payment
A commodity or token
Money is something that can be recognised and divided into small parts
What are the three functions money performs
Medium of exchange
Unit of account
Store of value
Explain medium of exchange
Medium of exchange is an object that is generally accepted in return for goods and services
Without money you would have to exchange goods and services directly for other goods and services - an exchange caller barter
Explain unit of account
A unit of account is an agreed upon measure for stating the prices of goods and services
Explain store of value
A store of value is any commodity or token that can be held and exchanged later for goods and services
The more stable the value of a commodity or token, the better it can act as a store of value and the more useful it is as money.
Explain fiat money
Money in the world today is called fiat money
Fiat money is objects that are money because the law decrees or orders them to be money
The objects we use as money today are currency and deposits at banks and other financial institutions
The reserve bank of Australia noted and coins minted by the royal Australian mint are known as currency
RBA banknotes are money because the government declares them to be with the words printed on every banknote: "this note is legal tender"
Why are deposits also money
Because they can be converted into currency on demand and are used directly to make payments
Explain M1, M2 and M3 are measures of money
M1 consists of currency held by individuals and businesses and current deposits owned by individuals and businesses
M2 consists of M1 Plus term deposits, other deposits and certificates of deposits
M3 consists of M1 plus all other bank deposits including term deposits which can only be withdrawn after a fixed amount of time and certificates the deposit which are similar to savings accounts
Are M1 and M3 means of payment
The test of whether something is money is whether it is generally accepted as a means of payment
M1 passes this test and is money
Some deposits in m3 are just as much a means of payment as the current deposits in M1
Some savings deposits, term deposits and certificates it deposits are not instantly convertible and are not a means of payment
Explain Cheques, Credit cards and debit cards
A cheque is not money. It is an instruction to a bank to make a payment
Credit cards: a credit card is not money because it does not make a payment. When you use your credit card you create a debt or outstanding balance on your card account which you eventually pay off with money
Debit cards are not money. It is like an electronic cheque, it is an electronic equivalent of a paper cheque. Debit card transactions are handled by the eftpos system. Eftpos is electronic funds transfer at point of sale.
Explain deposit taking institutions
A deposit taking institution is a private firm authorised by the banking act of 1959 to take deposits from households and businesses. Deposits at three institutions make up the nations money. That are:
Explain banks, building societies and credit unions
Bank: a private firm that pursued profits for its shareholders by receiving deposits and making loans
Building societies: a building society is a cooperative firm entitled to recurve deposits and make loans to provide mortgage finance to buy owner occupied housing
Credit unions: a credit union is a non profit firm entitled to recieve deposits from and make loans to its members of finance mainly the purchase of consumer durables
Explain banks source of funds
Bank capital, deposits and borrowing.
Banks use capital, deposits and other borrowing to earn an incoming for their shareholders by lending at a higher interest rate than that at which they borrow.
Uses of funds
Banks allocate its funds across four types of assets
Bank reserves - noted and coins in the banks vault and its deposit at the reverse back of australia.
Liquid assets - Australian government securities with a short term maturity
Investment securities - longer term Australian government bonds and other bonds
Loans commitments of fixed amounts of money for agreed upon period of time
What are three ways the reverse bank is unique
It is a banker to banks and government: only customers are the banks, building societies, credit unions, Aus gov and other central banks of other countries
Issuer of banknotes: only bank permitted too
Landed of last resort: ready to make loans to banks when the banking system as a whole is short of reserves. If some banks are short of reverses while other banks are in surplus, banks borrow from other banks in overnight loans market.
Explain. The reserve banks balance sheet and monetary base
Balance sheet is a statement of its liabilities and assets. Liabilities; reserve bank banknotes and banks reserve deposits. Reserve bank liabilities plus and the coins minted by the royal Australian many is called the monetary base; coins are excluded when monetary base is counted.
Assets: divided in two groups.
Gold and foreign exchange
Australian dollar securities
The monetary base is backed by the reserve banks assets - 85 percent is backed by gold and foreign exchange and 15 per cent is securities
Explain creating deposits by making loans
Banks create deposits when they make load and the new deposits created are new money. The quantity of deposits that banks can create is limited by three factors: the monetary base, desired reserves and desired currency holding
Explain the monetary base
The monetary base is the sum of coins, reverse bank notes and banks deposits at the reserve bank. The size of the mentally bare limits the total quantity of money that the banking system can create because banks have deserted reserves and households and firms have desired currency holdings. And both of these desired holdings of monetary base depend on the quantity of money.
Explain desired reserves
A banks actual reserves consists of notes and coins in its vault an its deposits at the reserve bank. The fraction of a banks total deposits held as reserves is the reserve ratio. The desired reserve ratio is the ratio of reserves to deposits that a bank choices to hold to meet its daily business requirements. Excess reserves equal the banks actual reserves minus its desired reserves
Explain desired currency holding
We hold money in the form of currency and bank deposits and some fraction of their money as currency. So when the total quantity of money increases so does the quantity of currency that people want to hold. Because desired currency holding increases when deposits increase, currency leaves the bank when they make loans and increase deposits. This leakage of currency is called the the currency drain. The ratio of currency to deposits is called the currency drain ratio
Explain. The reserve banks policy tools
The reverse banks most important tasks are to influence the interest rate and regulate the amount of money circulating in Australia. The reserve bank perform these tasks by adjusting the reserves of the banking system. The reserve banks policy tools are cash rate and open market operations
Explain cash rate and open market operation
Cash rate is the interest rate in the interbank loans market - when one bank is short of reserves, it borrows from another bank and pays cash rate on the loan.
Open market operation is the purchase or sale of government securities by the reserve back in the open market.
How does open market operations change the monetary base
When the reserve bank buys securities in an open market operation, it lags for them with newly created bank reserves and money
With more reserves in the banking system, the supply of interbank loans increases the demand for interbank loans decreases and the cash rate falls
When the reserve bank sells securities in an open market operation buyers pay for them with bank reserves and money
With fewer reserves in the banking system, the supply of inter bank loans decreases, the demand for interbank loans increases and the cash rate rises.
The reserve bank sets a target for the cash rate and conducts open market operations on the scale needed to hit its target
A change in the cash rate is only the first stage in an adjustment process that follows an open market operation.
If banks reserves increase, they increase their lending, which increases the quantity of money
If banks reserves decease, they decrease their lending which decreases the quantity of money
Explain the multiplier effect of an open market operation
An open market purchase that increases bank reserves also increases the monetary base. The increase in the monetary base equals the amount of the open market purchase. The quantity of bank reserves increases and gives the banks excess reserves that they can start to lend.
The following sequence of events takes place: an open market purchase created excess reserves, banks lend excess reserves, bank deposits increase, the quantity of money increases, new money is used to make payments, some of the new money is held as currency - currency drain, some of the new money remains on deposit in the banks, banks desired reserves increase and excess reserves decrease but remain positive. This process repeats until excess reserves have been eliminated
Explain the money multiplier
The money multiplier is the number by which a change in the monetary base is multipled to find the resulting change in the quantity of money. It is also the ratio of the change in the quantity of money to the change in the monetary base. The magnitude of the money multiplier depends on the desired reserve ratio (reserves to deposits) and the currency drain ratio (currency to deposits)
The larger the currency drain and the larger the desired reserve ratio, the small is the money multiplier. Desired reserves = R ; currency = C. Monetary base MB is the sum of reserves and currency so MB = (R+C) . The quantity of money M is the sum of deposits and currency so M = deposits + currency = (D+C).
So M = D+c divided by MB = R+ C. Money multiplier = (1+ C/D) divided by (R/D + C/D). The quantity of money changes by the change in the monetary base multiplied by (1+c/d)/(r/d + c/d).
Explain the demand for money
Quantity of money demanded is the amount of money that households and forms choose to hold. Benefit of holding money: is the ability to make payments. The more money you hold, the easier it is for you to make payments
The marginal benefit of holding money decreases as the quantity of money held increases
Opportunity cost of holding money: the opportunity cost of holding money is the interest forgone on an alternative asset.
Nominal interest is a real cost: the OC of holding money is the nominal interest rate because it is the real interest rate On an alt asset plus the expected inflation rate (the rate at which money loses buying power).
The demand for money is the relationship between the quantity of money demanded and the nominal interest rate, when all other influences on the amount of money that people want to hold remain the same. The lower the nominal interest rate (the OC of holding money), the greater is the quantity of money demanded. Other things remaining the same : 1. A rise in nominal interest rate decreases the quantity of the real money demanded (this is real demand curve), 2. A fall the nominal interest rate increases the quantity of money demanded.
Explain changes in the demand for money
A change in the nominal interest rate brings a change in the quantity of money demanded. A change in any other influence on money holdings changes the demand for money. The three main influences are the price level, real GDP and financial technology.
The price level: a X per cent rise in the price level brings an X per cent increase in the quantity of money that people pls. To hold because the number of dollar s we need to make payments is proportional to the price level.
Real GDP: the demand for money increases as real GDP increases because expenditures and incomes increase when real GDP increases
Financial technology: changes in technology change the demand for money. Most changes in financial technology come from advances in computing and record keeping and they decrease the demand for money.
Explain the supply for money
The supply for money is the relationship between the quantity of money supplied and the nominal interest rate. The quantity of money supplied is determined by the actions of the banking systems and the reserve bank. On any given day, the quantity of money is fixed independent of the interest.
The nominal interest rate adjusts to make the quantity of money demanded equal the quantity of money supplied on any given day the price level, real GDP and state of financial technology is fixed so the demand for money is given. The nominal interest rate is only influence on the quantity of money demanded that is free to fluctuate to achieve money market equilibrium.
If the interest rate is 6 percent a year the quantity of money held exceeds the quantity demanded. People buy bonds, the price of a bond rises and the interest rate falls. As the nominal interest rate falls, the quantity of money demanded increases. If the interests rate is 4 per cent a year, the quantity of money held is less than the quantity demanded. People sell bonds, the price of bonds falls and the interest raises. A rise in the nominal interest rate decreases the quantity of money demanded. If the interest rate is 5 percent a year, the quantity of money held equals the quantity demanded. The money market is in equilibrium.
Explain the interest rate and bond price when moving in opposite directions
When the gov issues a bond, it specifies the dollar amount of interest that it will pay each year. The interest rate on the bond is the dollar amount received divided by the price of the bond. If the price of the bond falls, the interest rate rises. If the price of the bond rises, the interest rate falls.
Interest rate adjustment: when the interest rate is above its equilibrium level, the quantity of money supplied exceeds the quantity of money demanded. People are holding too much money so they try to get rid of money by buying other financial assets. The demand for financial assets increases the prices of these assets rise, and the interest rate falls. Conversely, when the interest rate is below its equilibrium level, the quantity of money demanded exceeds the quantity of money supplied. People are holding too little money, so they try to get more money by selling other financial assets. The demand for financial assets decreases, the prices of these assets fall and the interest rate rises.