Monetary Policy Flashcards
(18 cards)
What are the functions of money?
- Medium of exchange
- Unit of account
- Standard of deferred payment
- Store of value
What are the 5 criteria of a suitable medium of exchange?
- Scarce
- Uniform in quality
- Durable
- Portable
- Divisible
What is commodity money?
A good used as money that also has its intrinsic value e.g. gold, sea shell, salt
What are some problems with commodity money?
- deteriorate in quality over time e.g. tobacco
- debasement e.g. gold
- heavy/bulky to carry e.g. gold
- storing commodity has opportunity cost e.g. can’t eat the wheat
- value can fluctuate e.g. good harvest will reduce value of wheat
What is fiat money?
Money (usually issued by the central bank) that has value because the law says so.
What is M1?
The narrowest definition of the money supply, which includes all currency (paper money and coins) in circulation, plus the value of all demand deposits with banks (deposits in financial institutions that are transferable by cheque)
What is M3?
M1 + all other deposits with domestic and foreign owned banks operating in Australia.
Includes term deposit-taking institutions (e.g. building societies, credit unions)
What is broad money?
M3 + deposits into non-bank financial intermediaries such as finance companies, money market corporations and cash management trusts
What are financial markets?
Platforms where the supply of funds and the demand for funds are coordinated. A market is a facility which enable trading; it is not necessarily a physical place.
What are financial intermediaries?
Act as a go-betweens for borrowers and lenders.
E.g. banks and non-bank intermediaries (managed funds, superannuation funds and insurance companies)
What are the 4 functions of intermediaries?
- Cover mismatch
- Risk sharing/management
- Liquidity - the ease with which financial securities (shares, bonds) can be exchanged for cash
- Specialisation on collecting info (e.g. returns, credit worthiness)
What is fractional reserve banking? (What are reserves and the reserve ratio?)
Reserves: deposits that a bank keeps as cash in its vault or on deposit with the RBA.
Reserve Ratio: a bank’s ratio of reserves to deposits.
What is the simple money multiplier equation (simple deposit multiplier)?
Total deposit created = initial deposit / r
where r = reserve requirement ratio (e.g. 10% = 0.1)
K = total deposit created / initial deposit
What are the 3 objectives of monetary policy?
a. Stability of the currency of Australia
b. Maintenance of full employment
c. Economic prosperity and welfare
a and b are achieved by keeping CPI at 2-3%
The tool used by the RBA for conducting monetary policy is…?
The cash rate
What Open Market Operation (OMO)?
The purchase or sales of Commonwealth Government Securities by the RBA to influence the interest rates and money supply by controlling the cash rate.
If the bank has shortage of reserves, it borrows from other banks.
The cash rate is the interest for over-night inter-bank borrowing.
Open market purchase (sale) can increase (decrease) reserves in the banking system.
By increasing (decreasing) reserves, the RBA lowers (increases) the cash rate.
What is monetary expansionary (OM Purchase)?
When the cash rate goes down, other interest rates also go down:
- Costs of borrowing go down (C & I go up)
- Cash flow goes up (due to reduced loan repayments) (C goes up)
- Asset prices go up (wealth goes up) (C goes up)
What is monetary contraction?
Cash rate goes up
Consumption and Investment spending go down
Price level goes down
