Money, prices and the reserve bank.

Question 1

How does the financial system allocate saving to productive uses?

Answer 1

There are two distinct ways:

1. A financial system provides information to savers about the best investment choices and thus how to get the highest return of money from these choices.
2. Financial systems share the risk with the saver in making investment choices so the saver does have excessive risk.

Essentially, it comes down to the banks being effective at researching investment choices.

Question 2

What is the banking system?

Answer 2

It is a system whereby commercial banks give loans by collecting deposits from individuals and firms.

Question 3

What are financial intermediaries?

Answer 3

Firms that give credit to borrowers from funds saved up by savers.

Banks are the most important example of such a firm.

Question 4

Why are financial intermediaries such as banks, which stand between savers and investors, necessary?

Answer 4

It is because banks have a comparative advantage in gathering research about investment choices.

They can evaluate the quality of borrowers (checking their background, whether they have a sound business plan, and monitoring of the borrower’s activities throughout the term of the loan).

In other words, they are can gather information better at lower costs than individual savers.

Question 5

Is there any advantage to many individuals pooling their money into one financial intermediary, and if so, why or why not?

Answer 5

Yes there is an advantage. They can give out larger loans and each large loan only needs to be evaluated (by the borrower) once instead of confirming with many different individuals.

Question 6

Do smaller businesses or individuals benefit from banks, and if so, how?

Answer 6

They do benefit as if they need to gather a large amount of money in a short time, often they can only turn to banks. i.e. banks provide credits to users that might not otherwise be available.

This is levels the playing field against larger corporations a little, as larger companies often have other ways of raising money.

Question 7

What is a bond?

Answer 7

A legal obligation to repay a debt. It is a way often used by large corporations to raise funds - they sell their bonds to people who wish to earn a steady income from interest.

Question 8

How would repayments occur in a bond?

Answer 8

Repayments occur in two parts:

1. Repaying the principal, or original, amount at some date in the future called the maturation date.
2. Owner of bond (called bondholder) receives regular interest (or coupon payments) until maturation date

Question 9

What is the coupon rate?

Answer 9

The interest rate promised when a bond is given. Annual coupon rate is the coupon rate * principal amount.

Question 10

What is credit risk? And what might this mean for corporations that are not well-established?

Answer 10

Credit risk is the risk that the borrower might go bankrupt and thus be unable to repay the bondholder. If you are viewed as a risky firm, you will have to offer higher coupon rates for savers to be willing to fund you.

Question 11

What is the bond market?

Answer 11

It is a market where bondholers can sell their bonds. The price of the bond depends on the interest rate of financial markets and the interest rate at the time the bond was issued (i.e. bond has lower coupon rates than financial markets and you’d make more money by selling then reinvesitng).

Question 12

What is a stock?

Answer 12

A claim to partial ownership of a firm. Firms can sell equity to raise funds. Revenue the firm makes has some of that paid out as dividends to shareholders.

Question 13

What is a dividend?

Answer 13

A regular payment received by shareholders for each stock they own,

Question 14

What are the three principle uses of money?

Answer 14

1. A medium of exchange
2. A store of value
3. A unit of account

Question 15

What is money?

Answer 15

Any asset that can be used for purchases. It is something that people recognise is of value. In this case, paper notes, gift cards, coins, etc.

Question 16

What is a medium of exchange?

Answer 16

An asset used in purchasing goods and services.

Question 17

What is barter?

Answer 17

Directly trading goods or services with out goods or services. This occurs when a medium of exchange is not established and is difficult for economic growth to occur as a result.

Question 18

Is bartering inefficient?

Answer 18

No, because it requires a double coincidence (where the services you offer coincides with the other party’s interest).

Question 19

What is a unit of account?

Answer 19

It is a basic meausre of economic value. This function allows money to exist in divisible amounts that can be compared to the value of different goods.

Question 20

What is a store of value?

Answer 20

An asset that serves as a means of storing wealth. Essentially, its value can be stored for later use.

Question 21

What are the four main measures of money?

Answer 21

1. Currency: Money in circulation between you (households) and firms.
2. M1:Currency AND current (short term) bank deposits from the private sector. This is useful for gauging amount of money being actively used in transactions.
3. M3: M1 AND all other bank deposits from the private sector (so it’s stored in account but not necessarily being activel used).
4. Brand money:M3 AND borrowings from non-bank depository corporations e.g. credit union

Question 22

In what sense do commercial banks create money?

Answer 22

Money is created in the form of deposits. People may prefer exchanging money via bank deposits rather than direct transactions.

Question 23

What is a bank’s reserves?

Answer 23

The money that banks hold. It is held in two forms:

1. Physical currency
2. Exchange Settlement Accounts with the Reserve Bank Australia.

Question 24

What is the R/D ratio?

Answer 24

The ratio of reserves to deposits. The idea is that 100% reserve banking is not needed as people will never use 100% of their money at once. They can loan out a portion to earn interest revenue.

The ratio helps to ensure that commercial banks can repay their liabilities i.e. the deposits as the reserves does not equal deposits.

Question 25

What is the fractional-reserve banking system?

Answer 25

A banking system in which the reserve:deposit ratio is less than 100%. Look at example question in book and repeat 2 times.

Question 26

What is the relation between money supply and the eneral level of prices?

Answer 26

The more money in an economy and the higher its growth rate, the more likely prices will be higher as there is more wealth in the economy. Too much usually leads to inflation.

Question 27

What is the velocity of money?

Answer 27

How fast money circulates throughout an economy. Given by V = Nominal GDP/Money supply, or V= PxY/m. Do example questions.

Question 28

What is the quantity theory of money?

Answer 28

Basically just more money supply, higher price. Based on the assumption that: 1. Velocity of GDP is constant 2. Real GDP is constant In this way, RBA can affect price level and control inflation.

Question 29

What roles does the Reserve Bank play in the economy?

Answer 29

Two main roles: 1. Monetary policy which means RBA controls interest rate 2. Oversight and regulation of financial markets As a side note, it also plays a major role during periods of crisis in the financial markets.

Question 30

What is financial deregulation?

Answer 30

The process of removing the power of financial markets to control price and quantity, letting the market forces of supply and demand to apply instead.

Question 31

What is an Exchange Settlement Account?

Answer 31

They are accounts kept by commercial banks with the RBA, and are used to manage the flow of funds between commercial banks (instead of always just physically transferring money - convenience) generated by the commercial activities of their customers e.g. I transfer money from Comm. Bank to Westpac. Inconvenient to physically transport on a wheel burrow or something.

Question 32

What is an open market purchase?

Answer 32

It is when the RBA buys government bonds from the public to increase amount of money in commercial bank's exchange settlement accounts. This raises the level of the reserves.

Question 33

What is an open-market sale?

Answer 33

When the RBA sells government bonds to the public to reduce amount of money in exchange settlement accounts. This reduces bank reserves.

Question 34

What is the overnight cash rate?

Answer 34

The rate of interest applied to loans in the overnight cash market.

Question 35

What is the overnight cash market?

Answer 35

A specialised segment of financial system where banks borrow and lend money for very short periods of time to manage their exchange settlement accounts. This is in case reserves get too low and they want to maintain the right R/D ratio.

Question 36

How does the RBA control overnight market cash rate?

Answer 36

To target a cash rate, the RBA either sells its financial assets or buys financial assets from commercial banks. If the cash rate is below the target cash rate, the RBA buys financial assets from commercial banks, which means the commercial banks have less assets and would seek higher return on loans (subsequently increasing cash rate). If cash rate is above target cash rate, RBA sells financial assets, which means there is less demand for loans from commercial banks and to compete, they offer lower rates (subsequently decreasing cash rate).

Question 37

Why is controlling cash rate important for the RBA?

Answer 37

Long story short, it affects the overall interest rates of the economy. This is because of supply and demand, the financial assets the RBA buys and sells essentially create competition and interest rates have to match to compete. For example, if the RBA wants interest rates to be higher, by having a high cash rate (you have to pay more interest for borrowing from RBA), interest rates would have higher demand and thus can be issued at a higher level. If the RBA wants interest rates to be lower, by having a low cash rate, interest rates in financial markets have to match the RBA or else firms may prefer to borrow from the RBA, even if it is short term as it will let them save more.

Question 38

Why is coontrolling interest rates effective in controlling inflation?

Answer 38

Lower interest rates means more people can afford to get a loan, meaning there is overall more supply of money circulating and thus price levels rise (inflation) to match the increase in wealth. High interest rates means not as many people can get a loan, and thus there is less money circulating leading to a decrease in inflation (so firms can sell their products).