Money, Private Banks and the RBA

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[1]While fiscal policy is somewhat effective in reducing output gaps, there exists a more effective policy, known as monetary policy, which is used in most economies today. Monetary policy involves the banking system changing the real rate of interest in the economy affecting both savings and investment. Monetary policy and fiscal policy as usually complements to each other even though they are geared by different bodies. This chapter introduces the banking system and the RBA and forms the groundwork to understanding how monetary policy is implemented (discussed in the next chapter).

Contents

Textbook Readings

Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011), pp. 190-204 (Chapter 7) and p. 216.

Explaining Money

[2]Money is a broad term used for any form of currency or object with buying power. While historically "money" referred to anything from feathers to sea shells to gold and silver, it has always been used as a baseline for trade: instead of trading clothing for food, one could keep their clothes and just transfer "value" in the form of money. Today, money refers to an amount in dollar (or currency) and it can be physical money in the form of coins and notes or even completely intangible such as a balance on a savings account.

In general, money has three uses:

  1. Medium of exchange- that is, money is a more convenient method of trading as assets aren't being passed around, only "value" or money. This allows for trade without barter (direct trade of goods and services for other goods or services), the down side of which is that, for example, trading food for clothing invokes problems such as clothes not fitting the new owner or food being consumed quickly (or go off). Either way value is not directly traded. In addition, barter requires that both parties be interested in the goods or services traded which is highly inefficient. A baker will make bread but selling it only occurs if people want bread and if the baker wants the clothes or items that those people bring to trade with.
  2. Unit of Account- that is, money is used as a base measurement of economic value. By measuring everything in dollar (or other currency) amount, it is easy to compare to economic entities and value. For example it is easy to quantify water in amount of litres and grain in kilograms but this method makes it difficult to measure which has more value. Using money generally solves this problem.
  3. Store of Value- that is, money is a form of wealth. The more one has it the wealthier they are said to be (generally). However it is important to note that shares and bonds are also forms of value storage so that money is not the only economic object with this property.

Measuring Money

[3]Trying to count how much money there is in an economy is quite difficult since figuring out what should and shouldn't be counted as money isn't always straightforward. Obviously coins and notes are counted as money but houses might not. In order to get around this problem, economists define different categories of money and count those. The categories are:

  • Currency- Notes and coins on issue minus holdings of notes and coins by all banks (including the Reserve Bank)
  • M1- Currency plus current deposits in banks (savings and cheque accounts)
  • M3- M1 plus all deposits of private non bank sector
  • Broad Money- M3 plus borrowings from private sector by non bank corporations minus holdings of currency and deposits of non bank corporations

Creation of Money

[4]If one assumes that people prefer keeping money in a bank rather than holding it, then a model can be set up for the creation of money. The model is very simplistic but it attempts to explain how the banking system can create, and hence increase the amount of, money. Roughly, it says that:

  1. Suppose there is only $1m in circulation in the economy
  2. Suppose all that money is stored in banks rather than held by owners
  3. Then the banks hold a total of $1m in their vaults (reserves), and they owe that money to the people (depositors)
    1. Note that money held by the bank is not circulated in the economy, only the "value" of the money is, as depositors send money from their accounts to others' accounts. Hence the amount of money in the economy remains $1m
  4. Now suppose that banks realise that keeping the $1m in their vaults (or in reserves) is unnecessary as most people will not choose to withdraw all their accounts in one go, so that the banks decide to lend out some of the money in their reserves and gain interest. After some observation, the banks realise that only 10 percent of their reserves are needed to meet the demand for withdrawals from accounts and that the other 90 percent can be lent out
  5. Now the bank has reserves of $0.1m (10 percent of 1m = $100,000) and is owed $0.9m (90 percent of 1m = $900,000). In turn it owes $1m to the original depositors. At this stage, no new money has been created as the amounts the bank have (as physical cash and as money lent) equals the amount they owe to depositors
  6. However we that people prefer to keep money in the bank rather than holding it. Therefore the $0.9m lent out by banks is returned to them as deposits.
  7. The banks now have $0.1m as reserves, plus an extra $0.9m handed to them as deposits. The reserves are now $1m ($0.1m + $0.9m = $1m), the money lent out is still $0.9m, and the amount of deposits is $1.9m
  8. Again, the banks realise that they have too many reserves than needed and decide to lend out 90 percent. That 90 percent circulates back to the bank and the deposits grow again. The process now continues!
  9. The banks will continue to lend as long as it is profitable. Continuing the same method for a few more rounds yields total reserves to be $1m, total money lent to be $9m and total deposits to be $10m.

The point here is to show how a fractional-reserve banking system can be used to increase the money supply in an economy. The fractional-reserve banking system refers to a banking system where not all the money deposited is kept as reserves, but rather some of it (a fraction of it) is lent out. Here, the banks noticed that only 10 percent of money is necessary as reserves and the final result was an amount of money ten times the original amount circulating in the economy. By contrast, a 100 percent reserve banking system refers to a system in which all money deposited is kept as reserves (and no loans are made).

[5]The reserve-deposit ratio is the ratio of how much banks want to keep as reserves as a fraction of the amount of deposits made to them. In other words:

Reserve-Deposit Ratio = Reserves/Deposits

and can be rearranged for deposits to give:

Deposits = Reserves/Reserve-Deposit Ratio

In the example given above, the amount of deposits that the banks will reach before it is not profitable for them to lend is $10m, given by the equation above where:

Reserves (original) = $1m
Reserve-Debt Ratio = 0.1
Deposites = $1m/0.1 = $10m

Creation of Money: Deposits and Currency

[6]In reality, the amount of money in the economy is not only measured by deposits in banks since there is still money held by individuals as currency. Fortunately, finding the total money supply in an economy is not very difficult even with currency. Firstly, note that the amount of money is simply given by:

Money Supply = Currency + Bank Deposits

But bank deposits can be found from the equation given above. Therefore:

Money Supply = Currency + Reserves/Reserve-Deposit Ratio

Money Supply, Prices and Inflation

[7]Quite intuitively, if the amount of money supply in an economy grows, then so does the general level of prices (or inflation). The reason for this is that if there is more money, then individuals can bid at higher and higher prices and effectively pushing up the price level in the economy.

To understand this relationship further, the concept of velocity is introduced. In macroeconomics, velocity is defined as the value of transactions completed in a period of time divided by the stock of money required to make those transactions. In simpler terms, it is measure of the speed at which money is circulated in the economy. In mathematical form, its given by:

Velocity = Value of Transactions/Money Stock

Now since the value of transactions is too difficult to determine, economists use Nominal GDP instead. If Velocity = V, Money Stock = M and Nominal GDP is the price level (P) times real GDP (or P.y) then:

V = (P.y)/M

Now by rearranging the equation, one finds that:

M.V = P.y

And assuming that velocity and nominal GDP remain constant, it is easy to see that any increases in money supply (M) must be matched by an increase in the price level (P), or inflation.

The Reserve Bank of Australia

[8]The Reserve Bank of Australia (RBA) is Australia's Central Bank which is a very specialised arm of the government. It has two main responsibilities:

  1. Responsible for Monetary Policy
  2. Responsible for the efficiency and stability of financial markets

The main idea behind monetary policy is to affect the interest rate in an economy. By doing so, the RBA can affect the money stock in the economy (see above) as well as stabilise it. The way the RBA implements monetary policy is complicated but an overview is given here. The process is:

  1. The RBA acts as a bank for other banks. That is, it holds deposits made by other banks
  2. Banks deposit money with the RBA in special accounts known as exchange settlement accounts, the point of which is to be able to lend and borrow money from each other
  3. The RBA implements a rule where banks are never allowed to have an exchange settlement account of zero, they must always have some money
  4. However if a bank find it needs to overdraw its account, it uses the overnight cash market, where it is allowed to borrow money over a period of 24 hrs from another bank's exchange settlement account
  5. The price for borrowing on the overnight cash market is an interest rate, known as the overnight cash rate, determined by the demand for money by banks
  6. However, the RBA can choose to buy or sell bonds for cash and enter that money into the banking system, affecting the supply of cash. By doing this, the RBA ensures that the overnight cash flow increases or decreases as demand increases or decreases, thus stabilising the market. The process of buying or selling bonds is known as open market operations.
  7. The RBA uses this system in order to maintain a target cash rate that is predetermined

A further mechanism the RBA utilises is of creating upper and lower bounds for borrowing from the RBA itself (as opposed to borrowing from other banks). The RBA creates a policy where it pays interest rates on exchange settlement accounts that is lower than the target interest rates but charges an interest rate that is higher than the target interest rate on any loans. By doing this, the RBA creates incentives for banks to borrow money from it or lend money to other banks (depending on the situation) but always maintain a base level cash rate with an upper and a lower bound.

The RBA and Interest Rates

[9]Since the RBA can control the overnight cash rate, the question is, can it control other interest rates? The answer is yes, and will be explained in more detail in the next chapter on monetary policy. However just as a brief introduction, we look at the effect of changing the overnight cash rate on the economy.

The important thing to note is that the overnight cash rate is a borrowing and lending system for banks over short periods (24 hrs or less). In addition, banks cannot get by without this market since they must always have money with the RBA. As the RBA changes the overnight cash rate, banks can only change the amount in their exchange settlement accounts, but can never withdraw completely. As a result, if the RBA increases the overnight cash rate, banks find that it is more lucrative to lend in the overnight cash market (and less lucrative to hold money in their exchange settlement accounts) and hence lending in other markets decrease. Since lenders leave other markets and move to the overnight cash market, other markets now want to borrow and are willing to increase their interest rates to attract lenders. These interest rates will increase until they at least match the overnight cash rate when lenders find no incentive in choosing the one market over the other. Through this process, interest rates in other markets tend to match the overnight cash rate and hence the RBA is indirectly able to change interest rates throughout the whole economy. The process works in a similar way if the RBA chooses to decrease the overnight cash rate.

Note also that the RBA only affects the nominal interest rate, however given that the real interest rate is given by:

r = i - π

Where:

r = real interest rate
i = nominal interest rate
π = inflation rate

Any changes in nominal interest rates will affect real interest rates as well in a one-to-one relationship, especially if we assume (relatively correctly) that inflation does not change very quickly in comparison to interest rates.

References

"Textbook" refers to Bernanke, Olekalns and Frank, Principles of Macroeconomics, (3rd ed, Sydney, McGraw Hill, 2011).

  1. Textbook p.191
  2. Textbook p. 192
  3. Textbook p. 192
  4. Textbook p.193
  5. Textbook p. 196
  6. Textbook p. 196
  7. Textbook p. 197
  8. Textbook p. 200
  9. Textbook p. 216
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