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    Gsb728   lecture note topic 5a Gsb728 lecture note topic 5a Presentation Transcript

    • Economics for Management GSB728 Topic 9: Money and Interest Rates 1
    • Note: This lecture note was prepared based on the teaching material provided by the publisher of the textbook Principles of Economics. 2
    • Learning Objectives 1. The meaning and functions of money – What is this thing called ‘money’? 2. The financial system in Australia – Where do banks and other financial institutions fit in? 3. The supply of money – How is it measured and what determines its size? 4. The demand for money – How much money do we want to hold at any one time? 5. Equilibrium – What effect does the demand and supply of money have on interest rates? 3
    • Money • The functions of money: – Medium of exchange. – Means of evaluation. – Means of storing wealth. • What should count as money? – Cash: Yes – Goods: No – Financial assets such as bank and credit union accounts, stock and shares: It depends how narrowly money is defined. 4
    • Australia’s Financial System • The role of the financial sector: – Financial intermediaries serve to channel funds from depositors to borrowers. – Financial intermediaries: • Banks. • Non-bank financial institutions (NBFIs). 5
    • Shares of Australian Financial Institutions (March, 2012) Type of Institution Banks Total Assets at March 2012 ($ Billions) 2,859 Building societies 22 Credit unions 50 Money market corporations 48 Finance companies 103 Securitisers 128 Insurance companies 383 Superannuation funds 1,162 Unit trusts 264 Other* 39 TOTAL 5,058 *: Other includes Cash management trust, Common funds and Friendly societies. Source: Reserve Bank of Australia (RBA) (2013). 6
    • Australia’s Financial System (contd.) • Banks: – Assets and liabilities: • Assets: loans; currency; deposits with the Reserve Bank of Australia (RBA). • Liabilities: deposits. – Liquidity and profitability: • Liquidity: how easy an asset can be transformed into cash without loss. Cash is perfectly liquid. • Profitability: objective of the banks (lend money at a rate higher than the one paid to depositors). • Liquidity and profitability move in opposite directions. 7
    • Australia’s Financial System (contd.) • Non-bank financial intermediaries: • Credit unions, building societies, finance companies. 8
    • The Reserve Bank of Australia – Functions: • Issues notes. • Acts as a bank for banks. • Acts as a lender of last resort to banks not NBFIs. • Acting for the Federal government and States governments. • Holds the official foreign currency reserves. • Operates monetary policy: – Stability of currency. – Maintenance of full employment. – Economic prosperity and welfare of people in Australia. 9
    • The Supply of Money • Measuring the money supply – Monetary base: • Notes, coins, deposits held by banks at the RBA. – Broad money: • Cash in circulation, bank deposits, deposits in NBFIs. 10
    • Alternative Measures of the Money Supply (July, 2013) $ Billions Currency 55 Plus current deposits with banks 219 Equals M1 Plus all other deposits at banks Equals M3 Plus net borrowing from the private sector by NBFIs Equals Broad Money 274 1,294 1,567 6 1,574 Source: Reserve Bank of Australia (RBA) (2013). 11
    • The Supply of Money (contd.) • Credit creation: – Expansion of the amount of bank deposits and therefore the money supply. 12
    • Example of Credit Creation (I): Bank’s Original Balance Sheet Assets $Bn Liabilities $Bn Balances with the Reserve Bank 10 Deposits 100 Advances 90 Total 100 Total 100 Source: Sloman et al. (2014).
    • Example of Credit Creation (II): Initial Effect of an Additional Deposit of $10 Billion Assets $Bn Liabilities $Bn Balances with the Reserve Bank (old) 10 Deposits (old) 100 Balances with the Reserve Bank (new) 10 Deposits (new) 10 Advances 90 Total 110 Total 110 Source: Sloman et al. (2014).
    • Example of credit creation (III): The full effect of an additional deposit if $10 billion Assets $Bn Liabilities $Bn Balances with the Reserve Bank (old) 10 Deposits (old) 100 Balances with the Reserve Bank (new) 10 Deposits (new: initial) 10 Advances (old) 90 Deposits (new: subsequent) 90 Advances 90 Total 200 Total 200 Source: Sloman et al. (2014).
    • The Supply of Money (contd.) – The bank multiplier: • 1/L where L = liquidity ratio – Banks’ liquidity ratio may vary: • Banks may choose a different liquidity ratio. • Customers may not want to take up the credit on offer. – Banks may not operate a simple liquidity ratio. – Some of the extra cash may be withdrawn from the banks. 16
    • The Supply of Money (contd.) • What is the relationship between the money supply and the rate of interest? 17
    • Rate of interest The Supply of Money Curve: (a) Exogenous Money Supply 0 Source: Sloman et al. (2014). MS Quantity of money 18
    • Rate of interest The Supply of Money Curve: (b) Endogenous Money Supply 0 Source: Sloman et al. (2014). MS Quantity of money 19
    • Exogenous and Endogenous Variables • Models are composed by : – Exogenous variables: those that come outside of the model. – Endogenous variables: those that a model tries to explain. Source: Mankiw (2013). 20
    • The Demand for Money • The motives for holding money: – Transactions motive. – Precautionary motive. – Speculative motive. 21
    • The Demand for Money (contd.) • Determinants of the size of the demand for money: – Rate of interest (opportunity cost). – Nominal GDP. – Frequency with which people are paid. – Financial innovations. – Speculation about future return on assets. 22
    • Rate of interest The Demand Curve for Money MD 0 Source: Sloman et al. (2014). Quantity of money 23
    • Equilibrium • Equilibrium in the money market: • Equilibrium interest rate. • Where demand for money (Md) and supply of money (Ms) are equal. 24
    • Rate of interest Equilibrium in the Money Market MS re Md 0 Source: Sloman et al. (2014). Me Quantity of money 25
    • Effects of an increase in Money Supply • Full effect of changes in the money supply (Ms): – Ms –r –I ,C –r r (interest rates) I ,C AD , GDP , inflation exchange rate X ,M 26
    • Relationships Among Money, Prices and Interest Rate Source: Mankiw (2013). 27
    • References Mankiw, N. G. (2013). Macroeconomics (8th ed.). New York: Worth. Morales, L. E., Simons, P. and Valle de Souza, S. (2014). GSB728: Economics for Management [Topic Notes]. Armidale, Australia: University of New England, Graduate School of Business. Reserve Bank of Australia (RBA) (2013). Statistics. Retrieved from http://www.rba.gov.au/. Sloman, J., Norris, K and Garratt, D. (2014). Principles of Economics (4th ed.). French Forest, Australia: Pearson. 28