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TOPIC 5. MONEY,
INFLATION AND INTEREST
1
FUNCTIONS
OF
MONEY
1. Medium of Exchange
2. Measure of Value
3. Store of Wealth
4. Standard for Deferred
Payment
2
Inflation can be defined as a
persistent increase in the general
level of prices.
It reduces the value of money
because ea...
4
AUSTRALIA’S INFLATION
RATE COMPARED WITH THE
OECD AVERAGE
Compared with
Australia: 2.4%
in May 2011
(average
annualised
in...
INFLATION
Two ways to measure it; both rely on looking at the
prices for a typical ‘basket of goods and services’:
• the p...
A basket of goods
and services
(ABS)
7
THE INFLATION SPIRAL …..
As prices increase, business
costs also increase, so
businesses must increase
their prices to com...
With high inflation, money rapidly loses its
purchasing power. It is destabilising to the
economy and leads to loss of bus...
MONEY includes:
•notes and coins in
circulation (called M1)
•funds deposited in bank
and non-bank financial
institution ac...
MAIN SOURCES OF CHANGE IN
THE MONEY SUPPLY …….
1. Government transactions – whether it is in surplus
or deficit.
But how i...
MAIN SOURCES OF CHANGE IN
THE MONEY SUPPLY …….
2. International transactions – from trade, investment
• Money flows of A$ ...
Credit creation is going on all
the time in the banking system. It
is the number of times that an
initial deposit can mult...
WHAT IS THE RESERVE ASSET RATIO?
……. This is the
amount (eg. a percent-
age of deposits) that a
bank, by law, must hold
in...
Govt / Central Bank action in increasing the money
supply (and other factors)
Downward pressure on interest rates
Increase...
Govt / Central Bank very gentle action in increasing
the money supply
Increases aggregate demand
Downward pressure on inte...
WHAT ARE
INTEREST
RATES?
Another way of defining them:
From the lender’s point of view, the
interest rate on a security (s...
Factors Determining Interest
Rates
1. degree of risk
2. inflation rate
3. administration costs
4. maturity term
5. degree ...
RBA
OFFICIAL CASH
RATE (through
govt. bonds)
ALL OTHER INTEREST RATES
19
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12013 forecast topic 5 slides

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12013 forecast topic 5 slides

  1. 1. TOPIC 5. MONEY, INFLATION AND INTEREST 1
  2. 2. FUNCTIONS OF MONEY 1. Medium of Exchange 2. Measure of Value 3. Store of Wealth 4. Standard for Deferred Payment 2
  3. 3. Inflation can be defined as a persistent increase in the general level of prices. It reduces the value of money because each dollar pays less. 3
  4. 4. 4
  5. 5. AUSTRALIA’S INFLATION RATE COMPARED WITH THE OECD AVERAGE Compared with Australia: 2.4% in May 2011 (average annualised inflation, compared with May 2010) 5
  6. 6. INFLATION Two ways to measure it; both rely on looking at the prices for a typical ‘basket of goods and services’: • the previous quarter’s price increases for the basket (ie. inflation figure) X 4 • eg. previous quarter went up by 0.7%, so on annualised basis = 2.8% inflation • the previous quarter’s prices for the basket compared with the same basket’s prices at the same time last year, giving a ‘price index’ • eg. previous quarter $1000, same date last year $935; index = 1.0695, inflation = 6.95% 6
  7. 7. A basket of goods and services (ABS) 7
  8. 8. THE INFLATION SPIRAL ….. As prices increase, business costs also increase, so businesses must increase their prices to compensate. Governments also must increase taxes to cover their costs. Both cause an upward spiral of inflation …… 8
  9. 9. With high inflation, money rapidly loses its purchasing power. It is destabilising to the economy and leads to loss of business confidence and investment. This can cause a collapse in a country’s monetary system. So a major goal of government is to reduce inflation. Reserve Bank of Australia governor Glenn Stevens 9
  10. 10. MONEY includes: •notes and coins in circulation (called M1) •funds deposited in bank and non-bank financial institution accounts •deposits of banks with the RBA •credit (lending) by banks, or even the RBA, to the private sector 10
  11. 11. MAIN SOURCES OF CHANGE IN THE MONEY SUPPLY ……. 1. Government transactions – whether it is in surplus or deficit. But how is a deficit financed? ……. two methods that affect the money supply: a. the Federal Govt issuing securities b. borrowing from abroad and some methods that don’t affect the money supply: borrowing from banks, increasing taxes just after the deficit period, and borrowing from the non-bank sector (corporations, etc.) 11
  12. 12. MAIN SOURCES OF CHANGE IN THE MONEY SUPPLY ……. 2. International transactions – from trade, investment • Money flows of A$ into the country are expansion- ary, & out of the country are contractionary (Topic 1). • This would be much stronger if there were a ‘fixed exchange rate’ (eg. pegged to the $US). With our ‘floating exchange rate’, however, expansion / contraction tends to be cancelled by market forces. • (Note that the RBA may buy or sell A$, too; if it buys dollars from the banks this is contrac- tionary since it reduces the amount available for lending) 12
  13. 13. Credit creation is going on all the time in the banking system. It is the number of times that an initial deposit can multiply, boosting the money supply and therefore causing expansion. 13
  14. 14. WHAT IS THE RESERVE ASSET RATIO? ……. This is the amount (eg. a percent- age of deposits) that a bank, by law, must hold in liquid form, such as cash deposits that can’t be lent out. 14
  15. 15. Govt / Central Bank action in increasing the money supply (and other factors) Downward pressure on interest rates Increased investment and aggregate demand …….BUT ALSO increased inflationary pressure Central Bank increases interest rates to slow the economy and prevent uncontrolled inflation KEYNESIAN APPROACH (….. or vice-versa with all of the above!)15
  16. 16. Govt / Central Bank very gentle action in increasing the money supply Increases aggregate demand Downward pressure on interest rates, more investment, upward inflation pressure BUT ….Central Bank should NOT intervene to increase interest rates (instead, only role of Central Bank is to change money supply if necessary to affect aggregate demand and stop inflation or deflation, ie. ‘price stability’) ‘MONETARIST’ (MILTON FRIEDMAN) APPROACH (….. or vice-versa with all of the above!)16
  17. 17. WHAT ARE INTEREST RATES? Another way of defining them: From the lender’s point of view, the interest rate on a security (such as a govt. bond, shares, or bank deposit) is the annual Rate of Return on the market price of the security that will be earned if the security is held to maturity eg. average of 4.5% over a 10-year period Interest rates are payments made for the use of funds, expressed as a ratio between dollars paid per year and dollars borrowed eg. $5 / $100 = 5% 17
  18. 18. Factors Determining Interest Rates 1. degree of risk 2. inflation rate 3. administration costs 4. maturity term 5. degree of liquidity 6. expectations about future interest rates vs. 18
  19. 19. RBA OFFICIAL CASH RATE (through govt. bonds) ALL OTHER INTEREST RATES 19

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