4. Money Inflation & Monetary System
Terms in this set (25)
Facilitates trade (makes things easier)
Set of assets in the economy which people use to buy G+S
Ease of asset (money in 'exchange')
money is the economy medium of exchange
- Medium of exchange
- Unit of account
- Store of value
- Commodity money
- Commodity backed
- Fiat money
form of commodity with intrinsic value
eg; Gold/ cigarettes
Paper money is exchanges for a fixed quantity of commodity for intrinsic value
eg; money for gold
Money without intrinsic value (what we use today)
Money in the economy
- Notes and coins held by the public (the monetary base)
- M1 - Notes and coins plus transaction account balances -chequable, EFTPOS or sweep accounts deposits - most liquid part of the money supply
- M2 - all call deposits - includes other highly liquid assets
- M3 - all funding ie deposits - here money is more a store of value than as a medium of exchange
Note : credit cards are a means of deferring payment
RBNZ divides out money
management of liquidity conditions (money supply) in economy by central bank
Sole objective of Monetary policy
achieve inflation stability
Between 1% - 3%
Money Supply; Fractional reserve banking
- Commercial banks hold only a fraction of deposits as reserves (10%)
- Lend out the rest.
- Fraction of deposits held by commercial banks = reserve ratio.
Reserve Ratio determined
- OCR and the market interest rate (opportunity cost!)
- Capital adequacy ratios determined by the RBNZ,
- RBNZ's publication of the commercial banks' liquidity ratios.
(Optimal reserve ratio = impact on economy's money supply.)
Equation caused from fractional banking ($100 banked = $10 kept = $90 loaned out = another 0.1/ 10% kept and the rest loaned out.....)
Money Multiplier example
1/ reserve ratio = 1/0.1= 10
Change in money supply = 10*100=1000
"setting" of the money supply by policymakers in the central bank.
The money supply
refers to the quantity of money available in the economy
Objectives and Functions of the RBNZ
- Implement monetary policy objectives set out by the PTA.
- issue notes and coins.
- Provide banking services to registered banks (includes settlement accounts)
- Registers banks, and supervision of the financial system (can intervene)
Settlement cash accounts
Settlement cash - cash held by trading banks in settlement cash accounts at the RBNZ to "settle up"
Official Cash Rate (OCR)
- interest rate set by the RBNZ that determines the interest banks get on deposits with the RBNZ (settlement cash balance)
- interest that banks pay to borrow overnight cash from the RBNZ.
(0.5 basis point above the OCR.)
(set eight times a year)
RBNZ in face of inflation pressures:
- Increases OCR
- Banks hold more reserves in settlement accounts
- Higher reserve rations leads to lower money multiplier
- Credit creation process less
interest rates rise
- Reducing household credit consumption (C), credit funded investment spending of firms (I) and with associated pressure on exchange rates squeezing net exports (NX)
= Slowing economic activity
Optimal Reserve Ratio (ORR):
Ratio of settlement cash to current deposits that a bank opts to maintain.
Higher OCR induces banks to hold more settlement cash/reserves
Higher market interest rate induces banks to hold less settlement cash/reserves.
he interest rate and the money supply
If the interest rate (not the OCR) increases, banks will supply additional funds by running down their reserves
If the interest rate decreases, banks will increase their reserves
There is a positive relationship between the money supply and the interest rate.
An increase in the OCR will induce banks to hold more settlement cash/reserves and reduce the money supply (via the money multiplier)
Quantity Theory of Money
Hypothesis that changes in prices correspond to changes in the monetary supply.
Quantity Equation (Fisher Equation of Exchange)
V = P
V = the velocity of money - speed at which a $1 funds transactions
M = money
Y = real output
P = the price level
MV represents total spending in an economy.
PY is the money value of national income or nominal GDP.
Can be used to compare eras :
Min wage 2000 = $7.70 CPI = 842.8
Min wage 2015 = $14.75 CPI = 1193
Min wage from 2000 = 7.70 x (1193/842.5) = $10.90 in 2015 dollars
Min wage from 2015 = $14.75 x (842.5/1193) = $10.42 in 2000 dollars
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3. Inflation & Measuring the cost of living
6. Exchange Rates and the Real Exchange Rate