ECON1102 Week 10 - The Financial Sector and monetary Policy

Case against RBA Independence

- An independent central bank isn't directly accountable to voters, and may implement monetary policy against the wishes of the electorate. Too much economic power may be concentrated in the hands of a single or small group of non-elected people - those on the RBA board. - Some argue that central banks are prone to capture by the banking sector. Many have argued that QE shows that there's at least some banking sector influence on Central Bank policy since QE has served to 'bail out' financial institutions often with those institutions providing little in return.

If Fisher is correct in that ΔP = ΔM - ΔY and V was constant, then the following is true.

- If M grows at a faster rate than economic growth, there will be inflation. - If M grows at a slower rate than economic growth, there will be deflation. - If M grows at the same rate as economic growth, the price level will be stable. The net difference between real and monetary growth will be expressed as inflation or deflation in the nominal price level. However, Fisher was incorrect in stating that V is constant, V did change in response to economic conditions, breaking down the ability to control inflation by strict rules for growth in M. Inflation in the long-run results from the money supply growing at a faster rate than the economic growth rate.

Effects of monetary policy on real GDP and the price level.

- Over time, potential GDP increases and the LRAS curve shifts to the right. - The factors shifting the LRAS also shift the SRAS curve to the right, as firms will now be supplying more goods and services. - During most years, aggregate demand also increases, and the curve shifts to the right.

Distributional impacts of Contractionary monetary policy:

- Savers can benefit and increase their spending. - Borrowers (individuals and businesses) face higher interest repayments on loans. - Low-income earners are often 'marginal' borrowers and may be at a higher risk of loan defaults.

Changes in interest rate affect these 3 components of aggregate demand:

1. Consumption. 2. Investment. 3. Net exports. BUT it won't affect government purchases.

Legislated Goals of Monetary Policy

1. Full employment of the labour force. 2. Stability of the Australian currency. 3. Economic prosperity and welfare for the people of Australia.

The RBA (and any central bank) try to influence 3 key financial variables to achieve the goals of monetary policy:

1. Market interest rate. 2. Liquidity in the economy. 3. Money market equilibrium, i.e. the dynamics of supply and demand for money. These are inter-related.

The Functions of Money

1. Medium of Exchange. - more efficient than bartering 2. Unit of account. - a clear and easy to use benchmark is provided against which to measure all prices and transactions against. 3. Store of value. - money can 'hold', in abstract, the value of resources reliably and across time. - money is an 'abstraction' (derived) from real goods which allows value to be stored, saved and retrieved. 4. Standard of deferred payment. - facilitating economic transactions across time (borrowing and lending)

DIfferent kinds of Policy Lags

1. Recognition Lag - A delay before the RBA recognises that a contraction is imminent. 2. Impact lag - The time taken for monetary policy to affect real GDP. Time lags may reduce the ability of monetary policy to impact on the economy at the appropriate time.

An expansion policy (steps)

1. Reserve Bank Board decreases the cash rate. 2. Other interest rates fall. 3. Investment, consumption and net exports increase. 4. The AD curve shifts to the right by more than it otherwise would have. 5. Real GDP and the price level rise by more than they would have without policy.

A contractionary policy

1. Reserve Bank Board increases the cash rate. 2. Other interest rates rise. 3. Investment, consumption and net exports decrease. 4. The AD curve shifts to the right by less than it otherwise would have. 5. Real GDP and the price level rise by less than they would have without policy.

5 criteria for suitable medium of exchange

1. The good must be acceptable to most people. 2. Should be of a standardised quality. 3. Should be durable. 4. Should be valuable relative to its weight so it can be easily transported. 5. Should be divisible.

2 Basic Dimensions of a Commercial Bank

1. They operate as private businesses to connect savers and borrowers and earn profit in the form of spread. 2. They have systematic functions: a) To provide for an efficient allocation of funds across present and future. b) Leveraging existing 'official' money into a larger money supply or money creation. (3.) Bank credit also serves to increase financial liquidity in the economy and this is another systematic banking function.

3 Major Roles of the RBA

1. To maintain financial integrity and stability of the Australian financial system. 2. To implement monetary policy. 3. TO intervene, as needed, in foreign exchange (FX) markets.

The Central Bank

A Central Bank is an institution that is responsible for managing a country's money supply and usually its banking system as well.

Minsky Moment

A Minsky Moment may occur when there is: - A softening in general economic conditions that affects overall confidence and AD, which reduces profitability of bank debtors. - This in turn leads to a fall in asset prices that might also affect confidence, which will reduce the value of collateral, which increases loan defaults.

Reserve Ratio (RR)

A bank's ratio of reserves to deposits. If a bank has $100 in deposits and puts aside $10 in reserves, its RR is $10/$100 = 0.1 = 10%.

Fractional Reserve Banking

A banking system in which only a fraction of bank deposits are backed by actual cash on hand and are available for withdrawal. This is done to expand the economy and by freeing up capital that can be loaned out to other parties. Banks only keep a certain portion of deposits as a buffer to make sure that they can meet withdrawals and then lend out the rest - this is the primary way that banks leverage money which then increases the money supply in the economy, a process called 'money creation'.

Commercial banking

A business where an entity (the commercial bank) first accepts money from savers, primarily in the form of interest-bearing deposits. The bank then lends out that borrowed money. The core business of a commercial bank and the economic function it services is to efficiently connect surplus financial units to deficit financial units.

Liability

A liability is an obligation and it is reported on a company's balance sheet. Includes accounts payable, which arises when a company purchases goods or services on credit from a supplier. A liability represents a financial claim that an outsider has against the institution keeping the balance sheet.

Demand Deposits

Also called current deposits, these are deposits in financial institutions that are transferable by cheque, debit cards at EFTPOS terminals and through electronic transfer between accounts. (called demand deposits because they're available on demand and are repayable in notes and coins)

Financial Intermediaries

An institution, such as a bank, that holds funds from lenders in order to make loans to borrowers - it facilitates money transactions.

Slope of the Money Supply Curve

Because the central bank provides the money supply as a monopoly and with little marginal cost, we don't have a typical supply curve that relates quantity to price (interest rate) to MC of production. Instead, our default MS curve is a vertical line, i.e. the monetary authority sets a Q of money and the interaction of that Q with existing MD yields an equilibrium interest rate.

Distributional impacts of expansionary monetary policy:

Borrowers benefit more than savers.

What does the RBA aim to achieve tactically to achieve its legislatively mandated strategic objectives?

Broadly, the RBA seeks to have: 1. Low and stable price inflation. 2. Sufficient financial system liquidity (not too much or too little). 3. A calibrated foreign exchange rate. 4. Overall financial system integrity, including in financial institutions.

Banking Crises: 2 Approaches

Business downturns that start with a financial crisis are especially severe. There are 2 broad views: 1. 'Fundamentals' based crises - These theorists tend to posit a financial crisis as a period of adjustment to shifts in real economic forces as reflected in financial system adjustments. (This is closely related to exogenous supply or demand shocks). 2. Financial Panics and/or speculative excesses - Theorists broadly speak of 'normal' financial system leverage and functioning morphing into speculation leading to price 'bubbles', overvaluation and ultimate collapse (This is more Keynesian in nature).

Shifts in the money demand curve

Changes in variables other than the interest rate cause the money demand curve to shift. The 2 most important variables that shift the money demand curve are: 1. Real GDP - the greater income is, the greater the demand for money. 2. Price Level - as (nominal) prices increase you need more (nominal) cash to make any given purchase.

Inflation targeting

Conducting monetary policy so as to commit the central bank to achieving a publicly announced level of inflation. The RBA's target inflation rate is between 2% and 3% per annum, on average over the business cycle.

M3

Defined as M1 plus deposits into non-bank deposit-taking institutions minus holdings of currency and deposits of non-bank depository corporations. Non-bank depository corporations include finance companies, money market corporations and cash management trusts.

Reserves

Deposits that a bank keeps as cash in its vault or on deposit with the RBA.

Equilibrium in Money Market

Equilibrium is where MD equals MS - where the 2 curves intersect.

Financial Panics and Speculative Excesses

History shows that the financial sector can generate its own shocks. E.g. a lending boom, i.e. a rapid increase in bank credit growth to the economy, with the source of increase in banks' capacity to lend often coming from large capital inflows. Loans are often made at the expense of credit quality either through sloppy underwriting (i.e. banks fail to properly assess the borrower riskiness in their haste to earn more spread) or because distinguishing between good and bad credit risks is harder when the economy is expanding rapidly and many borrowers are temporarily profitable. A lending boom is often accompanied by asset price bubbles (stock market, real estate).

Bank Runs

If too many depositors suddenly decide to take out their money, then a bank run can occur, and that can mean the bank will literally run out of cash before it can meet all the demand for cash from its depositors, even if technically solvent (i.e. having positive net worth with total assets higher than liabilities).

'Fundamentals': Domestic and External Shocks and the Financial Sector

In the SR models we have been using, the financial sector becomes important mainly in how it 'transmits' real or monetary shocks through to the real economy. E.g. increase in domestic interest rates by the central bank may have unintended consequences for the macroeconomy if the banking sector is overleveraged with slow output growth fundamentally weakening the ability of borrowers to service their loans and/or an increase in nonperforming assets for financial intermediaries.

Central Bank Independence

Institutionally, the RBA, like most central banks, is 'independent', that is, it operates separately from the main arms of government. Money should be issued in exchange for short-term 'real bills' (assets) of adequate value, and that in so doing a central bank can avoid inflation of its money by always keeping enough assets to back the money it has issued. Obviously if a Central Bank is run directly by the government Treasury then there will be an incentive to issue excess money, not backed by anything but pure fiat, to make the government's finances easier. This would also be prone to the use of monetary policy to further other political goals. E.g. lowering interest rates before an election.

Balance Sheet

It is a financial statement that tracks an entity's net wealth or worth. It is a statement of the assets, liabilities, and capital of a business or other organisation at a particular point in time.

Money Demand Curve

It is downward sloping to show the inverse relationship between the interest rate on financial assets and the quantity of money demanded. Money demand is a 'derived demand' (i.e. derived from the demand for other goods and services which must be bought using the means of money).

Credit

Loans, advances and bills provided to the private non-bank sector (individuals and firms) by all financial intermediaries.

The exchange equation and the quantity theory of money

M x V = P x Y M = money supply V = velocity of money P = price level Y = real GDP ΔM + ΔV = ΔP + ΔY Growth rate of M plus growth rate in V = growth rate in P plus growth rate in Y. ΔP = ΔM + ΔV - ΔY Inflation rate = growth in M plus growth in V minus growth in Y. Crude monetarists assumed that V was constant and expressed Y as T - total transactions - and assumed this was constant so they reduced the driver of inflation to M growth: ΔP = ΔM

The Financial Instability Hypothesis

Minsky argued that normal real fluctuations were magnified by the financial sector and, indeed, creation of a financial crisis by the financial sector was an inevitable product of modern capitalism. Modern enterprise needs leveraged finance to produce the kind of growth capitalist economics need and desire but that financial booms and panics are inevitable as a result.

Monetary Policy asymmetry

Monetary Policy is more effective at reducing the rate of inflation during an economic boom than it is at stimulating aggregate demand during a contraction or recession - that is, the effects are asymmetrical. In bad times, businesses will be unwilling to borrow if the economic outlook is not good. Banks may also be reluctant to make loans, as occurred in the GFC.

Gold Standard

Monetary system in which standard economic unit of account is based on a fixed quantity of gold.

Money Supply

Money supply is a bit unique because: a) Money isn't desired in and of itself. b) Money is supplied largely 'monopolistically' by the monetary authority (and augmented by the money creation supply). So the RBA (and any central bank) is the primary driver behind money supply.

Commodity Money

Money whose value comes from a commodity of which it is made. Problem: overall money supply is fixed by the available supply of metal backing it up - this can limit the possibility of inflation but it also can lead to deflation.

Focus of Loanable funds Model

More concerned with longer term borrowing and lending. Think of this as the market for 'financial capital' which is deployed for longer-term consumption and investment needs.

Fiat Money

Not backed by any physical commodity. It is money that is authorised by a central bank or government body and doesn't have to be exchanged by the central bank for gold or some other commodity money.

Currency

Notes and coins held by the private non-bank sector.

Quantitative Easing (QE)

Quantitative Easing is at its heart both simple and radical: A central bank prints money and uses this money to buy assets off of firms and bank balance sheets - generally financial securities such as shares and bonds. This is OMO on steroids. Generally the prices paid by the central bank were well above the actual market price - done so that financial institutions don't become insolvent, leading to financial death spiral that occurred in Great Depression.

Seigniorage

Refers to the difference between the value of money and the cost to the State to produce and distribute it. Seigniorage derived from paper money is the difference between interest earned on securities acquired in exchange for bank notes and the costs of producing and distributing those notes.

FInancial Leverage

Refers to the use of debt to acquire additional assets. It is also known as trading on equity.

'Loose' vs. 'Tight' Monetary Policy: Expansionary monetary policy ('loose')

Refers to the use of monetary policy by the RBA to decrease interest rates to increase real GDP. The RBA decreases the interest rate through OMO and cash rate decreases. This decrease typically flows through to decreases in interest rates which then affect the entire economy. Lower interest rates may encourage investment, increase net exports, and may increase consumer spending. Real GDP and the price level will rise.

'Loose' vs. 'Tight' Monetary Policy: Contractionary monetary policy ('tight')

Refers to the use of monetary policy by the RBA to increase interest rates to reduce inflation. The RBA increases the interest rate (through OMO/cash rate) and this typically flows through to increases in interest rates through the entire economy. Sometimes, aggregate demand may be increasing too fast, leading to inflation, and the economy may be in equilibrium beyond potential GDP. Contractionary monetary policy is used during periods of high or rising inflation rates. The RBA uses contractionary monetary policy to slow the rate of increase of aggregate demand to less than it would have increased without policy. Higher interest rates may reduce new investment growth, decrease net exports, and may reduce the growth rate of consumer spending. The slower growth in aggregate demand may reduce the inflation rate.

Excess Reserves

Reserves above the normal ratio of reserves to deposits. Banks like to keep the smallest amount possible in reserves because reserves is simply cash in the vault and they earn no return and, with inflation, depreciate in value. But a bank cannot keep zero reserves because depositors do withdraw money from time to time and there needs to be sufficient cash to service that demand. But if banks keep too much in reserves, the sacrifice spread.

Assets

Resources owned by a company and which have future economic value that can be measured and expressed in dollars. They are financial claims that the bank has aginst outsiders.

Minsky (Post-Keynesian schools)

Spread - Financial spread earned by the bank must be paid back through real returns on borrowed capital (through MPK of real investment by firms) Neoclassical economics and 'loanable funds market' equilibrium posits that these will be equal (recall R = MPK) but quite apart from Keynes' concerns about MEC, Minsky notes that financial intermediaries won't be guaranteed to set R = MPK (or provide liquidity at all) if the return they need to earn as institutions (and earned through a spread) must be higher or lower than this rate.

The RBA and the exchange equation

The RBA (and any central bank) keeps busy trying to keep the monetary side of the economy (P,M) to balance with the real side (V,Y) while at the same time using monetary policy tools to smooth the business cycle (i.e. keeping actual GDP = potential GDP).

How the RBA sets the MS curve

The RBA has 2 choices: 1. Set the money supply as a vertical line - i.e. choose a Q of money. This is called money targeting. 2. Supply money to the market until a desired market interest rate results, i.e. a horizontal curve. This is called interest rate targeting.

Money Supply Management

The RBA has a strong influence over the money supply more directly, being able to modulate the monetary base and overall system liquidity and credit.

Repurchase Agreement

The RBA offers to buy (or sell) Commonwealth Government Securities and other eligible financial instruments from banks or other authorised financial dealers, provided the same banks or dealers are prepared to repurchase (or resell) them at a future date, often in a few days' time, at a price agreed at the outset.

Open Market Operations (OMOs)

The RBA purchasing or selling financial instruments such as Commonwealth Government Securities and private bonds and securities, either by outright purchase or sale, or by the use of repurchase agreements. This is a way of indirectly setting the market interest rate of which the cash rate is only a part. OMO refers to the buying and selling of government securities in the open market in order to expand or contract the amount of money in the banking system, facilitated by the Federal Reserve (Fed). Purchases inject money into the banking system and stimulate growth, while sales of securities do the opposite and contract the economy. The Fed's goal in using this technique is to adjust and manipulate the federal funds rate, which is the rate at which banks borrow reserves from one another.

Spread

The Spread if the difference between the interest rate that the intermediary is paying to borrow its money and the interest rate that it charges others to whom it lends this borrowed money. It is the difference between 2 prices/interest rates.

Monetary Policy

The actions taken by the RBA (or any central bank) to manage the monetary system/interest rates in the pursuit of macroeconomic goals. Monetary policy is the process by which the monetary authority of a country controls the supply of money, often targeting an inflation rate or interest rate to ensure price stability and general trust in the currency.

Velocity of Money

The average number of times each dollar in the money supply is used to purchase goods and services which are included in GDP. V is affected by levels of Y, P and M. V = (P x Y)/M

Financial Magnification of the Real

The business cycle (positive or negative output gaps) is often magnified by financial intermediaries (FIs). In an up-cycle, there's lots of demand for credit as firms seek to meet high aggregate demand. Banks earn profit through lending and in these up-cycles they will be strongly tempted to increase their lending and possibly lower their lending interest rate.

Focus of the Money Market Model

The focus is on the short-term nominal rate of interest. This of this as the market for 'cash' or 'liquidity', a short-run need. When conducting monetary policy, it is the short-term nominal interest rate that is most affected by increases and decreases in liquidity. Often there's a close connection between movements in the short-term nominal interest rate and the long-term real interest rate.

Fundamentals: The Takeaways

The impact of these exogenous real shocks on the banking system depends on their duration, depth and variation and have feedback loops between the real and financial sectors that can get out of hand. It's also recognised that the financial sector itself will have periods of relative weakness/strength, making it more/less vulnerable to shocks. However, the fundamentals school of financial crisis doesn't consider the financial sector itself to be a generator of shocks, at least regularly. In other words, something happens from the outside which stresses the financial sector and causes financial feedback to the real economy.

Cash Rate

The interest rate on loans in the overnight money market. The RBA sets this directly. It is the rate of interest which the central bank charges on overnight loans to commercial banks.

M1

The narrowest definition of the money supply which is defined as currency plus bank current deposits from the private non-bank sector.

Interest rate on financial assets

The opportunity cost of holding money. - Low interest rates reduce the OC of holding money. - High interest rates increase the opportunity of holding money.

The Real-World Deposit Multiplier

The real-world deposit multiplier is smaller than the simple deposit multiplier because: - Banks may hold excess reserves - People don't deposit all their money

Exchange Rate Management

The value of the Australian dollar is determined by the interaction of the demand for and supply of the AUstralian dollar in international currency markets. However, the RBA very occasionally intervenes by buying and/or selling Australian dollars. The RBA also manages Australia's foreign currency and bonds, and gold reserves. The RBA is concerned with the value of the Aussie but generally seeks to influence it indirectly through changes in domestic interest rates. Trading volumes in 'FX' (foreign exchange) markets are so large that RBA intervention has little long-term effect.

Liquidity Trap

There is a limit to the effectiveness of interest rate cuts in especially hard times. At some point all money provided will simply be held rather than spent or lent. Keynes argued that in these circumstances, fiscal policy by government was necessary, i.e. a boost in G to boost AD.

International Financial Architecture

This consists of: - The International Monetary Fund (IMF) which expressly serves as an international LOLR. - The 'World Bank' which seeks to ensure that real economic development is more evenly spread to avoid real imbalances. -Various mechanisms to coordinate domestic financial policies such as the G7 and the G20. These institutions do internationally what Central Banks do domestically - ensure financial system stability and stem a crisis when required by injecting liquidity into the system.

LOLR (Lender of Last Resort)

This is a backstop to a financial system that may occasionally but inevitably go bust. A LOLR will provide liquidity into the financial system (either generally or to specific institutions) when the system is at risk of a general collapse. This is a key Central Bank function for a country and also a key aspect of international monetary institutions. A LOLR is an institution, usually a country's central bank, that offers loans to banks or other eligible institutions that are experiencing financial difficulty or are considered highly risky or near collapse.

Underwriting

Underwriting means receiving a remuneration for the willingness to pay for or incur a potential contingent risk.

Simple Deposit Multiplier

We can calculate the amount of money created by the deposit leveraging process using a deposit multiplier. The simple deposit multiplier is the ratio of the amount of deposits created by banks to the amount of new reserves. SDM = 1/RR

Asset bubble

When prices of securities or other assets rise so sharply and at such a sustained rate that they exceed valuations justified by fundamentals, making a sudden collapse likely - at which point the bubble 'bursts'

Fisher's relationship is thus:

ΔP = ΔM - ΔY Growth in P equals growth in M - growth in Y. Fisher argued that V was constant.