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ECON1002
Introductory Macroeconomics
Week 6 Lecture
School of Economics
Semester 1, 2022
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Lecture 6
6.1: Money, Prices and the Reserve Bank
 What is money?
 Money and the banking system
 Money and inflation
 Reserve Bank of Australia and the determination of interest rates
6.2: The Reserve Bank and the Economy
 Bond prices and interest rates
 How does the RBA affect all interest rates in the economy?
 How does monetary policy affect and respond to the economy?
 Case study: Unconventional monetary policy
Readings: Textbook Chs 9 &10.
 Otto, Glenn 2007, “Central Bank Operating Procedures: How the RBA achieves its Target for the Cash
Rate”, Australian Economic Review, 40, 2, pp. 216-224. [on Canvas Reading List or
https://onlinelibrary.wiley.com/doi/abs/10.1111/j.1467-8462.2007.00463.x
 McLeay, Michael and Radia, Amar and Thomas, Ryland, Money Creation in the Modern Economy, Bank of
England Quarterly Bulletin 2014 Q1, https://www.bankofengland.co.uk/-/media/boe/files/quarterly-
bulletin/2014/money-creation-in-the-modern-economy
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1. Medium of Exchange
Purchase goods & services.
2. Unit of Account
Wages and prices expressed
in dollars (currency)
3. Store of Value
Valued as an asset.
Without money, we would have to
rely on barter.
Money is also a unique asset as it
is supplied by a monopoly – the
government.
Need to satisfy the following
Is the cryptocurrency a money?
What is Money $$$?
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 In the early days, commodity money was standard. Government operated
a mint to produce coins from precious metals (gold and silver) to generate
seigniorage revenue. What is the problem with this?
 Free banking era (private bank notes): In the US (1837-1863), state
chartered (private) banks issued pieces of paper like a currency. What is
the problem with this? N.B. It was followed by National Banking era in the
US (1864-1912).
 Commodity-backed paper currency: Government issued paper currency
backed up by some commodity such as gold, exchanged at specified
price, known as the gold standard, (existed in the US before 1933). What
is the problem with this?
 Fiat money: Modern money, currency! It has no inherent intrinsic value,
but we believe others accept in exchange for goods in the future. What is
the problem with this?
A Brief History of Money
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A Brief History of Central Banks
 Amsterdam Wisselbank: A forerunner to modern central banks in 1609.
 Sveriges Riksbank (est in 1668): World’s oldest central bank but no monopoly
over printing money before 1904.
 Bank of England (est in 1694): takes the form of modern central bank.
 US Federal Reserve (est 1913): response to frequent banking panics and
stock market crashes around 1890 - 1912 in the national banking era. Set up
by private banks led by J.P. Morgan. (A conspiracy theory re the RMS Titanic
sinking in 1912, https://www.businessinsider.com.au/titanic-sinking-conspiracy-theories-2018-
4?r=US&IR=T)
 Reserve Bank of Australia (Reserve Bank Act 1959): took over the central
banking function from the Commonwealth Bank (est 1911). Australian dollar
introduced in 1966 to replace Australian pound.
https://www.rmg.co.uk/
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Currency = notes + coins
M1 = Currency + current deposits
M3 = M1 + all bank deposits
Broad Money = M3 + borrowings by Non-
Bank depository corporations less holdings
of currency and deposits of Non-Bank
depository corporations
Less Liquid
Monetary Aggregates: Definitions
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A Theory of Money and Inflation
Intuition: Suppose there are $100 in an economy, and there is
one transaction occurred to buy 20 units of a good priced $5.
Equation of Exchange: MV = PT, ($100*1 = $5*20).
 an identity which must be true
 V = PT/M ; velocity (frequency) of circulation
 At the aggregate level, Real GDP (Y) is a quantity,
proportional to transactions (T). So replace T with Y.
 Hence, MV = PY (where V = PY/M, PY = Nominal GDP)
 This is the quantity equation of money.
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% % % %
MV PY
M V P Y
=
∆ + ∆ = ∆ + ∆
% %M P∆ = ∆
Assume
(1) V is
constant
(2) Y is
constant
A Theory of Money and Inflation
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Money vs Inflation & Output
Source: "Some Monetary Facts" (Federal Reserve Bank of Minneapolis Quarterly Review, 1995)
Inflation is a monetary phenomenon in the LR! Money is neutral in the LR!
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Money and Inflation in US Data
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Reserves to deposits ratio = 100%
Fractional Banking System
Balance Sheet of Witch Bank: Initial
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Reserves to deposits ratio = 10%
Money and Banks
Target
Balance Sheet of Witch Bank:
after one round of loans
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Reserves to deposits ratio = 53%
Money and Banks
Balance Sheet of Witch Bank:
after a re-deposit of the loan
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Reserves to deposits ratio = 10%
Money and Banks
New loans this time = $81
Balance Sheet of Witch Bank:
after a new loan again
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Reserves to deposits ratio = 36%
Money and Banks
Balance Sheet of Witch Bank
continually changing………
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Reserves to deposits ratio = 10%
Money and Banks
New loans this time = $73
Balance Sheet of Witch Bank
continually changing………
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Reserves to deposits ratio = 10%
Money and Banks
Balance Sheet of Witch Bank: Final
The initial $100 deposit has created $1000 in deposits!
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Money and Banks
Bank reservesDesired reserves/deposit ratio
Bank deposits
 
=  
 
Bank reserves 100Bank Deposits = 1000
Desired reserve /deposit ratio 0.10

= =
Money = (1/rr) x Reserves
∆M = mm x ∆R
This is how money supply can be changed through money multiplier
(mm) under a fractional reserve banking system.
But, modern monetary policy no longer operates like this!
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Misconceptions of Monetary Policy
McLeay et al (2014) outline some misconceptions.
 “Deposit creates loans”. ⇒ Bank lending creates deposits.
 “Banks act simply as intermediaries” ⇒ In real world,
commercial banks are the creators of deposit money.
 “Central banks determine the quantity of loans and deposits
by controlling the quantity of central bank money (esp.
reserves), through the money multiplier process ”. ⇒ Money
and loans are endogenous. Central banks simply set the
price of reserves, interest rates.
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RBA and Interest Rates
Dr Phillip Lowe
Governor of the RBA (app. Sep 2016)
Who sits on the RBA Board?
https://www.rba.gov.au/about-rba/boards/rba-board.html
Reserve Bank of Australia (Reserve
Bank Act 1959): took over the central
banking function from the
Commonwealth Bank (est 1911).
Australian dollar introduced in 1966 to
replace Australian pound in favour of
decimalisation.
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The principal medium-term objective of monetary policy is to
control inflation, ……….. the appropriate target for monetary policy
is to achieve an inflation rate of 2–3 per cent, on average, over the
cycle, …………… provides discipline for monetary policy decision-
making, and serves as an anchor for private sector inflation
expectations. The inflation target is defined as a medium-term
average rather than as a rate (or band of rates) that must be held at
all times. This approach allows a role for monetary policy in
dampening the fluctuations in output over the course of the
business cycle. When aggregate demand in the economy is weak, for
example, inflationary pressures are likely to be diminishing and
monetary policy can be eased, which will give a short-term stimulus
to economic activity.
http://www.rba.gov.au/monetary-policy/about.html
Monetary Policy in Australia
Objectives and Framework
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Current target rate = 0.1% (10
basis points)
(Since Dec 1, 2020)
RBA and Interest Rates
“The Reserve Bank sets the target 'cash rate', which is the market interest
rate on overnight funds. It uses this as the instrument for monetary policy,
and influences the cash rate through its financial market operations.”
Source: http://www.rba.gov.au/monetary-policy/int-rate-decisions/index.html
How does the RBA set the cash rate?
https://www.rba.gov.au/media-
releases/2022/mr-22-05.html
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Decreasing the cash rate
Open Market Operation (OMO)
Example:
current cash rate = 1.5%
target cash rate = 1.25%
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RBA conducts Open
Market Operations
(buy financial assets
from banks)
Banks borrow or
lend in the
overnight cash
market (lend)
Changes balances in
Exchange Settlement
Accounts (credited by
the RBA)
Affects the overnight
cash market (more
funds => fall in the
cash rate)
Open Market Operation
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Example:
current cash rate = 1.5%
target cash rate = 1.75%
Increasing the cash rate
Open Market Operation (OMO)
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RBA conducts Open
Market Operations
(sell financial assets
from banks)
Banks borrow or
lend in the
overnight cash
market (borrow)
Changes balances in
Exchange Settlement
Accounts (debited by
the RBA)
Affects the overnight
cash market (less
funds => increase in
the cash rate)
Open Market Operation
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How does RBA set Interest Rates?
 Establish a narrow channel (interest rate corridor) around the target
level for their policy rates by providing a standing facility for reserves.
 RBA stands ready to borrow and lend reserves to designated financial
institutions at interest rates that are slightly below or above the target
rate.
 Banks hold accounts at the RBA called exchange settlement (ES)
accounts
 To clear payment transactions among banks
 For the settlement of accounts between the RBA, the federal
government and the banking system.
 Through its OMO, RBA can affect the level of ES funds in the banking
systems’ accounts
 For interbank lending/borrowing, use cash (interbank) market to trade
ES funds. Banks need keep a minimum balance in credit.
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RBA’s MP: Operating Procedures
Interest corridor: target – 0.25% ≤ cash rate ≤ target + 0.25%
RBA’s Standing Facilities
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RBA’s MP: Operating Procedures
Banking system’s demand for cash
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RBA’s MP: Operating Procedures
RBA’s forecast of cash supply on a given day
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RBA’s MP: Operating Procedures
RBA offers to buy securities (repo) equal to the estimate of
excess demand for cash at the target rate
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RBA’s MP: Operating Procedures
After OMO, RBA ensures the excess
demand for cash is met at the target rate
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 If i = 5%, $1 in t+1 =
 If i = 10%, $1 in t+1 =
 If i increases, the expected present discounted
value (i.e., price) falls!
The price you would pay for a bond varies inversely with its rate
of interest (bond yield):
Price (P) = Payoff / (1+i)
What if it is a multi-year bond?
95.
05.1
1
=
+
91.
10.1
1
=
+
Present Value and Bond Price
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Bond Prices and Interest Rates
Borrowers issue bonds to lenders
2 year bond (principal of $1000) with a
“coupon” rate = 5%
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Bond Prices and Interest Rates
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P90 day bills S
D
Q* Q (90 day bills)
P*
lending
borrowing
RBA, Bond Prices and Interest Rates
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P90 day bills S0
D0
Q Q (90 day bills)
P
Cash rate, bond prices and interest rates: How are they related?
Consider a monetary tightening (i.e. an increase in cash rate)
RBA, Bond Prices and Interest Rates
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RBA and Other Interest Rates
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Short-term and Long-term interest rates
Long-term interest rates are determined by both short-term interest rates
and expectations about future interest rates!
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RBA, Bond Prices and Interest Rates
RBA sets the cash rate (nominal interest rate).
Can the RBA affect the real interest rate?
Assume that π = 0, so that r = i.
N.B. Consumption and investment respond to
the real interest rate.
r i π= −
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PAE
Y
Ip0
C0
r
Monetary Policy and the Economy
W
hat happens to consum
ption
and investm
ent?
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Y
PAE
Y
450
PAE1 = C1 + IP1
PAE0 = C0 + IP0
Monetary Policy and the Economy
r
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PAE and the real interest rate: A numerical example
– In an economy described by:
Cd = 640 + 0.8(Y – T) – 400r
Ip = 250 – 600r
G = 300
X = 20
T = 250
– Both Cd and Ip are affected by the interest rate, r.
PAE = Cd + Ip + G + X
= [640 + 0.8(Y – 250) – 400r] + [250 – 600r] + 300 + 20
= [1010 – 1000r] + 0.8Y
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Monetary Policy and the Economy
Let PAE = 1010 – 1000r + 0.8Y
Also, assume potential output
If r = 0.05, PAE =
In equilibrium,
Ye(1 – 0.8) = 960 => Ye = 4800 (eq’um output)
What’s the output gap?
Y* = 5000
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Monetary Policy and the Economy
Recall PAE = 1010 – 1000r + 0.8Y
What if r = 0.01?
r = 0.01 => Y = 1000 + 0.8Y (in equilibrium)
Ye (1 – 0.8) = 1000 => Ye = 5000
Did this eliminate the output gap?
Y* = 5000
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Central bank fights a recession in the Keynesian model
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Y
S
Monetary Policy and the Economy
Recession90 day
bill rate
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*0.01 0.5 0.5
*
π− = + + 
 
Y Yr
Y
Policy Reaction Function (PRF) and Taylor Rule
r if (i) Y < Y* and/or (ii) inflation (π) decreases
r if (i) Y > Y* and/or (ii) inflation (π) increases
Example: If inflation is 3% and output gap is zero, the Federal Reserve should set:
 The real interest rate 0.01 + 0.5 x 0 + 0.5 x 0.03 = 0.025 = 2.5%
 The nominal rates at 2.5% + 3% = 5.5%.
John Taylor proposed a policy rule for the US MP as follows.
https://web.stanford.edu/~johntayl/
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Y
interest rate
(r)
inflation
RBA’s policy
reaction function
(PRF)
Monetary Policy and the Economy
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Y
interest rate
(r)
inflation
RBA’s PRF
Monetary Policy and the Economy
What happens when the
RBA takes a more
aggressive (‘hawkish’)
stance, e.g. a lower
inflation target?
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Case Study: “Unconventional” Monetary Policy
 Suppose target value for policy rate has been reduced to zero. Central
bank has reached the limits of Conventional Monetary Policy.
 Welcome to the world of “Unconventional” Monetary Policy.
 Negative Policy Rates
 Quantitative Easing (QE)
 Forward Guidance
With QE,
 Central bank buys long-term assets which it pays for by creating new
bank reserves.
 CB actions drive up the price of long-term assets and reduce long-term
yields. Recall an inverse relation between the bond price and yields!
 Directly boosts broad money (with non-banks) without requiring an
increase in lending via the banking system.
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Case Study: “Unconventional” Monetary Policy
Source: https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html
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Case Study: “Unconventional” Monetary Policy
Source: https://www.rba.gov.au/speeches/2019/sp-gov-2019-11-26.html