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TOPIC 5. MONEY, INFLATION AND INTEREST
FUNCTIONS OF
MONEY
1. Medium of Exchange2. Measure of Value3. Store of Wealth4. Standard for Deferred
Payment
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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.
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AUSTRALIA’S INFLATION RATE COMPARED WITH
THE OECD AVERAGECompared with Australia: 2.4% in May 2011 (average annualised inflation, compared with May 2010)
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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 $935; index = 1.0695, inflation = 6.95%
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A basket of goodsand services (ABS)
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THE INFLATION SPIRAL …..As prices increase, business
costs also increase, so businesses must increase their prices to compensate.
Governments also must increase taxes to cover their costs. Both cause an upward
spiral of inflation ……
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With high inflation, money rapidly loses its purchasing power. It is destabilising to the
economy and leads to loss of business confidence and investment. This can cause a collapse in a country’s monetary system. So a major goal of government is to reduce
inflation.
Reserve Bank of Australia governor Glenn
Stevens
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MONEY includes:
•notes and coins in circulation (called M1)•funds deposited in bank and non-bank financial institution accounts•deposits of banks with the RBA•credit (lending) by banks, or even the RBA, to the private sector
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MAIN SOURCES OF CHANGE IN THE MONEY SUPPLY …….
1. Government transactions – whether it is in surplus or deficit.
But how is a deficit financed? …….two methods that affect the money supply: a. the Federal Govt issuing securities b. borrowing from abroadand some methods that don’t affect the money supply:
borrowing from banks, increasing taxes just after the deficit period, and borrowing from the non-bank sector (corporations, etc.)
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MAIN SOURCES OF CHANGE IN THE MONEY SUPPLY …….
2. International transactions – from trade, investment• Money flows of A$ 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
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.
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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.
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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!)
a ‘government
intervention’ approach
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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!)
mainly a ‘market
forces’ approach
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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%
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Factors Determining Interest Rates
1. degree of risk2. inflation rate3. administration costs4. maturity term5. degree of liquidity6. expectations about future
interest rates
vs.
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RBA
OFFICIAL CASH RATE (through
govt. bonds)
ALL OTHER INTEREST RATES19
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