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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