TUTORIAL 7 (5 9 MAY) ANSWER KEY

Money, Private Banks and the RBA

Textbook Reference: Chapter 7
Main Concepts
Definition and measures of money
Demand for and the supply of money
Fractional-reserve banking
Reserve Bank of Australia (RBA)
Exchange settlement accounts
Open-market operations
Overnight cash rate
Review Questions
Question 1
(i)
What are the motives for holding money? Why are people willing to hold money
when it typically pays a rate of return that is less than other financial assets?
Money refers to any asset that can be used in making purchases (examples are cash and cheque
account balances). Note that credit cards are not money, but are a means of recording the value of
transactions that need to be later paid for with money.
People hold money despite its lower return precisely because of its usefulness in transactions; a
person who held no money and wanted to make a purchase would either have to resort to timeconsuming barter or else incur the costs of selling other assets to obtain money. If the rate of return
on financial assets is zero, then we would expect that an individual would hold all of their assets in
cash. It should be clear that interest bearing financial assets are imperfect substitutes to the money
aggregates which do not explicitly bear interest.

(ii)
Discuss the main economic factors that influence the demand for money. Why is the
demand for money inversely related to the nominal interest rate? Why does money
demand depend upon the nominal rather than the real interest rate?
Demand for money is influenced by:
the nominal interest rate,
price level (if nominal money demand)
real income.
financial innovation and financial regulation
We can write the real demand for money as:
(

and the nominal demand as:

(

Since the price or nominal value of money is fixed, it is the nominal interest rate that matters rather
than the real rate. For example even if the real interest rate on other assets is zero, so that the
nominal interest rate only reflects inflation, there is still a cost to holding money which is the loss in its
real value due to inflation.

Question 2
(i)
What three properties must an item possess for it to be called money?
A medium of exchange, store of value and a unit of account.
(ii)

What are the money aggregates?

From http://www.rba.gov.au/statistics/tables/index.html#money_credit file D3:

The money (or monetary) aggregates are measures of the money supply.
M0 (money base):
Holdings of notes and coins by the private sector (currency) plus
deposits of banks with the Reserve Bank and other Reserve Bank liabilities to the private nonbank sector.
M1: Currency plus current deposits with banks.
M3: M1 plus all other deposits at banks (including certificates of deposits) from the private
non-ADI (authorised depository institutions) sector, plus Deposits with non-bank ADIs.
Broad Money:
M3 plus Other borrowings from private sector by AFIs, includes nondeposit borrowings (from non-AFIs) by ADIs, RFCs (registered financial corporations such as
money market corporations, finance companies, pastoral finance companies and general
financiers) and cash management trusts.
(ii)
Which properties do each of the following possess, and hence which can we define
as money? If defined as money, to which monetary aggregate does each belong?
- Funds deposited into your bank account by your employer.
All properties, M1.
- Your transaction card for accessing your deposit account.
The card does not possess any properties, not money
- The 24k gold coins that you received as part of your inheritance.
Store of value, not money.
- Your iPhone
Store of value, not money.
- Your credit card.
Store of value, not money.
- A bank cheque.
No properties, not money.
- Bit coins.
Store of value, unit of account, not a medium of exchange, not money.
- The portion of your superannuation held in a money market mutual fund.
Store of value, unit of account, only a medium of exchange when you reach preservation age,
broad money.
- A bank bill.
Store of value, unit of account, medium of exchange, M3.

Question 3
(i)
A countrys bank reserves are 100, the public holds 200 in currency and the desired
reserve-deposit ratio is 0.25. Find deposits and the money supply.
( )

( )

(ii)
A countrys money supply is 500 and currency held by the public equals bank
reserves. The desired reserve-deposit ratio is 0.25. Find currency held by the public and
bank reserves.
Let C = currency held by the public = bank reserves (R).
D = Deposits.
Then the money supply equals:
( )

(iii)
A countrys money supply is 1250, of which 250 is currency held by the public. Bank
reserves are 100. Find the desired reserve-deposit ratio and the money multiplier.
As the money supply is 1250 and the public holds 250 in currency, bank deposits must equal 1000.

( )
( )
( )

(iv)
Explain why the money multiplier is generally greater than 1. In what case would it
be equal to 1?
The money multiplier is (

, where the reserve-deposit ratio is either desired or required.

In a fractional-reserve banking system (where the reserve/deposit ratio is less than one), banks loan
out part of their deposits. The process of banks making loans and the public redepositing their funds
in banks increases deposits and the money supply, until the point that the banking system has reached
its desired/required ratio of reserves to deposits. Because each dollar of reserves ultimately
supports several dollars of deposits, one extra dollar of bank reserves results in an increase in the
money supply of several dollars (the money multiplier is greater than one). The money multiplier
equals one only in the case of 100% reserve banking. In that case reserves are equal to deposits, so
that an extra dollar of bank reserves increases deposits and the money supply by only one dollar.