LECTURE 6 (2009) - ECON 1002 Introductory Macroeconomics...

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1 1 Introductory Macroeconomics Week 6 The Reserve Bank and the economy ECON 1002
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2 Demand for money Amount of wealth an individual wishes to hold in money Benefits : very liquid. So when income increase, demand for money increases as people want more money to go shopping Costs : no interest. Opportunity cost of holding money is the interest rate that could have been earned on interest-bearing assets
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3 Macroeconomic determinants of the demand for money Nominal interest rates Opportunity cost of holding money The price level The higher the price level the more money is needed to purchase goods
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4 Shifts in the money demand curve Interest rate Quantity of money Increase in prices and/or GDP shifts the money demand curve to the right
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5 Money supply The supply of money is affected by the Reserve Bank’s open market operations NOT by interest rates. Remember from WEEK 5. The Reserve Bank can chose to determine the level of the money supply (money supply targeting) and it will have to accept the interest rates that come with it OR the Reserve Bank can try and determine the level of interest rates by setting the level of money supply that will result in the chosen interest rates (interest rate targeting)
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6 Money supply Example 1: To increase/inject liquidity in the banking sector, the Reserve Bank might buy Government Bond in the short term money market using newly created money eg quantitative easing in UK and Us in 2009 Example 2: To cap inflationary pressures, the Reserve Bank might wish to raise interest rates by selling Government Bonds in the short term money market, thereby decreasing the money supply
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7 Example 1:The money supply curve Interest rate Quantity of money Money supply curve Money demand curve The Reserve Bank chose to supply a certain quantity of money in the market at any level of interest (money supply targeting) i
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8 Determination of the equilibrium interest rate The cash rate is the rate prevalent in the short term money market: it is determined by the Reserve Bank open market operations (Week 5) Changes in the cash rates will flow through to the overall interest rate maturities How? let’s have a look at the bond market (Government and corporate bonds)
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9 Determination of the equilibrium interest rate: the bond market The government or any firm may wish to borrow money. They can do so by issuing bonds. The bonds is a legal promise to repay a debt. It includes the principal amount (the amount initially borrowed) and coupon rates ( interest payments) The holder of a bond will receive coupon payments which includes the coupon rates times the principal amount Example: 1,000,000A$ bond with a coupon of 0.05 will return annually 5% of 1,000,000 =50,000A$
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10 Determination of the equilibrium interest rate: the bond market (2) Bonds are sold on the bond market. As financial asset they have a price that is determined by the supply and demand for those bonds.
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