Money supply and monetary policy 2 the demand for

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1. Money supply and monetary policy 2. The Demand for Money 3. Money market Equilibrium 4. Transmission Mechanism 5. Policy Reaction Function
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23 interest rate (i) money 0 M D M S set M S or i * i *
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24 interest rate (i) money 0 M D M S set M S or i * i *
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Banks hold accounts with RBA called ‘exchange settlement accounts’ The balance in the exchange settlement accounts are called ‘exchange settlement funds’ or cash The CASH RATE is the interest rate which brings together the supply and demand for exchange settlement funds into balance RBA uses OMO to influence the CASH RATE 25
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The RBA buying and selling short-term government bonds - Selling government bonds means bank reserves fall, as the buyers pay for them and draw on their bank deposits => cash rate rises - Buying government securities means bank reserves rise, as the RBA pays for them and the sellers deposit the proceeds in banks => cash rate falls Money supply is whatever is required to maintain the cash rate 26
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At its monthly meeting the RBA board decides what changes, if any, shall be made to the cash rate RBA then conducts ‘open market operations’ to achieve this rate RBA is also required to intervene on an ongoing basis to keep the cash rate at its target level Flow on to other interest rates => RBA can influence overall level of interest rates in economy 27
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Motives for holding money: Transactions Precautionary Speculative Determinants of the demand for money: Nominal interest rates Real incomes (GDP), prices Financial innovation Seasonal/policy impacts Money - cash and bank deposits (pays little or no interest) vs Other financial assets bonds, shares, property (pay positive rate of return)
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How much of their wealth will an individual hold in the form of money? Portfolio allocation decision Given wealth of $50,000, how is this allocated among various assets? Money, Bonds, Equities, Housing, etc.
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Risky assets need to pay a higher expected return to induce individuals to hold them. Benefits and Costs of Holding Money Main benefit from holding money is its usefulness in making transactions medium of exchange function Transactions demand for money can be affected by financial innovation eg. credit cards
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Many forms of money pay zero interest (currency) or very low rates of interest (transactions or demand accounts). There is an opportunity cost of holding money, which is the return that could have been earned by holding wealth in the form of other assets: Bonds pay a fixed amount of interest each period Equities pay dividends
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Assume: Money pays a zero nominal interest rate The (expected) nominal return on other assets is positive Represent the nominal interest rate on other assets by i Other things equal, an increase in the nominal interest rate will raise the opportunity cost of holding money and reduce the amount demanded
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The demand for money by households and firms is affected by three main factors:
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