This document discusses several topics related to money, inflation, and interest rates. It defines money as including notes, coins, bank deposits, and credit. It explains that inflation is a persistent rise in general price levels and discusses how Australia's inflation rate compares to other OECD countries. Interest rates are defined as the annual return on securities and payments for the use of funds. The document also outlines factors that influence money supply, inflation, and interest rates, such as government transactions, credit creation, and central bank actions.

1. TOPIC 5. MONEY,
INFLATION AND INTEREST
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2. FUNCTIONS
OF
MONEY
1. Medium of Exchange
2. Measure of Value
3. Store of Wealth
4. Standard for Deferred
Payment
2

3. 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.
3

4. 4

5. AUSTRALIA’S INFLATION
RATE COMPARED WITH THE
OECD AVERAGE
Compared with
Australia: 2.4%
in May 2011
(average
annualised
inflation,
compared with
May 2010)
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6. 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 $935; index
= 1.0695, inflation = 6.95%
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7. A basket of goods
and services
(ABS)
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8. THE INFLATION SPIRAL …..
As prices increase, business
costs also increase, so
businesses must increase
their prices to compensate.
Governments also must
increase taxes to cover their
costs. Both cause an upward
spiral of inflation ……
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9. With high inflation, money rapidly loses its
purchasing power. It is destabilising to the
economy and leads to loss of business
confidence and investment. This can cause a
collapse in a country’s monetary system. So a
major goal of government is to reduce inflation.
Reserve Bank of Australia
governor Glenn Stevens
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10. MONEY includes:
•notes and coins in
circulation (called M1)
•funds deposited in bank
and non-bank financial
institution accounts
•deposits of banks with the
RBA
•credit (lending) by banks,
or even the RBA, to the
private sector
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11. MAIN SOURCES OF CHANGE IN
THE MONEY SUPPLY …….
1. Government transactions – whether it is in surplus
or deficit.
But how is a deficit financed? …….
two methods that affect the money supply:
a. the Federal Govt issuing securities
b. borrowing from abroad
and some methods that don’t affect the money supply:
borrowing from banks, increasing taxes just after the
deficit period, and borrowing from the non-bank
sector (corporations, etc.)
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12. MAIN SOURCES OF CHANGE IN
THE MONEY SUPPLY …….
2. International transactions – from trade, investment
• Money flows of A$ 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

13. 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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14. 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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15. 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!)15

16. 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!)16

17. 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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18. Factors Determining Interest
Rates
1. degree of risk
2. inflation rate
3. administration costs
4. maturity term
5. degree of liquidity
6. expectations about future
interest rates
vs.
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19. RBA
OFFICIAL CASH
RATE (through
govt. bonds)
ALL OTHER INTEREST RATES
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