ECON30005 Money and Banking

How ECON30005 is assessed

What ECON30005 covers

The subject runs across a 12-week semester in teaching order, from what money is and how it is measured through to central banking, the GFC and the international monetary system.

Continuous assessment — weekly Canvas quizzes, tutorial participation and two group assignments — carries 40%, while a 2-hour closed-book examination in the examination period carries 60% and must be passed on its own (a 50% hurdle) to pass the subject, so your WAM in ECON30005 turns on exam mastery.

Use SWOTVAC to drill the OLG, Diamond-Dybvig and Taylor-rule models that recur across true/false, short essays and the worked question.

It follows one through-line — how the financial system channels savings into intermediation, credit and money creation, liquidity provision, and ultimately investment, inflation and output — across four blocks.

Weeks 1-3 build the theory of money: its three functions and evolution, the measurement of monetary aggregates (US M1/M2 and the RBA's currency/M1/M3/broad money), the quantity theory MV=PY and Keynesian money demand, and the overlapping-generations (OLG) model that delivers long-run money neutrality alongside short-run non-neutrality and the economics of inflation and hyperinflation.

Weeks 4-6 turn to banking and intermediation: why asymmetric information (adverse selection and moral hazard) makes intermediaries necessary, how banks create money by lending, the money multiplier 1/(required reserve ratio), banking risk and Basel-style regulation, the costly-state-verification model of the optimal debt contract, and the Diamond-Dybvig model of liquidity insurance and self-fulfilling bank runs.

Weeks 7-8 cover central banking and monetary policy: the toolkit (open-market operations, interest on reserves, the policy rate), the Taylor rule, the monetary transmission mechanism, the New Keynesian model, inflation targeting and time-inconsistency.

Weeks 9-11 close with financial crises and the international system: the global financial crisis and securitisation, exchange rates and the policy trilemma, and emerging-market twin crises. This subject is decided by its final exam.

Continuous assessment — tutorial participation (10%), weekly pre-tutorial Canvas quizzes (10%) and two group assignments (10% each) — carries 40%, and a 2-hour closed-book end-of-semester examination worth 60% carries a hurdle: you must score at least 50% on the final exam itself to pass the subject, however well you did on the coursework.

The exam runs three sections (true/false, short essays and a worked model) and a Casio FX82 calculator is permitted. Confirm the current assessment structure, weights and exam timing on Canvas and the UniMelb Subject Guide; your ECON30005 result feeds the Weighted Average Mark (WAM) that later economics subjects build on.

Worked example · free

The costly-state-verification optimal debt contract (Section 3 archetype)

Key terms

Quantity theory of money (MV = PY)

The equation of exchange: money supply M times velocity V equals the price level P times real output Y. Always true as an identity; it becomes a theory of inflation once V is assumed stable and Y is at potential, giving π ≈ money growth − output growth.

Money neutrality

The proposition that a one-off, permanent change in the money supply changes only nominal variables (the price level rises equiproportionately) and leaves real variables — output, capital, the real interest rate — unchanged. It holds in the long run in the OLG model; short-run non-neutrality can arise from unanticipated injections.

Money multiplier

The maximum expansion of deposits from an injection of reserves in the textbook model: 1/(required reserve ratio). A ceiling, not a mechanism — the modern view is that bank lending creates deposits and reserves adjust, and several economies (including Australia) have no reserve requirement.

Diamond-Dybvig demand-deposit contract

A contract (c1, c2) that pools depositors' funds to insure against idiosyncratic liquidity shocks: impatient depositors withdraw c1 in period 1, patient depositors receive c2 in period 2, with the optimum characterised by u′(c1) = βR·u′(c2) and satisfying 1 < c1 < c2 < R. It creates liquidity but admits a self-fulfilling bank-run equilibrium under sequential service.

Taylor rule

A monetary-policy reaction function: i = π + r* + w_π(π − π*) + w_y(y − y*). The Taylor principle requires w_π > 0 so nominal rates rise more than one-for-one with inflation, raising the real rate to stabilise inflation.

Policy trilemma (impossible trinity)

A country can have only two of: a fixed exchange rate, free capital mobility and independent monetary policy. Fixing the rate with open capital markets forces the domestic policy rate to track the anchor country's, so monetary independence is lost.

ECON30005 FAQ

Questions students ask in each ECON30005 chapter

How is money different from wealth or income?

Money is the narrow set of things generally accepted in payment — currency and spendable deposits. Wealth is a stock of all stores of value (money plus bonds, shares, property), and income is a flow received per period. A statement that 'a rich person has a lot of money' confuses wealth with money; in this subject money is the means of payment, not net worth. Chapter 01 · Money: Definitions, Functions and Evolution

Why is MV = PY an identity but the quantity theory a theory?

MV = PY is true by construction: velocity is defined as PY/M, so the equation always holds. It becomes the quantity theory of money — a theory of inflation — only once you add assumptions: that velocity is stable (set by transaction institutions) and that real output is at its full-employment level. Under those assumptions changes in the money supply map into proportional changes in the price level. Chapter 02 · Money Demand and the Quantity Theory of Money

Why does a permanent money increase leave the real economy unchanged?

Because steady-state capital per worker is determined by preferences and technology (θ, α, A) and contains no money term. Since capital pins down the real wage and the real interest rate, those are unchanged too, and with the real goods the young sell fixed, the price level P = M/[N(w − k)] simply scales with M. Nominal money and prices rise together, so real balances and every real variable are unchanged. That is long-run neutrality. Chapter 03 · A Simple OLG Model with Money and Money Neutrality

How can money be neutral in the long run but not the short run?

In the long run a permanent, anticipated money increase scales all prices and leaves real variables unchanged — neutrality. In the short run an unanticipated injection can have real effects because behaviour was set before the surprise: in the OLG model the current old are stuck holding money that now buys less, so they lose while the recipient of the new money gains. Whether output moves depends on who receives the injection — a subsidy to the young raises their capital and temporarily lifts output. Chapter 04 · Inflation: Short-Run Non-Neutrality, Costs and Hyperinflation

What is the difference between adverse selection and moral hazard?

Timing. Adverse selection happens before the loan is made: because borrowers know their own type and lenders do not, the applicant pool is skewed toward the riskiest projects (the lemons problem). Moral hazard happens after the loan is made: once the borrower has the money, they may take hidden actions that raise the chance of default. Banks fight selection with screening, collateral and covenants, and hazard with monitoring and covenants. Chapter 05 · Banking and Financial Intermediation

How can banks 'create' money just by lending?

When a bank approves a loan it does not hand over someone else's cash; it credits the borrower's deposit account, creating a new deposit and a matching loan asset at the same instant. Since deposits are money, the money supply rises by the loan amount. If the borrower spends the money at another bank, reserves move between banks but the deposit stays in the system, so the money stays created. This 'loans create deposits' view is how modern money creation actually works. Chapter 06 · Money Creation Through Banking

Why is bank capital so important?

Capital is the buffer that absorbs losses before depositors and other creditors are hit. When loans go bad, the losses first reduce equity; only if losses exceed capital does the bank become insolvent. So a well-capitalised bank can weather a downturn, while a thinly capitalised one fails at the first shock. The trade-off is that more capital lowers return on equity, which is why banks resist holding it and why regulators mandate minimums. Chapter 07 · Banking Risk and Financial Regulation

Why does the bank contract make everyone better off than going it alone?

Because savers are risk-averse and do not know in advance whether they will be impatient or patient. Under autarky an impatient saver is stuck with the low early-liquidation value 1 and a patient saver gets the full R, a risky spread. The bank pools funds and offers (c1, c2) with 1 < c1 < c2 < R, raising the low outcome and lowering the high one. Since the depositor values the smoother allocation, expected utility is higher ex ante — that is liquidity insurance. Chapter 08 · The Diamond-Dybvig Model of Bank Runs

How does a central bank actually set the policy rate?

By managing the market for reserves. In a corridor or floor system the central bank uses open-market operations (mostly repos and reverse repos) to adjust reserve supply, and it sets standing-facility rates — interest on reserves as a floor and the discount rate as a ceiling — so that the overnight interbank rate settles at target. It does not decree the rate directly; it makes the target rate the market-clearing rate for reserves. Chapter 09 · Central Banking and the Tools of Monetary Policy

Why do expectations matter so much in the New Keynesian model?

Because both key equations are forward-looking. In the Phillips curve, firms that can reset their price only occasionally set it based on expected future inflation, so with β near one a change in expected inflation passes almost one-for-one into current inflation. In the IS curve, forward-looking households base spending on the whole expected path of real rates. Iterating the equations makes today's output and inflation depend on the entire expected future, which is why credibility and commitment are decisive. Chapter 10 · Monetary Transmission, Expectations and Inflation Targeting

How did securitisation change banking before the GFC?

It shifted banking from originate-to-hold to originate-to-distribute. Traditionally a bank kept the loans it made, bore the credit risk, and therefore screened borrowers carefully. Securitisation let banks pool loans, tranche them, and sell them as MBS and CDOs, which freed funding, transferred risk to investors and cut regulatory capital. But because originators no longer held the risk, their incentive to screen and monitor weakened, and strong investor demand for highly rated products fuelled lax underwriting and excess lending — especially subprime — setting up the crisis. Chapter 11 · The Global Financial Crisis: Securitisation and Shadow Banking

How can a currency depreciate in nominal terms but appreciate in real terms?

Because the real exchange rate also depends on relative prices: e_R = e·P/P*, so %Δe_R = %Δe + π − π*. If domestic inflation exceeds foreign inflation by more than the nominal depreciation, the real exchange rate rises even though the nominal rate fell. For example a 6% nominal depreciation with domestic inflation 10 points above foreign inflation gives a 4% real appreciation. The lesson is that competitiveness depends on the real, not the nominal, exchange rate. Chapter 12 · Exchange Rates and the International Financial System

Why does foreign-currency debt make a depreciation so dangerous?

Because it creates a currency mismatch. A bank or firm with unhedged foreign-currency debt but domestic-currency assets sees the domestic value of its liabilities jump when the currency depreciates, while its assets do not keep pace. Net worth can go from positive to negative purely from the exchange-rate move, turning a currency crisis into a banking crisis. This is the core reason the Asian crisis, with heavy short-term dollar borrowing under pegs, was so destructive. Chapter 13 · Emerging-Market Crises: The Asian and Twin Crises

How to study for the exam

Treat ECON30005 as a small set of models you can reproduce under pressure rather than a reading subject, and rehearse them weekly rather than in SWOTVAC.

Build a one-page derivation sheet for the three exam-critical models — the OLG money model (budget constraints, the money-demand equation m/P = θ(1 + 1/i)w, price determination P = M/[N(w − k)], and why steady-state capital does not depend on M), the costly-state-verification contract (zero-profit condition, solving for D, the lending rate D/B, and the net-worth comparative static), and Diamond-Dybvig (the resource constraint, the FOC u′(c1) = βR·u′(c2) and the ordering 1 < c1 < c2 < R) — and redo each from a blank page every week.

Drill the small calculations that recur in true/false and short essays: the exact nominal rate (1 + i) = (1 + r)(1 + π) versus the Fisher approximation, the money multiplier 1/rr, the Taylor rule, and PPP real-versus-nominal depreciation.

For the short-essay section, practise structured mark-by-mark answers (why intermediation exposes banks to risk; how securitisation changed banking pre-GFC; the Asian-crisis current-account reversal) — two to four scorable points each. Because the exam carries a 50% hurdle, cover breadth first so you can attempt every question, then deepen the models you find hardest.

When a step will not click, ask Sia to explain that single step a different way and set you a fresh practice question in the same style; it teaches the method and checks your reasoning, and it never substitutes for your own graded work. Confirm the exam date, room and permitted materials on Canvas and the University of Melbourne exam timetable.

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