ECON1002 · Introductory Macroeconomics
Money, Banking & the Reserve Bank
Money is the medium of exchange, unit of account and store of value, measured by aggregates M1 and M3. The quantity equation MV = PY delivers long-run money neutrality, and fractional-reserve banking creates deposits via the money multiplier 1/rr. The RBA sets the cash rate through open-market operations within an interest-rate corridor, bond prices move inversely to yields, and the policy reaction function (Taylor rule) sets the appropriate real rate.
It is examined as a money-multiplier calculation, a bond-price/yield direction question, and a policy-reaction-function computation of the real and nominal cash rate.
What this chapter covers
- 011. Functions of money (medium of exchange, unit of account, store of value); aggregates M1, M3
- 022. Quantity equation MV = PY; long-run money neutrality (%ΔM = %ΔP with V, Y fixed)
- 033. Fractional-reserve banking; money multiplier mm = 1/rr; ΔM = mm × ΔR
- 044. The RBA cash rate set via open-market operations (buy assets ⇒ rate falls)
- 055. The interest-rate corridor (target ± band); inflation target 2-3%
- 066. Bond price vs yield: P = Payoff/(1 + i); price falls when the interest rate rises
- 077. PAE and the real interest rate: lower r shifts PAE up, raises equilibrium Y
- 088. Policy reaction function (Taylor rule): r = 0.01 + 0.5·(output gap) + 0.5·(π − πᵀ); nominal i = r + π
Policy reaction function — the real and nominal cash rate
- 1 markSubstitute into the rule: r = 0.01 + 0.5 × 0.01 + 0.5 × (0.06 − 0.025) = 0.01 + 0.005 + 0.5 × 0.035.
- 1 markCompute the inflation-gap term and sum: 0.5 × 0.035 = 0.0175, so r = 0.01 + 0.005 + 0.0175 = 0.0325 = 3.25%.
- 1 markConvert to the nominal cash rate with Fisher: nominal i = r + π = 3.25% + 6% = 9.25%.
Key terms
- Monetary aggregates (M1, M3)
- Measures of the money supply by liquidity: currency plus current (cheque) deposits make up M1; M3 adds all other bank deposits. Broader aggregates include less-liquid forms of money.
- Quantity equation (MV = PY)
- The identity that the money stock M times its velocity V equals the price level P times real output Y. If V and Y are roughly constant in the long run, then %ΔM ≈ %ΔP — inflation is ultimately a monetary phenomenon and money is neutral.
- Money multiplier
- In fractional-reserve banking, an injection of reserves supports a larger increase in deposits: money = (1/rr) × reserves, so the multiplier is mm = 1/rr, where rr is the reserve-to-deposit ratio. A lower reserve ratio means more deposit creation.
- Cash rate & open-market operations
- The cash rate is the overnight interest rate the RBA targets. It is steered by open-market operations: buying assets adds reserves and pushes the cash rate down, selling assets drains reserves and pushes it up, kept within an interest-rate corridor.
- Bond price-yield relationship
- A bond's price is the present value of its payoff, P = Payoff/(1 + i), so price and yield move inversely: when market interest rates rise, existing bond prices fall, and vice versa.
- Policy reaction function (Taylor rule)
- A rule for the policy real rate that responds to the output gap and the inflation gap, e.g. r = 0.01 + 0.5·(output gap) + 0.5·(π − πᵀ). The nominal cash rate is then i = r + π. It formalises how the RBA leans against booms and inflation.
Money, Banking & the Reserve Bank FAQ
How is the money and RBA material examined in ECON1002?
Three recurring calculation types: a money-multiplier question (total deposits = (1/rr) × reserves), a bond-price/yield direction question (a higher cash rate means lower bill prices and higher yields), and a policy-reaction-function computation of the real then nominal cash rate. These appear on both the sample and past finals, plus concept MCQ on the functions of money and money neutrality.
How does the money multiplier create money?
When a bank receives a deposit it keeps a fraction rr as reserves and lends the rest; the loan is re-deposited, and the next bank lends most of that, and so on. The rounds sum to total deposits = (1/rr) × the initial reserves, so a $1 reserve injection supports $(1/rr) of deposits. With rr = 5%, the multiplier is 20, so $250 of reserves can support $5,000 of deposits.
Why do bond prices fall when interest rates rise?
Because a bond's price is the present value of its fixed future payoff: P = Payoff/(1 + i). When market interest rates i rise, that fixed payoff is discounted more heavily, so the price falls; when rates fall, the price rises. So an RBA tightening that pushes up the cash rate lowers the price of existing short-term bills and raises their yield.
What is money neutrality and when does it hold?
Money neutrality is the proposition that changes in the money supply affect only nominal variables (the price level) and not real output in the long run. It follows from the quantity equation MV = PY when V and Y are fixed, giving %ΔM = %ΔP. It is a long-run result: in the short run, with sticky prices, monetary policy does move real output (which is why the RBA can fight recessions).
Exam move
Drill the three calculation types separately. (1) Money multiplier: total deposits = (1/rr) × reserves — multiply by 1/rr, never by rr, and remember the initial deposit is part of the final total. (2) Bonds: anchor on P = Payoff/(1 + i) and the direction rule 'rate up ⇒ price down, yield up' so the MCQ is instant. (3) Policy reaction function: substitute the output gap and the inflation gap (π − πᵀ) with their 0.5 weights to get the REAL rate, then add ACTUAL inflation for the nominal rate. Keep one-line notes on money neutrality (%ΔM = %ΔP from MV = PY in the long run) and on how open-market operations move the cash rate, since those feed straight into the AD-AS chapter via the policy reaction function.
