CH10 - The Monetary System

Question 1

meaning of money

Answer 1

the set of assets in an economy that people regularly use to buy goods and services from other people

Question 2

3 functions of money

Answer 2

1) Medium of exchange = An item used to purchase goods and services (given by buyers to sellers)

2) Store of value = One item that people can use to transfer purchasing power from the present to the future

3) Unit of account = The standard/yardstick people use to post prices and record debts

Question 3

Legal tender def

Answer 3

a county’s official notes and coins / money approves in a country for paying

Question 4

Liquidity def

Answer 4

the ease at which stores of wealth can be converted to the economy’s medium of exchange

Question 5

what makes good money?

Answer 5

1- stability of value
2- convenience

Question 6

2 kinds of money

Answer 6

1- commodity money: has intrinsic value
2- fiat money: no intrinsic value, backed by government

Question 7

Money supply def

Answer 7

quantity of money available in the economy

Question 8

money aggregates (differ based on liquidity)

Answer 8

“Monetary base” or (“hard money”) - most liquid
- Currency in circulation plus bank reserves

M1+: Currency in circulation plus checkable deposit accounts

M2: M1+ plus non-checkable deposit accounts plus notice deposits

Notice deposits: funds that require advance notice prior to withdrawal

M3: least liquid
- M2 plus term deposits plus foreign-currency deposits of residents
- Term deposits: funds that can be withdrawn only after the term has ended

Question 9

Structure of the BoC

Answer 9

Managed by a Board of Directors, composed of the Governor, Senior Deputy Governor, 12 outside directors, and the Deputy Minister of Finance (ex officio non-voting member)
- The 12 outside directors are appointed by the Cabinet for 3-year terms
- The Governor and Senior Deputy Governor are appointed by the outside directors with the approval of the Cabinet, for a 7-year term

Question 10

Core functions of the BoC

Answer 10

(Issue) currency – design and issue bank notes

Financial system – banker to the commercial banks and oversight of payments systems

Funds Management – banker to the Canadian government

Monetary policy – manage the money supply / interest rates (most important)

Question 11

Monetary policy def

Answer 11

The Bank of Canada has the power to increase or decrease the number of dollars in the economy -> make changes in the money supply

Question 12

bank reserves and the reserve ratio

Answer 12

reserve = money that banks keep on hand to meet daily requests for cash (not loaned out)
reserve ratio = fraction/percentage/share of the demand deposits that banks hold as cash reserves

Question 13

process of money creation

Answer 13

banks repeatedly accepting deposits and landing out a fraction of those deposits

Question 14

money multiplier

Answer 14

he amount of money the banking system can generate with each dollar deposited
1 / R

Question 15

run on banks

Answer 15

all loans are called in, everyone wants their currency back at the same time

Question 16

BoC’s 3 tools of monetary control

Answer 16

1) changing the policy interest rate (main)
2) Open-market operations
3) reserve requirement

Question 17

Policy interest rate (+what it affects)

Answer 17

=> When output or inflation deviate from desired levels, central banks raise or lower the rate used for one-day or “overnight” loans between financial institutions
=> Lower interest rates increase AD; higher interest rates reduce AD
Affect:
-> prime rate (interest rate commercial banks charge their most creditworthy customers)
-> ripple effect on interest rates (bonds, mortgages, etc.)

Question 18

The overnight rate def

Answer 18

The overnight rate is the interest rate charged for one-day or “overnight” loans between major financial institutions

Financial institutions assess their need for liquidity on a daily basis

Financial institutions are required to settle outstanding balances with each other at the end of each day
-> They do so by routinely borrowing and lending money “overnight” among themselves
-> They may also borrow money from, or deposit excess cash with, the central bank

Question 19

Open-market operations (+foreign exchange market operations + sterilization)

Answer 19

-> buying or selling government bonds
buying bonds: increases the stock of money held by the public => downward pressure on interest rates
selling bonds: upward pressure on interest rates

Foreign exchange market operations : buying (increase M) or selling (decrease) foreign currencies

Sterilization: the process of offsetting foreign exchange market operations with open-market operations, so that the effects on the money supply cancel out (buying USD and selling gov bonds)

Question 20

Reserve requirements

Answer 20

regulations on the minimum amount of reserves that banks must hold against deposits, R

An increase in R means that banks must hold more in reserves, and thus can loan less which reduces the money multiplier and decreases the money supply

Question 21

Problems with controlling the money supply

Answer 21

The BoC’s control of the money supply is not precise

It must wrestle with two problems that arise due to fractional reserve banking

The BoC does not control the amount of money that:
=> Households choose to deposit in banks
- The more people deposit, the more money banking systems can create
- If people lose confidence in the banking system and withdraw deposits, the money supply will fall

=> Commercial bankers choose to lend
- They may choose to hold excess reserves
- If bankers become more cautious about economic conditions and reduce lending, the money supply will fall