CH10 - The Monetary System Flashcards
meaning of money
the set of assets in an economy that people regularly use to buy goods and services from other people
3 functions of money
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
Legal tender def
a county’s official notes and coins / money approves in a country for paying
Liquidity def
the ease at which stores of wealth can be converted to the economy’s medium of exchange
what makes good money?
1- stability of value
2- convenience
2 kinds of money
1- commodity money: has intrinsic value
2- fiat money: no intrinsic value, backed by government
Money supply def
quantity of money available in the economy
money aggregates (differ based on liquidity)
“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- Term deposits: funds that can be withdrawn only after the term has ended
Structure of the BoC
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
Core functions of the BoC
(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)
Monetary policy def
The Bank of Canada has the power to increase or decrease the number of dollars in the economy -> make changes in the money supply
bank reserves and the reserve ratio
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
process of money creation
banks repeatedly accepting deposits and landing out a fraction of those deposits
money multiplier
he amount of money the banking system can generate with each dollar deposited
1 / R
run on banks
all loans are called in, everyone wants their currency back at the same time
BoC’s 3 tools of monetary control
1) changing the policy interest rate (main)
2) Open-market operations
3) reserve requirement
Policy interest rate (+what it affects)
=> 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.)
The overnight rate def
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
Open-market operations (+foreign exchange market operations + sterilization)
-> 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)
Reserve requirements
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
Problems with controlling the money supply
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