Chapter 10 Flashcards
THE MEANING OF MONEY
Money is the set of assets in the economy that people regularly use to buy goods and services from other people.
The Functions of Money
Medium of exchange is an item that buyers give to sellers when they want to purchase goods or services.
Unit of account is the yardstick people use to post prices and record debts.
Store of value is an item that people can use to transfer purchasing power from the present to the future.
- Wealth is the total of all stores of value, including both monetary and non-monetary assets.
- Liquidity describes the ease with which an asset can be converted into a medium of exchange.
Money is the most liquid of assets.
The Kinds of Money
Commodity money is money that takes the form of a commodity with intrinsic value.
The term intrinsic value means that the item would have value even if it were not used as money. One example of commodity money is gold.
Fiat money is money without intrinsic value that is accepted as money because of government decree.
Example is money in wallet vs. monopoly money, money in wallet is accepted as it was declared by government.
Money in the Canadian Economy
The quantity of money circulating in the economy is called the money stock.
- It has a powerful influence on many economic variables.
Currency is the paper bills and coins in the hands of the public.
Demand deposits are the balances in bank accounts that the depositors can access on demand by writing a cheque or using a debit card.
THE BANK OF CANADA
The Bank of Canada (BoC) is the central bank of Canada.
Central bank is an institution designed to regulate the quantity of money in the economy.
The Bank of Canada Act
Prior to the 1930s:
- Bank notes were issued by the Department of Finance and the commercial banks.
- Canada was on the gold standard.
With the collapse of the gold standard as a result of the Great Depression, a need arose to control the quantity of fiat money in the economy.
The Bank of Canada Act (cont’d)
The government enacted the Bank of Canada Act in 1934.
The BoC was established in 1935 and nationalized in 1938.
The BoC is managed by a board of directors, including:
* The governor, the senior deputy governor, and 12 directors, including the deputy minister of finance.
The current governor of the BoC is Tiff Macklem.
In practice, the BoC is independent of the government.
The Bank of Canada Act (cont’d)
The primary responsibility of the BoC is to act in the national interest.
The BoC has four main functions:
- issue currency
- banker to the commercial banks
- banker to the Canadian government
- control the money supply
Money supply and monetary policy
Money supply is the quantity of money available in the economy.
Monetary policy is the setting of the money supply by policymakers in the central bank.
Monetary Policy
The Bank of Canada:
* has the power to increase or decrease the number of dollars in the economy
* is an important institution because changes in the money supply can profoundly affect the economy
FIGURE 10.1 Two Measures of the Money Stock for the Canadian Economy
Two important measures of the money stock are what the Bank of Canada defines as M1+ and M2.
M1 is the chequable deposits taking the majority of the bar and currency taking up a sliver of the bar
M2 is everything in M1 + Nonpersonal demand and notice deposits + a couple minor categories
Obviously M2 is larger as it includes M1
COMMERCIAL BANKS AND THE MONEY SUPPLY
Although the Bank of Canada alone is responsible for Canadian monetary policy, the central bank can control the supply of money only through its influence on the entire banking system.
What is the role played by commercial banks (which include credit unions, caisses populaires (French equal to credit union), and trust companies) in the monetary system?
The Simple Case of 100 Percent-Reserve Banking
Assumptions:
* Currency is the only form of money.
* The initial supply of money is $100.
* Now suppose someone opens a bank: First National Bank.
* All deposits received by First National Bank are held as reserves: 100 percent-reserve banking.
Reserves are deposits that banks have received but have not loaned out.
The Simple Case of 100 Percent-Reserve Banking: T Accounts
Using a T-account to show changes in the bank’s assets and liabilities.
The T-account for First National Bank if the economy’s entire $100 of money is deposited in the bank:
On the left-hand side of the T-account are the bank’s assets of $100 (the reserves it holds in its vaults).
On the right-hand side of the T-account are the bank’s liabilities of $100 (the amount it owes to its depositors).
Each deposit in the bank reduces currency and raises demand deposits by exactly the same amount, leaving the money supply unchanged.
Thus, if banks hold all deposits in reserve, banks do not influence the supply of money.
Money Creation with Fractional-Reserve Banking
Fractional-reserve banking is a banking system in which banks hold only a fraction of deposits as reserves.
Reserve ratio is the fraction of deposits that banks hold as reserves.
Assuming a reserve ratio of 10 percent …
They work with other banks for loaning and such, so each bank can have a rate and each rate applies to the deposit amount from one bank to another
Fractional-Reserve Banking: T Accounts
The money supply (currency + deposits) = $100 + $90 = $190
When banks hold only a fraction of deposits in reserve, banks create money!
Let’s suppose that First National has a reserve ratio of 10 percent. This means that it keeps 10 percent of its deposits in reserve and loans out the rest.
First National still has $100 in liabilities because making the loans did not alter the bank’s obligation to its depositors. (right side of account or T)
But now the bank has two kinds of assets:
* $10 of reserves in its vault
* loans of $90
Fractional-Reserve Banking Bank 2
The creation of money does not stop with First National Bank.
Lets look at the $90 loan from bank 1 to bank 2
So now bank 2 has a deposit liability of $90
The assest side uses the 10% and reserves $9 and loans out $81
The money supply (currency + deposits) = $100 + $90 + $81 = $271
Fractional-Reserve Banking Bank 3
Bank 3 gets the $81 deposit that bank 2 loans out
Using the same reserve ratio of 10% they have $8.1 reserved and $72.90 loaned out
The money supply = $100 + $90 + $81+ $72.90 = $343.90
Overall Bank Calcs Added Up
Original Deposit = $100
First Bank Lending = $90 (1-0.10) * 100
Second Bank Lending = $81 (0.9 * 90)
Third Bank Lending = $72.90 (0.9 * 81)
Forth Bank Lending = $65.61 (0.9 * 72.90)
So on and so forth you end up at $1000 created in this economy
The Money Multiplier
Money multiplier is the amount of money the banking system generates with each dollar it receives.
In the previous example, where the $100 of reserves generates $1000 of money, the money multiplier is 10.
The money multiplier is the reciprocal of the reserve ratio.
The ratio is 1/r
It turns out that even though this process of money creation can continue forever, it does not create an infinite amount of money
The Bank of Canada’s Tools of Monetary Control
Central banks have three main tools for monetary control:
1. Changing the overnight rate:
* Overnight rate is the interest rate on very short-term loans between commercial banks.
* Bank rate is the interest rate charged by the Bank of Canada on loans to the commercial banks.
2. Open-market operations
3. Changing reserve requirements
Changing the Overnight Rate Tool #1
The BoC can alter the money supply by changing the bank rate, causing an equal change in the overnight rate.
A higher overnight rate discourages banks from borrowing reserves from the BoC, thus reducing reserves in the banking system (i.e., the money supply contracts).
Changes to the overnight rate are posted eight times a year.
The BoC can also change the overnight rate at any time, if extraordinary action is needed.
FIGURE 10.2 The Bank of Canada’s Overnight Rate since 2008
At the beginning of 2008, the Bank of Canada quickly reduced the overnight rate in response to a recession.
Signs of economic recovery saw the Bank increase the overnight rate in 2010.
Renewed concern over the possibility of recession prompted the Bank to reduce the overnight rate beginning in January 2015.
The effects of the COVID-19 pandemic in early 2020 prompted an extraordinarily rapid reduction in the overnight rate.
Open-market operations Tool #2
Open-market operations is the purchase or sale of Government of Canada bonds by the Bank of Canada.
- To increase the money supply, the BoC buys bonds (or/and Treasury bills) from the public.
- To reduce the money supply, the BoC sells bonds (or/and Treasury bills) to the public.
Quantitative easing is the purchase and sale by the central bank of nongovernment securities or government securities with long maturity terms.
**Foreign exchange market operations **is the purchase or sale of foreign money by the Bank of Canada.
- If the Bank of Canada buys $100 M U.S. in the foreign exchange market for $150 M Canadian, the Canadian money supply increases immediately by $150 M.
- If the Bank of Canada sells foreign currency from its foreign exchange reserves, it receives in exchange Canadian dollars, and the Canadian money supply is reduced.
Open-Market Operations: Sterilization and Reserve Requirements
Sterilization is the process of offsetting foreign exchange market operations with open-market operations, so that the effect on the money supply is cancelled out.
Reserve requirements are the regulations on the minimum amount of reserves that banks must hold against deposits.
- An increase means that banks must hold more reserves.
- It raises the reserve ratio.
- This lowers the money multiplier.
- The money supply decreases.
Problems in Controlling the Money Supply
The BoC does not control the amount of money households choose to hold as deposits in banks.
The BoC does not control the amount of money banks choose to lend.
