Chapter 24 Money, Price level, Inflation

Question 0

Means of payment

Answer 0

Is a method of settling a debt.

Question 1

Money

Answer 1

Any commodity or token that is generally acceptable as a means of payment.

Question 2

Money has three other functions:

Answer 2

• Medium of exchange
• Unit of account
• Store of value.

Question 3

Medium of Exchange

Answer 3

Object that is generally accepted in exchange for goods and services.

Question 4

Barter:

Answer 4

In absence of money, people would need to exchange goods and services directly. However, barter requires a double coincidence of wants, which is rare, so barter is costly.

Question 5

Unit of Account

Answer 5

Is an agreed measure for stating the prices of goods and services.

Question 6

Store of Value

Answer 6

money can be held for a time and later exchanged for goods and services.

Question 7

Money in Canada consists of:

Answer 7

• Currency

- Deposits at banks and other depository institutions.

Question 8

Currency:

Answer 8

Notes and coins held by individuals and businesses.

Question 9

Official Measures of Money

Answer 9

M1 and M2

Question 10

M1

Answer 10

Consists of currency held by individuals and businesses plus checkable deposits owned by individuals and businesses.

Question 11

M2

Answer 11

Consists of M1 plus all other deposits, non chequable deposits and fixed term deposits.

Question 12

Are M1 and M2 Really money?

Answer 12

All items in M1 are means of payment. They are money. Some savings deposits in M2 are not means of payments. They are called liquid assets.

Question 13

Liquidity

Answer 13

The property of being instantly convertible into a means of payment with little loss of value.
Deposits are money, but cheques are not. Cheques are instructions to a bank to transfer money.
Credit cares are not money either. Credit care enables the holder to obtain a loan, but it must be repaid with money.

Question 14

The banking System

Answer 14

The banking system consists of private and public institutions that create money and managed the nations monetary and payments system.
We divide these institutions into two parts:
-Depository institutions
-Bank of Canada.

Question 15

Depository institution

Answer 15

A firm that takes deposits from households and firms and makes loan to other household and firms.
Deposits at three institutions make up the nation’s money:
Chartered banks
Credit Unions and Caisses Populaires
Trust and Mortgage loan companies.

Question 16

Chartered Banks

Answer 16

Private firm, chartered under the Bank Act of 1992 to receive deposits and make loans.

Question 17

Credit Unions and caisses Populaires

Answer 17

Credit union is a cooperative that operates under the cooperative Credit Association Act of 1992 and that receives deposits from and makes loans to its members.

Question 18

Depository Institutions, What do they do

Answer 18

The goal of any bank is to maximize wealth of its owners. To achieve this objective, the interest rate at which it lends exceeds the interest rate it pays on deposits.
But the banks must balance profit and prudence:
Loans generate profit
Depositors must be able to obtain their funds when they want them.

Question 19

A chartered bank puts the depositor’s funds into four types of assets:

Answer 19

1. Reserves: notes and coins in its vault or its deposit at the Bank of Canada.
2. Liquid Assets: Canadian government Treasury bills and commercial bills.
3. Securities: longer term Canadian government bonds and other bonds such as mortgage backed securities
4. Loans: commitments of fixed amounts of money for agreed upon periods of time.

Question 20

Economic Benefits Provided by Depository Institutions

Answer 20

Depository Institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans.

Question 21

Four benefits that depository institutions provide:

Answer 21

1. Create Liquidity
2. Pool risk
3. Lower the cost of borrowing
4. Lower the cost of monitoring borrowers.

Question 22

The Bank of Canada.

Definition: Central Bank

Answer 22

Is the central bank of Canada.
Central bank is the public authority that regulates a nation's depository institutions and control the quantity of money.
The Bank of Canada is:
-Banker to the banks and government
-Lender of last resort
-Sole issuer of bank notes

Question 23

Banker to Banks and Governements

Answer 23

The Bank of Canada accepts deposits from depository institutions that make up the payments system and the government of Canada.

Question 24

Lender of Last Resort

Answer 24

Bank of Canada is the lender of last resort, meaning that it stands ready to make loans when the banking system as a whole is short of reserves.
Banks lend and borrow reserves from other banks in the overnight loans market.

Question 25

Sole Issuer of Bank notes:

Answer 25

Bank of Canada is the only bank that is permitted to issue bank notes. The Bank of Canada has a monopoly on this activity.

Question 26

Bank of Canada’s Balance Sheet

Answer 26

Bank of Canada’s assets are government securities and last resort loans to banks. Its liabilities are Bank of Canada notes and deposits of banks and the government.

Question 27

Bank of Canada’s Balance Sheet:

Answer 27

The Bank’s balance sheet, the largest and most important asset is Canadian government securities. The most important liabilities are Bank of Canada notes in circulation and banks’ deposits.

Question 28

Monetary Base:

Answer 28

Liabilities of the Bank of Canada (& coins issued by the Canadian Mint) form the monetary base.
The monetary base is the sum of Bank of Canada notes outside the BAnk of Canada, banks’ deposits at the Bank of Canada and coins held by households, firms, and banks.

Question 29

Open market operation:

Answer 29

To change the monetary base, so the Bank of Canada conducts an open market operation, which is the purchase or sale of government of Canada securities by the Bank of Canada in the open market.

Question 30

Open Market Operations:

Answer 30

Is the purchase or sale of government securities by the Bank of Canada from or to a chartered bank or the public. When the Bank of Canada buys securities, it pays for them with newly created reserves held by the banks. When the bank of CAnada sells securities, they are paid for with reserves held by the banks. So open market operations influence bank reserves.

Question 31

How Banks Create Money: By creating deposits by making loans.

Answer 31

Banks create deposits when they make loans and the new deposits created are new money.
The quantity of deposits that banks can create is limited by three factors:
1. monetary base
2. Desired reserves
3. Desired currency holding

Question 32

How Banks Create Money: Monetary Base

Answer 32

The monetary base is the sum of Bank of Canada notes, coins and banks’ deposits at the Bank of Canada. Size of the monetary base limits the total quantity of money that the banking system can create because:

1. Banks have desired reserves.
2. Households and firms have desired currency holdings.

Both these desired holdings of monetary base depend on the quantity of money.

Question 33

Desired Reserves:

Answer 33

A bank’s actual reserves consists of notes and coins in its vault and its deposit at the Bank of Canada.

Question 34

Desired reserve Ratio:

Answer 34

Is the ratio of the bank’s reserves to total deposits that a bank plans to hold.
The desired reserve ratio exceeds the required reserve ratio by the amount that the bank determines to be prudent for its daily business.

Question 35

Desired currency holding:

Answer 35

People hold some fraction of their money as currency. So when the total quantity of money increases, so does the quantity of currency that people plan to hold. Because desired currency holding increases when deposits increase, currency leaves the banks when they make loans and increase deposits.

Question 36

Currency drain:

Answer 36

Is the leakage of reserves into currency. The ratio of currency to deposits is the currency drain ratio.

Question 37

Money Creation Process:

Answer 37

Begins with an increase in the monetary base. Bank of Canada conducts and open market operation in which it buys securities from banks. Bank of Canada pays for the securities with newly created bank reserves. Banks now have more reserves but the same amount of deposits so they have excess reserves.
Excess reserves = Actual reserves - Desired reserves.

Question 38

Money Multiplier:

Answer 38

Ratio of the change in the quantity of money to the change in the monetary base. Quantity of money created depends on the desired reserve ratio and the currency drain ratio. The smaller these ratios, the larger is the money multiplier.

Question 39

Influences on Money holding:

Answer 39

The quantity of money that people plan to hold depends on four main factors:

1. Price level
2. Nominal Interest rate
3. Real GDP
4. Financial innovation

Question 40

Price Level

Answer 40

Rise in the price level increases the quantity of nominal money, but doesn’t change the quantity of real money that people plan to hold.
Nominal Money is the amount of money measured in dollars:
Real money = Nominal \ Price Level.

Question 41

Nominal Interest Rate

Answer 41

Opportunity cost of holding wealth in the form of money rather than an interest bearing asset. Rise in the nominal interest rate on other assets decreases the quantity of real money that people plan to hold.

Question 42

Real GDP

Answer 42

An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.

Question 43

Financial innovation:

Answer 43

Lowers the cost of switching between money and interest bearing assets decreases the quantity of real money that people plan to hold.

Question 44

Demand for Money:

Answer 44

Relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same.

Question 45

Quantity Theory of Money

Answer 45

Proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level. Quantity theory of money is based on the velocity of circulation and the equation of exchange.

Question 46

Velocity of circulation:

Answer 46

Average number of times in a year a dollar is used to purchase goods and services in GDP.