Chapter 4 - Assets, Wealth and Money Flashcards
Explain Assets, Wealth and Money, What happens if income is greater or less than consumption?
Assets are used to accumulate Wealth.
Wealth is used to transfer consumption over time, i.e., to smooth out consumption path over time (maintaining a stable lifestyle), as income generally fluctuates.
If Income > Consumption → Buy assets → Wealth ↑
If Income < Consumption → Sell assets → Wealth ↓
Assets include money, gold, bonds, shares, land, buildings, and machinery.
Money is one form of stock of assets that can be readily used to make transactions.
What are the three primary functions of money?
Functions of Money:
Money serves as a unit of account:
Prices of all goods and services, wages, rents, etc., are measured in terms of money (relative prices).
Money serves as a medium of exchange for transactions:
In the absence of money, a barter economy would be needed, but this requires a double coincidence of wants.
Money serves as a store of value (an asset to store wealth):
However, it is an imperfect store of value because it does not pay a return and loses value when there is inflation.
What are the two main types of money and how do they differ?
Types of Money:
Commodity Money:
Money with intrinsic value, examples include:
Gold under the gold standard (convertible to gold in certain countries)
Gold, silver, and copper coins used in the past
Cigarettes in prisons
Stone wheels in Yap (a small island in the Pacific)
Fiat Money:
Money with no intrinsic value, examples include:
Paper money
Potentially digital money in the future
What is the money supply, and how does the Bank of Canada control it?
Money Supply and
Monetary Policies:
Money supply: The quantity of money available in the economy.
Influenced by: central bank, banking system, and the public.
Monetary policies: Conducted by the country’s central bank.
Bank of Canada’s Tools to Control Money Supply:
Open-market operations
Affecting the overnight rate
Deposit-switching
What tools does the Bank of Canada use to control the money supply, and how do they work?
Central Bank and Monetary Policies:
The Bank of Canada uses three main tools to control the money supply:
Open-market operations:
Buying government bonds increases money supply (expansionary policy).
Selling government bonds decreases money supply (contractionary policy).
Affecting the overnight rate:
Adjusting the interest rate on loans to commercial banks to influence overall borrowing costs.
Deposit-switching:
Moving funds between the government’s account at the Bank of Canada and commercial banks to influence bank reserves.
What components make up the M1 measure of Canadian money supply?
M1 is defined as Currency + Demand Deposits.
M1 = Currency + Demand Deposits
This includes: M1 =
Currency (cash) in circulation
+ Personal chequing accounts at chartered banks
+ Current accounts at chartered banks
What additional components are included in the M2 measure of Canadian money supply?
M2 is defined as M1 + Time Deposits (Saving Accounts)
M2 = M1 + Time Deposits (Saving Accounts)
This includes:
M1 (which is Currency + Demand Deposits)
+ Personal saving accounts at chartered banks (like GICs in Canada or CDs in the US)
+ Non-personal notice deposits at chartered banks
- Excludes interbank deposits
What additional components are included in the M3 measure of Canadian money supply?
M3 = M2 + additional deposits
M3 is defined as M2 + additional deposits, including:
M2 (which includes M1 + Personal Savings + Non-personal notice deposits)
Non-personal fixed term deposits of firms at chartered banks
Foreign currency deposits (booked in Canada) at chartered banks
As of March 2019, M3 was valued at $2468 billion.
What components are added in the M2+ measure of the Canadian money supply?
Different Measures of Canadian Money Supply:
M2+ = M2 + all deposits and shares at:
M2+ includes M2 plus all deposits and shares at:
Trust funds
Mortgage loan companies
Credit unions and Caisse Populaire
Government financial institutions
Individual annuities at life insurance companies
Money market mutual funds
…
What is the difference between 100-percent-reserve banking and fractional-reserve banking?
Money Supply:
Reserves (R): Portion of deposits banks hold and do not lend out.
Bank liabilities: Deposits.
Bank assets: Reserves and outstanding loans.
100-percent-reserve banking: System where banks hold all deposits as reserves.
Fractional-reserve banking: System where banks hold only a fraction of deposits as reserves.
In this system, banks create money by lending, but they do not create wealth. When banks lend, they create new money for borrowers but also create new debt of equal value.
What are the key assumptions in determining the money supply, specifically concerning reserve and cash-deposit ratios? formulas for ratios?
Combined Banks: All commercial banks are considered as one unit (or assumed to be a single bank).
Reserve-Deposit Ratio (rr):
Formula: rr = Reserves/Deposits = R/D
Depends on central bank and commercial bank policies.
Required reserve ratio (rr_min): Minimum reserve ratio set by the central bank, where rr > rrmin
Cash-Deposit Ratio (cr):
Formula: cr = Cash Deposits = C/D
Determined by household preferences for holding cash.
Central Bank Role: Acts as the banker to commercial banks, providing loans and accepting deposits.
Example 1: Open Market Operation Scenario
Scenario: The Central Bank buys $1000 in bonds from a person, which impacts the commercial bank’s balance sheet.
Cash-deposit ratio (cr)= People don’t hold cash.
Reserve-deposit ratio (rr)=1: 100% reserve banking.
Question:
What are the values for Deposits and Reserves on the commercial bank’s balance sheet after this transaction?
Given that the reserve-deposit ratio is 100%, what is the implication for loans?
Answer:
Deposits = $1000
Reserves = $1000
Since the reserve-deposit ratio is 100% (rr = 1), the bank holds all deposits as reserves, meaning no loans are made.
EXAMPLE 2: Open Market Operation Scenario
Scenario: The central bank buys $1000 in bonds from a person.
Given the following:
Cash-deposit ratio (cr) = 0 (people do not hold cash)
Reserve-deposit ratio (rr) = 20% (banks hold 20% of deposits as reserves)
Question:
What will the balance sheets look like at each stage as the banking system adjusts?
What are the final totals for reserves, loans, and deposits after multiple rounds?
First Round
Deposits = $1,000 (initial injection)
Reserves = rr×Deposits = 0.2×1,000 = 200
Loans = Deposits - Reserves = 1,000 − 200 = 800
Second Round (from $800 loaned out in the first round)
New Deposits = $800
Reserves = 0.2×800=160
Loans = 800−160=640
Third Round (from $640 loaned out in the second round)
New Deposits = $640
Reserves = 0.2×640 =128
Loans = 640−128=512
Summing Up
Total Reserves = 200+160+128+⋯≈1,000
Total Deposits = 1,000+800+640+⋯≈5,000
Total Loans = 800+640+512+⋯≈4,000
EXAMPLE 2: Balance Sheet Calculation for Commercial and Central Bank
Scenario: The Central Bank buys $1000 in bonds from a person, impacting the banking system as follows:
Commercial Bank has Reserves = $1000 and Loans = $4000
Deposits = $5000
Central Bank’s Assets include Bonds = $1000, and Liabilities include Reserves = $1000
Question:
Calculate the Monetary Base (B) as the reserves held by the banking system.
Determine the Money Supply (M) using the deposits held by the commercial bank.
Find the Money Multiplier (m) and express it as a ratio of Money Supply to Monetary Base. Simplify the formula.
Answer:
Monetary Base (B):
B=Reserves
B=1000
Money Supply (M):
M = Cash + Demand Deposits
Since Cash = 0, M = D = 5000
Money Multiplier (m):
m = M/B = 5000/1000 = 5
EXAMPLE 3: Open Market Operation Scenario: The central bank buys $1000 in bonds from a person. Given the following:
Cash-deposit ratio (cr) = 1/3 (people hold 1/3 of deposits as cash)
Reserve-deposit ratio (rr) = 20% (banks hold 20% of deposits as reserves)
Question:
What will the balance sheets look like at each stage as the banking system adjusts?
What is the final total for reserves, loans, deposits, and cash after multiple rounds?
First Round
Deposits = $1000 (initial injection)
Reserves = rr × Deposits = 0.2 × $1000 = $200
Loans = Deposits - Reserves = $1000 - $200 = $800
Cash = cr × Deposits = 1/3 × $1000 = $333 (rounded for simplicity)
Second Round (from $800 loaned out in the first round)
New Deposits = $800
Reserves = 0.2 × $800 = $160
Loans = $800 - $160 = $640
Cash = 1/3 × $800 = $267
Third Round (from $640 loaned out in the second round)
New Deposits = $640
Reserves = 0.2 × $640 = $128
Loans = $640 - $128 = $512
Cash = 1/3 × $640 = $213
Summing Up
Total Reserves = $200 + $160 + $128 + … ≈ $375
Total Deposits = $1000 + $800 + $640 + … ≈ $1875
Total Loans = $800 + $640 + $512 + … ≈ $1500
Total Cash = $333 + $267 + $213 + … ≈ $625
