Chapter 8 Flashcards
What is money?
Any commodity or token that is generally accepted as a means of payment
What is a means of payment?
A method of settling a debt
What are the 3 functions of money?
Medium of Exchange, Unit of Account, Store of Value
What is a medium of exchange?
Any object that is generally accepted in exchange for goods and services
How might goods and services be exchanged without a medium of exchange?
Barter
What is a unit of account?
An agreed-upon measure for stating the prices of goods and services
What is a store of value?
Something that can be held and exchanged later for goods and services
What is currency?
The notes and coins held by individuals and businesses
What are deposits?
Deposits of individuals and businesses at banks and other depository institutions, such as trust and mortgage companies, credit unions, and caisses populaires
What is M1?
Currency held outside banks by individuals and businesses plus chequable deposits owned by individuals and businesses
(C + Chequable Deposits)
What is M2?
M1 plus all other deposits—non-chequable deposits held by individuals and businesses
(M1 + Non-Chequable Deposits)
What are the three types of depository institutions that make up Canada’s money?
Chartered Banks
Credit Unions and Caisses Populaires
Trust and Mortgage Loan Companies
What is a Chartered Bank?
A private firm chartered under the Bank Act of 1991 to receive deposits and make loans
What are Credit Unions and Caisses Populaires?
They receive deposits from and make loans to their members. Caisse Populaire are similar and operate in Quebec
What are Trust and Mortgage Loan Companies?
They receive deposits, make loans, and act as trustee for pension funds and for estates
What are the 4 types of assets in a Chartered Bank?
Reserves
Liquid Assets
Securities
Loans
What are Reserves?
Notes and coins in a bank’s vault or its deposit account at the Bank of Canada
What are Liquid Assets?
Government of Canada Treasury bills and commercial bills
What are Securities?
Government of Canada bonds and other bonds such as mortgage-backed securities
What are Loans?
Commitments of funds for an agreed-upon period of time
What are the 4 benefits of depository institutions?
Create liquidity
Pool risk
Lower cost of borrowing
Lower cost of monitoring borrowers
How do depository institutions create liquidity?
They create liquidity by borrowing short and lending long—taking deposits and standing ready to repay them on short notice or on demand and making loan commitments that run for terms of many years.
How do depository institutions pool risk?
If you lend to one person who defaults, you lose the entire amount loaned. If you lend to 1,000 people (through a bank) and one person defaults, you lose almost nothing.
How do depository institutions lower the cost of borrowing?
They spread the cost over many borrowers
Firms and individuals can get a large loan from a single institution that gets deposits from a large number of people, spreading the cost of this activity over many borrowers
How do depository institutions lower the cost of monitoring borrowers?
Imagine how costly it would be if each household that lent money to a firm incurred the costs of monitoring that firm directly. Depository institutions can perform this task at a much lower cost.
How are depository institutions regulated?
Insolvency, and Illiquidity
What is insolvency?
The value of debts exceed the value of loans
How do banks avoid insolvency?
To make insolvency extremely unlikely, the banks are required to maintain a required amount of owners’ capital as a percentage of total assets, called a capital buffer
What is illiquidity?
Can’t repay what it has borrowed with available cash
How do banks avoid illiquidity?
To avoid illiquidity, the Bank of Canada ensures that the banks and other depository institutions have adequate reserves
What is the Aim of Financial Innovation?
Lower the cost of deposits or to
increase the return from lending
What are the 3 special properties of the Bank of Canada?
Banker to Banks and Government
Lender of Last Resort
Sole Issuer of Bank Notes
Who does the Bank of Canada accept deposits from?
Depository institutions
What are 2 influences on Financial Innovation?
1.) Economic environment
2.) Technology
What does the Lender of Last Resort mean?
The Bank of Canada is ready to make loans when the banking system as a whole is short of reserves.
If some banks are short of reserves while others have surplus reserves, the overnight loan market moves the funds from one bank to another.
What are the Bank of Canada’s assets?
Government Securities
Loans to Depository Institutions
What are the Bank of Canada’s liabilities?
Bank of Canada Notes
Depository Institution Reserves
What is the Monetary Base?
Bank of Canada’s Liabilities
Coins issued by Royal Canadian Mint
What are the Bank of Canada’s Policy Tools?
Open Market Operations
Bank rate
What is an Open Market Operation?
The purchase or sale of government securities by the Bank of Canada in the loanable funds market
What are the effects of an Open Market Purchase? (Suppose the Bank of Canada buys $100 million of government securities from CIBC)
- CIBC has $100 million less securities. The Bank of Canada has $100 million more securities
- The Bank of Canada pays for the securities by placing $100 million in CIBC’s reserve deposit at the Bank of Canada
What are the effects of an Open Market Sale? (Suppose the Bank of Canada sells $100 million of government securities to CIBC)
- CIBC has $100 million more securities and the Bank of Canada has $100 million less securities.
- CIBC has $100 million less reserves and the Bank of Canada has $100 million more reserves
What is the Bank Rate?
The interest rate made on short-term loans, typically one-day loans, to major depository institutions when the banking system is short of reserves
How do banks create money?
Banks create deposits when they make loans
What are three limits on the quantity of loans and deposits that the banking system can create?
The monetary base
Desired reserves
Desired currency holding
What are a bank’s desired reserves?
The reserves a bank plans to hold
How is the quantity of desired reserves determined?
The desired reserve ratio -
Reserves/Deposits the bank plans to hold
What is the currency drain ratio?
Currency / Deposits
What is currency drain?
The leakage of bank reserves into currency
How is money created? (9-Step Process)
- Bank of Canada buys securities from banks and pays with newly created bank reserves (open market purchase)
- Banks have excess reserves
- Banks lend excess reserves
- The quantity of money increases
- New money is used to make payments
- Some of the new money remains on deposits
- Some of the new money is a currency drain
- Desired reserves increase because deposits have increased
- Excess reserves decrease
What is the quantity of money demanded?
The inventory of money that people plan to hold on any given day
What are the 4 factors that influence the quantities of money demanded?
- Price level
- Nominal interest rate
- Real GDP
- Financial Innovation
How does the price level effect the quantity of money demanded?
Increase in price level - need to hold more money - increase in quantity of money demanded - rightward shift of demand curve
How does the nominal interest rate effect the quantity of money demanded?
Increase in nominal interest rate of OTHER assets - people want to hold less money - decrease in QUANTITY DEMANDED for money
How does Real GDP effect the quantity of money demanded?
Increase in Real GDP - Increase in expenditure - increase in quantity demanded of money - rightward shift in demand curve
How does financial innovation effect the quantity of money demanded?
More financial innovation - easier to transfer between assets and money - lower quantity of money demanded - leftward shift in demand curve
What is the Demand for Money?
The relationship between the quantity of real money demanded and the nominal interest rate
What is the short-run effect of a increase in the quantity of money?
People buy bonds
Increase in Demand for Bonds
Bonds are more expensive
Lower interest rate
(decrease in money has all opposite effects)
What is the Quantity Theory of Money
MV=PY
What does the Quantity Theory of Money tell us?
In the long run, an increase in the quantity of money brings an equal percentage increase in the price level
What is the Velocity of Circulation?
The average number of times a dollar of money is used annually to buy the goods and services that make up GDP
What is the equation for the Velocity of Circulation?
Velocity = (Price Level * Real GDP)/Quantity of Money
Money Multiplier Long Form Equation
mm = (Deposits + Currency)/(Reserves + Currency)
