Questions from end chapters Flashcards
What is money? Describe the three functions of money.
Money is anything that is generally acceptable as a means of payment. Money has three functions: medium of exchange (money is accepted in exchange for goods and services), unit of account (prices are quoted in terms of money), and store of value (money can be held and exchanged for goods and services later)
Describe the problems that arise when a commodity is used as money.
Commodities are not used as money because of several problems. Many commodities are bulky. And many commodities change in value over time. Using as money a commodity that changes in value would be awkward. Prices would change simply because the commodity’s value changed. Additionally, using a commodity as money has a higher opportunity cost than do currency and bank deposits because the commodity has alternative uses that must be foregone.
Describe the official measures of money in Canada. Are all the measures really money?
The official measures of money are M1+ (the sum of currency outside banks, personal chequable deposits, and non-personal chequable deposits) and M2 (the sum of M1, personal non-chequable deposits, non-personal non-chequable deposits, and fixed term deposits). All of the components of M1+ are truly money because they serve as a means of payment. However, some of the components of M2 are not truly money because they are not a means of payment. (For example, funds’ saving deposits are not a means of payment). But all of these “non-money” assets are liquid assets and are very quickly converted into a means of payment. So, the items in M2 are counted as money.
Are cheques and credit cards money? Explain.
Cheques and credit cards are not money because they are not a means of payment. A cheque is an order to transfer a deposit from one person to another. The deposits are money, but the cheques are not. A credit card is an ID card that lets a person take out a loan at the instant they buy something. The loan still needs to be repaid with money, so the credit card is not a means of payment; that is, it is not money.
describe the structure and functions of the Bank of Canada (a.k.a. central bank).
The central bank of Canada is the Bank of Canada, and it is responsible for providing banking services to banks and regulating financial institutions and markets. The reading assignment outlines several main functions of the Bank of Canada. Of these functions, perhaps the most important one is the conduct of monetary policy. Monetary policy is the altering of the economy’s money supply or monetary base in order to achieve a desired inflation rate.
Section 10-2
explain how chartered banks create money by making loans.
By now, you should know that when we say money, we mean either M1+ or M2; that is, currency outside banks plus deposits. What commercial banks create is deposits, not currency. They create deposits by making loans. The banks’ freedom to create money, however, is limited by its excess reserves.
To see how commercial banks create deposits, assume for simplicity that there is only one chartered bank in the monetary system. Let us call this bank CIBC. Now suppose you decide to take a loan from CIBC to pay your tuition at Athabasca University (AU). CIBC lends you $5,000 and credits your account with that amount. When you write a cheque of $5,000 to AU, your bank deposits will fall by $5,000, but the bank deposits of AU at CIBC rises by $5,000. So bank deposits have not changed. However, by lending $5,000 to you, the bank has created money.
In the real world, however, there are many commercial banks, and loans generated by an initial deposit may end up being deposited in banks other than the lending bank. The reading assignment in the textbook (see Section 10-3c) explains the creation of deposits in a banking system. The money multiplier presented in the textbook is the simplest form, with required reserves as the only leakage to the banking system. A more realistic multiplier would include other leakages such as the currency drain. Such considerations, however, reduce the size of the multiplier. More specifically, if we denote (required) reserve ratio by Rr and the currency drain ratio by Cd, the money multiplier changes from
to
Some people think that the money creation process is unsustainable and dangerous for the depositors. This is true if, for example, the bank’s depositors become unduly concerned for any reason (e.g., depositors fear that their bank has made bad loans and will perhaps run out of cash). In such a case, the bank faces the risk of a “run on the bank” as frightened depositors withdraw their deposits in cash, ensuring the very event they fear. Such risks can be minimized, however, through a combination of good management and government regulation. Adequate cash reserves must be maintained, and provisions must be made for emergency shortages of reserves. Government regulations must ensure that banks cannot make too many high-risk loans or investments. Deposit insurance will minimize the risk of depositors withdrawing their deposits in a panic.
describe the tools used by the Bank of Canada to alter money supply.
To change the monetary base, the Bank of Canada can use any of the three tools: the bank rate (and bankers’ deposit rate), government deposit shifting, and open market operations (OMO). The required reserve ratio has not been used as a monetary policy tool since 1992. There is a straightforward relationship between, on one hand, the bank rate, the bankers’ deposit rate, and government deposit shifting and, on the other hand, the banks’ reserves and loans (and thus the quantity of money). The bank rate and banker’s deposit rate are positively related to banks’ reserves and loans: when the Bank of Canada shifts government deposits to commercial banks, the commercial banks’ reserves and loans increase, and when the Bank of Canada shifts government deposits away from commercial banks, the commercial banks’ reserves and loans decrease. The relationship between OMO and the quantity of money is more complex because it depends on whether the Bank of Canada buys securities from chartered banks or the general non-bank public. The Bank of Canada does not directly purchase bonds from the federal government because it would appear as if the government was printing money to finance its expenditures.
That said, the Bank of Canada does not control the amount of money that households choose to deposit in commercial banks or the amount that commercial banks choose to lend. These factors make the Bank of Canada’s control over money supply less certain.
Sections 10-3e and 10-3f
explain how, in the long run, the quantity of money determines the price level and how money growth brings inflation.
explain how the nominal interest rate responds to the inflation rate.
describe the costs that inflation imposes on society.
