Transcript Chapter15

Chapter 15 The Monetary System
• The Meaning of Money
• The Bank of Canada
• Commercial Banks and the Money Supply
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• Imagine that there was no item in the economy widely
accepted in exchange for goods and services. People would
have to rely on barter-the exchange of one good or service
for another- to obtain the things they need. Any economy
that relies on barter will have trouble allocating its scarce
resources efficiently. In such an economy, trade is said to
require the double coincidence of wants- the unlikely
occurrence that two people each have a good or service that
the other wants.
• The existence of money makes trade easier.
• The social custom of using “money” for transactions is
extraordinarily useful in a large, complex society.
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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: anything that is readily acceptable as
payment.
 Unit of Account: serves as a unit of account to help us
compare the relative values of goods.
 Store of Value: a way to keep some of our wealth in a
readily spendable form for future needs.
• The Kinds of Money:
• Commodity Money: something that performs the function
of money and has alternative, non-monetary uses.
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– Examples: Gold, silver, cigarettes
• Fiat Money: something that serves as money but has no
other important uses.
– Examples: Coins, currency, debit cards
• Money in the Canadian Economy
• Money Stock is the quantity of money circulating in the
economy.
• Different ways of measuring the money stock in the
economy:
– M1: The most familiar form of money used includes:
Currency (the paper bill and coins in the hands of the
public)& Demand Deposits ( balances in bank accounts
that depositors can access on demand by writing a cheque
or using a debit card)
– M2: A broader measure of money than M1, includes:
M1 + Savings Deposits + Personal Term Deposits 4
• Where is All The Currency?
• In 2000 there was about $33 billion of Canadian currency
outstanding ($1,300 in currency per adult).
• The outstanding currency may be in the hands of tax
evaders, drug dealers and other criminals.
• See Table 15-1 on page 324
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The Bank of Canada
• The Bank Of Canada (“B of C”) serves as the nation’s
central bank, which is designed to control the quantity of
money in the economy.
• In 1934, Parliament enacted the Bank of Canada Act, which
laid down the responsibilities of the Bank of Canada.
• The “B of C” is owned by the Canadian government,
established in 1935 by a royal commission and nationalized
in 1938.
• The B of C is run by its Board of Governors which is
composed of:
– The Governor.
– The Senior Deputy Governor.
– Twelve directors including the Deputy Minister of
Finance.
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– All members are appointed by the Finance Minister.
• The Bank of Canada is controlled by the Canadian
government which appoints the Board of Directors.
• As a last resort the government can issue a written directive
to the Governor with which he must comply.
• In practice the Bank of Canada is largely independent of the
government.
• Four Primary Functions of the B of C
Issue currency.
 Act as a banker’s bank, making loans to other banks and as
a lender of last resort.
 Act as banker to the Canadian government.
 Control the money supply, the quantity of money available
in the economy, with monetary policy, the setting of the
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money supply by policymakers in the central bank.
Commercial Banks and the Money Supply
• The behaviour of banks can influence the quantity of
demand deposits in the economy and therefore, the money
supply.
• Fractional Reserve Banking System: The practice of
holding a fraction of money deposited as reserves and
lending out the rest.
• Deposits into a bank are recorded as both assets and
liabilities. Deposits that have been received but not lent out
are called reserves.
• Reserve Ratio: the fraction of deposits that banks hold as
reserves
• The supply of money in the economy is affected by the
amount of deposits that are kept in the bank as reserves and
the amount that is lent out. Loans become an asset to the
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bank.
• Money Creation with Fractional-Reserve Banking
• When a bank makes a loan (from its reserves) the money
supply increases. When banks hold only a fraction of
deposits in reserve, banks create money.
• The creation of money through loans does not create any
wealth, but allows banks to charge interest several times on
the same bit of wealth.
• The money multiplier
• When one bank loans money, that money is generally
deposited into another or the same bank thus creating more
deposits and more reserves to be lent out.
• The Money Multiplier is the amount of money that the
banking system generates with each dollar of reserves.
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• What determines the size of the money multiplier?
• The money multiplier is the reciprocal of the reserve ratio.
M = 1/R
– With a reserve requirement (R) of 20% or 1/5 . . .
– The multiplier will be 5.
• The Bank of Canada’s Tools of Monetary Control
• The B of C has many instruments of monetary control:
• Open-Market Operations:
– Buying and selling bonds: The primary way in which the
B of C changes the money supply is done through the
purchase and sale of Canadian government bonds.
– To increase the money supply, the B of C buys
government bonds from the public.
– To decrease the money supply, the B of C sells
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government bonds to the public.
• Foreign Exchange Market Operations: buying and selling
foreign currency.
• Changing the Reserve Ratio: Increasing or decreasing the
ratio.
• Changing the Bank Rate: The interest rate the B of C
charges other banks for loans.
• If the Bank of Canada buys $100 million USD in the foreign
exchange market for $ 150 million CAD, the Canadian
money supply increases immediately by $150 million.
• Sometimes, the B o C wants to sell foreign currency in the
foreign exchange market to support the Canadian dollar’s
exchange rate, but it does not want the money supply to fall.
To do this, the Bank uses the Canadian dollars it acquires in
the foreign exchange market to buy government bonds, thus
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putting the Canadian dollars back into circulation.
• Sterilization: the process of offsetting foreign exchange
market operations with open-market operations, so that the
effect on the money supply is cancelled out.
• Problems in Controlling the Money Supply
Two problems that the B of C must “wrestle” that arise due to
fractional-reserve banking:
The B of C does not control the amount of money that
households choose to hold as deposits in banks.
The B of C does not control the amount of money that
bankers choose to lend.
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