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Chapter 27 Money.docx

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Marilyn Cottrell

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Two Perspectives on Money The Classical View of Money  Relative prices and real GDP determined only by real things  Technology and preferences Money is neutral  Change in the money supply causes no change in real variables  Change in the money supply does lead to a proportionate change in the price level The modern view Short run:  Changes in the money do generate changes in output and other real variables Long run:  Money is neutral  Changes in money and price level are closely linked Countries with high inflation rates often have higher rates of growth of the money supply Nature of money Money is a medium of exchange  Acceptable as payment for goods and services  Without money, would need a system of barter  Barter is inefficient  Requires double coincidence of wants Not a problem when a general medium of exchange is used Money is a store of value  Without high inflation, money retains its value Alternative media of exchange- ice cream?  Do not necessarily hold their value well. Money is a unit of account  The unit of measure we use to keep out financial accounts The Origins of Money Metallic money  Coin worth market value of metal  Led to debasing Gresham’s Law:  “bad money drives out good” When two types of money used  One with greater intrinsic value will be driven out by circulation Paper money  Backed by precious metal  Convertible on demand  Referred to as bank notes because it was issued by private banks Fractionally backed paper money  Goldsmiths (banks) found they didn’t need to keep 1 oz. Of gold in vaults for every receipt for 1 oz.  Issued more “receipts” than the gold in their vaults Fiat money  Paper money or coinage  Neither backed by nor convertible into anything else  Decreed by the government to be acceptable as legal tender  Today most currency is fiat money Modern Money Deposit Money:  Money held by the public in form of deposits with commercial banks and other financial institutions  Bank deposits are money Money Creation:  Banks create money by using more promises to pay (deposits) than they have available in their cash reserves The Canadian Banking System Consists of:  Commercial banks  A central bank Central bank:  Acts as a bank to commercial banking system  Usually government-owned  Sole money-issuing authority Bank of Canada [BOC] is central Bank in Canada BOC  Operates under system of joint responsibility- 1967  Operates monetary policy on a day-to-day basis  Free of political influence  Ultimately answerable to Parliament Basic functions of BOC 1. Banker to commercial banks 2. Banker t federal government 3. Regulate money supply 4. Regulate, support, and monitor financial markets 1. Banker to commercial banks:  Accepts deposits (commercial bank reserves)  Transfers funds to other commercial banks to settle debts  Lends to commercial banks (lender of last resort) Currency in circulation is the Bank of Canada’s largest liability 2. Banker to Federal Government  Holds some government deposits  May lend to federal government by buying treasury bills (short term bonds) or regular bonds  Important for conduct of monetary policy 3. Regulator of Money supply  Controls money supply  Two main liabilities of BOC are:  Currency in circulation  Chartered bank reserves  Controlling liabilities, controls money supply 4. Regulate and Support Money Markets  Financial institutions  Banks, borrow short and lend long Problems:  Unexpected interest rate rise  Banks must pay higher interest rates to keep deposits  Funds loaned out a lower rate BOC can adjust interest rates to prevent these problems. These four functions may conflict with each other. Commercial Banks in Canada  Privately owned  Profit-seeking institution  Provide a variety of financial services  Accepting deposits  Making loans, ect. Bank Act  Provides for commercial banks  Other financial institutions  Credit unions, trust companies, caisses popularies in Quebec, ect. Interbank Activities: Banks cooperate with each other in some areas:  Pool very large loans  Credit cards operated by groups of banks  Banks operate clearing house  Settle interbank debts each day  Transfer funds to settle cheques At end of day  If bank A owes bank B money  Transfer money from its account at BOC Reserves Money in Demand Deposits at bank  Bank keeps part of deposit  Lends out the rest Reserves:  Portion of loan (new deposit in next bank) that is kept  Normally quite small  Only a small fraction of deposits want their money at any time  Needed to assume depositors can withdraw deposits on demand Bank’s reserve ratio:  Fraction of deposits it actually holds as reserves Reserves held as:  Vault cash  Deposits with central bank Bank’s target reserve ratio  Fraction of its deposits it wants to hold as reserves  Target ratio was legally imposed until early 1992  Now determined by the bank itself Canadian banking system: Fractional-reserve system  Banks reserves approx. 3%  Panic rush to withdraw funds  Banks run out of reserves  Banks borrow reserves from BOC Excess reserves:  Any reserves in excess of target reserves  Excess reserves are loaned out Money Creation by Banking System Assumptions:  Banks can invest in only one kind of asset- loans  Only one kind of deposit – a demand deposit  Fixed target reserve ratio  No
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