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Lecture 17

Economics – Lecture 17-19 Notes.docx

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Bridget O' Shaughnessy

Economics – February 25 , 2013 – Lecture 17 Fractional-Reserve Banking  Fractional-reserve banking: a banking system in which a bank holds only a fraction of deposits as reserves  Reserve ratio: fraction of total deposits that a bank holds as reserves Demonstration  This classroom is a closed economy. I have $50,000 in currency and there is no banking system.  What is the current money supply? M = C + D = $50,000 + 0 = $50,000  Now, I deposit my $50,000 into a bank. The reserve ratio is 50%.  What is the current money supply? M = C + D = $3,125 + 50,000 + 25,000 + 12,500 + 6,250 = $96,875 How do banks create money? Money Creation Using T-accounts  Question: Suppose someone deposits $100. What happens immediately? What happens after all adjustments have taken place? MCMASTER UNIVERSITY BANK Assets Liabilities Reserves: $200 Deposits: $600 Loans: $400 MCMASTER UNIVERSITY BANK Assets Liabilities Reserves: $120 Deposits: $600 Loans: $480 Money Multiplier  Money multiplier: the amount of deposits the banking system generates with each dollar of reserves  Money multiplier = (1)/(reserve ratio) Ex. Suppose the reserve ratio is 5%. If $100 is deposited into the banking system what happens to total deposits  Money multiplier = 1/0.5 = 20  $100 x 20 = $2000 Bank of Canada  Established in 1935  Bank of Canada is Canada’s central bank  Other central banks: o Bank of England o Bank of Japan o Board of Governors of the Federal Reserve System (US)  The Bank of Canada has four main areas of responsibility: 1. Monetary Policy: controls the money supply 2. Currency: designs, produces and issues currency 3. Financial System: facilitate cheque-clearing and act as a “lender of last resort” 4. Funds Management: acts as a banker for the Canadian government Bank of Canada’s Tools of Monetary Control  The Bank of Canada controls the money supply by: 1. Open-market operations: buying and selling government bonds 2. Changing the overnight rate: the government can change the bank rate, which equally changes the overnight rate Economics – February 26 , 2013 – Lecture 18 Banks Runs and the Money Supply  Depositors believe that a bank might go bankrupt  Problem for banks using the fractional-reserve banking system  Canada Deposit Insurance Corporation ($100,000)  All banks are insured up to $100,000  Clients will get money back up to that amount if bank goes bankrupt  Prevents bank run from happening Why is the inflation rate 2.5% in Canada but 19% in Venezuela?  Assume that all of $100 will end up in various reserves in banking system  Assume that banks do not keep excess reserves  Initial deposit of $100 will cause total deposits in banking system to go up $2000 because the reserve rate is 5%  M = C + D  Know deposits increases by $2000  Not sure about what happens to money supply  Depends where $100 comes from  If it was out circulating C goes down by $100  If Bank of Canada created $100 there is no offsetting decrease Classical Theory of Inflation  Price of a good: reflects value  Money: value falls as price level rises o If price of everything doubles money you have buys half as much o Value of money goes down  Demand for money (households): as prices rise we need more money to buy the same goods  The demand for money curve has a negative slope Graph  Money is on horizontal axis  Value of money on vertical axis (1/P) d  M – shift out if Y rises or if households decide to increase their money holdings for some other reason  Y: income  M vertical – position determined by the central bank Quantity Theory of Money  Quantity theory of money: o The quantity of money determines the price level o The growth rate of money determines the inflation rate  Classical dichotomy: the separation of real and nominal variables s  Monetary neutrality: changes M affect nominal variables, but not real variables  Real variables measured in physical quantities or relatively or in some form of constant dollar (base year)  Nominal variables measured in Velocity  Velocity: the rate at which money changes hands  Ex: o Produce 2000 cups of h
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