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Chapter 11 Summary.pdf

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McMaster University
Bridget O' Shaughnessy

Summary of Lecture Notes from Chapter 11 and Practice Questions KEY POINTS: 1. The term money refers to assets that people regularly use to buy goods and services. 2. Money serves three functions. As a medium of exchange, it provides the item used to make transactions. As a unit of account, it provides the way in which prices and other economic values are recorded. As a store of value, it provides a way of transferring purchasing power from the present to the future. 3. Commodity money, such as gold, is money that has intrinsic value: It would be valued even if it were not used as money. Fiat money, such as paper dollars, is money without intrinsic value: It would be worthless if it were not used as money. 4. In the Canadian economy, money takes the form of currency and various types of bank deposits, such as chequing accounts. 5. The Bank of Canada, Canada’s central bank is responsible for controlling the supply of money in Canada. The governor and senior deputy governor of the Bank of Canada are appointed for seven- year terms, and the other directors are appointed for three-year terms. All these appointments are made by the Canadian government, which owns the Bank of Canada. 6. The Bank of Canada controls the supply of money primarily through changes in the overnight rate. Lowering the overnight rate increases the money supply, and raising the overnight rate reduces the money supply. The Bank of Canada also controls the money supply through open-market operations. The purchase of government bonds increases the money supply, and the sale of government bonds reduces the money supply. 7. When banks loan out some of their deposits, they increase the quantity of money in the economy. Because of this role of banks in determining the money supply, the Bank of Canada’s control of the money supply is imperfect. I. The Meaning of Money A. Definition of money: the set of assets in an economy that people regularly use to buy goods and services from other people. B. The Functions of Money 1. Money serves three functions in our economy. a. Definition of medium of exchange : an item that buyers give to sellers when they want to purchase goods and services. b. Definition of unit of account : the yardstick people use to post prices and record debts. c. Definition of store of value: an item that people can use to transfer purchasing power from the present to the future. 1 2 ☞ Chapter 11/The Monetary System 2. Definition of liquidity: the ease with which an asset can be converted into the economy’s medium of exchange. a. Money is the most liquid asset available. b. Other assets (such as stocks, bonds, and real estate) vary in their liquidity. c. When people decide in what forms to hold their wealth, they have to balance the liquidity of each possible asset against the asset’s usefulness as a store of value. C. The Kinds of Money 1. Definition of commodity money : money that takes the form of a commodity with intrinsic value. 2. Definition of fiat money : money without intrinsic value that is used as money because of government decree. D. Money in the Canadian Economy 1. The quantity of money circulating in Canada is sometimes called the money stock. 2. Included in the measure of the money stock are currency, demand deposits and other monetary assets. a. Definition of currency: the paper bills and coins in the hands of the public. b. Definition of demand deposits : balances in bank accounts that depositors can access on demand by writing a chegue or using a debit card. 3. FYI: Credit Cards, Debit Cards, and Money a. Credit cards are not a form of money; when a person uses a credit card, he or she is simply deferring payment for the item. b. Because using a debit card is like writing a cheque, the account balances that lie behind debit cards are included in the measures of money. 4. Figure 11.1 shows the monetary assets included in two important measures of the money stock, M1 and M2. II. The Bank of Canada System A. Definition of Bank of Canada: the central bank of Canada. B. Definition of central bank : an institution designed to regulate the quantity of money in the economy. Chapter 11/The Monetary System ☞ 3 C. The Bank of Canada Act 1. In 1934, Parliament enacted the Bank of Canada Act, which laid down the responsibilities of the Bank of Canada. 2. The Bank of Canada has a board of directors composed of the governor, the senior deputy governor, and 12 directors, including the deputy minister of Finance. a. The board of directors are appointed for a three-year term. b. The governor and senior deputy governor are appointed for a seven-year term. 3. The Bank of Canada System has four jobs: a. To issue currency. b. To act as banker to commercial banks. c. To act as banker to the Canadian government. c. To control the quantity of money that is made available to the economy. 4. Definition of money supply : the quantity of money available in the economy. 5. Definition of monetary policy: the setting of the money supply by policymakers in the central bank. D. Monetary Policy 1. The Bank of Canada has the power to increase or decrease the number of dollars in the economy. 2. Changes in the money supply can have profound effects on the economy. a. Principle #9: Prices rise when the government prints too much money. b. Principle #10: Society faces a short-run tradeoff between inflation and unemployment. 4 ☞ Chapter 11/The Monetary System III. Commercial Banks and the Money Supply A. The Simple Case of 100-Percent-Reserve Banking 1. Example: Suppose that currency is the only form of money and the total amount of currency is $100. 2. A bank is created as a safe place to store currency; all deposits are kept in the vault until the depositor withdraws them. a. Definition of reserves: deposits that banks have received but have not loaned out. b. Under the example described above, we have 100-percent-reserve banking. 3. The financial position of the bank can be described with a T-account: FIRST NATIONAL BANK Assets Liabilities Reserves $100.00 Deposits $100.00 4. The money supply in this economy is unchanged by the creation of a bank. a. Before the bank was created, the money
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