ECN 204 Lecture Notes - Money Supply, Overnight Rate, Openmarket

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22 Apr 2012
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Chapter 10: The Monetary System
February 15th, 2012
What Money Is and Why It’s Important
Without money, you need to barter,
Transactions would require a double coincidence of wants the unlikely occurrence that two people
each have a good the other wants
People would have to spend time searching for others to trade with waste of resources.
This searching is unnecessary with money, the set of assets that people regularly use to buy g&s
from other people.
The 3 Functions of Money
Medium of exchange: an item buyers give to sellers when they want to purchase G&S
Unit of account: the yardstick people use to post prices and record debts
Store of value: an item people can use in the future if not used today
The 2 Kinds of Money
1. Fiat money: money without intrinsic value, used as money because of government decree Example:
the Canadian dollar
2. Commodity money: takes the form of a commodity with intrinsic value. Examples: gold coins,
Money in the Canadian Economy
The money supply (or money stock): the quantity of money available in the economy
What assets should be considered part of the money supply? Two candidates:
Currency: the paper bills and coins in the hands of the general public
Demand deposits: balances in bank accounts that depositors can access on demand by writing a cheque
or using a debit card.
Money supply = Currency + Deposits
Two Measures of the Money Stock for the Canadian Economy
The Bank of Canada established in 1935 and nationalized in 1938, now owned by Canadian gov’t
- Managed by a board of directors [governor (Mark Carney), the senior deputy governor, and 12
directors (appointed by minister of Finance, w/ 7-year terms for the governor and senior deputy
governor, and 3-year terms for the other directors), plus the minister of Finance]
Central bank: an institution designed to regulate the money supply in the economy.
Bank of Canada: the central bank of Canada
Four Primary Functions of the Bank of Canada
Create money
Responsible to provide $$ to commercial banks
Responsible to provide $$ to the Canadian government
Control the money supply
Controlling the money supply
The money supply is the quantity of money available in the economy.
Money supply = Currency ($$ ppl have) + Deposits
Decisions by policymakers concerning the money supply constitute monetary policy (the act
of changing the $$ supply)
Commercial Banks (the big 5) and the Money Supply
the central bank can control the supply of money only through its influence on the entire banking
Commercial banks include credit unions, caisses populaires, and trust companies
Commercial banks have a huge impact on the chequing accounts
Reserves : cash that commercial banks hold
In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the
rest to make loans.
Banks may hold more than this minimum amount if they choose.
The reserve ratio, R
= % of deposits that banks hold as reserves
= total reserves as a percentage of total deposits
Bank T-account - a simplified accounting statement
that shows a bank’s assets & liabilities
Banks’ liabilities include deposits,
assets include loans & reserves.
In this example, notice that R = $10/$100 = 10%.
Banks and the Money Supply: An Example
(Suppose $100 of currency is in circulation. To determine
banks’ impact on money supply, we calculate the money supply in 3 different cases)
1. Case: No banking system
- Public holds the $100 as currency.
Money supply = $100.
2. Case: 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans
- Public deposits the $100 at First National Bank (FNB).
- FNB holds 100% of deposit as reserves:
- Money supply = currency + deposits = $0 + $100 = $100
* In a 100% reserve banking system,
banks do not affect size of money supply.
Reserves $ 10
Loans $ 90
Loans $ 0
3. Case: Fractional reserve banking system
- Suppose R = 10%. FNB loans all but 10% of the deposit:
- Money supply = $190 (!!!)
Depositors have $100 in deposits,
Borrowers have $90 in currency.
* How did the money supply suddenly grow?
- When banks make loans, they create money.
The borrower gets
$90 in currency (an asset counted in the
money supply)
$90 in new debt/loan (a liability)
* A fractional reserve banking system creates money, but not wealth.
Money multiplier: the amount of money the banking system generates with each dollar of reserves
The money multiplier equals 1/R.
In our example,
R = 10%
money multiplier = 1/R = 10
$100 of reserves creates $1000 (10x100) of money
The Bank of Canada’s Tools of Monetary Control
The BOC has two tools in its monetary toolbox:
Open-market operations:
The Bank of Canada conducts open-market operations when it buys government bonds from or
sells government bonds to the public:
Buying bonds causes the money supply to increase.
Selling bonds causes the money supply to decrease.
Foreign Exchange Market Operations
The Bank of Canada conducts foreign exchange market operations when it buys or sells foreign
The money supply increases when the Bank of Canada buys foreign currency with
Canadian currency.
The money supply decreases when the Bank of Canada sells foreign currency.
Changing the overnight rate:
Central banks like the Bank of Canada act as bankers to the commercial banks.
bank rate: interest rate the Bank of Canada is charging on loans to the commercial
Since 1998 the Bank of Canada has allowed commercial banks to borrow freely at the bank
rate, and has paid commercial banks the bank rate, minus half a percent, on their deposits at
the Bank of Canada.
overnight rate: the interest rate on very short-term loans between commercial banks
Problems in Controlling the Money Supply
The Bank of Canada’s control of the money supply is not precise.
The Bank of Canada must wrestle with two problems that arise due to fractional-reserve banking.
The Bank of Canada does not control the amount of money that
households choose to hold as deposits in banks.
commercial bankers choose to lend.
Reserves $10
Loans $ 90
Deposits $100