Lecture notes for week 9

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University of Toronto Scarborough
Economics for Management Studies
Iris Au

BANKING SYSTEM AND MONETARY POLICY Outline N Discuss the two types of bankscommercial bank & central bank. N The balance sheet of a commercial bank. N The role of the banking systemhow it generates money. N What is the monetary system? N Measures used by the central bank to affect money supply. N The link between monetary policy and the real side of the economya revisit. Types of Banks There are two types of banks: commercial banks and central bank. Commercial Banks N Commercial banks are privately owned, profit-seeking institutions that provide a variety of financial services such as accepting deposits from customers and making loans and other investments. N In Canada, the banking industry is dominated by chartered banks. N Chartered banks in Canada include RBC, BMO, CIBC, TD-Canada Trust, and Scotiabank. N Chartered banks are subject to federal regulations and only until recently were required to hold reserves with the Bank of Canada (BOC) against their deposit liabilities. N The required reserve requirement was eliminated in 1994 but chartered banks still hold voluntary reserves with the BOC. Central bankthe Bank of Canada (BOC) N The BOC was established in 1935 and became a crown corporation in 1938. N In practice, the operation of the BOC is independent of the Federal government (i.e., the government could not intervene into the operation of the Bank of Canada). N The BOC performs the following functions: 1) Print money & in charge of money supply 2) Lender of last resort: The BOC acts as bankers bank. o If commercial banks need to borrow money to stay afloat or remain liquid, they can borrow from the BOC. o However, there is no free lunch. When commercial banks borrow from the BOC, the BOC will charge them interest. The interest rate that the BOC charged is called the bank rate. 3) Banker to Canadian government: BOC manages government bank accounts, foreign exchange reserves, and national debt. The Balance Sheet of a Bank N The balance sheet of a (commercial) bank: Assets Liabilities Cash & reserves Demand deposits Loans Equity Note: N Cash & reservescash held by the commercial bank. Commercial bank keeps sufficient cash on hand to be able to meet the depositors day-to-day requirements for cash. N Equitythe difference between banks assets and banks liabilities. The Reserve Ratio N The reserve ratio (rr) refers to the fraction of its deposits that a commercial bank holds as cash & reserves. o The reserve ratio is fraction 1 > rr > 0. N Before 1994, commercial banks were required to hold required reserves. o The law required commercial banks to hold a minimum amount of cash as reserves for every dollar they accepted as deposits. N Now, there is no required reserve requirement but banks do hold voluntary or target reserves. Why? o To ensure that they have cash to satisfy daily withdrawals of the depositors to avoid bank run. N We should interpret the reserve ratio as the target reserve ratiothe fraction of deposits that commercial banks would like to hold in the form of cash and reserves. Commercial Banks and Money Creation N This section examines how commercial banks help to create money. The Set Up N Initially there are no banks and total quantity of currency circulated is $200, all held by the public (currency in circulation = $200). MS = currency in circulation + demand deposit MS = $200 + $0 = $200 N Now, someone dreams up the idea of a chartered bank and opens one with $40 of cash invested in the bank (banks equity = $40). o People can deposit their money in the bank. o Once they open bank account and deposit money in their accounts, they can write cheques. N Now, suppose that people deposit another $60 of their cash in the bank. o The new bank has $100 in cash ($40 in equity, $60 in demand deposits). www.notesolution.com
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