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ECO102H1 Lecture Notes - Excess Supply, Opportunity Cost, Output Gap

Course Code
James Pesando

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Topic 19 t Money, Banking and Monetary Policy
Feb 28th t March 14th
1. What is Money?
2. How Banks Create Money
-- Desired Reserve Ratio
-- Multiple Deposit Creation
3. Demand for Money
4. Bond Prices Fall as Interest Rate Rises
5. Interest Rate Determination ( Short - Run )
6. Bank of Canada
-- Controls the money supply
-- Multiplier effect of open market operations
7. Monetary Policy in AD - AS Model
z What is money (Canada: Currency + Bank Deposits)
-- Purpose: Medium of exchange
Store of value
Unit of account
-- Alternative to money: barter (very inefficient)
-- Banking system
1. Central bank (Bank of Canada)
-- Uses control of money supply and interest rates to influence Aggregate Demand
2. Commercial Banks
-- Create money as by-product of profit-seeking activities;
z Motivation
e.g. Overnight Interest Rate (Determined b Bank of Canada)
December 2007 (prior to recession) 4.5%
March 2009 (during the recession) 0.5% (almost zero)
March 2011 (During recession) 1.0%
March 3 2009; Bank of Canada lowers key interest rate from 1% to 0.5%
1. Why?
^The outlook for the global economy has continued to deteriorateYThe nature of the US particularly challenging for Canada._
2. Purpose
To increase Aggregate Demand, to reduce ^spillovers_ from recession in US.

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3. How? Transmission Mechanism.
-- Commercial banks create money
-- Money supply and money demand determine interest rates
-- Bank of Canada controls money supply/changes interest rates
-- Interest rate affect aggregate demand
z How do Banks create money
-- Simplifying Assumptions:
-- All banks have same desired/target reserve ratio;
-- No cash drain (amount of cash held by public is fixed) (implication: c=0: cash to deposit ratio = 0)
-- Bank capital is zero (for numerical examples)
-- Desired Reserve ratio of Bank
Simple Balance Sheet
Assets (A) Liabilities (L)
Reserves $40 Deposits $400
Loans 360
Reserves = Vault cash + Deposits at Bank of Canada
Reserves earn low or zero interest; Loans earn market interest rate
Desired Reserve ratio = Desired reserves/Deposits
-- Multiple deposit creation (Numerical Example)
Assume: Desired Reserve ratio =0.10
1. Step one: Individual deposits $100 in Cash at Bank 1
Bank 1 (Initial)
Reserve +100 Deposits +100
Bank 1(Intermediate)
Desired Reserves +10 Deposits +100
Excess Reserves +90
Bank 1 (Final)
Reserves +10 Deposits +100
Loans +90
2. Step Two:
Individuals who borrow 90 spend this sum on textbooks for inventory.
Textbook seller deposits cheque in Bank 2.
Bank 2 (Initial)
Reserves +90 Deposits +90
(Since excess reserves earns no
interest income, so makes additional
loans, e.g. 90 to individuals who
operate bookstore)
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