Overnight Interest Rate (determined by back of canada)
December 2007 (Prior to recession) 4.50%
March 2009 (During recession) 0.50% (Almost zero)
March2011 (During recovery) 1.00%
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
deteriorate… the nature of the U.S. recession…. Is particularly
challenging for canada.”
2. Purpose? To increase Aggregate demand, to reduce “spillovers” from
recession in U.S.
3. How? Transmission mechanism (mechanism through which the actions
of bank of canada are transmitted into the world economic system).
-commercial banks create money
-money supply and money demand determine interest rates
-interest rates affect Aggregate Demand
1. Centeral bank (Bank of Canada)
Uses control of money supply and interest rates to influence Aggregate
2. Commercial banks
Create money as by-product of profit-seeking activities
(Canada: Currency + Bank Deposits)
Medium of exchange
Store of value
Unit of account
2. Alternative to money: barter(very inefficient)
How do banks create money?
Simplifying assumptions (in order to answer question)
1. All banks have same desired/target reserve ratio
2. No cash drain (amount of cash held by public is fixed)
3. Bank capital is zero (for numerical examples)
Desired Reserve Ratio of Bank
Simple Balance Sheet
Assets (A) Liabilities (L)
Reserves 40 Deposits 400
www.notesolution.com Loans 360
Reserves = Vault cash + Deposits at Bank of Canada
Reserves earn low or zero interest (Cash, doesn’t earn any interest,
therefore no profit)
Loans earn market interest rate
Desired Reserve Ratio = Desired Reserves / Deposits
Assume: Desired Reserve Ratio = 0.10
Multiple Deposit Creation
Step one: individual deposits $100 in cash at bank 1
Bank 1 Initial
Reserves + 100
Desired reserves +10 Deposits +100
Excess Reserves +90
Earns no interest income on excess reserves, so makes additional loans (90 to
individuals who operate bookstore)
Bank 1 Final
Reserves +10 Deposits +100
Individuals who borrow 90 spend this sum on textbooks for inventory.
Testbook seller deposits cheque in Bank 2.
Bank 2 Initial
Reserves +90 Deposits +90
(when cheques clear, Bank 2 has additional reserves of 90)
Bank 2 Intermediate
www.notesolution.com A L
Desired Reserves +9 Deposits +90
Excess Reserves +81
To earn interest income, Bank 2 makes additional loan of 81
Bank 2 Final
Reserves +9 Deposits +90
Additional Deposits (increases in Money Supply)
Bank 1: +100
Bank 3: +81
Deposit (money) Multiplier = Δ deposits/ Δ reserves
= 1/ desired Reserve ratio
If an individual withdraws $100 in cash from Bank 1
Desired reserves > actural reserves
Bank 1 calls in (reduces) loans
Result is multiple deposit contraction
Conclusion: Multiple Deposite Creation
Δ Deposits = Δ Reserves/ Target reserve ratio
TEXT (lipsey-ragan): ΔD = Δ Reserves/(c+v), c=cash-deposit ratio, v=target
ΔD = ΔReserves/v , when c=0 (in class example).
If you look at simplifying assumptions #2, c = 0 for simplicity.
Bond Prices Fall As Interest Rate Rises
1. households hold wealth: money “bond”
2. Single- [payment bond ($100, in one year)
Bond price = 100/ (1+r) r = interest rate
r= 2% bond price = $98.04 100/(1.02) = 98.04
www.notesolution.com r= 5% bond price = $95.24 100/ (1.05)=95.24
r=10% bond price = $90.91 100/(1.10) = 90.91
1) if invested $95.24 for 1 year at %5, this sum wouuld grow to 100$
2) 95.24 is present valuye of $100 due in one year if discount rate is %5.
Money Supply: Currency + bank deposits
Money supply, money demand: determine interest rate
What are determinants of money demand?
The Demand for Money: Intuition
Assume: household has two assets
1) money (currency + bank deposits): pays no interest
2) bonds: pay interest
you have: money $1,000
would you increase or reduce money holdings if:
1)The interest rate rises from %5 to 10%?
2) your income rises, so you will be spending more on goods and services?
3) Prices in the economy increase, so you will have to pay more for the same
goods and services you plan to purchase?
DEMAND FOR MONEY
-Falls as interest rate increases.