Class Notes (839,460)
Canada (511,348)
Economics (1,591)
ECO100Y1 (438)


8 Pages

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James Pesando

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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 Banking System 1. Centeral 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 Money (Canada: Currency + Bank Deposits) 1. Purposes 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 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 A L Reserves + 100 Bank1 Intermediate A L 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 A L Reserves +10 Deposits +100 Loans +90 Step Two: Individuals who borrow 90 spend this sum on textbooks for inventory. Testbook seller deposits cheque in Bank 2. Bank 2 Initial A L Reserves +90 Deposits +90 (when cheques clear, Bank 2 has additional reserves of 90) Bank 2 Intermediate A L Desired Reserves +9 Deposits +90 Excess Reserves +81 To earn interest income, Bank 2 makes additional loan of 81 Bank 2 Final A L Reserves +9 Deposits +90 Loans +81 Additional Deposits (increases in Money Supply) Bank 1: +100 Bank2: +90 Bank 3: +81 [Continues] +1000 Deposit (money) Multiplier = Δ deposits/ Δ reserves = 1/ desired Reserve ratio = 1/0.1 =10 Student Exercise 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 reserve ratio 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 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 bonds $10,000 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 Result: Reason: -Falls as interest rate increases.
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