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Topic 19 - Money,Banking and Monetary Policy.pdf

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James Pesando

Topic 19 – Money, Banking and Monetary Policy th th Feb 28 – March 14 Outline: 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  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;  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 deteriorate…The nature of the US particularly challenging for Canada.” 2. Purpose To increase Aggregate Demand, to reduce “spillovers” from recession in US. 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  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) A L Reserve +100 Deposits +100 Bank 1(Intermediate) (Since excess reserves earns no A L interest income, so makes additional Desired Reserves +10 Deposits +100 loans, e.g. 90 to individuals who Excess Reserves +90 operate bookstore) Bank 1 (Final) A L 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) A L Reserves +90 Deposits +90 Bank 2 (Intermediate) A L To earn interest income, Bank 2 makes additional loan of 81; Desired Reserves +9 Deposits +90 Excess Reserves +81 Bank 2 (Final) A L Reserves +9 Deposits +90 Loans +81 3. Additional Deposits (Increases in Money Supply) Bank 1: +100; Bank 2: +90 Bank3: +81 …. sum = 1000 4. Deposit (money) multiplier = change in deposits / change in reserve; Deposit (money) multiplier = 1/desired reserve ratio = 1/.10 =10 (in the numerical example) Student exercise: If an individual withdraws $100 in cash from Bank 1 Desired reserves > actual reserves  Bank 1 calls in (reduces) loans; Result is multiple deposit contraction; 5. Conclusion: multiple deposit creation △deposits = △reserves/target reserve ratio △D = △R/c+v (In Text) v=target reserve ratio c=cash-deposit ratio △D =△reserves/v if c=0 (as in class example) (Recall assumption: no cash drain)  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/(1.1)=$90.91 1) If invested $95.24 for one year at 5%, this sum would grow to $100; 2) $95.24 is present value of $100 due in one year if discount rate is 5%;  Demand for Money 1. Intuition: Households hold two assets: Money (currency + bank deposits): pays no interest; Bonds: pay interest You have: Money $ 1,000 Bonds $ 10,000 Would you increase or reduce money holdings if: a) The interest rate rises from 5% to 10% b) Your income rises, so you will be spending more on goods and services? c) Prices in the economy increases, so you will have to pay more for the same goods and services you plan to purchase; 2. Demand for Money: The amount of money that everyone in the economy wants to hold; 3. Determinants of Money Demand: -- Interest Rate (i/r): Demand FALLS as interest rate INCREASES (speculative demand for money) Reason: a) Money does not pay interest b) Opportunity cost (interest forgone) of holding money increases -
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