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ECO100 - FEB 27 The Banking System, money

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University of Toronto St. George
James Pesando

Policy Roots Real life.. March 3, 2009 ● Bank of Canada lowers the key interest rate from 1% to 0.5% because o The outlook for the global economy has continued to deteriorate… the nature of the US recession.. is particularly challenging for Canada ● Why lower interest rate? o Try to increase AD o Stimulate borrowing, § Mortgages, loans, etc ● How? Transmission Mechanism ○ How the interest rate impacts the AD - and the equilibrium Government Tools to Influence AD ● 1. Fiscal Policy o Government expenditure and Taxes o Positive shock for the economy ● 2. Monetary Policy o Interest Rate & the money supply § Optimal borrowing and lending o Print more money The Banking System ● 1. Commercial Banks o Take deposits from savers and loan it to spenders o Create money as a by-product of profit seeking activities § Money supply is doubled when cash is transferred between two parties ● 2. Central Bank (The Bank of Canada) o A bank for Commercial Banks & the Federal Government o Controls the interest rate and the money supply (to influence AD) o Can print of burn cash o Regulatory agency Money ● Money: Currency + Bank deposits o 1) Bank of Canada creates & destroys currency o 2) Chartered banks create deposits (Multiple deposit creation) ● Liquid funds that you can use ● Purpose of Money o Medium of exchange § Inefficiency of barter disappears § Double coincidence of want o Store of value o Unit of account § Can use money to compare two different things ● How do commercial banks create money? o Only small account of deposits are available for withdrawal & make loans with the excess money o The loans earn the market interest rate (profits), reserves do not o Reserves = vault cash + deposits at the Bank of Canada § Reserves are the funds the bank does not loan § Desired Reserve Ratio = Desired reserves/Deposits · Around 1% ● Simplifying Assumptions o 1. All banks have the same target/desired reserve ratio o 2. No cash drain (amount of cash held by the public is fixed) o 3. Bank capital is zero (in numerical examples) - is just a financial intermediary Balance Sheets & Multiple Deposit Creation ● Suppose the Desired reserve ratio is 0.10 ● Simple Balance Sheet Assets (A) Liabilities (L) Reserves: $40 Deposits: $400 Loans: $360 400 400 ● Reserve Ratio = 40/400 = 0.1 ● How is money created? Multiple Deposit Creation ● Step one: An individual deposits $100 in Bank 1 o The immediate change in Bank 1’s balance sheet A L Reserves +100 Deposits + 100 ● Since the bank’s desired reserves is 0.1, only 10% of the new deposits will be kept as reserves. The rest is excess A L Desired Reserves + 10 Deposits +100 Excess Reserves + 90 ● The bank earns 0 interest on the excess reserves, there is a motivation to make additional loans to maximize profits (lends 90 to a bookstore owner) ● The final change in bank 1’s balance sheet: A L Desired Reserves +10 Deposits +100 Loans + 90 ● Step two: Suppose the individual who borrowed the $90 spent this sum on textbook for inventory. The text
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