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Chapter 24 Notes.docx

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Western University
Economics 1022A/B
Jeannie Gillmore

Chapter 24 Notes Money  money is defined as any commodity or token that is generally acceptable as a means of payment o means of payment refers to a method of settling a debt  serves three main functions: o medium of exchange  it is generally accepted in exchange for goods and services  allows for the overcoming of double coincidence of wants with the barter system  a credit card is a medium of exchange, but not money (it only creates more debt) o unit of account  agreed measure for stating the price of goods and services o store of value  money can be held and exchanged later for goods and services  other stores of value include cars and houses  the more stable the value of a commodity or token, the better it can act and the more useful it is as money, though no store has completely stable value  to make money a useful store of value, a low inflation rate is needed Money in Canada  money consists of: o currency  the notes and coins held by individuals and businesses are known as currency  notes are money because the government declares them legal tender  notes and coins inside banks are not counted as currency because they are not held by individuals o deposits at banks and other depository institutions (trust/mortgage companies, credit unions)  deposits are money because the owners of the deposits can use them to make payments  official measures of money o M1  currency held by individuals and businesses plus chequable deposits owned by individuals and businesses o M2  consists of M1 plus all other deposits (non- chequable deposits and fixed term deposits)  the test of whether an asset is money is whether it serves as payment o M1  currency passes  chequable deposits are money because they can be transferred from one person to another by writing a cheque or using a debit card  thus, M1 is money o M2  some savings deposits are not a means of payment  liquid assets  liquidity is the property of being easily convertible into a means of payment without a loss in value  because the deposits in M2 that are not means of payment can be converted into a means of payment (currency or chequable deposit), they are counted as money  cheques are not money o a cheque is not additional money in circulation, it is just instructions to transfer money from one account to another  credit cards are not money o a credit card is an ID card that lets you take out a loan the instant you buy something  “I agree to pay for these goods when the credit card company bills me” o to make payment, you need to have currency or a chequable deposit Depository Institutions  a depository institution is a private firm that takes deposits from households and firms and makes loans to other households and firms  three institutions that make up the nation’s money: o chartered banks  private firms that receive deposits and make loans  14 Canadian owned banks, 33 foreign-owned banks o credit unions and caisses populaires cooperative organization that receives deposits from and makes loans to its member o trust and mortgage companies  privately owned firm that receive deposits, make loans, and act as trustee for pension funds and for estates  depository institutions provide services such as cheque clearing, account management, credit cards, and Internet banking o earn most of their income by using the funds they receive from depositors to make loans and buy securities that earn a higher interest rate than that paid to depositors o puts its funds into four types of assets:  reserves  notes and coins in its vault or its deposit account at the Bank of Canada  used to meet depositors’ currency withdrawals and to make payments to other banks  in normal times, a bank keeps about 0.5% of deposits as reserves  liquid assets  Government of Canada T-bills and commercial bills  first line of defence is reserves are needed  can be sold and instantly converted into reserves with no risk of loss  low risk = low interest rate  securities  GoC bonds and others (e/x mortgage backed securities)  converted into reserves at prices that fluctuate  riskier than liquid assets, but a higher interest rate  loans  commitments of funds for an agreed-upon period of time  make loans to corporations for the purchase of capital, and to households for homes and durable goods (e/x cars)  risky, cannot be converted to reserves until repaid Economic Benefits Provided by Depository Institutions  create liquidity o done by borrowing short and lending long  taking deposits and standing ready to repay them on short notice or on demand and making loan commitments that run for long terms  pool risk o if you lend to one person, there is high risk as if default occurs you lose the entire loan amount o if you lend to 1000 people and one person defaults, you lose almost nothing  lower the cost of borrowing o lower the cost by making it convenient for firms to find a place to obtain a loan  a firm can get $1 million from a single institution that gets deposits from a large number of people but spreads the cost of this activity over many borrowers  lower the cost of monitoring borrowers o by monitoring borrowers, a lender can encourage good decisions that prevent defaults  only one firm has to monitor the borrowers, as opposed to several individual households Bank of Canada  the Bank of Canada is Canada’s central bank  public authority that supervises other banks and financial institutions, financial markets, and the payments systems, and conducts monetary policy  three defining characteristics: o banker to banks and Government  only accepts the business of the depository institutions, the Government of Canada, and the central bank of other countries  the deposits made are part of the banks reserves o lender of last resort  it stands ready to make loans when the banking system as a whole is short of reserves  if some banks are short of reserves while others have surplus, the overnight loan market moves the funds from one bank to another o sole issuer of bank notes  in Canada, the central bank has a monopoly on this activity Bank of Canada’s Balance Sheet  influences the economy by changing interest rates o to do this, the Bank must change the amount of money in the economy  depends on the size and composition of its balance sheet  assets o holds GoC securities  Treasury bills  buys in the bills market o makes loans to depository institutions  in normal times, this is small or 0  liabilities o Bank of Canada notes are the dollar bills that are used in daily transactions  held by individuals and businesses o depository institution deposits are part of the reserves of these institutions The Monetary Base  the Bank of Canada’s liabilities together with coins issued by the Mint (coins are not the liabilities of the Bank of Canada) make up the monetary base o the monetary base is the sum of Bank of Canada notes, coins, and depository institution deposits at the BoC  to change the monetary base, the Bank of Canada conducts an open market operation, which is the purchase or sale of government securities by the Bank of Canada in the open market  open market purchase example o the BoC buys $100 of government securities from CIBC  CIBC then has $100 less securities, and the BoC has $100 more securities  BoC pays for the securities by placing $100 in CIBC’s deposit account at the bank of Canada o the BoC assets and liabilities increased by $100, CIBC’s total assets are unchanged (100 in securities  100 in reserves)  open market sale example o the BoC sells $100 of government securities from CIBC  CIBC has 100 more securities and the BoC has $100 less  CIBC pays for the securities by using $100 million of its reserve deposits Creating Deposits by Making Loans  example: o Andy is issued a Visa card by CIBC, and uses it to buy a tank of gas from shell  when Andy signs the card sales slip, he takes a loan from CIBC and obligates himself to pay it at a later date  at the end of the business day, a Shell clerk takes a pile of signed credit card sales slips to the bank, which credits Shell’s account with the value of slips (minus commissions) o this creates a bank deposit and a loan  Andy increased the size of his loan, and Shell has increased the size of its bank deposit  because bank deposits are money, CIBC has created money  three factors limit the quantity of loans and deposits that the banking system can create through these types of transactions: o the monetary base  the size of the monetary base limits the total quantity of money that the banking system can create  the reason is that banks have a desired level of reserves, households and firms have a desired holding of currency, and both of these desired holdings of the monetary base depend on the quantity of deposits o desired reserves  a bank’s desired reserves are the reserves that it plans to hold (different from required reserves)  the quantity of desired reserves depends on the level of deposits and is determined by the desired reserve ratio  the ratio of reserves that banks plan to hold  this exceeds the required reserve ratio by an amount that the banks determine to be prudent on the basis of their daily requirements and in light of the current financial markets o desired currency holding  the proportions of money held as currency depend on how households and firms plan to make payments  ei
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