Class Notes (835,133)
Canada (508,952)
Economics (1,511)
EC140 (417)

Chapter 24.doc

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Rizwan Tahir

Chapter 24: Money, the Price Level, Inflation Tuesday, February 26, 2013 1:02 PM Money: any commodity or token that is generally acceptable as means of payment (method of settling debt) • 3 other functions: • medium of exchange  An object that is generally accepted in exchange for goods and services  In absence of money, people would need to barter: exchange goods and services directly (requires a double coincidence of wants, which is rare so barter is costly) • unit of account  An agreed measure for stating prices of goods and services • store value  Money can be held for a time and later exchanged for goods and services • Money in Canada: • Currency: the notes and coins held by individuals and firms is called deposits at banks and other depository institutions • We use "flat money"  Notes not backed by anything tangible  Has value as medium of exchange because government says so, government can maintain its value  Paper and coins have no intrinsic value, their value is ONLY value of what money can do • Official measures of money • M1: consists of currency and chequable deposits of individuals and businesses • M2: consists of M1 plus all other deposits • All items in M1 are means of payment • Some saving deposits in M2 aren't means of payments- these are called liquid assets • Deposits are money, but cheques aren't  Cheque is instruction to bank to transfer money (deposit is the money, not cheque itself) • Credit cards aren't money  Credit card enables holder to obtain a loan, but must be repaid with money The Banking System • Banking system consists of private and public institutions that: • Create money • Manage nation's monetary and payments systems • Consists of two institutions that play crucial role in financial markets • Depository institutions: firm that takes deposits from households and firms and makes loans to other households and firms  Institutions in banking system divide into: • Chartered banks • Credit unions and caisses populaires • Trust and mortgage loan companies  To make money (profit), banks lend money at higher rate of interest than the rate they pay on deposits  But banks must balance profit and prudence: • Loans generate profit • Depositors must be able to obtain their funds when they want them  Chartered bank puts depositors' funds into four types of assets • Reserves: notes and coins in its vault or its deposit at Bank of Canada • Liquid Assets: government of Canada Treasury bills and commercial bills • Securities: longer-term government of Canada bonds and other bonds such as mortgage-backed securities • Loans: commitments of fixed amounts of money for agreed-upon periods of time  Benefits: • Create liquidity: lend money when people/firms need it • Pool risk: loss of any one small loan to bank is minimal • Lower cost of borrowing: reduces search costs for firms in finding money • Lower cost of monitoring borrowers: they are set up to encourage good borrowing and repayment practices • The Bank of Canada  The central bank of Canada • Central bank: public authority that regulates a nation's depository institutions and control quantity of money  Bank of Canada is • Banker to banks and government • Accepts deposits from depository institution, government of Canada • Lender of last resort • Means that it stands ready to make loans when banking system as whole is short of reserves • Banks lend/borrow reserves from other banks in overnight loans market • Sole issuer of bank notes • Bank of Canada is only bank that is permitted to issue bank notes • Bank of Canada has monopoly on this activity  Understanding Bank of Canada's balance sheet is key for understanding money creation process (changes to its balance sheet after the monetary base, which is one step in money creation process)  Assets are: government securities, loans to depository institutions  Liabilities: Bank of Canada notes, deposits of banks and government  Monetary Base: sum of Bank of Canada notes, banks' deposits at Bank of Canada, and coins issued by the Mint • To initiate changes in economy, Bank of Canada changes interest rates (Monetary Policy) • First step in this process- alters monetary base • Bank of Canada conducts open market operation- purchase or sale of government of Canada securities by Bank of Canada in open market • Increase in monetary base, gaining reserves • Decrease monetary base, sell government securities to chartered banks How Banks Create Money • Reserves held at Bank of Canada aren't money • Bank of Canada open market operation changes monetary base (reserves) but doesn’t directly create currency or deposits • Changes reserves, but reserves aren't money • Money i
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