Topic 9: Banking System and Monetary Policy - Knowledge Summary and Exam Analysis

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Economics for Management Studies
Iris Au

Knowledge Summary: Topic 9: Part A – Banking System Types of Banks • Commercial Banks o Privately owned, profit-seeking institutions that provide a variety of financial services such as accepting deposits from customers and making loans and other investments o In Canada, the banking industry is dominated by chartered banks (e.g. RBC, BMO, TD, CIBC, and Scotiabank) o Chartered banks are subject to federal regulations and only until recently were required to hold reserves with the Bank of Canada against their deposit liabilities • Central bank – the Bank of Canada (BOC) o The operation of BOC is independent of the Federal government o The BOC performs the following functions: 1) Print money & take charge of money supply 2) Lender of last resort: The BOC acts as bankers’ bank  If commercial banks need to borrow money to stay afloat or remain liquid, they can borrow from BOC  However, when commercial banks borrow from the BOC, the BOC will charge them interest. The interest rate that the BOC charges is called the “bank rate” (+0.25% above overnight target rate) 3) Banker to the Canadian government  The BOC manages government banks accounts, foreign exchange reserves, and national debt The Balance Sheet of a Bank Assets Liabilities Cash & reserves Demand deposits Loans Equity Note: • Cash & reserves – cash held by the commercial bank to meet daily depositor’s requirements • Equity – the difference between bank’s assets and bank’s liabilities The Reserve Ratio • The reserve ratio (rr) refers to the fraction of its deposits that a commercial bank holds as cash & reserve • rr = (Cash held by chartered bank + Reserves)/ Demand deposit o The reserve ratio is a fraction (1 > rr > 0 ) • CBanks hold target reserves to satisfy daily withdrawals of the depositors and to avoid bank run • The reserve ratio should be interpreted as the “target reserve ratio” – the fraction of deposits banks would like to hold in the form of cash and reserves Commercial Banks and Money Creation • CBanks creates money by making loans until the target reserve ratio is met • Whenever a loan is created, the “Loans” account on the Assets side is increased, while also increasing the “Demand deposits” account on the Liabilities side • MS = currency in circulation + demand deposits • ∆MS = “Final” MS – “Initial” MS • An increase in loans means an increase demand deposits, thus increasing MS Topic 9: Part B – Monetary Policy The Banking System and the Money Supply • The BOC can affect the MS by using monetary policies • Case 1 – An Open Market Purchase (Expansionary monetary policy) o When the central bank runs an open market purchase, it is essentially buying government bonds on the open market o Immediately after the purchase, the “Cash & reserves” and “Demand deposits” increases by the same amount o However, at this point, the CBank has excess reserve, thus it tries to decrease its reserve ratio by making more loans to the public until the target reserve ratio is reached o Ultimately, as more loans are created, demand deposits increase, which leads to an increase in MS • Case 2 – An Open Market Sale (Contractionary monetary policy) o When the central bank runs an open market sale, it is essentially selling government bonds on the open market o Immediately after the sale, the “Cash & reserves” and “Demand deposits” decreases by the same amount o However, at this point, the CBank’s reserve ratio is less than target reserve ratio. It needs to increase its reserve ratio by calling back its loans, which leads to a decrease in demand deposits o As demand deposits decrease, so does the MS Topic 9 – Final Past Paper Answers 2006 Final Q22 – Q25: 22) Initial Balance Sheet: Assets Liabilities Reserves 2000 Demand deposits 120000 Loans 133000 Equity 15000 After BOC buys $100 in bonds: Assets Liabilities Reserves 2100 Demand deposits 120100 Loans 133000 Equity 15000 Excess Reserves = 2100 – 120100(1/60) = 98.33 Answer is J 23) When equilibrium is restored from purchase of $100 bonds: DD = 2100/(1/60) = 126000 ∆MS = 126000 – 120000 = 6000 Answer is P 24) When $45 is withdrew from DD account: DD = (2000 – 45)/(1/60) = 117300 ∆MS = 117300 – 120000 = -2700 Answer is K 25) When target reserve ratio changes to 1/61: DD = 2000/(1/61) = 122000
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