12I Money, Banking, and Monetary Policy

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Gustavo Indart

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MONEY DEMAND/SUPPLY AND EQUILIBRIUM Money is a medium of exchange (acceptable in exchange for goods and services) Functions of money: Different forms of money: - medium of exchange - commodity money - unit of account - convertible paper money - standard of deferred payments - fiat money - a store of value - deposit money Three Measures of Money: M1 = currency in circulation + demand deposits M2 = M1 + notice deposits M3 = M2 + fixed-term deposits Money supply: M = CU + P Currency: CU = CU + PU B Bank Reserves: RE = CU + DB CB Bank of Canada As Canada’s central bank, the Bank of Canada controls and regulates financial institutions and markets. It is responsible for monetary policy and is independent from central government. Functions of the Bank of Canada: - Banker to the commercial banks - Lender of last resort to commercial banks - Banker to the federal government - Controller and regulator of the money supply - Regulator and supporter of money markets Balance Sheet of the Bank of Canada: Assets: Liabilities: - Loans to commercial banks (L )CB - Deposits of the commercial banks (D CB - Government bonds (GB) - Currency in circulation (CU = CUP+ CU )B - Foreign-currency reserves - Deposits of the Government (D )G Balance Sheet of a Commercial Bank Assets: Liabilities: - Loans made to its customers (L) - Deposits of its customers (D) - Deposits with the Bank of Canada (D )CB - Deposits of the Government (D )G - Government Bonds (GB) - Currency in its vault (CB ) Reserves of Commercial Banks: RE = CU +BD CB CU B to meet customers’ needs, D CB= to settle accounts with other banks Reserve Ratio Target or desired reserve ratio (v) → v = RE/D The reserve ratio is fraction of its deposits that a commercial bank holds as reserves in the form of cash or deposits with the central bank. Excess reserves imply that the reserve ratio is above the desired or target level. The Bank of Canada can affect the level of the desired reserve ratio by changing the interest rate it charges on loans to commercial banks (this is called the bank rate). The overnight rate is the rate at which commercial banks lend money to each other. Money Creation by Banking System M = CU +PD Banks cannot affect CU bPt can affect D by making loans to their customers. Whenever banks have excess reserves, they are able to create money by lending out the excess reserves. Assumptions: fixed desired reserve ratio (v) and no cash drain from the banking system The Money Multiplier
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