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Chapter 24 and 26 Econ Exam Notes.docx

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York University
ECON 2000
Mokhles Hossain

Chapter 24: What is money? Money: any commodity or token that is generally acceptable as a means of payment Means of payment: method of settling a debt Money serves three functions: 1. Medium of exchange (any object that is generally accepted in exchange for goods and services) - Without it, goods/services must be exchanged for other goods and services (called barter) - This requires a ―double coincidence of wants‖ when you must find someone that will trade their good and at the same time want the good you have to offer 2. Unit of Account (an agreed measure for stating the prices of goods and services) - Movie costs $8, and case of pop costs $4, we know movie costs two cases of pop instead of movie costing 2 cases of pop which costs 3 ice cream cones which costs 4 packs of gum 3. Store of value (it can be held and exchanged later for goods and services) - to make money as useful as possible as store of value, low inflation rate necessary In Canada, money consists of: - Currency (notes and coins held by individuals and businesses) - Deposits (deposits of individuals and businesses at banks/other depository institutions such as trust and mortgage companies, credit unions) 2 Official measures of money in Canada: - M1 (currency outside banks, personal chequable deposits, non-personal chequable deposits) - M2 (M1 + personal non- chequable deposits, non-personal non-chequable deposits, fixed term deposits) - Since M2 deposits that are not means of payment are easily convertible (liquid) to a means of payment, they are money - Deposits are money, but not cheques because they involve a transfer of deposits - Credit card is not money because swiping it to buy something is an instant loan. Money is used when the credit card company bills you The Banking System: 1. Depository Institution (private firm that takes deposits from households and firms and makes loans to other households and firms) - Chartered banks (private firms, by far the largest institutions in the banking system, chartered under Bank Act of 1992 to receive deposits and make loans) - In 2008, 14 Canadian owned banks (TD, CIBC, RBC) and foreign owned banks owned bulk of M1 and M2 deposits - Credit Union (cooperative organization operating under the Cooperative Credit Association Act of 1992, receives deposits from and makes loans to its members) - Caisse populaire in Quebec - Trust and mortgage loan company (privately owned depository institution operates under Trust and Loan Companies Act of 1992, receive deposits, make loans, act as trustee for pension funds and estates) - Since 1992, all these institutions have increasingly similar functions, basically all called banks - Depository institutions clear cheques, manage accounts, credit cards, internet banking - Use funds they receive from depositors and make loans and buy securities that earn higher interest rate than paid to depositors, they must weigh return against risk Chartered bank puts received funds into 4 types of assets: - Reserves (notes and coins in a bank’s vault or in a deposit account at Bank of Canada - Liquid assets (government of Canada Treasury bills and commercial bills; bank’s first line of defence if they need reserves; low risk low interest rate - Securities (government of Canada bonds and other bonds such as mortgage-backed securities; a bond is a promise to make specific payments on a specific date; high risk high interest rate - Loans (commitments of funds for an agreed-upon period of time; made to corporations to finance purchase of capital; individuals for mortgages and consumer goods; highest risk and can’t be converted to reserves easily) Economic benefits provided by depository institutions: - Create liquidity (by borrowing short and lending long, taking deposits and ready to repay them on short notice) - Pool Risk (lend to thousands of people because if one person defaults on their loan, not a big deal) - Lower cost of borrowing (firms know where to go to get a loan, don’t have to go searching various places) - Lower cost of monitoring borrowing (Banks can monitor firms that households have given money to) Bank of Canada is Canada’s central bank, a public authority that supervises other banks and financial institutions, financial markets, and the payment system, and conducts monetary policy - Banker to banks and government (accepts deposits from depository institutions and they become parts of the reserves of these banks) - Lender of last resort (ready to make loans when banking system is short of reserves) - Sole issuer of bank notes (only bank permitted to issue bank notes, unlike Ireland and Scotland) Assets: government securities, loans to depository institutions (increased in 2008, recession) Liabilities: Bank of Canada notes, depository institution deposits Monetary Base - the sum of Bank of Canada notes, coins, and depository institution deposits at the Bank of Canada - base that supports nation’s money - to change monetary base, Bank conducts open market operation, which is sale of government of Canada securities (Treasury bills and bonds) in the open market Payments system (system through which banks make payments to each other to settle transactions by their customer; operated by Canadian Payments Association (CPA)) How Banks Create Money - When you use your credit card issued by the bank, you are taking a loan from your bank. Wherever card is used (e.g. Petro Canada), they will go to their bank at the end of the day and give the credit card slips, and that amount will be credited to the Petro Canada account. - This transaction creates a bank deposit and a loan. You increase the size of your loan and Petro Canada increases size of its bank deposit (deposits are money). The quantity of deposits that the banking system can create limited by: - Monetary base (size of base limits total quantity of money banking system can create) - Desired reserves Actual reserves consist of the notes and coins in its vaults and its deposit at the Bank of Canada. Uses its reserves to meet depositors’ demand for currency and payments to other banks The fraction of a bank’s total deposits that are held in reserves is called the reserve ratio. Desired reserves are reserves that bank wishes to hold. Desired reserve ratio is desired reserves expressed as a percentage of total deposits. Excess reserves are its actual reserves minus its desired reserves. With excess reserves, bank makes loans and creates money; when it is short, loans and deposits shrink. - Desired currency holdings Desired currency holdings increase when deposits increase, currency leaves the banks when loans are made and deposits increase. Leakage of currency = currency drain. Ratio of currency to deposits = currency drain ratio. Higher the ratio, smaller is quantity of deposits and money that banking system can create from given amount of monetary base. Creation of money: 1. Banks have excess reserves 2. Banks lend excess reserves 3. Quantity of money increases 4. New money is used to make payments 5. Some of the new money remains on deposit 6. Some of the new money is a currency drain 7. Desired reserves increase because deposits have increased 8. Excess reserves decrease but remain positive Money multiplier is th
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