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Chapter 10-13

Economics - Chapter 10-13 Notes.docx

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McMaster University
Bridget O' Shaughnessy

CHAPTER TEN – THE MONETARY SYSTEM  If did not have money would have to barter  Double coincidence of wants: unlikely for two people to each have a good/services that the other wants  Money makes trade easier The Meaning of Money  Money: set of assets in an economy that people regularly use to buy goods/services from other people  Money only includes wealth that is accepted by sellers in exchange for goods/services The Functions of Money  Money has three functions in economy: 1. Medium of exchange: item that buyers give to sellers when they want to purchase good/service 2. Unit of account: the yardstick people use to post prices and record debt (use money to record value) 3. Store of value: item people can use to transfer purchasing power from present to future  Liquidity: ease with which an asset can be converted into the economy’s medium of exchange  Money is the most liquid asset  Stocks and bond can be sold easily so relatively liquid  Things that require more time/effort to sell are less liquid The Kinds of Money  Commodity money: money that takes the form of a commodity with intrinsic value (ex. gold, cigarettes)  Intrinsic value: item would have value even if were not used as money  Fiat money: money without intrinsic value that is used as money because of government decree  Government must establish what can be accepted as money  People must also want to accept money (ex. cigarettes are not declared money by government but are more valuable than money in prison) Money in the Canadian Economy  Currency: paper bills and coins in the hands of the public  Currency is most widely accepted medium of change  Demand deposits: balances in bank accounts that depositors can access on demand by writing a cheque or using a debit card  Should consider both currency and demand deposits as part of money stock The Bank of Canada  Bank of Canada: central bank of Canada  Central bank: an institution designed to regulate the quantity of money in the economy The Bank of Canada Act  Bank of Canada Act laid down responsibilities of the Bank of Canada  Bank of Canada: o Developed after Great Depression of the 1930s o Controlled by Canadian government o Gives any profits to government o Primary responsibility is to act in national interest  Bank of Canada has four jobs: o Issue Canada o Act as banker to commercial banks o Act as banker to Canadian government o Control quantity of money that is made available to the economy  Money supply: quantity of money available in the economy  Monetary policy: setting of the money supply by policymakers in the central bank Monetary Policy  Bank of Canada has power to increase/decrease number of dollars in the economy  Prices rise when government prints too much money  Bank of Canada’s policy decisions influence: o Economy’s rate of inflation in long run o Economy’s employment/production in the short run Commercial Banks and the Money Supply The Simple Case of 100 Percent-Reserve Banking  Total quantity of currency in economy is $100  Bank opens in economy and everyone deposits money in bank  Reserves: deposits that banks have received but have not loaned out  100 percent-reserve banking: all deposits are held as reserves  Before bank money supply was $100 of currency that people were holding  After bank opens money supply is $100 of demand deposits  If bank holds all deposits in reserve banks do not influence supply of money Money Creation with Fractional-Reserve Banking  Fractional-reserve banking: banking system in which banks hold only a fraction of deposits as reserves  Bank starts to give out loans as well as keeping deposits  Reserve ratio: fraction of deposits that banks hold as reserves  Reserve requirement: minimum amount of reserves that a bank must hold so it does not run out of cash  Before making loans: money supply is $100 of deposits in bank  After making loans: demand deposits are $100 and currency from loans is $90 so money supply is $190  When banks hold fraction of deposits in reserve banks create money The Money Multiplier  More money is made each time money is taken from one bank and deposited in another  Money multiplier: amount of money the banking system generates with each dollar of reserves  Money multiplier is reciprocal of reserve ratio  R = reserve ratio so each dollar of reserves generates 1/R dollars of money  The higher the reserve ratio: o The less of each deposit banks loan out o The smaller the money multiplier The Bank of Canada’s Tools of Monetary Control  Open-Market Operations: o Open-market operations: purchase/sale of Government of Canada bonds by the Bank of Canada o Central banks can increase supply of money in circulation by buying government bonds o Can decrease supply of money by selling government bonds o Foreign exchange market operations: purchase/sale of foreign money by the Bank of Canada o If buys foreign currency Canadian money supply increases o If sells foreign currency Canadian money supply decreases o Sterilization: process of offsetting foreign exchange market operations with open-market operations so that the effect on the money supply is cancelled out  Changing Reserve Requirements: o Reserve requirements: regulations on minimum amount of reserves that banks must hold against deposits o Influence how much money banking system can create with each dollar of reserves o Increase in reserve requirements:  Banks must hold more reserves  Can loan out less of each dollar deposited  Raises reserve ratio  Lowers money multiplier  Decreases money supply o Decrease in reserve requirements:  Lowers reserve ratio  Raises money multiplier  Increases money supply o Reserve requirements no longer used in banks  Changing the Overnight Rate: o Bank of Canada is banker to commercial banks o Bank rate: interest rate charged by Bank of Canada on loans to the commercial banks o Bank of Canada pays commercial banks bank rate minus half a percent on deposits o Commercial banks never need to pay more than bank rate for short- term loans (because can always get that from Bank of Canada) o Never need to accept less than bank rate minus half a percent o Overnight rate: interest rate on very short-term loans between commercial banks o Increase in overnight rate:  Discourages banks from borrowing from Bank of Canada  Reduces quantity of reserves in banking system  Reduces money supply o Lower overnight rate:  Encourages banks to borrow from Bank of Canada  Increases quantity of reserves  Increases money supply Problems in Controlling the Money Supply 1. Bank of Canada does not control amount of money households choose to hold as deposits in banks o More money households deposit o More reserves banks have o More money banking system can create 2. Bank of Canada does not control amount that commercial bankers choose to lend o Money deposited in bank only creates more money when bank loans it out o Money supply will fall if do not lend out money CHAPTER ELEVEN – MONEY GROWTH AND INFLATION The Classical Theory of Inflation The Level of Prices and the Value of Money  Inflation is economy-wide phenomenon that concerns the value of the economy’s medium of exchange  Can view price level as price of basket of goods/services  Price level rises: people have to pay more for goods/services they buy  Can view price level as measure of value of money  Price level rises: lower value of money because each dollar buys smaller quantity of goods/services  P: price of goods/services measured in terms of money  1/P: value of money measured in terms of goods/services Money Supply, Money Demand and Monetary Equilibrium  Supply and demand for money determines value of money  Demand for money reflects how much wealth people want to hold in liquid form  How much money people hold in wallets depends on how much they use credit cards/whether ATM is easy to find  Quantity of money demanded depends on: 1. Interest rate person could earn by using money to buy interest-bearing bond rather than leaving it in wallet  Demand for money depends on average level of prices in economy 2. People use money to buy goods/services 3. How much money they hold depends on prices of goods/services 4. Higher prices mean people must hold more money to pay for items 5. Higher price level (lower value of money): increases quantity of money demanded  In the long run: overall level of prices adjusts to level at which demand for money equals supply  Price above equilibrium: o People want to hold more money than Bank of Canada created o Price level must fall to balance supply/demand o Price level below equilibrium: o People want to hold less money than Bank of Canada has created o Price level must rise to balance supply/demand o Equilibrium: quantity of money people want to hold equals quantity of money supplied by Bank of Canada o Graph:  Supply curve is vertical because BofC has fixed quantity of money available  Demand curve is downward sloping: when value of money is low people demand larger quantity of it The Effects of a Monetary Injection  Increase in money supply makes dollars more plentiful  Results is increase in price level that makes each dollar less valuable  Quantity theory of money: o Quantity of money available in economy determines price level o Growth rate in quantity of money is primary cause of inflation A Brief Look at the Adjustment Process  Immediate effect of monetary injection is to create excess supply of money  Before injection economy was in equilibrium  Now people have more dollars in wallets than they want  Quantity supplied exceeds quantity demanded  People get rid of excess money by: o Buying more goods/services o Make loans to others by guying bonds o Deposit money into bank savings account  Injection of money increases demand for goods/services  Greater demand causes prices of goods/services to increase  Increase in price level increases quantity of money demanded  End up in new equilibrium The Classical Dichotomy and Monetary Neutrality  Nominal variables:  Variables measured in monetary units  Ex. income of corn farmer because measured in dollars  Real variables:  Variables measured in physical units  Ex. quantity of corn famer produces because measured in tons  Classical dichotomy: theoretical separation of nominal and real variables  Prices usually quoted in terms of money (nominal variables)  Relative price:  Price of one thing compared to another  Will be a real variable  Ex. price of one ton of corn is two tons of wheat  Different forces influence real/nominal variables  Changes in supply of money affect nominal variables not real variables  Monetary neutrality: proposition that changes in money supply do not affect real variables Velocity and the Quantity Equation  Velocity of money: rate at which money changes hands  V = (P x Y)/M  P: price level (GDP deflator)  Y: quantity of output (real GDP)  M: quantity of money  Quantity equation: M x V = P x Y  Relates quantity of money, velocity of money, dollar value of economy’s output of goods/services  M: quantity of money  V: velocity of money  P: price of output  Y amount of output  Elements to explain equilibrium price level and inflation rate: o Velocity of money is relatively stable over time o When central bank changes quantity of money (M): causes proportionate changes in nominal value of output (P x Y) o Output of goods/services (Y) is determined by factors (labour, physical capital, human capital, natural resources) and available technology so money does not affect output o When central bank alters money supply (M) and induces proportional changes in nominal value of output (P x Y) there is change in price level (P) o When central bank increases money supply rapidly, result is high rate of inflation The Inflation Tax  Inflation tax: o Revenue the government raises by creating money o Tax is subtle o Price level rises and dollars in pocket are less valuable o Like a tax on everyone who holds money  Government can make money by: o Levying taxes (income, sales, etc.) o Selling government bonds to public o Printing money it needs The Fisher Effect  Increase in rate of money growth raises rate of inflation  Nominal interest rate: o Rate given at the bank o Tells you how fast number of dollars in bank account will raise over time  Real interest rate: o Corrects nominal interest rate for effects of inflation o Tells you how fast purchasing power of savings account will raise over time  Real interest rate = Nominal interest rate – Inflation rate  Nominal interest rate = Real interest rate + Inflation rate  When Bank of Canada increase rate of money growth result is: o Higher inflation rate o Higher nominal interest rate  Fisher effect: one-for-one adjustment of nominal interest rate to the inflation rate The Cost of Inflation A Fall in Purchasing Power? The Inflation Fallacy  Inflation does not reduce people’s real purchasing power  Nominal incomes keep pace with rising prices  Feel robbed if do not get all of raise because of inflation rate  Raise would be lower without inflation Shoeleather Costs  Can avoid inflation tax by holding less money  Can do this by going to bank more often  Can keep more money in savings than in wallet  Inflation erodes value of money in wallet  Shoeleather cost: resources wasted when inflation encourages people to reduce money holdings  Cost of reducing money holdings is time/convenience you must sacrifice to keep less money on hand than if there were no inflation Menu Costs  Firms change price infrequently because costs money to change prices  Menu costs: costs of changing prices  Include: cost of deciding new prices, cost of printing new prices, cost of sending new prices to customers, cost of advertising new prices, cost of dealing with customer annoyance over price changes  Inflation increases menu costs Relative-Price Variability and the Misallocation of Resources  Prices change only once and a while  Inflation causes relative prices to vary more than they otherwise would  Market economy rely on relative prices to allocate scarce resources  Consumers decide what to buy by comparing quality/prices of goods/services  Inflation: o Distorts relative prices o Distorts consumer decisions o Markets less able to allocate resources Inflation-Induced Tax Distortions  Taxes are more problematic with inflation  Lawmakers do not take inflation into account
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