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ECON 110 (199)
Chapter 27

Chapter 27 Notes

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ECON 110
Ian James Cromb

Chapter 27 – Money and Banking  In the long-run, an increase in money won’t increase potential real GDP, but has important effects in the short-run 27.1 – The Nature of Money What is Money?  Medium of Exchange: anything generally accepted in return for goods and services sold  Without money, we’d have to use Barter System (goods traded directly for other goods) which requires a double coincidence of wants  Money allow for specialization and division of labour  Must be durable, widely accepted, hard to fake, easy to carry  Money is only a good store of value when the value of money is relatively stable  Hyperinflation occurs when inflation exceeds 50% per month, only likely in cases of war, government upheaval The Origins of Money  Used to use gold and silver, measured for each transaction until the development of coins  Ribbing on the edge of a coin was preventative measure for clipping small amounts off to keep  Debasing coins (mixing in less valuable metal) increased the overall money supply, and caused inflation  Gresham’s Law: theory that “bad,” or debased money drives “good,” or un-debased money out of circulation  Paper money originated with goldsmiths, people who give their gold to goldsmiths and get a paper of the amount owing in return. When goldsmith was trusted by both parties, this note could be exchanged  Bank Notes: paper money issued by commercial banks, backed by gold and convertible on demand  Banks realized they didn’t need to keep all the gold on hand since most had no wish to convert it, so notes became fractionally backed  Whenever people panicked and lost confidence in banks, they were unable to fully convert and people were left with worthless notes  Gold Standard: currency standard where a country’s currency is convertible into gold at a fixed rate of exchange  Gold standard was abandoned after world wars, adopting Fiat Money (paper money/coinage not backed or convertible, but is described by the government to be accepted as legal tender  Legal Tender: anything that by law must be accepted for the purchase of goods or repayment of debt Modern Money: Deposit Money  Banks lost the authority to issue bank notes, but not to create deposit money  Deposit Money: money held by the public in the form of deposits with commercial banks  These take the form of cheques and now debit cards  Banks still issue more promises to pay than they hold on reserve, using fiat money instead of gold 27.2 – The Canadian Banking System  Central Bank: bank that acts as banker to the commercial banks and often government. Government-owned institution that controls the banking system and is the sole money-issuing authority  Financial intermediaries, acting between savers and investors, include chartered banks, trust companies, and credit unions The Bank of Canada  The bank has considerable autonomy in monetary policy (to keep it from day-to-day political influence) but is not entirely independent, called “joint responsibility”  Decisions rest normally with the governor of the bank, who meets regularly with minister of finance  The bank serves four major purposes…  Banker to the Commercial Banks o Accepts deposits and transfers money between banks o Keeps reserves, deposits from bank, which are liabilities to the Central Bank o Lenders of last resort to banks  Banker to the Federal Government o When government requires money, it issues government securities (short-term treasury bills or long-term bonds) sold to financial institutions, portfolio managers, and the Central Bank o Central Bank hold securities as asets, liabilities to government, and makes money through interest  Regulation of Money Supply o Money Supply -> supply of currency plus money help in deposits at commercial banks o By changing its liabilities (currency plus reserves) the bank can change the money supply  Regulation and Supporter of Financial Markets o Preventing wide-scale panic and resulting bank failures o Controlling interest rates Commercial Banks in Canada  Commercial Banks: privately owned profit-seeking institution that provides a variety of financial services, like accepting deposits from customers and making loans and other investments  All commercial banks hold deposits, permits transfers to any other bank in the country, make loans to households and firms, and invest in government securities  Other institutions like credit unions and trust companies also accept deposits/grants loans  Sometimes banks cooperate and share loans; “pool loan” divides it up into manageable segments between banks  Banks cooperate in bank credit cards (Visa, MasterCard)  Clearing House: institution where interbank indebtedness, arising from the transfer of cheques between banks, is computed and offset and net amounts owing are calculated  Banks earn profits through interest and dividends from securities they own, and obtained by using the money their customers have deposited  Competition for deposits is fierce; offer more interest, and specials features attract customers Reserves  Banks only keep a fraction of reserves on hand, enough to meet depositor’s day-to-day needs  Bank Run: many depositors rush to withdraw their money, possibly leading to bank’s financial collapse  Bank would have to close their doors until they could borrow enough money, and sell ass
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