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Week 9 chapter notes

Economics for Management Studies
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Chapter 27 Money and Banking Notes
27.1 The Nature of Money
What is Money?
x medium of exchange Æ anything that is generally accepted in return for goods and services sold
x barter Æ a system in which goods and services are traded directly for other goods and services
x the double coincidence of wants is unnecessary when a medium of exchange is used
The Origins of Money
x Gresham’s law Æ the theory that “bad”, or debased, money drives “good”, or undebased, money out of circulation
x law predicts that when 2 types of money are used side by side, one with greater intrinsic value will be driven out of circulation
x bank notes Æ paper money issued by commercial banks
x gold standard Æ a currency standard whereby a country’s currency is convertible into gold at a fixed rate of exchange
x fiat money Æ paper money or coinage that is neither backed by nor convertible into anything else but is decreed by the
government to be accepted as legal tender
x legal tender Æ anything that by law must be accepted for the purchase of goods and services or the repayment of a debt
x if fiat money is generally acceptable, it is a medium of exchange; it its purchasing power remains stable, it is a satisfactory store
of value; if both of these things are true, it serves as a satisfactory unit of account; today, almost all currency is fiat money
Modern Money: Deposit Money
x deposit money Æ money held by the public in the form of deposits with commercial banks
x bank deposits are money; today, just as in the past, banks create money by issuing more promises to pay (deposits) than they
have cash reserves available to pay out
27.2 The Canadian Banking System
x central bank Æ a bank that acts as banker to the commercial banking system and often to the government as well; usually a
government-owned institution that controls the banking system and is the sole money-issuing authority
The Bank of Canada
x the system of joint responsibility keeps the conduct of monetary policy free from day-to-day political influence while ensuring
that the government retains ultimate responsibility for monetary policy
x basic functions of the bank—banker to the commercial banks, banker to the federal government, regulator of the money supply,
and regulator and supporter of financial markets
Commercial Banks in Canada
x commercial bank Æ a privately owned, profit-seeking institution that provides a variety of financial services, such as accepting
deposits from customers and making loans and other investments
x clearing house Æ an institution where interbank indebtedness, arising from the transfer of cheques between banks, is computed
and offset and net amounts owing are calculated
x the reserves needed to ensure that depositors can withdraw their deposits on demand will normally be quite small
x bank run Æ a situation in which many depositors rush to withdraw their money, probably leading to a banks financial collapse
x fractional-reserve system Æ a banking system in which commercial banks keep only a fraction of their deposits in cash or on
deposit with the central bank
x reserve ratio Æ fraction of its deposits that commercial bank holds as reserves in form of cash or deposits with central bank
x target reserve ratio Æ the fraction of its deposits that a commercial bank wants to hold as reserves
x excess reserves Æ reserves held by a commercial bank in excess of its target reserves
27.3 Money Creation by the Banking System
The Creation of Deposit Money
x if v is target reserve ratio, new deposit to banking system will increase total amount of deposits by 1/v times new deposit
x with no cash drain from the banking system, a banking system with a target reserve ratio of v can change its deposits by 1/v
times any change in reserves
Excess Reserves and Cash Drains
x deposit creation does not happen automatically; it depends on the decisions of bankers; if banks do not choose to lend their
excess reserves, there will not be an expansion of deposits
x the larger is the cash drain from banking system, the smaller will be total expansion of deposits created by a change in reserves
27.4 The Money Supply
x money supply Æ the total quantity of money in an economy at a point in time; also called the supply of money
Kinds of Deposits
x term deposit Æ an interest-earning bank deposit, subject to notice before withdrawal
x the long-standing distinction between money and other highly liquid assets used to be that, narrowly defined, money as a
medium of exchange that did not earn interest, whereas other liquid assets earned interest but were not media of exchange; today,
this distinction has almost completely broken down
Definitions of the Money Supply
x M1 Æ currency plus demand deposits
x M2 Æ M1 plus savings deposits at the chartered banks
x M2+ Æ M2 plus deposits held at institutions that are not chartered banks
Near Money and Money Substitutes
x near money Æ liquid assets that are easily convertible into money without risk of significant loss of value and can be used as
short-term stores of value but are not themselves media of exchange
x money substitute Æ something that serves as a medium of exchange but is not a store of value
27.1 The Nature of Money
x Money is anything that serves as a medium of exchange, a store of value, and a unit of account.
x Money arose because of the inconvenience of barter, and it developed in stages: from precious metal to metal coinage, to paper
money convertible to precious metals, to taken coinage and paper money fractionally backed by precious metals, to fiat money,
and to deposit money.
27.2 The Canadian Banking System
x The banking system in Canada consists of tow main elements: the Bank of Canada (which is the central bank) and the
commercial banks.
x The Bank of Canada is a government-owned corporation that is responsible for the day-to-day conduct of monetary policy.
Though the Bank has considerable autonomy in its decisions, ultimate responsibility for monetary policy resides with the
x Commercial banks are profit-seeking institutions that allow their customers to transfer deposits from one bank to another by
means of cheques or debit cards. They create money as a by-product of their commercial operations by making or liquidating
loans and various other investments.
27.3 Money Creation by the Banking System
x Because most customers are content to pay by cheque or debit card rather than with cash, banks need only small reserves to back
their deposit liabilities. It is the fractional reserve aspect of the banking system that enables commercial banks to create deposit
x When the banking system receives a new cash deposit, it can create new deposits equal to some multiple of this amount. For a
target reserve ratio of v and a cash-deposit ratio of c, the total change in deposits following an injection of reserves is:
û Deposits = û Reserves / (c + v)
27.4 The Money Supply
x The money supplythe stock of money in an economy at a specific moment—can be defined in various ways. M1, the
narrowest definition, includes currency and chequable deposits. M2 includes M1 plus savings deposits and smaller term deposits.
M2+ includes M2 plus deposits at nonbank financial institutions and money-market mutual funds.
x Near money includes interest-earning assets that are convertible into money on a dollar-for-dollar basis but that are not currently
a medium of exchange. Money substitutes are things such as credit cards that serve as a medium of exchange but are not money.
Chapter 29 Monetary Policy in Canada Notes
29.1 How the Bank of Canada Implements Monetary Policy
Money Supply Versus the Interest Rate
x monetary policy can be implemented by influencing money supply directly or by influencing interest rate directlybut not both
x in principle, monetary policy can be implemented either by setting the money supply or by setting the interest rate; but for a
given MD curve, both cannot be set independently
x the Bank of Canada cannot directly control the money supply, though it can influence it by changing the amount of cash reserves
in the banking system; in addition, the slope and position of the MD curve cannot be accurately predicted; as a result, the Bank of
Canada chooses not to implement its monetary policy by attempting to control the money supply
x by directly setting the interest rate, the Bank of Canada can avoid the problems associated with imperfect control over the money
supply and uncertainty about the slope and position of the MD curve
The Bank of Canada and the Overnight Interest Rate
x overnight interest rate Æ the interest rate that commercial banks charge each other for overnight loans
x bank rate Æ the interest rate the Bank of Canada charges commercial banks for loans
x the Bank’s policy instrument is its target for the overnight interest rate; by raising or lowering its target rate, the Bank affects the
actual overnight interest rate; changes in the overnight rate then lead to changes in other, longer-term, interest rates
The Money Supply is Endogenous
x open-market operation Æ the purchase and sale of government securities on the open market by the central bank
x through its open-market operations, the Bank of Canada changes the amount of currency in circulation; but the Bank does not
initiate these transactions; it conducts them to accommodate the changing demand for currency by the commercial banks
29.2 Inflation Targeting
Why Target Inflation?
x high and uncertain inflation leads to arbitrary income redistributions and also undermines the efficiency of the price system
x economists and central bankers argue that monetary policy is most important determinant of country’s long-run rate of inflation
The Role of the Output Gap
x output gaps pressure for the rate of inflation to change; to keep the rate of inflation close to the 2% target, the Bank of Canada
closely monitors real GDP in the short run and designs its policy to keep real GDP close to potential output
Inflation Targeting as a Stabilizing Policy
x inflation targeting is a stabilizing policy; positive shocks will be met with a contractionary monetary policy; negative shocks will
be met with an expansionary monetary policy
x inflation targets are not as “automatic” a stabilizer as the fiscal stabilizers built into the tax-and-transfer system; but if the central
bank is committed to maintaining the credibility of its inflation target, its policy adjustments will act to stabilize the economy
Complications in Inflation Targeting
x due to the volatility of food and energy prices that is often unrelated to the level of output gap in Canada, the Bank of Canada
closely monitors the rate of “core” inflation even though its formal target of 2% applies to the rate of CPI inflation; changes in
core inflation are a better indicator of Canadian excess demand than are changes in CPI inflation
x many economic events can lead to changes in the exchange rate; the cause of any change must be known before the appropriate
monetary policy (MP) response can be determined
x changes in exchange rate can signal need for changes in stance of monetary policy; only once cause of exchange-rate change is
determined, however, can the Bank of Canada design a policy response appropriate for keeping inflation close to its target
29.3 Long and Variable Lags
What are the Lags in Monetary Policy?
x MP is capable of exerting expansionary & contractionary forces on economy, but operates with time lag that’s long and variable
Destabilizing Policy?
x long time lags in effectiveness of monetary policy make monetary fine-tuning difficult; policy may have destabilizing effect
Political Difficulties
x time lags in monetary policy require that decisions regarding a loosening or tightening of monetary policy be forward-looking;
this often leads to criticism of monetary policy, especially by those who do not recognize the long time lags
29.4 30 Years of Canadian Monetary Policy
Economic Recovery: 1983 – 1987
x main challenge for monetary policy in this period was to create sufficient liquidity to accommodate the recovery without
triggering a return to the high inflation rates that prevailed at the start of the decade
Rising Inflation: 1987 – 1990
x by 1987, many economists argued that if monetary policy was not tightened, Canada would experience gradually increasing
inflation until once again a severe monetary restriction would be required to reduce the rate of inflation
Disinflation: 1990 1992
x despite the Bank’s explicit policy of “price stability”, the actual inflation rate increased slightly in the years immediately
following John Crow’s policy announcement, from 4% to just over 5% in 1990