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ECO102H1 (54)
Chapter 27

ECO100Y1 Chapter 27 Notes
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Department
Economics
Course
ECO102H1
Professor
Robert Gazzale
Semester
Winter

Description
ECO100Y1 Textbook Notes Chapter 27 27.1 The Nature of Money  Money: any generally accepted medium of exchange. o Medium of exchange: anything that is generally acceptable in return for goods and services sold. o Money acts as a store of value and as a unit of account.  Barter: a system in which goods and services are traded directly for other goods and services.  Double coincidence of wants: anyone who is specialized in producing one commodity has to find someone who wants that commodity and who specializes in producing the item that the first person needs.  The double coincidence of wants is unnecessary when a medium of exchange is used.  Money must: o Be easily recognizable o Be readily acceptable o Have a high value relative to its weight o Be divisible o Be reasonably durable o Be difficult (if not impossible) to counterfeit  When the price level is stable, the purchasing power of a given sum of money is also stable; when the price level is highly variable, so is the purchasing power of money, and the usefulness of money as a store of value is undermined. o Between the 1970s and early 1990s, inflation in Canada was high enough and sufficiently variable to diminish money’s usefulness as a store of value.  Precious metals came to circulate as money and to be used in many transactions because: o They had high and stable prices o They were easily recognizable o They were easily divisible into extremely small units o They did not easily wear out  The invention of coins eliminated the need to carry around bulk quantities of metals and also the need to weigh amounts. o A king/queen would affix his/her seal, which guaranteed the amount of precious metal that the coin contained. o The face value of the coin was nothing more than a statement that a certain weight of metal was contained therein.  Clipping: the practice whereby people would clip off pieces of coins and keep the clippings (undermined the acceptability of coins).  Milling: the process whereby coins were minted with a rough edge so that if the edge of a coin was smooth, it was known that it had been clipped.  Debasing: when rulers would remint coins by melting them down, adding in inexpensive metals and giving back just what had been given and putting the extras in the royal vault. o This increased the amount of money in the economy (but not the amount of gold). o This caused inflation since when rulers paid their bills, the recipients of the extra coins could be expected to spend them.  This caused a net increase in demand (bid up prices).  Gresham’s law (after Sir Thomas Gresham, an advisor to the Elizabethan court): the theory that “bad,” or debased, money drives “good,” or undebased, money out of circulation. o It predicts that when two types of money are used side by side, the one with the greater intrinsic value will be driven out of circulation.  This was seen when Queen Elizabeth I minted new coins that contained their full face value in gold which quickly disappeared out of circulation.  Would you rather use the debased or undebased coins to make a purchase? o This law is the reason why modern coins are merely tokens that contain a metallic value that is only a small fraction of their face value.  The invention of paper money should be credited to the process by which people would deposit their gold at goldsmiths who would in return give the depositor a note promising to return the gold on demand. o If the goldsmith was reliable and well known, people often simply traded the notes when making a purchase. o When paper money first came into being, it represented a promise to pay so much gold on demand.  The paper money was backed by precious metal and was convertible on demand into this metal.  Was issued by banks, and was called bank notes (each bank had a different one).  Bank notes: paper money issued by commercial banks.  Banks quickly began to issue more paper money redeemable in gold than the amount of gold that it held in its vaults. o They had noticed that people were constantly trading, depositing and sometimes withdrawing. o The currency issued in such a situation is said to be fractionally backed by reserves. o If banks issued too much paper money, they could easily run into trouble if confidence was lost in the bank or if demand for gold rose (would not be able to satisfy claims).  Soon it was only central banks who were able to issue currency in a country. o Gold would be brought to the central bank, which would issue currency in the form of “gold certificates”.  This set an upper limit on the amount of currency that could circulate in the economy. o Gold standard: a currency standard whereby a country’s currency is convertible into gold at a fixed rate of exchange. o The central banks, however, still issued more currency than they had in reserves.  In normal times, only a small fraction of the outstanding currency was presented for payment at any one time.  The smaller the fraction held in reserves, the larger the supply of paper currency that could be supported with a given stock of gold.  Between World Wars, countries abandoned the gold standard for fiat money. o Fiat money: 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.  Legal tender: anything that by law must be accepted when offered either for the purchase of goods or services or to repay a debt. o Gold backing for Canadian currency was eliminated in 1940.  If fiat money is generally acceptable, it is a medium of exchange. If 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. o Almost all currency today is fiat money.  Deposit money: money held by the public in the form of deposits with commercial banks.  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  Central Bank: 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.  Financial intermediaries: privately owned institutions that serve the general public. o Intermediaries because they stand between savers, whom they accept deposits, and investors, to whom they make loans.  Many of the world’s early central banks were private, profit-making institutions that provided services to ordinary banks (close ties developed with the government causing them to eventually become central banks). o The Bank of England is one of the world’s oldest and most famous central banks.  Began to operate in the 17 century, but was formally taken over by the government in 1947.  The Bank of Canada commenced operations on March 11, 1935. o It is a publicly owned corporation. o All its profits accruing from its operations are remitted to the Government of Canada. o The responsibilities for the Bank’s affairs rests with a board of directors composed of:  The governor  There have been eight since its inception (7 year term).  The senior deputy governor  The deputy minister of finance  12 directors o It’s organization is designed to keep the operation of monetary policy free from day-to-day political influence. o The ultimate responsibility for the Bank’s actions rest with the government, since it is the government that must answer to Parliament.  Known as the “joint responsibility” system (dates back to 1967).  In this system, the governor of the Bank and the minister of finance consult regularly.  In the case of a fundamental disagreement over monetary policy, the minister of finance can issue an explicit directive to the governor. o The governor would carry out the minister’s directive (or resign), and the responsibility for monetary policy would rest with the government.  In the absence of such a directive, responsibility rests with the governor of the Bank. o 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. o A central bank serves four main functions:  A banker for private banks  The central bank accepts deposits from commercial banks and will, on order, transfer them to the account of another bank.  These deposits with the Bank are called reserves.  Lenders of last resort: whereby central banks lend money to private banks that had sound investments but were in urgent need of cash.  A bank for the government  When the government requires more money than it collects in taxes, it needs to borrow, and it does so by issuing government securities. o The Bank buys many of these and the interest earned on these securities is largely what accounts for the Bank’s profits every year.  The regulator of the nation’s money supply  Most measures of money supply include currency in circulation plus deposits held at commercial banks. o The majority of the Bank’s liabilities are either currency held by the public or the reserves of the commercial banks.  Thus, by changing the levels of its assets and liabilities (can be done in many different ways), as its liabilities rise and fall, so does the money supply.  A regulator and supporter of financial markets  Central banks usually assume a major responsibility to support the country’s financial system and to prevent serious disruption by wide-scale panic and resulting bank failures. o I.e. The Bank’s action during the ’07-’08 recession in which it attempted
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