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Principles of Macroeconomics ECONS 202

COQUITLAM COLLEGE

Kojo Laryea

THE MONETARY SYSTEM

Chapter 10

Objectives

▪Consider the nature of money and its functions in the economy

▪Learn about the Bank of Canada

▪Study how the banking system helps determine the supply of money

▪Examine the tools used by the Bank of Canada to alter the supply of money

THE MONETARY SYSTEM

▪In this chapter, the role of money in the economy

is explored.

▪ What is money?

▪ What are the various forms of money?

▪ The creation of money by the banking system.

▪ How the government controls the quantity of money

in circulation.

THE MEANING OF MONEY

▪Money: The set of assets in the economy that people regularly use to buy goods and

services from other people.

THE FUNCTIONS OF MONEY

▪ Medium of exchange: An item that buyers give to sellers

when they want to purchase goods or services.

▪ When you buy a shirt at a clothing store, the store gives you

the shirt, and you give the store your money

▪ This transfer of money from buyer to seller allows the

transaction to take place

▪ When you walk into a store, you are confident that the store

will accept your money for the items it is selling because

money is the commonly accepted medium of exchange

THE MEANING OF MONEY

THE FUNCTIONS OF MONEY

▪ Unit of account: The yardstick people use to post prices and record debts.

▪ When you go shopping, you might observe that a shirt costs $20 and a hamburger cost $2.

▪ Even though it would be accurate to say that the price of a shirt is 10 hamburgers and the price of a hamburger is 1/10 of a shirt, prices are never quoted in this way

▪ Similarly, if you take out a loan from a bank, the size of your future loan payments will be measured in dollars, not in a quantity of goods and services

THE MEANING OF MONEY

THE FUNCTIONS OF MONEY

▪ Store of value: An item that people can use to transfer purchasing power from the present to the future. ▪ When a seller accepts money today in exchange for a good

or service, that seller can hold the money and become a buyer of another good or service at another time

▪ Money is not the only store of value in the economy because a person can transfer from the present to the future by holding assets

▪ Wealth: The total of all stores of value, including both monetary and non-monetary assets.

THE MEANING OF MONEY

THE FUNCTIONS OF MONEY (CONTINUED)

▪Liquidity: Describes the ease with which an asset

can be converted into a medium of exchange

▪Money is the most liquid of assets because it is

a medium of exchange

▪Other assets vary widely in their liquidity

▪Most stocks and bonds can be sold easily with

small cost, so they are relatively liquid assets

THE MEANING OF MONEY

THE KINDS OF MONEY

▪ Commodity money: Money that takes the form of a

commodity with intrinsic value.

▪ One example of commodity money is gold

▪ Gold has an intrinsic value because it can be used to make

jewelry

▪ Another example, is cigarette. During the World War II,

prisoners traded goods and services with one another using

cigarettes

THE MEANING OF MONEY

THE KINDS OF MONEY

▪ Fiat money: Money without intrinsic value that is accepted as money because of government decree. ▪ For example, compare the paper dollar in your wallet and the

paper dollar from a game of monopoly.

▪ Why can you use the first to pay your bill at a restaurant but not the second?

▪ The answer is that the Canadian government has decreed its dollar to be valid money

▪ Each paper dollar in your wallet reads “this note is legal tender”

THE MEANING OF MONEY

MONEY IN THE CANADIAN ECONOMY ▪ The quantity of money circulating in the economy is called

the money stock. ▪ It has a powerful influence on many economic variables. ▪ What is the quantity of money? Suppose you are given

the task of measuring how much money there is in the Canadian economy, what would you include in your measure

▪ Currency: The paper bills and coins in the hands of the public. ▪ Currency is clearly the most widely accepted medium of exchange

in our economy

▪ There is no doubt that it is part of the money stock

THE MEANING OF MONEY

MONEY IN THE CANADIAN ECONOMY

▪ Demand deposits: The balances in bank accounts that the depositors can access on demand by writing a cheque or using a debit card. ▪ Once you start to consider balances in chequing accounts as

part of the money stock, you are led to consider the larger variety of other accounts that people hold against the balances in their savings accounts, and they can easily transfer funds from savings into chequing accounts

▪ In addition, depositors in money market mutual funds can sometimes write cheques against their balances. Thus, these other accounts should plausibly be part of the Canadian money stock Copyright © 2017 by Nelson Education Ltd. 10-13

THE MEANING OF MONEY

MONEY IN THE CANADIAN ECONOMY

For the purposes in the lecture, we need to dwell on the

difference between the various measures of money

The important point is that the money stock for the

Canadian economy includes not just currency but also

deposits in banks and other financial institutions that can

be readily accessed and used to buy goods and service

THE MEANING OF MONEY

FIGURE 10.1 Two Measures of the Money Stock for the Canadian Economy

✓ List and describe the three functions of money.

Quick

Quiz

THE BANK OF CANADA

▪ The Bank of Canada (BoC): The central bank of

Canada.

▪ Central bank: An institution

designed to regulate the

quantity of money in the

economy.

THE BANK OF CANADA ACT

▪ Prior to the 1930s:

▪ Bank notes were issued by the Department of Finance

and the commercial banks.

▪ Canada was on the gold standard.

▪ With the collapse of the gold standard as a result of the

Great Depression, a need arose to control the quantity

of fiat money in the economy.

THE BANK OF CANADA

THE BANK OF CANADA ACT (CONTINUED)

▪ The government enacted the Bank of Canada Act in

1934.

▪ The BoC was established in 1935 and nationalized in

1938.

▪ The BoC is managed by a board of directors, including:

▪ The governor, the senior deputy governor, and 12

directors, including the deputy minister of finance.

THE BANK OF CANADA

THE BANK OF CANADA ACT (CONTINUED)

▪ In practice, the BoC is independent of the government.

▪ The primary responsibility of the BoC is to act in the

national interest.

▪ The preamble to the BoC Act: http://laws-

lois.justice.gc.ca/eng/acts/B-2/page-1.html

THE BANK OF CANADA

http://laws-lois.justice.gc.ca/eng/acts/B-2/page-1.html

THE BANK OF CANADA ACT (CONTINUED)

▪ The BoC has four main functions:

1. Issue currency.

2. Banker to the commercial banks.

3. Banker to the Canadian government.

4. Control the money supply.

THE BANK OF CANADA

THE BANK OF CANADA ACT (CONTINUED)

▪Money supply: The quantity of money available

in the economy.

▪Monetary policy: The setting of the money supply

by policymakers in the central bank.

THE BANK OF CANADA

MONETARY POLICY

The Bank of Canada:

▪ Has the power to increase or decrease the number of dollars in the economy.

▪ Is an important institution because changes in the money supply can profoundly affect the economy.

THE BANK OF CANADA

✓ What is the difference between a central bank like the Bank of Canada and a commercial bank like the Bank of Montreal?

Quick

Quiz

COMMERCIAL BANKS AND THE MONEY SUPPLY

▪ Although the Bank of Canada alone is

responsible for Canadian monetary

policy, the central bank can control the

supply of money only through its

influence on the entire banking system.

▪ What is the role played by commercial

banks (which include credit unions,

caisses populaires, and trust companies)

in the monetary system?

Th in

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10-25

COMMERCIAL BANKS AND THE MONEY SUPPLY

▪ Recall that the amount of money you hold includes both currency (the bills in your wallet and coins in your pocket) and demand deposits (the balance in your chequing account)

▪ Because demand deposits are held in banks, the behavior of banks influence the quantity of demand deposits in the economy and, therefore, the money supply

▪ This section examines how banks affect the money supply and, in doing so, how they complicate the Bank of Canada’s job of controlling the money supply.

THE SIMPLE CASE OF 100 PERCENT-RESERVE BANKING

▪ Assumptions:

▪ Currency is the only form of money.

▪ The initial supply of money is $100.

▪ Now suppose someone opens a bank: First National

Bank.

▪ All deposits received by First National Bank are held

as reserves: 100 percent-reserve banking.

▪ Reserves: Deposits that banks have received but

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE SIMPLE CASE OF 100 PERCENT-RESERVE BANKING (CONTINUED)

▪ We can express the financial position of First National Bank with a T-

account

▪ Using a T-account to show changes in the bank’s assets and

liabilities.

▪ The T-account for First National Bank if the economy’s entire $100 of

money is deposited in the bank:

COMMERCIAL BANKS AND THE MONEY SUPPLY

FIRST NATIONAL BANK

Assets Liabilities

Reserves $100 Deposits $100

THE SIMPLE CASE OF 100 PERCENT-RESERVE BANKING (CONTINUED)

▪ On the left-hand side of the T-account are the bank’s

assets of $100 (the reserves it hold in its vaults)

▪ On the right-hand side of the T-account are the bank’s

liabilities of $100 (the amount they owe to its depositors)

▪ Notice that the assets and liabilities of first National bank

exactly balance

▪ If the bank holds all deposits in reserves, banks do not

influence the supply of money

COMMERCIAL BANKS AND THE MONEY SUPPLY

MONEY CREATION WITH FRACTIONAL-RESERVE BANKING

▪ Fractional-reserve banking: A banking system in which

banks hold only a fraction of deposits as reserves.

▪ Reserve ratio: The fraction of deposits that banks hold as

reserves

▪ Assuming a reserve ratio of 10% …

COMMERCIAL BANKS AND THE MONEY SUPPLY

MONEY CREATION WITH FRACTIONAL-RESERVE BANKING

▪ Eventually, the bankers at First National Bank may start to

reconsider their policy of 100 percent-reserve banking

▪ Leaving all that money sitting idle in their vaults seems

unnecessary

▪ Why not use some of it to make loans?

▪ First National Bank has to keep some reserves so that

currency is available if depositors want to make

COMMERCIAL BANKS AND THE MONEY SUPPLY

FIRST NATIONAL BANK

Assets Liabilities

Reserves $10 Deposits $100

Loans $90

• The money supply (currency + deposits) = $100 + $90 =

$190

• When banks hold only a fraction of deposits in reserve,

banks create money! 10-32

MONEY CREATION WITH FRACTIONAL-RESERVE BANKING (CONTINUED)

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE MONEY MULTIPLIER

▪ The creation of money does not stop with First National

Bank

▪ Suppose the borrower from First National uses the $90 to

buy something from someone who then deposits the

currency in Second National Bank:

COMMERCIAL BANKS AND THE MONEY SUPPLY

SECOND NATIONAL BANK

Assets Liabilities

Reserves $9 Deposits $90

Loans $81

*The money supply = $100 + $90 + $81 = $271

10-34

THE MONEY MULTIPLIER

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE MONEY MULTIPLIER

▪ After the deposits, this bank has liabilities of $90

▪ If Second National also has a reserve ratio of 10 percent, it

keeps assets of $9 in reserve and makes $81 in loans

▪ In this way, Second National Bank creates an additional

$81 of money.

▪ If this $81 is eventually deposited in Third National Bank,

which also has a reserve ratio of 10 percent, this bank

COMMERCIAL BANKS AND THE MONEY SUPPLY

THIRD NATIONAL BANK

Assets Liabilities

Reserves $8.10 Deposits $81.00

Loans $72.90

*The money supply = $100 + $90 + $81+ $72.90 = $343.90

10-36

THE MONEY MULTIPLIER (CONTINUED)

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE MONEY MULTIPLIER

▪ The process goes on and on. Each time the money is

deposited and a bank loan is made, more money is

created

COMMERCIAL BANKS AND THE MONEY SUPPLY

Original deposit = $100.00

First National lending = $90.00 (= 0.9 × $100.00)

Second National lending = $81.00 (= 0.9 × $90.00)

Third National lending = $72.90 (= 0.9 × $81.00)

. .

. . Total money supply = $1000

10-38

THE MONEY MULTIPLIER (CONTINUED)

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE MONEY MULTIPLIER (CONTINUED)

▪ It turns out that even though this process of money

creation can continue forever, it does not create an

infinite amount of money

▪ The amount of money the banking system generates

with each dollar of reserves is called the money

multiplier

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE MONEY MULTIPLIER (CONTINUED)

▪ Money multiplier: The amount of money the banking

system generates with each dollar it receives.

▪ In the previous example, where the $100 of reserves

generates $1000 of money, the money multiplier is 10.

▪ The money multiplier is the reciprocal of the reserve

ratio.

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE MONEY MULTIPLIER (CONTINUED)

▪ The formula shows how the amount of money that

banks create depends on the reserve ratio

▪ If the reserve ratio was only 1/20 (5 percent), then the

banking system would have 20 times as much in

deposits as in reserves, implying a money multiplier of 20

▪ Similarly, if reserve ratio was 1/5 (20 percent), deposits

would be 5 times reserves, the money multiplier would

be 5, and each dollar of reserves would generate $5 of

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE MONEY MULTIPLIER (CONTINUED)

▪ The higher the reserve ratio, the less of each deposit

banks loan out, and the smaller the money multiplier

COMMERCIAL BANKS AND THE MONEY SUPPLY

While cleaning your apartment, you look under the sofa

cushion and find a $50 bill (and a half-eaten taco). You

deposit the bill in your chequing account.

The bank’s reserve requirement is 20% of deposits.

A. What is the maximum amount that the money

supply could increase?

B. What is the minimum amount that the money

supply could increase?

10-43

Active Learning Banks and the Money Supply

If banks hold no excess reserves, then

money multiplier = 1/R = 1/0.2 = 5

The maximum possible increase in deposits is

5 × $50 = $250

But money supply also includes currency,

which falls by $50.

Hence, max increase in money supply = $200.

You deposit $50 in your chequing account.

A. What is the maximum amount that the money supply

could increase?

10-44

Active Learning Answers

Answer: $0

If your bank makes no loans from your deposit, currency

falls by $50, deposits increase by $50, money supply does

not change.

You deposit $50 in your chequing account.

A. What is the maximum amount that the money supply

could increase?

Answer: $200

B. What is the minimum amount that the money supply

could increase?

10-45

Active Learning Answers

▪ Central banks have three main tools for monetary

control:

1. Open-market operations

2. Changes in reserve requirements

3. Changes in the overnight rate

▪ The BoC uses changes in the overnight rate to control

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE BANK OF CANADA’S

TOOLS OF MONETARY CONTROL

THE BANK OF CANADA’S TOOLS OF MONETARY CONTROL:

CHANGING THE OVERNIGHT RATE

▪ Bank rate: The interest rate charged by the Bank of

Canada on loans to the commercial banks.

▪ Overnight rate: The interest rate on very short-term loans

between commercial banks.

COMMERCIAL BANKS AND THE MONEY SUPPLY

▪ The BoC can alter the money supply by changing the bank

rate. This causes an equal change in the overnight rate.

▪ A higher overnight rate discourages banks from borrowing

reserves from the BoC, thus reducing reserves in the banking

system. The money supply contracts.

▪ Changes to the overnight rate are posted eight times a year.

▪ It can also change the overnight rate at any time, if

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE BANK OF CANADA’S TOOLS OF MONETARY CONTROL:

CHANGING THE OVERNIGHT RATE (CONTINUED)

FIGURE 10.2 The Bank of Canada’s Overnight Rate since 2008

▪ Open-market operations: The purchase or sale of

Government of Canada bonds by the Bank of Canada

▪ To increase the money supply, the BoC buys bonds

(or/and Treasury bills) from the public.

▪ To reduce the money supply, the BoC sells bonds

(or/and Treasury bills) to the public.

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE BANK OF CANADA’S TOOLS OF MONETARY CONTROL: OPEN-MARKET OPERATIONS

▪ Quantitative easing: The purchase and sale by the

central bank of nongovernment securities or

government securities with long maturity terms.

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE BANK OF CANADA’S TOOLS OF MONETARY CONTROL:

OPEN MARKET OPERATIONS (CONTINUED)

▪ Foreign exchange market operations: The purchase or sale

of foreign money by the Bank of Canada.

▪ If the Bank of Canada buys $100 M U.S. in the foreign

exchange market for $150 M Canadian, the Canadian

money supply increases immediately by $150 M.

▪ If the Bank of Canada sells foreign currency from its

foreign exchange reserves, it receives in exchange

Canadian dollars and the Canadian money supply is

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE BANK OF CANADA’S TOOLS OF MONETARY CONTROL:

OPEN-MARKET OPERATIONS (CONTINUED)

▪ Sterilization: The process of offsetting foreign exchange

market operations with open-market operations, so that

the effect on the money supply is cancelled out.

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE BANK OF CANADA’S TOOLS OF MONETARY CONTROL:

OPEN-MARKET OPERATIONS (CONTINUED)

▪ Reserve requirements: Regulations on the minimum

amount of reserves that banks must hold against

deposits.

▪ An increase in reserve requirements means that

banks must hold more reserves.

▪ It raises the reserve ratio.

▪ This lowers the money multiplier.

COMMERCIAL BANKS AND THE MONEY SUPPLY

THE BANK OF CANADA’S TOOLS OF MONETARY CONTROL:

CHANGING RESERVE REQUIREMENTS (CONTINUED)

✓ Describe how banks create money.

✓ If the BoC wanted to use all three of its policy tools to decrease the money supply, what would it do?

Quick

Quiz

THE END

Chapter 10