Day 1

MONEY AND MONEY AND MONETARY POLICYMONETARY POLICY

MeansOf

ExchangeStore

Of

PurchasingPower

MeasureOf

Value

Functions of MoneyFunctions of Money

Means of ExchangeMeans of Exchange• Without money, market participants

must trade one product for another product, a transaction known as barter.

• For example in a barter market, a barber who would wants to buy a clock must find a clockmaker who wants a haircut. Because it is hard for a barber to find a clockmaker that wants a haircut, trade is hence discouraged, so most people living in a barter system produce many items for themselves.

Means of Exchange Means of Exchange ContinuedContinued• The benefits of money as a means of

exchange are far-reaching. • People can minimize the time they

spend finding others with whom they can buy and sell.

• Specialization promotes the division of labor and allows an economy to achieve higher levels of output. Therefore, the use of money not only facilitates transactions of goods and services - it also raises living standards.

Store of Purchasing PowerStore of Purchasing Power

• Money’s second function is to providing a safe and accessible store of wealth. Money is an attractive store of purchasing power during the period from when it is earned to when it is spent. The advantage of money is its liquidity. Assets are most liquid when they can be quickly turned into money with little or no loss. For an economic choice there is and opportunity cost.

• People hold wealth as money when– BENEFITS OF LIQUIDITY > THE INCOME IT COULD

EARN IN A DIFFERENT FORM.

Measure of ValueMeasure of Value• Money provides buyers and sellers with a

unit of account, or pricing standards. The unit of account allows all products to be valued consistently against a common measure – in other words, it provides a point of comparison between two products.

• So if apples and oranges cost $ 2.00/kg and $ 4.00/kg respectively, one can say that oranges cost double that of the cost of the apples. The unit of account does the same on a grander scale; expressing GDP as a dollar value simplifies the picture by allowing a wide range of products to be quantified and combined.

Chartered Banks

Near Banks

Deposit TakersDeposit Takers

The Canadian Financial SystemThe Canadian Financial System• The supply of money is closely

associated with institutions known as deposit takers (bank itself) which accepts funds provided by savers and lend these funds to borrowers.

• Therefore the money the bank borrows from the savers is a liability, but on the other hand the money it lends out to money borrowers are its assets.

• Therefore, the profit maker, for the deposit takers is the difference in the interest charged by the lenders and the interest charged by the banks to its money borrowers.

The Canadian Financial System ContinuedThe Canadian Financial System Continued

• Cash reserves are the amount of money that flows into the institution but doesn’t flow out.

• It is used, when money borrowers come to the institution to make actual cash withdrawal. The deposit takers make no profit on these cash reserves. Deposit takers can be categorized as chartered and near banks.

Chartered BanksChartered Banks• Chartered banks are

regular banks that form the backbone of the Canadian Financial System. These banks receive charters from the federal government, allowing the banks to sell a variety of financial services. Therefore, this oligopoly market is dominated by:

Near BanksNear Banks

• Near banks, unlike chartered banks have more specialized services. The most important are trust companies, mortgage loan companies and credit unions.

The Supply of MoneyThe Supply of Money

• The supply of money is made up of :– Currency– Deposits– Demand Deposits– Notice Deposits– Term Deposits– Foreign Currency Deposits

Division of Money Supply

Credit and Debit CardsCredit and Debit Cards• Credit Cards: a means of payment that

provides instantly borrowed funds. There are a variety of credit card companies such as Master Card, Visa and American Express which one uses to build upon their credit. One’s credit can be used to borrow funds from money lenders, to for example to buy a house etc.

• Debit Cards: a means of payment that instantaneously transfers funds from buyer to seller. The money is instantaneously debited from one’s account and directly deposited into another’s account.

THE MONEY THE MONEY MARKETMARKET

The Demand for MoneyThe Demand for Money

• To Recall: Money functions as a means of exchange, a store of purchasing power, as well as a measure of value.

• Money as a means of exchange and a store of purchasing power are reasons why money is demanded within the economy.

Transactions DemandTransactions Demand•This function is connected to money’s use as means of exchange.•If real output in the economy increases, then transactions also increases and vice versa.•If price levels in the economy increases, then quantity of money exchanged also increases and vice versa•The relationship between real output and transactions, as well as price levels and quantity of money exchanged is direct.•Moreover, any changes in the transactions will affect the amount of money demanded.

Asset DemandAsset Demand• Connected to money’s function in terms of a store of

purchasing power.

• Recall: main cost of holding money is the added income that could have been earned by converting into a higher-paying liquid asset like a bond.

• Bonds are defined as formal contracts that set out the amount borrowed, by whom, for what period of time, and at what interest rate.

• The most popular way for large businesses and governments to raise funds is with bonds because they can be bought easily and sold before their term ends. They also offer liquidity and relatively high rates of returns.

• Beneficial to those who hold wealth because bonds offer the likeliest alternative for holding money.

Asset Demand Continued• Asset demand for money is inversely related to the

real interest rate on bonds.

• Example: If the interest rate increases, bond prices decreases, which causes more people to convert their own money into bonds and thereby decreasing the asset demand for money.

• By contrast, if the interest rate decreases, bond prices increases, causing wealth holders to hold on their money and thereby increasing the asset demand for money.

• Money Demand: The amounts of money demanded at all possible interest rates . It can be shown in a table called the money demand schedule and on a graph where money demand is called the money demand curve.

Asset Demand Continued

• Slope of money demand curve negative at lower interest rates, there is a greater quantity of money demanded.

• Slope is determined by asset demand for money.• Since the relationship between asset demand for money

and real interest rates on bonds is inverse a change in asset demand causes a change in the quantity of money demanded, or a movement along the demand curve.

Asset Demand ContinuedAsset Demand Continued

• Example: If interest rates rise from 3% to 5%, the quantity of money demanded will decrease (from point b to point a).

• A change in the transactions demand will change the amounts demanded at all interest rates (It causes an entire shift in the money demand curve).

• Transactions demand is affected by either an increase or decrease in either real output or the price levels in the economy.

• In figure 14.3, an increase in transactions demand shifted the money curve to the right from Dm0 to Dm1.

The Supply For MoneyThe Supply For Money

•A set amount determined by government decision-makers.•Like money demand, money supply can be expressed in a money supply schedule and on a graph which shows the money supply curve.•Amount of money supplied is always perfectly elastic and stays at a constant value shown which is shown through the vertical supply curve.•Only shifts if government decision-makers decide to change the money supply. •An increase shifts it to the left, and a decrease shifts it to the right.

Equilibrium in the Money MarketEquilibrium in the Money Market

•Laws of supply and demand for money bring about equilibrium in money market. Intersection of money demand and supply indicate equilibrium for real interest rates and quantity demanded at that rate. •A surplus occurs when at any point on the graph where Sm > Dm at a particular interest rate.

Equilibrium in the Money Market Continued Equilibrium in the Money Market Continued

• A shortage occurs when at any point on the graph where Dm > Sm at a particular interest rate.

• If a surplus occurs, people will want to buy assets that will provide high future earnings causing demand for assets to rise, which forces bond prices to increase as well and causing real interest rate to decrease.

• If a shortage occurs, people will want to sell their assets to get money, forcing asset prices to fall, which causes real interest rate to increase.

• These trends of interest rates falling and rising will continue until equilibrium is reached.

THE BANK OF CANADATHE BANK OF CANADA

The Bank of The Bank of CanadaCanada• Has served as Canada’s central bank since

1935• It is a wholly government-owned institution• The “Bank” has been give four basic functions

relating to money and the financial system: – Managing the money supply– Acting as “the Banker’s bank– Acting as the federal government’s fiscal agent– Ensuring the stable operation of financial markets

Managing the Money SupplyManaging the Money Supply

• Most important role of the Bank of Canada is to control the amount of money circulating in the economy

• The Bank decides and implements monetary policy

• The Bank issues paper currency and affect the activities of chartered banks to adjust the interest rate and the supply of money

Managing the Money Supply Managing the Money Supply ContinuedContinued

• The Bank of Canada has three main goals with managing the money supply– Minimizing inflation in order to preserve the

purchasing power of the dollar– Maintaining real output as close as possible to its

potential level– Regulating the external value of the Canadian

dollar on foreign exchange markets

Acting as the Bankers’ BankActing as the Bankers’ Bank

• The bank holds the deposits of financial institutions that are members of the Canadian Payments Association (CPA)

• CPA includes the chartered banks and some near banks.

• The association also acts as a cleaning house for cheques of both chartered banks and near banks.

Acting as the Bankers’ Bank Acting as the Bankers’ Bank ContinuedContinued• For example, the Depositor A has a chequing

account with Canada Trust. He writes a $50 cheque to Depositor B, who deposits this cheque in her account at Scotia Bank, increasing her deposit balance by $50. Scotia Bank delivers the cheque to Canada Trust, and receives $50 in return. This payment between the two banks is actually made by using the accounts kept by both institutions at the Bank of Canada. The $50 is transferred from Canada Trust’s account to Scotia Bank’s account at the Bank of Canada. To complete the entire exchange, Canada Trust then cancels the cheque it has received and reduces Depositor A’s deposit account by $50. Each day, every cheque transaction like this is added up by the Bank of Canada, and the accounts of members of the CPA are all “cleared” at once.

Acting as the Bankers’ Bank Acting as the Bankers’ Bank ContinuedContinued• Cash reserves from the chartered banks are accounts held

at the Bank of Canada• When a chartered bank finds that its cash reserves are too

low, it can borrow from the Bank of Canada. The Bank provides a short-term loan by depositing the required funds in the chartered bank’s account at the Bank of Canada.

• Bank rate : the interest rate chartered banks are charged on advance from the Bank of Canada

• Because the bank rate is higher then the interest rates on other available sources of loans, chartered banks rarely take out Bank of Canada advances.

Acting as the Federal Government’s Fiscal AgentActing as the Federal Government’s Fiscal Agent

• The Federal government needs a bank to manage its transactions and financial assets

• The Bank of Canada’s responsibility as the government’s fiscal agent are– Holding some of the government’s bank deposits and

decides where other deposits should be held– Acts as the government banker by clearing federal

government cheques– Handles the financing of the federal governments debts

by issuing bonds

Acting as the Federal Government’s Fiscal AgentActing as the Federal Government’s Fiscal Agent

• Canada Savings Bonds : federal government bonds that have a set value throughout their term– Savers know exactly how much they will receive for the bond

during its entire term

– Increases the attractiveness to Canadian Savings Bonds

• Treasury bills : short-term federal government bonds that provide no interest, but are sold at a discount– Terms of three months to a year

– Usually issued in large denominations

– Sold at a marked down price

Acting as the Federal Government’s Fiscal AgentActing as the Federal Government’s Fiscal Agent

• For example, a treasury bill is worth $100 000 might be bought for $95 000. Once the treasury bill matures, the holder receives the face vale of $100 000, thereby earning an income of $5000.

• The price for federal treasury bills is decided at an auction conducted each Tuesday by the Bank of Canada

Ensuring the Stability of Financial MarketsEnsuring the Stability of Financial Markets

• The Bank of Canada supervises the operation of financial markets to ensure the stability of them, especially for chartered banks.

• This protects the safety of depositors’ funds and the soundness of the financial system

The End of Day OneThe End of Day OneHave a Terrific Tuesday