Principles of Macroeconomics: Ch 15 Second Canadian Edition Chapter 15 The Monetary System © 2002 by Nelson, a division of Thomson Canada Limited

Principles of Macroeconomics: Ch 15 Second Canadian Edition

Chapter 15The Monetary System

© 2002 by Nelson, a division of Thomson Canada Limited


Overview

The functions and measurement of money

The Bank of Canada and its functionsFractional reserve banking - how does

it work?The money multiplierTools of Monetary control


The Meaning of Money

Money is the set of assets in the economy that people regularly use to buy goods and services from other people.


Three Functions of Money

Medium of Exchange: anything that is readily acceptable as payment.

Unit of Account: serves as a unit of account to help us compare the relative values of goods.

Store of Value: a way to keep some of our wealth in a readily spendable form for future needs.


The Two Types of MoneyCommodity Money: something that

performs the function of money and has alternative, non-monetary uses.– Examples: Gold, silver, cigarettes

Fiat Money: something that serves as money but has no other important uses.– Examples: Coins, currency, debit

cards


Money in the Canadian Economy

Money Stock is the quantity of money circulating in the economy.

Different ways of measuring the money stock in the economy:

– M1

– M2


The most familiar form of money used includes:– Currency

– Demand Deposits

Measurement of Money

M1


Measurement of Money

A broader measure of money than M1, includes:– M1 +

– Savings Deposits +

– Personal Term Deposits M2


Where is All The Currency?

In 2000 there was about $33 billion of Canadian currency outstanding ($1,300 in currency per adult).

The outstanding currency may be in the hands of tax evaders, drug dealers and other criminals.


Quick Quiz!

List and describe the three functions of money.


Overview





The Bank of Canada

The Bank Of Canada (“B of C”) serves as the nation’s central bank, which is designed to control the quantity of money in the economy.

The “B of C” is owned by the Canadian government, established in 1935 by a royal commission.


The B of C’s Organization

The B of C is run by its Board of Governors which is composed of:– The Governor.

– The Senior Deputy Governor.

– Twelve directors including the Deputy Minister of Finance.

– All members are appointed by the Finance Minister.


The B of C’s OrganizationThe Bank of Canada is controlled by

the Canadian government which appoints the Board of Directors.

As a last resort the government can issue a written directive to the Governor with which he must comply.

In practice the Bank of Canada is largely independent of the government.


Four Primary Functions of the B of C

Issue currency. Act as a banker’s bank, making

loans to other banks and as a lender of last resort.

Act as banker to the Canadian government.

Control the money supply with monetary policy.


Money Supply Changes by the B of COpen-Market Operations: The primary

way in which the B of C changes the money supply is done through the purchase and sale of Canadian government bonds.

- To increase the money supply, the B of C

buys government bonds from the public. -To decrease the money supply, the B of C

sells government bonds to the public.


Quick Quiz!

How does the

B of C increase the supply of money in the economy?


Overview





Banks and The Money Supply

The behaviour of banks can influence the quantity of demand deposits in the economy and therefore, the money supply.

Fractional Reserve Banking System: The practice of holding a fraction of money deposited as reserves and lending out the rest.


Fractional Reserve BankingDeposits into a bank are recorded as both

assets and liabilities. Deposits that have been received but not lent out are called reserves.

The supply of money in the economy is affected by the amount of deposits that are kept in the bank as reserves and the amount that is lent out. Loans become an asset to the bank.


Bank “T-Account” Example

Assets Liabilities

First Canadian Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00

Total Liabilities$100.00


Bank “T-Account” Example

A “T-Account” illustrates the financial position of a bank that accepts deposits, keeps a portion as reserves and lends out the rest.

Assets Liabilities

First Canadian Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00



Money Creation with Fractional-Reserve Banking

When a bank makes a loan (from its reserves) the money supply increases. When banks hold only a fraction of deposits in reserve, banks create money.

The creation of money through loans does not create any wealth, but allows banks to charge interest several times on the same bit of wealth.


Overview





The Money Multiplier

When one bank loans money, that money is generally deposited into another or the same bank thus creating more deposits and more reserves to be lent out.

The Money Multiplier is the amount of money that the banking system generates with each dollar of reserves.



Assets Liabilities

First Canadian Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00




Assets Liabilities

First Canadian Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00


Assets Liabilities

Second Canadian Bank

Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00




Assets Liabilities

First Canadian Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00


Assets Liabilities


Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00




Assets Liabilities

First Canadian Bank

Reserves$10.00

Loans$90.00

Deposits$100.00

Total Assets$100.00


Assets Liabilities


Reserves$9.00

Loans$81.00

Deposits$90.00

Total Assets$90.00


Total Money Supply = $190.00!


What determines the size of the money multiplier?

The money multiplier is the reciprocal of the reserve ratio.– With a reserve

requirement (R) of 20% or 1/5 . . .

– The multiplier will be 5.

1 R

M =


Overview





Tools of Monetary Control The B of C has three instruments of

monetary control:Open-Market Operations:

– Buying and selling bonds.Foreign Exchange Market Operations:

– Buying and selling foreign currency.Changing the Reserve Ratio:

– Increasing or decreasing the ratio.Changing the Bank Rate:

– The interest rate the B of C charges other banks for loans.


Problems in Controlling the Money Supply

Two problems that the B of C must “wrestle” that arise due to fractional-reserve banking:

The B of C does not control the amount of money that households choose to hold as deposits in banks.

The B of C does not control the amount of money that bankers choose to lend.


Overview




Documents

Principles of Macroeconomics: Ch 15 Second Canadian Edition Chapter 15 The Monetary System © 2002 by Nelson, a division of Thomson Canada Limited