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

2. Principles of Macroeconomics: Ch 15 Second Canadian Edition Overview  The functions and measurement of money  The Bank of Canada and its functions  Fractional reserve banking - how does it work?  The money multiplier  Tools of Monetary control

3. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

4. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

5. Principles of Macroeconomics: Ch 15 Second Canadian Edition The Two Types of Money  Commodity 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

6. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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

7. Principles of Macroeconomics: Ch 15 Second Canadian Edition  The most familiar form of money used includes: –Currency –Demand Deposits Measurement of Money M1M1

8. Principles of Macroeconomics: Ch 15 Second Canadian Edition Measurement of Money  A broader measure of money than M 1, includes: –M1 + –Savings Deposits + –Personal Term Deposits M2M2

9. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

10. Principles of Macroeconomics: Ch 15 Second Canadian Edition Quick Quiz!  List and describe the three functions of money.

11. Principles of Macroeconomics: Ch 15 Second Canadian Edition Overview The functions and measurement of money  The Bank of Canada and its functions  Fractional reserve banking - how does it work?  The money multiplier  Tools of Monetary control

12. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

13. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

14. Principles of Macroeconomics: Ch 15 Second Canadian Edition The B of C’s Organization  The 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.

15. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

16. Principles of Macroeconomics: Ch 15 Second Canadian Edition Money Supply Changes by the B of C  Open-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.

17. Principles of Macroeconomics: Ch 15 Second Canadian Edition Quick Quiz!  How does the B of C increase the supply of money in the economy?

18. Principles of Macroeconomics: Ch 15 Second Canadian Edition Overview The functions and measurement of money The Bank of Canada and its functions  Fractional reserve banking - how does it work?  The money multiplier  Tools of Monetary control

19. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

20. Principles of Macroeconomics: Ch 15 Second Canadian Edition Fractional Reserve Banking  Deposits 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.

21. Principles of Macroeconomics: Ch 15 Second Canadian Edition Bank “T-Account” Example AssetsLiabilities First Canadian Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00

22. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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. AssetsLiabilities First Canadian Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00

23. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

24. Principles of Macroeconomics: Ch 15 Second Canadian Edition Overview The functions and measurement of money The Bank of Canada and its functions Fractional reserve banking - how does it work?  The money multiplier  Tools of Monetary control

25. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

26. Principles of Macroeconomics: Ch 15 Second Canadian Edition The Money Multiplier AssetsLiabilities First Canadian Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00

27. Principles of Macroeconomics: Ch 15 Second Canadian Edition The Money Multiplier AssetsLiabilities First Canadian Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 AssetsLiabilities Second Canadian Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00

28. Principles of Macroeconomics: Ch 15 Second Canadian Edition The Money Multiplier AssetsLiabilities First Canadian Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 AssetsLiabilities Second Canadian Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00

29. Principles of Macroeconomics: Ch 15 Second Canadian Edition The Money Multiplier AssetsLiabilities First Canadian Bank Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 AssetsLiabilities Second Canadian Bank Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $90.00 Total Liabilities $90.00 Total Money Supply = $190.00!

30. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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. 1R 1R M =

31. Principles of Macroeconomics: Ch 15 Second Canadian Edition Overview The functions and measurement of money The Bank of Canada and its functions Fractional reserve banking - how does it work? The money multiplier  Tools of Monetary control

32. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

33. Principles of Macroeconomics: Ch 15 Second Canadian Edition 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.

34. Principles of Macroeconomics: Ch 15 Second Canadian Edition Overview The functions and measurement of money The Bank of Canada and its functions Fractional reserve banking - how does it work? The money multiplier Tools of Monetary control