1 Chapter 15 The Monetary System The Meaning of Money The Bank of Canada Commercial Banks and the Money Supply

2 Imagine that there was no item in the economy widely accepted in exchange for goods and services. People would have to rely on barter-the exchange of one good or service for another- to obtain the things they need. Any economy that relies on barter will have trouble allocating its scarce resources efficiently. In such an economy, trade is said to require the double coincidence of wants- the unlikely occurrence that two people each have a good or service that the other wants. The existence of money makes trade easier. The social custom of using “money” for transactions is extraordinarily useful in a large, complex society.

3 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. The 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 Kinds of Money: Commodity Money: something that performs the function of money and has alternative, non-monetary uses. –Examples: Gold, silver, cigarettes

4 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: The most familiar form of money used includes: Currency (the paper bill and coins in the hands of the public)& Demand Deposits ( balances in bank accounts that depositors can access on demand by writing a cheque or using a debit card) –M2: A broader measure of money than M1, includes: M1 + Savings Deposits + Personal Term Deposits

5 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. See Table 15-1 on page 324

6 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. In 1934, Parliament enacted the Bank of Canada Act, which laid down the responsibilities of the Bank of Canada. The “B of C” is owned by the Canadian government, established in 1935 by a royal commission and nationalized in 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.

7 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. 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, the quantity of money available in the economy, with monetary policy, the setting of the money supply by policymakers in the central bank.

8 Commercial 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. Deposits into a bank are recorded as both assets and liabilities. Deposits that have been received but not lent out are called reserves. Reserve Ratio: the fraction of deposits that banks hold as 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.

9 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. 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.

10 What determines the size of the money multiplier? The money multiplier is the reciprocal of the reserve ratio. M = 1/R –With a reserve requirement (R) of 20% or 1/5... –The multiplier will be 5. The Bank of Canada’s Tools of Monetary Control The B of C has many instruments of monetary control: Open-Market Operations: –Buying and selling bonds: 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.

11 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. If the Bank of Canada buys $100 million USD in the foreign exchange market for $ 150 million CAD, the Canadian money supply increases immediately by $150 million. Sometimes, the B o C wants to sell foreign currency in the foreign exchange market to support the Canadian dollar’s exchange rate, but it does not want the money supply to fall. To do this, the Bank uses the Canadian dollars it acquires in the foreign exchange market to buy government bonds, thus putting the Canadian dollars back into circulation.

12 Sterilization: the process of offsetting foreign exchange market operations with open-market operations, so that the effect on the money supply is cancelled out. 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.