Overview-10

1. Overview-10 • The functions and measurement of money • The Bank of Canada and its functions • Fractional reserve banking - how does it work? • The money multiplier • Monetary control-how does B of C control money supply? Principles of Macroeconomics: Canadian Edition

2. tutorials • DEPARTMENT OF ECONOMICS • CARLETON UNIVERSITY • ECON 1000B • TUTORIAL GROUPS • WINTER TERM 2011 • Professor Douglas Smith • 1. WHEN • Tutorial groups will begin in the week of January 24. Groups will meet EVERY OTHER WEEK. The last group will meet in the week of March 21. Each group will meet FOUR (4) times in the Winter term. The 8 week time period does NOT include reading week. Time, location and start dates for each group are shown below. • 2. WHERE • You are in the same group as in the Fall. Locations are shown below. DISCUSSSION GROUP GRADES ARE PROVIDED TO ME BY THE TAs. YOU MUST ENSURE THAT YOU ARE ON THE GRADE LIST MAINTAINED BY YOUR TA FOR THIS TERM. • NOTE ROOM CHANGES! • 3. TUTORIAL GRADES • There will be THREE (3) assignments per term. Assignments will be provided on my web page and must be handed in to your discussion group leader on THE ASSIGNED DATE. Assignments will be accepted by TAs at the end of the tutorial session, ONLY from students who attended that session. The best TWO (2) will count as your discussion group grade. In each term, tutorial group assignments will count for 20% of the final grade. [That is, 10 out of 50 in each term]. • Some tutorial assignments will require you to work ahead of the material being covered in class. • OPTION: It is in your interest to attend groups and do the assignments. If you do not hand in assignments, however, the assignment grade weight will be transferred to the April exam. • GROUP SCHEDULE • Group • Number Day Time Start Date Location • B01 TUES 1:35 JAN 25 Southam 309 • B02 TUES 1:35 FEB 1 313 Southam • B03 TUES 1:35 JAN 25 311 Southam • B04 THURS 12:35 FEB 3 313 Southam • B05 THURS 12:35 JAN 27 311 Southam • B06 THURS 12:35 FEB 3 TB431 • B07 THURS 4:35 JAN 27 309 Southam • B08 THURS 4:35 FEB 3 313 Southam • B09 THURS 1:35 JAN 27 TB210 • B10 THURS 1:35 FEB 3 TB447 • B11 MON 9:35 JAN 25 ME3190

3. WHY MONEY? • Without money, trade would require barter, the exchange of one good or service for another. • Every transaction would require a double coincidence of wants – the unlikely occurrence that two people each have a good the other wants. • Most people would have to spend time searching for others to trade with – a huge waste of resources. • This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.

4. 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. Principles of Macroeconomics: Ch 10 Canadian Edition

5. 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. Principles of Macroeconomics: Ch 10 Canadian Edition

6. 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 Principles of Macroeconomics: Ch 10 Canadian Edition

7. 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 Principles of Macroeconomics: Ch 10 Canadian Edition

8. Measurement of Money • The most familiar forms of money used include: • Currency • Demand Deposits:balances in banks that depositors can access on demand by writing a check or using a debit card. M1 Principles of Macroeconomics: Ch 10 Canadian Edition

9. Measurement of Money • A broader measure of money than M1, includes: • M1 +Savings Deposits +Personal Term Deposits M2 Principles of Macroeconomics: Ch 10 Canadian Edition

10. M1 and M2

11. Where is All The Currency? • In 2006 there was about $46 billion of Canadian currency outstanding ($1,797 in currency per adult). • Banks and companies hold some. • The outstanding currency may be in the hands of tax evaders, drug dealers and other criminals. Principles of Macroeconomics: Ch 10 Canadian Edition

12. Tutorials • http://http-server.carleton.ca/~dosmith/ • Rooms have changed. • Check my webpage. • See Schedule and Agenda • All assignments are now up. • Also chapters 5-9.

13. groups

14. Money • Debit cards are money. Like cheques, they allow direct access to money. • Credit cards are NOT money. They provided for deferred payment. • Cheques or transfers used to pay card balances are money.

15. Money: Medium of exchange • Allows you to pay for things. • C$1,000 cash in you wallet. • 8 PM, system failure-all ATMs down • Visiting Toronto, Buffalo, Atlanta, Istanbul • What if you had $US1,000?? • Medium of exchange is what is accepted.

16. 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. • Interacts with chartered banks. • US counterpart is the Fed-Federal Reserve System Principles of Macroeconomics: Ch 10 Canadian Edition

17. The B of C’s Organization • The B of C is run by its Board of Governors which is composed of: • The Governor. Mark Carney • The Senior Deputy Governor. • Twelve directors including the Deputy Minister of Finance. • All members are appointed by the Finance Minister. Principles of Macroeconomics: Ch 10 Canadian Edition

18. 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 who must comply. • In practice the Bank of Canada is largely independent of the government. Principles of Macroeconomics: Ch 10 Canadian Edition

19. Four Primary Functions of the B of C • Issue currency. • Act as a banker’s bank, making loans to chartered banks and as a lender of last resort. • Act as banker to the Canadian government. • Control the money supply with monetary policy. Principles of Macroeconomics: Ch 10 Canadian Edition

20. 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. “OMO” - 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. Principles of Macroeconomics: Ch 10 Canadian Edition

21. OMO • Think of a cashier’s window • Only Money and Bonds are transacted • 1. Bonds flow out and dollars flow in: SELLS • 2. Dollars flow out and bonds flow in: BUYS • 1 is OMO to contract MS • 2 is OMO to expand MS What BofC changes is liquidity 2 Replaces unspendable bonds with money OMO 2 increases liquidity –OMO1 decreases it

22. 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 (RR)of money deposited as reserves and lending out the rest. Principles of Macroeconomics: Ch 10 Canadian Edition

23. 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. Principles of Macroeconomics: Ch 10 Canadian Edition

24. 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. First Canadian Bank Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Total Liabilities $100.00 Total Assets $100.00 Principles of Macroeconomics: Ch 10 Canadian Edition

25. Bank T-account • T-account: a simplified accounting statement that shows a bank’s assets & liabilities. • Banks’ liabilities include deposits, assets include loans & reserves. • In this example, notice that R/D = $10/$100 = 10%.

26. 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 the economy has more liquidity-more of the medium of exchange. Principles of Macroeconomics: Ch 10 Canadian Edition

27. The Money Multiplier • When one bank lends 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. Principles of Macroeconomics: Ch 10 Canadian Edition

28. First Canadian Bank Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Total Assets $100.00 Total Liabilities $100.00 The Money Multiplier Principles of Macroeconomics: Ch 10 Canadian Edition

29. First National Bank Second Canadian Bank Assets Liabilities Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $100.00 Total Liabilities $100.00 Total Assets $90.00 Total Liabilities $90.00 The Money Multiplier Principles of Macroeconomics: Ch 10 Canadian Edition

30. First Canadian Bank Second Canadian Bank Assets Liabilities Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $100.00 Total Liabilities $100.00 Total Assets $90.00 Total Liabilities $90.00 The Money Multiplier Principles of Macroeconomics: Ch 10 First Canadian Edition

31. First Canadian Bank Second Canadian Bank Assets Liabilities Assets Liabilities Reserves $10.00 Loans $90.00 Deposits $100.00 Reserves $9.00 Loans $81.00 Deposits $90.00 Total Assets $100.00 Total Liabilities $100.00 Total Assets $90.00 Total Liabilities $90.00 The Money Multiplier Total Money Supply = $190.00! Principles of Macroeconomics: Ch 10 First Canadian Edition

32. What determines the size of the money multiplier? 1 RR • The money multiplier is the reciprocal of the reserve ratio. • With a reserve requirement (RR) of 10% or 1/10 . . . • The multiplier will be 10. • Traces through n banks M = Principles of Macroeconomics: Ch 10 First Canadian Edition

33. Money multiplier Money Assumptions In example, R/D=10% Initial R=$100 MS=R*(1/RR) =100*10 Do Study Guide • $100 • $90 • $81 • $72.90 • Etc • Total $1,000

34. Tools of Monetary Control The B of C has three instruments of monetary control: • 1.Open-Market Operations: • Buying and selling bonds. • 2.Changing the Reserve Ratio: • Increasing or decreasing the ratio. • 3.Changing the overnight rate -The interest rate the B of C charges other banks for loans.

35. OMO • Open-Market Operations --OMO • The Bank of Canada conducts open-market operationswhen it buys government bonds from or sells government bonds to the public: • Buying bonds causes the money supply to increase. • Selling bonds causes the money supply to decrease.

36. Bank of Canada’s Tools of Monetary Control • Foreign Exchange Market Operations • The Bank of Canada conducts foreign exchange market operationswhen it buys or sells foreign currencies • The money supply increases when the Bank of Canada buys foreign currency with Canadian currency. • The money supply decreases when the Bank of Canada sells foreign currency.

37. FX • Foreign Exchange Market Operations • If the Bank of Canada wants to sell foreign currency to support the Canadian exchange rate, but does not want the money supply to fall, it uses the Canadian currency obtained in the exchange to buy government bonds. • This process of offsetting a foreign exchange market operation with an open-market operation is called sterilization.

38. Overnight rate • Bank rate is the rate that BofC charges chartered banks for loans. • Overnight rate is the rate on very short term loans. • If BofC raises bank rate and overnight rate, banks borrow less reducing reserves and MS. • Raising rates reduces MS and VV

39. Problems in Controlling the Money Supply • Two problems that the B of C must deal with 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. ???excess reserves Principles of Macroeconomics: Ch 10 Canadian Edition

40. CHAPTER SUMMARY • The term money refers to assets that people regularly use to buy goods and services. • Money serves three functions in an economy: as a medium of exchange, a unit of account, and a store of value. • Commodity money is money that has intrinsic value. • Fiat money is money without intrinsic value. • The Bank of Canada, the central bank of Canada, controls the Canadian money supply through open-market operations.