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Chapter 10 (Lecture Notes and Textbook Notes)

Tuesday, March 22, 2023
Birdget O’Shaughnessy
ECON 1BB3 C02

Lecture Notes (Tuesday, March 22, 2023)

 Functions of money
1. Asset (store of value)
2. Unit of account
3. Medium of exchange
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Textbook Notes (pg 292 – 328)

10.1 What is Money, and Why Do We Need it?
 Money = asset that people willing to accept in exchange for goods/services or for payment of
debts
 Asset = anything of value owned by person/firm

Barter and the invention of money

 Barter economies are where goods/services traded directly for others goods and services
 Have double coincidence of wants = each person want what other has
 Commodity money = good used as money that also has value independent of use as
money
 People become more productive by specializing b/c pursue comparative advantage
 By making exchange easier, money allows people to specialize, become more productive, and
earn higher incomes

Functions of money
 Anything used as money must serve functions in economy
1. Medium of exchange
 Sellers willing to accept it in exchange for goods/services
2. Unit of account
 Once single good used as money, each good has single price rather than many
prices
3. Store of value
 Hold rest of money to use in future
 Most liquid asset
4. Standard of differed payment
 Facilitate exchange at point in time by providing medium of exchange and unit
of account
 Value of money depends on purchasing power

What can serve as money?

 These five criteria make an asset suitable for use as a medium of exchange:
1. Acceptable to most people
2. Standardized quality so that any two units identical
3. Durable so that value not lost by quickly wearing out
4. Valuable relative to weight so that amounts large enough to be useful in trade easily
transported
5. Divisible so that used in purchases of low and high-priced goods
 Value something as money only if believe others accept it from you as payment

Commodity money
 Has value independent of its use as money
 Gold is example b/c medium of exchange, unit of account, store of value, and standard of
deferred payment
 Using gold has problem: money supply difficult to control b/c depends partly on
unpredictable discoveries of new gold fields
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Flat money
 Money authorized by central bank/govt body and doesn't have to be exchanged by central bank
for gold/some other commodity money
 In modern economies, paper issued by central bank, which is agency of govt that regulates
money supply
 Bank of Canada = central bank of Canada
 Currency is legal tender in Canada = federal govt requires that accepted in payment of debts and
requires cash/cheques denominated in dollars be used in payment of taxes
 Households/firms have confidence that if accept paper dollars in exchange for goods/services,
dollars not lose much value during time they hold them

10.2 How is Money Measured in Canada Today?

 Changes in money supply affect other economic variables
 Money supply include other assets used as medium of exchange even though they not as liquid
as currency/chequing account deposits
 Bank of Canada uses 6 definitions of money supply: M1+, M1++, M2, M2+, M2++, and M3

The M1+ and M1++ Definitions of the Money Supply

 M1+ = narrowest definition of money supply
 Includes currency and other assets that have cheque-writing features
 Includes
1. Currency
2. Value of all chequable deposits at charted banks. Trust and mortgage loan
companies (TML), and credit unions and caisses popularise (CUCP)
 M1++ = border definition of money supply
 Includes everything in M1+ and non-chequable deposits at charted banks, TML, and
CUCP

The M2, M2+, and M2++ definitions of the money supply

 M2 = monetary aggregate that includes currency outside banks and personal deposits at charted
banks, non-personal demand and notice deposits at charted banks, and fixed-term deposits
 M2+ = broader monetary aggregate that includes M2 plus deposits at TML, CUCP, life insurance
company induvial annuities, personal deposits at govt-owned saving institutions, and money
market mutual funds
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The M3 Definition of the money supply

 Includes everything in M2 plus non-personal deposits at charted banks and foreign currency
deposits of residents at charted banks
 Key points about money supply
1. Consists of both currency and chequing and non-chequing account deposits
2. Banks play important role in way money supply increases and decreases

What about credit cards and debit cards?

 Credit cards not included in definitions of money supply
 When buy something w credit card, taking out loan from bank that issued credit card
and pay at end of month
 W debit card, funds to make purchase taken directly from chequing account
 Cards themselves not represent money

10.3 How do Banks Create Money?

 Banks are profit-making private businesses
 Fulfill key function in money supply process

Bank balance sheets

 Capital = banks shareholder's equity
 Key assets on bank’s balance sheet reserves, loans, and securities
 Reserves = deposits that bank keeps as cash in vault/on deposit w BOC
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 Desired reserves = reserves that bank desires to hold, based on its chequing
account deposits (rd)
 Excess reserves = reserves that banks hold over and above desired amounts
 Loan is asset to bank b/c represents promise by person taking out loan to make certain
specified payments to bank
 Make consumer loans to households and commercial loans to businesses
 Deposits bank's largest liability

Using T-accounts to show how a bank can create money

 T-account is a stripped-down version of a balance sheet that shows only how a transaction
changes a bank’s balance sheet

 Both sides must =

The simple deposit multiplier

 Ratio of amount of deposits created by banks to amount of new reserves

 Calculate total increase in chequing account deposits from increase in bank reserves

The simple deposits multiplier versus the real world deposit multiplier
 In deriving simple deposit multiplier, made 2 assumptions
1. Banks hold no excess reserves
2. Whole amount of every cheque deposited in bank; no one takes any of it out as
currency
 Reduce real-world deposit multiplier
 Most important part of money supply is chequing account balance component
 Summarize important conclusions
1. When banks gain reserves, make new loans, and money supply expands
2. When banks lose reserves, reduce loans, and money supply contracts

10.4 The Bank of Canada

 Fractional reserve banking system = banking system in which banks keep < 100% of deposits as
reserves
 Canada has one
 When people deposit money in bank, bank loans most of money to someone else
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 Bank run = situation where many depositors simultaneously decide to withdraw money from
bank
 Bank panic = situation where many banks experience runs at same time
 Possible for bank to handle run by borrowing from others, but if many simultaneously
experience runs, banking system in trouble
 BOC act as lender of last resort to prevent bank panic

Establishment of the Bank of Canada (BOC)

 Conducts monetary policy, designs and issues currency, promotes stable financial system,
manages funds of federal govt, and engages in important economic research
 Board of directs = board w 15 members responsible for management of BOC
 Governing council = council w 6 members responsible for management of BOC
 BOC's quarterly Monetary Policy Report presenting projections for inflation/growth and
assessment of risks in economy
 Monetary policy = actions BOC takes to manage money supply and interest ratees to pursue
macro policy goals/objectives
 Govt has power to override decisions

Bank of Canada's operating band for the overnight interest rate

 Overnight interest rate = interest rate banks charge each other for overnight loans
 Key policy rate = BOC's target for overnight interest rate
 Collateralized transactions = tractions that involve property being pledged to lender to
guarantee payment in event that borrower unable to make debt payments
 Operating band = BOC's 50-basis point range for overnight interest rate
 Bank rate = interest rate BOC charges on loans to banks
 Settlement balances = deposits held by banks in accounts at BOC
 Advances to banks = loans BOC makes to banks
 Lower limit of operating band is rate BOC pays to financial institutions w + settlement
balances at end of day
 Midpoint of operating band is BOC's target for overnight interest rate

 Standing liquidity facilities = BOC's readiness to lend to/borrow from bank

How the BOC implements monetary policy

 Responsible for managing interest rates and money supply
 To manage interest rates and the money supply, the Bank of Canada mainly uses the following
two monetary policy tools
1. Open market buyback operations
 Buying and selling of govt securities by BOC to control money supply
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 Open market sales shrink bank reserves and monetary base, raising short-term
interest rates and lowering money supply
 Purchase and resale agreements (PRA) = BOC's purchase of govt securities form
primary dealers w agreement to resell later
 Sale and repurchase agreements (SRA) = BOC's sale of govt securities to primary
dealers, w agreement to repurchase them later
 BOC conducts monetary policy principally through open market buyback
operations for 3 reasons
1. Controls buyback volume
2. Make large and small open market buyback operations
3. Implement open market buyback operations quickly, w no admin
delay/required changes in regulations
2. Lending to financial institutions
 BOC lending important in preventing financial panics
 Provides emergency lending assistance

Bank of Canada's approach to monetary policy

 Implements monetary policy by changing policy rate to influence short-term interest rates,
exchange rate, and level of economic activity
 BOC expects economy to slow down and ease monetary conditions

 BOC expects economy to exceed capacity at some point in future

The "Shadow Banking System" and the global financial crisis of 2007-2009
 In past 25 years important developments occurred in financial system
1. Banks begun to resell many of their loans
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2. Financial firms other than commercial banks become sources of credit to businesses
Securitization comes to banking
 Security = financial asset that can be bought and sold in market
 When asset first sold, sale takes place in primary market
 Investor resells asset, sale takes place in secondary market
 Securitization = process of transforming loans/other financial assets into securities
Shadow banking system
 Financial system transformed in 90s and 2000s by increasing importance of nonbank financial
firms
 Late 90s, investment banks expanded buying of mortgages, bundling together into bonds
(mortgage-backed securities) and reselling them
 Paid higher rates than other securities
 Money market mutual funds become important
 Sell shares to investors and use money to buy short-term securities
 Hedge funds raise money from wealthy investors and use sophisticated investment strategies

10.5 The Quantity Theory of Memory

Connecting money and prices: the quantity equation
 M × V =P ×Y
 Money supply (M) × velocity of money (V) = price level (P) × real output (Y)
 Velocity of money = average # of times per year each dollar in money supply used to purchase
goods/services included in GDP
P ×Y
 V=
M
 M1+ to measure money supply, GDP deflator to measure price level, and real GDP to measure
real output
 Velocity defined to = (P ×Y )/ M , know quantity equation hold true: LS = RS
 Quantity theory of money = theory about connection b/t money and prices that assumes
velocity of money constant

Quantity theory explanation of inflation

 Equation where variables multiplied together = equation where growth rates of variables added
together
 Growth rate of money supply + growth rate of velocity = growth rate of price level + growth rate
of real output
 Useful for investigating effect of changes in money supply on inflation rate
 Inflation rate = growth rate of money supply + growth rate of velocity - growth rate of real
output
 Inflation rate = growth rate of money supply - growth rate of real output
 Equation leads to predictions
 If money supply grows faster than real GDP = inflation
 If money supply grows at slower rate than real GDP = deflation
 If money supply grows at same rate as real GDP, price level stable
 In long run, inflation results from money supply growing at faster rate than real GDP

How accurate are estimates of inflation based on quantity theory ?

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 Accuracy of quantity theory depends on whether key assumption that velocity constant is
correct
 Most of variation in inflation rates across decades can explained by variation in rates of growth
of money supply

 Hyperinflation is rate of inflation > 50%

High rates of inflation

 Hyperinflation is caused by central banks increasing money supply at rate far in excess of growth
rate of real GDP
 Causes money to lose value rapidly so households and firms avoid holding
 Suffer from slow growth/recession
 Happens b/c govt want to spend more than able to raise through taxes