THE MONETARY SYSTEM

THE MONETARY SYSTEM

 The nature of money and its functions in the economy.
 The role of Central Bank or Bank of Canada.
 How the banking system helps determine the supply of money.
 What tools the Bank of Canada uses to alter the supply of
money.

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 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.
 Money includes only those few types of wealth that are regularly
accepted by sellers in exchange for goods and services

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 THE MEANING OF MONEY
THE FUNCTIONS OF MONEY
 Medium of exchange is an item that buyers give to sellers when they want to purchase
goods or services.
 Unit of account is the yardstick people use to post prices and record debts.
 Store of value is an item that people can use to transfer purchasing power from the
present to the future.
 Wealth is the total of all stores of value, including both monetary and
non-monetary assets.
 Liquidity describes the ease with which an asset can be converted into a medium of
exchange.
 Money is the most liquid of assets.

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 THE MEANING OF MONEY
THE FUNCTIONS OF MONEY (CONT’D)
 Money is the most liquid asset, but it is far from perfect as a
store of value.
 When prices increase the value of money falls.
 The link between the price level and the value of money is
very important for understanding how money affects the
economy.

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 THE MEANING OF MONEY
KINDS OF MONEY
1. Commodity money: money that takes the form of a
commodity with intrinsic value.
 Example: Gold

2. Fiat money: money without intrinsic value that is used as

money because of government decree.
 Although the government is central to establishing and regulating a system of fiat
money, other factors are also required for the success of such a monetary system.
 To a large extent, the acceptance of fiat money depends as much on expectations
and social convention as on government decree.
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THE MEANING OF MONEY
KINDS OF MONEY (CONT’D)

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 THE MEANING OF MONEY
MONEY IN THE ECONOMY
 The quantity of money circulating in the economy is called the money stock.
 Currency is the paper bills and coins in the hands of the public.
 Demand deposits are the balances in bank accounts that the depositors can
access on demand by writing a cheque or using a debit card.
 In a real economy it is not easy to draw a line between assets that can be called
“money” and assets that cannot
 The two important measures of the stock of money in the economy are M1+
and M2
 Each of these measures uses a slightly different criterion for distinguishing
monetary and nonmonetary assets 10-8
 THE BANK OF CANADA
 The Bank of Canada is designed to control the quantity of money
in the economy.
 The Bank was established in 1935 and nationalized in 1938, so it
is now owned by the Canadian government
 Other major central banks around the world include:
 the Bank of England,
 the Bank of Japan,
 the European Central Bank, and
 the Federal Reserve of the United States. 10-9
 RESPONSIBILITIES OF THE BANK OF
CANADA

There are four main responsibilities of the Bank of Canada:

1. The first responsibility is to issue currency
2. The second responsibility is to act as banker to the commercial banks
3. The third responsibility is to act as banker to the Canadian government
4. The fourth and the most important responsibility is to control the
quantity of money that is made available to the economy, called
the money supply.
 To learn more about the Bank of Canada, check out its website at
www.bankofcanada.ca.
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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
 The of Bank of Canada can control the supply of money only
through its influence on the entire banking system
 Recall that the amount of money you hold includes both currency
and demand deposits
 Because demand deposits are held in banks, the behaviour of banks
can influence the quantity of demand deposits in the economy and,
therefore, the supply of money

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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
THE SIMPLE CASE OF 100 PERCENT-RESERVE BANKING
 Assumptions:
 Economy without any bank
 Currency is the only form of money.
 The initial supply of money is $100.
 Now suppose someone opens a bank: First National Bank.
 First National Bank is only a depository institution
 All deposits received by First National Bank are held as reserves: 100
percent-reserve banking.
 Reserves are deposits that banks have received but have not loaned
out. 10-12
 COMMERCIAL BANKS AND
THE MONEY SUPPLY
100 PERCENT-RESERVE BANKING (CONT’D)
 Using a T-account to show changes in the bank’s assets and liabilities.
 The T-account for First National Bank if the economy’s entire $100 of
money is deposited in the bank:
FIRST NATIONAL BANK

Assets Liabilities

Reserves $100 Deposits $100

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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
100 PERCENT-RESERVE BANKING (CONT’D)
 What is the money supply in this economy?
 Before First National Bank opens, the money supply is the $100 of
currency that people are holding.
 After the bank opens and people deposit their currency, the money
supply is the $100 of demand deposits.
 Each deposit in the bank reduces currency and raises demand deposits
by exactly the same amount, leaving the money supply unchanged.
 If banks hold all deposits in reserve, banks do not influence the supply
of money. 10-14
 COMMERCIAL BANKS AND
THE MONEY SUPPLY
MONEY CREATION WITH FRACTIONAL-RESERVE BANKING
 First National Bank decides to use some of its reserves to make
loans
 If the flow of new deposits is roughly the same as the flow of
withdrawals
 The bank needs to keep only a fraction of its deposits in reserve.
 Fractional-reserve banking is a banking system in which banks hold only a fraction
of deposits as reserves.
 Reserve ratio is the fraction of deposits that banks hold as reserves

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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
FRACTIONAL-RESERVE BANKING (CONT’D)
 Suppose that First National has a reserve ratio of 10 percent
FIRST NATIONAL BANK
Assets Liabilities
Reserves $10 Deposits $100
Loans $90
 The money supply (currency + deposits) = $100 + $90 = $190
 When banks hold only a fraction of deposits in reserve, banks
create money!
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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
FRACTIONAL-RESERVE BANKING (CONT’D)
 Note that when First National Bank loans out some of its reserves
and creates money, it does not create any wealth.
 The borrowers are also taking on debts, so the loans do not make
them any richer
 When a bank creates the asset of money, it also creates a
corresponding liability for its borrowers
 At the end of this process of money creation, the economy is more
liquid in the sense that there is more of the medium of exchange,
but the economy is no wealthier than before
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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
THE MONEY MULTIPLIER
SECOND NATIONAL BANK

Assets ) Liabilities

Reserves $9 Deposits $90

Loans $81

 The money supply (currency + deposits) = $100 + $90 + $81 = $271

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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
THE MONEY MULTIPLIER (CONT’D)
THIRD NATIONAL BANK

Assets Liabilities

Reserves $8.10 Deposits $81.00

Loans $72.90
 The money supply = $100 + $90 + $81+ $72.90 = $343.90

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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
THE MONEY MULTIPLIER (CONT’D)
Original deposit = $100.00
First National lending = $90.00 (= 0.9 × $100.00)
Second National lending = $81.00 (= 0.9 × $90.00)
Third National lending = $72.90 (= 0.9 × $81.00)

. .

. .

. .

Total money supply = $1000

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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
THE MONEY MULTIPLIER (CONT’D)
 Money multiplier is the amount of money the banking
system generates with each dollar it receives.
 In this example the $100 of reserves generates $1000 of
money, the money multiplier is 10.
 The money multiplier is the reciprocal of the reserve ratio.

 The higher the reserve ratio, the less of each deposit banks
loan out, and the smaller the money multiplier 10-21
 COMMERCIAL BANKS AND
THE MONEY SUPPLY
BANK CAPITAL, LEVERAGE

 Banking system in the real world.

 In real world a bank gets financial resources not only from
accepting deposits but also from issuing equity and debt
 The resources that a bank obtains from issuing equity to its owners
are called bank capital
 Bank uses these financial resources in various ways to generate
profit for its owners
 Buying financial securities, such as stocks and bonds
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COMMERCIAL BANKS AND
THE MONEY SUPPLY
BANK CAPITAL, LEVERAGE (CONT’D)

MORE REALISTIC NATIONAL BANK

Assets Liabilities
Reserves $200 Deposits $800
Loans $700 Debt $150
Securities $100 Capital $50

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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
BANK CAPITAL, LEVERAGE (CONT’D)
 Leverage is the use of borrowed money to supplement existing
funds for purposes of investment.
 Leverage ratio is the ratio of assets to bank capital.
 In this example, the leverage ratio is $1000/$50, or 20
 A leverage ratio of 20 means that for every dollar of capital that the bank owners have
contributed, the bank has $20 of assets
 Capital requirement is a government regulation specifying a
minimum amount of bank capital.
 The amount of capital required depends on the kind of assets a bank holds.
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 Quick Quiz

3. If the reserve ratio is 1/4 and the 4. A bank has capital of $200 and a
central bank increases the quantity of leverage ratio of 5. If the value of the
reserves in the banking system by bank’s assets declines by 10 percent,
$120, the money supply increases by then its capital will be reduced to what
what amount? amount?
a. $90 a. $100
b. $150 b. $150
c. $160 c. $180
d. $480 d. $185

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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
THE BANK OF CANADA’S TOOLS OF MONETARY
CONTROL
 Central banks have three main tools for monetary
control:
1. Changing the overnight rate
2. Open-market operations
3. Changing reserve requirements
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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
CHANGING THE OVERNIGHT RATE
 Overnight rate is the interest rate on very short-term loans between
commercial banks.
 Bank rate is the interest rate charged by the Bank of Canada on loans
to the commercial banks.
 The Bank of Canada has allowed commercial banks to borrow freely at
the bank rate and has paid commercial banks the bank rate, minus half
a percent, on their deposits at the Bank of Canada.
 The overnight rate will always be about one-quarter of a percent below
the bank rate 10-27
 COMMERCIAL BANKS AND
THE MONEY SUPPLY
CHANGING THE OVERNIGHT RATE (CONT’D)
 The BoC can alter the money supply by changing the bank rate,
causing an equal change in the overnight rate.
 A higher overnight rate discourages banks from borrowing reserves
from the BoC, thus reducing reserves in the banking system (i.e., the
money supply contracts).
 Changes to the overnight rate are posted eight times a year.
 The BoC can also change the overnight rate at any time, if
extraordinary action is needed.

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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
OPEN-MARKET OPERATIONS
 Open-market operations is the purchase or sale of Government of Canada bonds by the Bank
of Canada.
 To increase the money supply, the BoC buys bonds (or/and Treasury bills) from the public.
 To reduce the money supply, the BoC sells bonds (or/and Treasury bills)
to the public.
 Foreign exchange market operations is the purchase or sale of foreign currency by the Bank
of Canada.
 If the Bank of Canada buys $100 M U.S. in the foreign exchange market for $150 M
Canadian, the Canadian money supply increases immediately by $150 M.
 If the Bank of Canada sells foreign currency from its foreign exchange reserves, it receives
in exchange Canadian dollars, and the Canadian money supply reduces
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 COMMERCIAL BANKS AND
THE MONEY SUPPLY
CHANGING RESERVE REQUIREMENTS
 Reserve requirements are the regulations on the minimum amount of reserves that
banks must hold against deposits.
• An increase in reserve requirements means that banks must hold more reserves and, therefore, can
loan out less of each dollar that is deposited; it raises the reserve ratio, lowers the money
multiplier, and decreases the money supply.

• Conversely, a decrease in reserve requirements lowers the reserve ratio, raises the money
multiplier, and increases the money supply.

 Since 1994, the Bank of Canada has phased out reserve requirements altogether to give
banks a level playing field with other financial institutions, which are not required to
hold reserves. 10-30
 PRACTICE PROBLEM 1
Suppose that the T-account for First National Bank is as follows:

Assets Liabilities
Reserves $100 000 Deposits $500 000
Loans 400 000

a) If the Bank of Canada requires banks to hold 5 percent of deposits as reserves,

how much in excess reserves does First National now hold?

b) Assume that all other banks hold only the required amount of reserves. If First
National decides to reduce its reserves to only the required amount, by how
much would the economy’s money supply increase?
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 PRACTICE PROBLEM 2
Assume there is a reserve requirement of 20 percent. Also assume that banks do not hold
excess reserves and there is no cash held by the public. The Bank of Canada decides that it
wants to expand the money supply by $40 million.

a) If the Bank of Canada is using open-market operations, will it buy or sell bonds?

b) What quantity of bonds does the Bank of Canada need to buy or sell to
accomplish the goal? Explain your reasoning.

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