Lecture15-ECO100 - Introduction to Introduction to...

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Unformatted text preview: Introduction to Introduction to Economics Economics Lecture 15: The Banking The Banking System and and the Supply of Money the Supply of Money © Gustavo Indart Slide 1 ECO 100Y ECO 100Y Two Two Views of Money Classical view: Changes in money supply lead to equal proportional changes in all prices Therefore, no change in relative prices no change in relative prices Money is neutral (i.e., doesn’t affect the level of real output) Modern view: Money is neutral only in the long-run is ne onl in the long Changes in money supply lead to increases in real output in the short-run © Gustavo Indart Slide 2 Definition Definition and Functions of Money Money Money is a medium of exchange A medium of exchange is anything that is acceptable in exchange for goods and services in exchange for goods and services Functions of money: A medium of exchange A unit of account A standard of deferred payments A store of value © Gustavo Indart Slide 3 Different Forms of Money Different Forms of Money Commodity money money Convertible paper money Fiat money Deposit money money © Gustavo Indart Slide 4 Three Measures of Money Three Measures of Money M1 – currency in circulation + demand deposits currency in circulation demand deposits M2 – M1 + notice deposits M3 – M2 + fixed-term deposits © Gustavo Indart Slide 5 Definitions Definitions Money supply: M = CUP + D Currency: CU = CUP + CUB Bank Reserves: RE = CUB + DCB © Gustavo Indart Slide 6 Bank of Canada Bank of Canada Canada’s central bank Controls and regulates financial institutions and markets markets Responsible for monetary policy Relatively independent from central government © Gustavo Indart Slide 7 Functions of the Bank of Canada Functions of the Bank of Canada Banker to the commercial banks Lender of last resort to commercial banks Banker to the government Controller and regulator of the money supply Regulator and supporter of money markets and supporter of money markets © Gustavo Indart Slide 8 Balance Balance Sheet of the Bank of Canada Canada Assets Loans to commercial banks (LCB) Government Bonds (GB) Bonds Foreign-currency reserves Liabilities Deposits of the commercial banks (DCB) Currency in circulation (CU = CUP + CUB) Deposits of the Government of Canada (DG) © Gustavo Indart Slide 9 Financial Intermediaries Financial Intermediaries Chartered or commercial banks or commercial banks Trust and mortgage loan companies Local credit unions and caisses populaires © Gustavo Indart Slide 10 Balance Balance Sheet of a Commercial Ban Bank Assets Loans made to its customers (L) Deposits with the Bank of Canada (DCB) with the Bank of Canada Government Bonds (GB) Currency in its vault (CUB) in its vault Liabilities Deposits of its customers (D) Deposits of the Government of Canada (DG) © Gustavo Indart Slide 11 Reserves of Commercial Banks Reserves of Commercial Banks RE = CUB + DCB CU CUB DCB to meet customers’ needs to settle accounts with other banks Target (or desired) reserves vs. required reserves © Gustavo Indart Slide 12 Reserve Reserve Ratio Target or desired reserve ratio (v) v = RE / D No longer determined by regulation Minimum safety level as determined by commercial banks The Bank of Canada can affect the level of the desired Bank of Canada can affect the level of the desired reserve ratio by changing the interest rate it charges on loans to commercial banks This rate is called the bank rate The overnight rate is the rate at which commercial banks lend money to each other © Gustavo Indart Slide 13 Money Money Creation by Banking System System M = CUP + D CU Banks cannot affect CUP but can affect D by making loans to their customers Whenever banks have excess reserves, they are able to create money by lending out the excess reserves Assumptions: Fixed desired reserve ratio (v) No cash drain from the banking system © Gustavo Indart Slide 14 Example: Example: Only one commercial bank Reserve ratio of 20 percent (v = 0.2) No excess (or insufficient) reserves New deposit of $100 bill That is, CUP decreases by $100 and D is CU by $100 and increases by $100 © Gustavo Indart Slide 15 Changes Changes in Balance Sheets (Step (Step 1) Public Assets CUP −100 D +100 Commercial Bank Bank Assets Liabilities +100 CUB +100 D Bank of Canada of Canada Assets Liabilities Liabilities M = CUP + D ∆M = ∆CUP + ∆D = –100 + 100 = 0 RE = CUB + DCB ∆RE = ∆CUB + ∆DCB = +100 ∆Desired Reserves = +20 Excess Reserves = ∆RE − ∆Desired Reserves = 80 © Gustavo Indart Slide 16 Changes Changes in Balance Sheets (Step (Step 2) Public Assets D D +100 +80 Liabilities CUP −100 L Commercial Bank Bank Assets Liabilities +100 +80 +80 CUB +100 D L +80 D Bank of Canada of Canada Assets Liabilities ∆M = ∆CUP + ∆D = –100 + 180 = +80 RE = CUB + DCB ∆RE = ∆CUB + ∆DCB = +100 ∆Desired Reserves = +36 Excess Reserves = ∆RE − ∆Desired Reserves = 64 © Gustavo Indart Slide 17 Changes Changes in Balance Sheets (Step (Step 3) Public Assets CUP −100 D +100 D +80 D +64 Commercial Bank Bank Assets CUB +100 L +80 L +64 Bank of Canada of Canada Assets Liabilities Liabilities L L +80 +64 Liabilities D D D +100 +80 +64 ∆M = ∆CUP + ∆D = –100 + 244 = +144 RE = CUB + DCB ∆RE = ∆CUB + ∆DCB = +100 ∆Desired Reserves = +48.8 Excess Reserves = ∆RE − ∆Desired Reserves = 51.2 © Gustavo Indart Slide 18 Money Money Creation by Banking System v = RE / D D = RE / v ∆D = ∆RE / v = +100 / 0.2 = +500 M = CUP + D ∆M = ∆CUP + ∆D = −100 + 500 = +400 ∆RE = ∆Desired Reserves © Gustavo Indart Slide 19 Final Final Change in Balance Sheets Sheets Public Assets Liabilities +400 Commercial Bank Assets CUB +100 L +400 Liabilities D +500 Bank of Canada Assets Liabilities CUP −100 L D +500 © Gustavo Indart Slide 20 The The Money Multiplier v = RE / D D = (1/v) RE ∆D = (1/v) ∆RE mm = 1/v money multiplier This is assuming that ∆CUB = 0 and thus ∆M = ∆D is assuming that and thus ∆M = mm ∆RE mm = 1/0.2 = 5 ∆M = mm ∆RE = 5 (+100) = +500 (+100) +500 © Gustavo Indart Slide 21 Open Market Operations Open Market Operations The Bank of Canada can affect the money supply by affecting the cash reserves of the Commercial Banks The Bank of Canada affects the cash reserves of the Commercial Banks by buying or selling Government Bonds to/from the Public or to/from the Commercial Banks An open market purchase will increase the money supply An open market sale will decrease the money supply © Gustavo Indart Slide 22 Open Market Purchase Open Market Purchase Public Assets GB −100 D +100 Liabilities Commercial Bank Bank Assets Liabilities +100 DCB +100 D Bank of Canada of Canada Assets Liabilities GB +100 DCB +100 RE = CUB + DCB CU ∆RE = ∆CUB + ∆DCB = +100 ∆Desired Reserves = +20 Reserves +20 Excess Reserves = ∆RE − ∆Desired Reserves = 80 ∆M = ∆CUP + ∆D = 0 + 100 = +100 100 +100 © Gustavo Indart Slide 23 Open Market Purchase Open Market Purchase (cont’d) Public Assets GB −100 D D +100 +100 +80 Liabilities L L Commercial Bank Assets Liabilities +100 +80 +80 +80 DCB +100 D +80 D +80 Bank of Canada Assets Liabilities GB +100 DCB +100 ∆RE = ∆CUB + ∆DCB = +100 ∆Desired Reserves = +36 Excess Reserves = ∆RE − ∆Desired Reserves = 64 ∆M = ∆CUP + ∆D = 0 + 180 = +180 © Gustavo Indart Slide 24 Money Money Creation by an Open Market Market Purchase Public Assets GB −100 100 D +500 Liabilities L L Commercial Bank Assets +400 Liabilities +500 +500 +400 DCB +100 D +400 Bank of Canada Assets Liabilities GB +100 DCB +100 +100 ∆RE = ∆CUB + ∆DCB = +100 ∆Desired Reserves = +100 Excess Reserves = ∆RE − ∆Desired Reserves = 0 ∆M = ∆CUP + ∆D = 0 + 500 = +500 ∆M = mm ∆RE = 5 (+100) = +500 (+100) +500 © Gustavo Indart Slide 25 Money Money Destruction by an Open Market Sale The same way that the money supply increases as a result of an increase in RE, the money supply decreases as a result of a decrease in RE ∆D = mm ∆RE If mm = 5 and ∆RE = −100, then ∆D = −500 mm 100 then 500 An open market sale will result in a decrease in RE Therefore, the v will fall below the desired level and commercial banks will start recalling loans to reduce D and increase v to the desired level th © Gustavo Indart Slide 26 Money Money Destruction by an Open Market Sale Public Assets D D −100 −400 Liabilities −400 L Commercial Bank Bank Assets Liabilities −400 Bank of Canada of Canada Assets −100 Liabilities DCB −100 GB +100 L DCB −100 D −400 D −100 GB 100 ∆RE = ∆CUB + ∆DCB = −100 ∆ Desired Reserves = −100 Reserves 100 Excess Reserves = ∆RE − ∆ Desired Reserves = 0 ∆M = ∆CUP + ∆D = 0 − 500 = −500 500 500 ∆D = mm ∆RE = 5 (−100) = −500 © Gustavo Indart Slide 27 The The Overnight Rate and the Desired Cash Reserve Ratio Desired Cash Reserve Ratio The Bank of Canada can also affect the desired cash reserve ratio of the commercial banks by changing the reserve ratio of the commercial banks by changing the target for the overnight rate When the Bank of Canada increases the target for the the Bank of Canada increases the target for the overnight rate (i.e, when it increases the bank rate), it becomes more expensive for commercial banks to borrow when they are short of reserves borrow when they are short of reserves Therefore, banks will try to reduce the possibility of being short of reserves by increasing their desired cash reserve ratio Banks increase their desired cash reserve ratio by recalling loans thus decreasing the public recalling loans, thus decreasing the public’s deposits and reducing the money supply © Gustavo Indart Slide 28 The The Overnight Rate and the Desired Cash Reserve Ratio Desired Cash Reserve Ratio When the Bank of Canada decreases the target for the overnight rate (i.e, when it decreases the bank rate), it (i becomes less expensive for commercial banks to borrow when they are short of reserves desired cash reserve rati io Therefore, banks will worry less about the possibility of being short of reserves and will decrease their Banks decrease their desired cash reserve ratio by giving new loans thus increasing the public giving new loans, thus increasing the public’s deposits and increasing the money supply © Gustavo Indart Slide 29 ...
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This note was uploaded on 01/19/2010 for the course ECONOMICS ECO100 taught by Professor J.l.carr during the Fall '08 term at University of Toronto.

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