Macro.Week9.2008 - II - 9/1 Review last week: How does...

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Unformatted text preview: II - 9/1 Review last week: How does government control money supply: Main way is through OPEN MARKET OPERATION The government enters the bond market and buys or sells government bonds TWO interesting questions from students: 1. Arent some bonds risky, since they stretch so far into the future? 2. Since bonds have different coupon rates, how can you talk about a single rate of interest? II - 9/2 Remember, the bond market is going on every day, and the government is normally cashing in bonds as they come due, and routinely selling new bonds to refinance the debt So, if an issue of $100 million in bonds comes due on Feb 1, the government routinely issues new bonds so as not to accidentally change the money supply Furthermore, every Tuesday, the government routinely sells a whole whack of short term bonds (1 month, 3 month, 6- month, 1-year) called Treasury Bills, or T-Bills So: To contract money supply, sell government bonds on open market. Mechanism: See diagram of liquidity demand At old interest rate, people have too little liquidity Try to acquire more liquidity by selling bonds Price of bonds falls, so r increases II - 9/3 Similarly, To expand money supply, buy government bonds on open market. Mechanism: See diagram of liquidity demand At old interest rate, people have too much liquidity Try to reduce liquidity by buying bonds Price of bonds rises, so r decreases Diagram: Linking Liquidity Preference diagram with Investment show two graphs, left one has L with r graphed against M, while right one has I, with r graphed against I: show effect on r and then I if M increases or decreases II - 9/4 RETURN TO NEW STUFF What is the role of the banking system?- it generates money (this is a really odd phenomenon!!) How do banks function? Two types of banks Chartered banks - eg. CIBC, RBC, TD-Canada Trust, Scotiabank, etc. Central bank: Bank of Canada banker for banks banker for government in charge of money supply II - 9/5 Assume one Chartered bank: Balance Sheet Assets Liabilities cash, reserves $100 demand deposits $1000 loans $940 equity $40 Why cash and reserves? to do business for prudence We need to define something called the reserve ratio = rr = (cash held by chartered bank + reserves)/DD Chartered Bank will run its business with some kind of target for rr which we call the target reserve ratio [Note: used to be a requirement, no more] II - 9/6 Now we will witness one of the oddest phenomena in Economics Money creation A large part of what we think of as money has no real substance To see this, imagine that there is no chartered bank and that everyone handles their affairs with cash. Imagine that people have a total of $200 in cash in their pockets....
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Macro.Week9.2008 - II - 9/1 Review last week: How does...

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