Solution to Problem Set 15-16 (ECO100)

The government issues new bonds and sells them to the

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The Government issues new bonds and sells them to the Bank of Canada in order to finance its deficit. Government bonds represent an asset from the point of view of the Bank of Canada, but they are a liability from the point of view of the issuer (i.e., the Government). So the asset column of the Bank of Canada increases by $1000 and so does the liability column of the Government. The Bank of Canada pays $1000 to the Government by increasing the deposits of the Government at the Bank of Canada by this amount. The deposits of the
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6 Government at the Bank of Canada represent an asset from its point of view, but a liability from the point of view of the Bank of Canada. Therefore, after the Government sells new bonds to the Bank of Canada, neither the reserves of the chartered bank nor the money supply have been affected. The Government now has the $1 billion it needs to finance the new expenditure, and thus it will spend it. Let’s see this process in greater detail through the changes in the balance sheets of the public, the chartered banks, the government, and the Bank of Canada (in millions): Public Chartered Bank Government Bank of Canada Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities D +1000 D +9000 L +9000 D CB +1000 L +9000 D +1000 D +9000 G D +1000 G D –1000 GB +1000 G D +1000 G D –1000 D CB +1000 As the Government spends $1000 (i.e., writes cheques to the public in this amount), the deposits of the Government at the Bank of Canada decrease by this amount. The public receives the cheques written by the Government and deposit them in their accounts at the chartered bank. The deposits of the public at the chartered bank represent an asset from their point of view, but a liability from the point of view of the chartered bank. The money supply has already increased by $1000. The chartered bank is now in possession of the cheques written by the Government and will deposit them in its account at the Bank of Canada. Therefore, the deposits of the chartered bank at the Bank of Canada will increase by $1000 (i.e., the bank’s reserves will increase by this amount. The chartered bank is now holding excess reserves since reserves increased by $1000 and the deposits of the public also increased by $1000. That is, is holding $900 in excess reserves which it will lend to the public. This process will continue until all excess reserves are eliminated and thus the money supply will increase by: M = mm RE = 10 ($1 billion) = $10 billion. Therefore, the banking system will create an additional $9000 in deposits by lending this amount to the public. Therefore loans will increase by $9000 and the total increase in deposits will be $10000.
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