Solution to Problem Set 15-16 (ECO100)

Lets see this process in greater detail through the

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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 GB +1000 D –1000 D CB –1000 D –1000 G D +1000 GB +1000 G D +1000 D CB –1000 The Government issues new bonds and sells them to the public in order to finance its deficit. Government bonds represent an asset from the point of view of the public, but they are a liability from the point of view of the issuer (i.e., the Government). So the asset column of the public increases by $1000 and so does the liability column of the Government. The public writes cheques in the amount of $1000 to the Government, and thus the public’s deposits decrease by this amount. 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. Now the Bank of Canada has the cheques written by the public on their accounts at chartered bank, and thus the Bank of Canada holds a claim on the chartered bank. Therefore, the Bank of Canada will reduce the deposits of the chartered bank at the Bank of Canada by $1000. Therefore, after the Government sells new bonds to the public, the money supply decreased by $1000 (equal to the change in deposits). Also, since the chartered bank’s deposits with the Bank of Canada are part of the chartered bank’s
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5 reserves, the reserves decreased by $1000. Indeed, since there is no cash drain from the banking system, RE = D CB = –$1 billion. The Government now has the $1 billion it needs to finance the new expenditure, and thus it will spend it. As the Government spends this amount (i.e., writes cheques to the public in this amount), the deposits of the public at the chartered bank will increase by $1000 and the whole previous process will be reversed as shown in the following table: Public Chartered Bank Government Bank of Canada Assets Liabilities Assets Liabilities Assets Liabilities Assets Liabilities GB +1000 D –1000 D +1000 D CB –1000 D CB +1000 D –1000 D +1000 G D +1000 G D –1000 GB +1000 G D +1000 D CB –1000 G D –1000 D CB +1000 Therefore, there will be no change in either the reserves of the chartered bank or the money supply. (e) When the government borrows $1 billion from the Bank of Canada the reserves of the chartered bank do not change. When the government spends it, then the reserves of the chartered bank will increase will increase by $1 billion. Therefore, the money supply will increase by $10 billion. Indeed, since there is no cash drain from the banking system, RE = D CB = +$1 billion. Accordingly, M = mm RE = 10 (+$1 billion) = +$10 billion. 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 G D +1000 GB +1000 GB +1000 G D +1000
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