PowerPoint Presentations for
Principles of Macroeconomics
Sixth Canadian Edition
by Mankiw/Kneebone/McKenzie
Adapted for the
Sixth Canadian Edition by
Marc Prud’homme
University of Ottawa
THE
MONETARY
SYSTEM
Chapter 10
Copyright © 2014 by Nelson Education Ltd.
10-2
THE MONETARY SYSTEM
 In this chapter, we begin to examine the role of
money in the economy.
 We discuss what money is, the various forms
that money takes, how the banking system
helps create money, and how the government
controls the quantity of money in circulation.
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THE MEANING OF MONEY
Money: the set of assets in the economy
that people regularly use to buy goods
and services from other people
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The Functions of Money
Medium of exchange: an item that buyers
give to sellers when they want to
purchase goods or services
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The Functions of Money
Unit of account: the yardstick people
use to post prices and record debts
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The Functions of Money
Store of value: 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 nonmonetary assets
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The Functions of Money
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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10-8
The Kinds of Money
Commodity money: money that takes the
form of a commodity with intrinsic value
Fiat money: money without intrinsic value
that is accepted as money because of
government decree
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Money in the Canadian Economy
The quantity of money circulating in the
economy, called the money stock, has a
powerful influence on many economic
variables.
Currency: These are the paper bills and
coins in the hands of the public.
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Money in the Canadian Economy
Demand deposits: These are the balances
in bank accounts that the depositors can
access on demand by writing a cheque
or using a debit card.
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FIGURE 10.1:
Two Measures of the Money Stock for the Canadian Economy
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QuickQuiz
List and describe the three functions of
money.
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THE BANK OF CANADA
The Bank of Canada (BoC): the central
bank of Canada
Central bank: an institution designed to
regulate the quantity of money in the
economy
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The Bank of Canada Act
Prior to the 1930s:
Bank notes were issued by the
Department of Finance and the
commercial banks.
Canada was on the gold standard.
With the collapse of the gold standard as a
result of the Great Depression, a need arose
to control the quantity of fiat money in the
economy.
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The Bank of Canada Act
 The government enacted the Bank of Canada Act
in 1934.
 The BoC was established in 1935 and nationalized in
1938.
 The BoC is managed by a board of directors,
including:
 the governor, the senior deputy governor, and 12
directors, including the deputy minister of
finance.
 The current governor of the BoC is Stephen Poloz.
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The Bank of Canada Act
 In practice, the BoC is independent of the government.
 The primary responsibility of the BoC is to act in the national
interest.
 The preamble to the BoC Act: http://lawslois.justice.gc.ca/eng/acts/B-2/page-1.html
 To this end, the BoC has four main functions:
1. Issue currency
2. Banker to the commercial banks
3. Banker to the Canadian government
4. Control the money supply
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The Bank of Canada Act
Money supply: the quantity of money
available in the economy
Monetary policy: the setting of the money
supply by policy makers in the central
bank
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Monetary Policy
The Bank of Canada has the power to
increase or decrease the number of
dollars in the economy.
The Bank of Canada is an important
institution because changes in the money
supply can profoundly affect the
economy.
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10-19
QuickQuiz
What is the difference between a central
bank like the Bank of Canada and a
commercial bank like the Bank of
Montreal?
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COMMERCIAL BANKS AND
THE MONEY SUPPLY
 Although the Bank of Canada alone is
responsible for Canadian monetary
policy, the central bank can control
the supply of money only through its
influence on the entire banking system.
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Thinkstock
 What is the role played by commercial
banks (which include credit unions,
caisses populaires, and trust
companies) in the monetary system?
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The Simple Case of
100 Percent-Reserve Banking
Assumptions:
An economy with no banks
Currency is the only form of money.
The initial supply of money is $100.
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The Simple Case of
100 Percent-Reserve Banking
 Now suppose someone opens a bank: First
National Bank.
 All deposits are held as reserves: 100 percentreserve banking.
 Reserves: deposits that banks have received but
have not loaned out
 Using a T-account to show changes in the bank’s
assets and liabilities …
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The Simple Case of
100 Percent-Reserve Banking
FIRST NATIONAL BANK
Assets
Reserves
Liabilities
$100
Deposits
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$100
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Money Creation with
Fractional-Reserve Banking
 Fractional-reserve banking: a banking system
in which banks hold only a fraction of deposits
as reserves
 Reserve ratio: the fraction of deposits that
banks
hold as reserves
 Assuming a reserve ratio of 10 percent …
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10-25
Money Creation with
Fractional-Reserve Banking
FIRST NATIONAL BANK
Assets
Liabilities
Reserves
$10
Loans
90
Deposits
$100
* The money supply (currency + deposits) = $190
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The Money Multiplier
SECOND NATIONAL BANK
Assets
Liabilities
Reserves
$9
Loans
81
Deposits
$90
* The money supply = $100 + $90 + $81 = $271
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The Money Multiplier
THIRD NATIONAL BANK
Assets
Liabilities
Reserves
$8.10
Loans
72.90
Deposits
$81
* The money supply = $100 + $90 + $81 + $72.90 =
$343.90
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10-28
The Money Multiplier
Original deposit
First National lending
Second National lending
Third National lending
.
.
.
Total money supply
= $100.00
= $90.00
= $81.00
= $72.90
(= 0.9 x $100.00)
(= 0.9 x $90.00)
(= 0.9 x $81.00)
.
.
.
= $1000
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The Money Multiplier
 Money multiplier: the amount of money the banking
system generates with each dollar it receives
 The money multiplier is the reciprocal of the reserve
ratio.
Bank Capital, Leverage, and
the Financial Crisis of 2007-09
 Bank capital: the resources the bank owners
put into an institution from issuing equity (e.g.,
stock)
 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.
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Bank Capital, Leverage, and
the Financial Crisis of 2007-09
MORE REALSITIC NATIONAL BANK
Assets
Liabilities
Reserves
$200
Deposits
$800
Loans
700
Debt
150
Securities
100
Capital
50
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10-32
Active Learning
Banks and the Money Supply
While cleaning your apartment, you look under the
sofa cushion and find a $50 bill (and a half-eaten
taco). You deposit the bill in your chequing account.
The bank’s reserve requirement is 20 percent of
deposits.
A. What is the maximum amount that the money
supply could increase?
B. What is the minimum amount that the money
supply could increase?
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Active Learning
Answers
You deposit $50 in your chequing account.
A. What is the maximum amount that the money
supply could increase?
If banks hold no excess reserves, then
money multiplier = 1/R = 1/0.2 = 5
The maximum possible increase in deposits is
5 x $50 = $250
But money supply also includes currency,
which falls by $50.
Hence, max increase in money supply = $200.
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10-34
Active Learning
Answers
You deposit $50 in your chequing account.
A. What is the maximum amount that the money
supply could increase?
Answer: $200
B. What is the minimum amount that the money
supply could increase?
Answer: $0
If your bank makes no loans from your deposit, currency
falls by $50, deposits increase by $50, money supply does
not change.
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10-35
Bank Capital, Leverage, and
the Financial Crisis of 2007-09
 Leverage: the use of borrowed money to
supplement existing funds for purposes of
investment
 Leverage ratio: the ratio of assets to bank
capital
 Capital requirement: a government regulation
specifying a minimum amount of bank capital
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10-36
The Bank of Canada’s
Tools of Monetary Control
 Central banks have three main tools for
monetary control:
1. Open-market operations
2. Changes in reserve requirements
3. Changes in the overnight rate
 The BoC uses changes in the overnight rate to
control the money supply.
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The BoC’s Tools of Monetary Control:
Changing the Overnight Rate
 Bank rate: the interest rate charged by the
Bank of Canada on loans to the commercial
banks
 Overnight rate: the interest rate on very shortterm loans between commercial banks
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The BoC’s Tools of Monetary Control:
Changing the Overnight Rate
 The BoC can alter the money supply by changing the
bank rate.
 This causes 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.
 The money supply contracts.
 Changes to the overnight rate are posted eight times a
year.
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10-39
The BoC’s Tools of Monetary Control:
Open-Market Operations
 Open-market operations: 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.
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10-40
The BoC’s Tools of Monetary Control:
Open-Market Operations
Quantitative easing: the purchase and
sale by the central bank of
nongovernment securities or government
securities with long maturity terms
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The BoC’s Tools of Monetary Control:
Open-Market Operations
 Foreign exchange market operations: the purchase or
sale of foreign money by the Bank of Canada
 If the Bank of Canada buys $100 M US dollars 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
is reduced.
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The BoC’s Tools of Monetary Control:
Open-Market Operations
Sterilization: the process of offsetting
foreign exchange market operations with
open-market operations, so that the
effect on the money supply is cancelled
out
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The BoC’s Tools of Monetary Control:
Changing Reserve Requirements
 Reserve requirements: 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.
 It raises the reserve ratio.
 This lowers the money multiplier.
 The money supply decreases.
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Problems in Controlling the Money Supply
1. The BoC does not control the amount of
money households choose to hold as
deposits in banks.
2. The BoC does not control the amount of
money banks choose to lend.
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10-45
QuickQuiz
Describe how banks create money.
If the BoC wanted to use all three of its
policy tools to decrease the money
supply, what would it do?
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Classroom Activity
What Can Be Learned from a Dollar?
Take a $5, $10, or $20 bill from wallets. Students without
any currency can share with someone who does. Please
read the bill.
What have you learned?
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THE END
Chapter 10
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