Day 1
MONEY AND
MONETARY POLICY
Functions of Money
Means
Of
Store
Of
Exchange Purchasing
Power
Measure
Of
Value
Means of Exchange
• Without money, market participants
must trade one product for another
product, a transaction known as barter.
• For example in a barter market, a barber
who would wants to buy a clock must
find a clockmaker who wants a haircut.
Because it is hard for a barber to find a
clockmaker that wants a haircut, trade is
hence discouraged, so most people
living in a barter system produce many
items for themselves.
Means of Exchange Continued
• The benefits of money as a means of
exchange are far-reaching.
• People can minimize the time they
spend finding others with whom they
can buy and sell.
• Specialization promotes the division of
labor and allows an economy to achieve
higher levels of output. Therefore, the
use of money not only facilitates
transactions of goods and services - it
also raises living standards.
Store of Purchasing Power
• Money’s second function is to providing a safe
and accessible store of wealth. Money is an
attractive store of purchasing power during the
period from when it is earned to when it is spent.
The advantage of money is its liquidity. Assets are
most liquid when they can be quickly turned into
money with little or no loss. For an economic
choice there is and opportunity cost.
• People hold wealth as money when
– BENEFITS OF LIQUIDITY > THE INCOME IT COULD
EARN IN A DIFFERENT FORM.
Measure of Value
• Money provides buyers and sellers with a
unit of account, or pricing standards. The
unit of account allows all products to be
valued consistently against a common
measure – in other words, it provides a point
of comparison between two products.
• So if apples and oranges cost $ 2.00/kg and
$ 4.00/kg respectively, one can say that
oranges cost double that of the cost of the
apples. The unit of account does the same
on a grander scale; expressing GDP as a
dollar value simplifies the picture by
allowing a wide range of products to be
quantified and combined.
Deposit Takers
Chartered Banks
Near Banks
The Canadian Financial System
• The supply of money is closely
associated with institutions known as
deposit takers (bank itself) which
accepts funds provided by savers and
lend these funds to borrowers.
• Therefore the money the bank borrows
from the savers is a liability, but on the
other hand the money it lends out to
money borrowers are its assets.
• Therefore, the profit maker, for the
deposit takers is the difference in the
interest charged by the lenders and the
interest charged by the banks to its
money borrowers.
The Canadian Financial System Continued
• Cash reserves are the amount of
money that flows into the
institution but doesn’t flow out.
• It is used, when money
borrowers come to the institution
to make actual cash withdrawal.
The deposit takers make no profit
on these cash reserves. Deposit
takers can be categorized as
chartered and near banks.
Chartered Banks
• Chartered banks are
regular banks that
form the backbone
of the Canadian
Financial System.
These banks receive
charters from the
federal government,
allowing the banks
to sell a variety of
financial services.
Therefore, this
oligopoly market is
dominated by:
Near Banks
• Near banks, unlike chartered banks
have more specialized services. The
most important are trust companies,
mortgage loan companies and credit
unions.
The Supply of Money
• The supply of money is made up of :
– Currency
– Deposits
– Demand Deposits
– Notice Deposits
– Term Deposits
– Foreign Currency Deposits
Division of Money Supply
Credit and Debit Cards
• Credit Cards: a means of payment that
provides instantly borrowed funds. There
are a variety of credit card companies such
as Master Card, Visa and American Express
which one uses to build upon their credit.
One’s credit can be used to borrow funds
from money lenders, to for example to buy a
house etc.
• Debit Cards: a means of payment that
instantaneously transfers funds from buyer
to seller. The money is instantaneously
debited from one’s account and directly
deposited into another’s account.
THE MONEY
MARKET
The Demand for Money
• To Recall: Money functions as a
means of exchange, a store of
purchasing power, as well as a
measure of value.
• Money as a means of exchange
and a store of purchasing power
are reasons why money is
demanded within the economy.
Transactions Demand
•This function is connected to money’s use as
means of exchange.
•If real output in the economy increases, then
transactions also increases and vice versa.
•If price levels in the economy increases, then
quantity of money exchanged also increases
and vice versa
•The relationship between real output and
transactions, as well as price levels and quantity
of money exchanged is direct.
•Moreover, any changes in the transactions will
affect the amount of money demanded.
Asset Demand
• Connected to money’s function in terms of a store of
purchasing power.
• Recall: main cost of holding money is the added
income that could have been earned by converting
into a higher-paying liquid asset like a bond.
• Bonds are defined as formal contracts that set out the
amount borrowed, by whom, for what period of time, and
at what interest rate.
• The most popular way for large businesses and
governments to raise funds is with bonds because they
can be bought easily and sold before their term ends.
They also offer liquidity and relatively high rates of
returns.
• Beneficial to those who hold wealth because bonds offer
the likeliest alternative for holding money.
Asset Demand Continued
• Asset demand for money is inversely related to the
real interest rate on bonds.
• Example: If the interest rate increases, bond prices
decreases, which causes more people to convert
their own money into bonds and thereby decreasing
the asset demand for money.
• By contrast, if the interest rate decreases, bond
prices increases, causing wealth holders to hold on
their money and thereby increasing the asset demand
for money.
• Money Demand: The amounts of money demanded
at all possible interest rates . It can be shown in a
table called the money demand schedule and on a
graph where money demand is called the money
demand curve.
Asset Demand Continued
• Slope of money demand curve negative at lower
interest rates, there is a greater quantity of money
demanded.
• Slope is determined by asset demand for money.
• Since the relationship between asset demand for money
and real interest rates on bonds is inverse a change in
asset demand causes a change in the quantity of money
demanded, or a movement along the demand curve.
Asset Demand Continued
• Example: If interest rates rise from 3% to
5%, the quantity of money demanded will
decrease (from point b to point a).
• A change in the transactions demand will
change the amounts demanded at all
interest rates (It causes an entire shift
in the money demand curve).
• Transactions demand is affected by either
an increase or decrease in either real
output or the price levels in the economy.
• In figure 14.3, an increase in transactions
demand shifted the money curve to the
right from Dm0 to Dm1.
The Supply For Money
•A set amount determined by government decision-makers.
•Like money demand, money supply can be expressed in a
money supply schedule and on a graph which shows the money
supply curve.
•Amount of money supplied is always perfectly elastic and stays
at a constant value shown which is shown through the vertical
supply curve.
•Only shifts if government decision-makers decide to change the
money supply.
•An increase shifts it to the left, and a decrease shifts it to the
right.
Equilibrium in the Money Market
•Laws of supply and demand for money bring
about equilibrium in money market. Intersection of
money demand and supply indicate equilibrium
for real interest rates and quantity demanded at
that rate.
•A surplus occurs when at any point on the
graph where Sm > Dm at a particular interest rate.
Equilibrium in the Money Market Continued
• A shortage occurs when at any point on the
graph where Dm > Sm at a particular interest
rate.
• If a surplus occurs, people will want to buy
assets that will provide high future earnings
causing demand for assets to rise, which forces
bond prices to increase as well and causing real
interest rate to decrease.
• If a shortage occurs, people will want to sell
their assets to get money, forcing asset prices
to fall, which causes real interest rate to
increase.
• These trends of interest rates falling and
rising will continue until equilibrium is
reached.
THE BANK OF CANADA
The Bank of Canada
• Has served as Canada’s central bank since
1935
• It is a wholly government-owned institution
• The “Bank” has been give four basic functions
relating to money and the financial system:
–
–
–
–
Managing the money supply
Acting as “the Banker’s bank
Acting as the federal government’s fiscal agent
Ensuring the stable operation of financial markets
Managing the Money Supply
• Most important role of the Bank of
Canada is to control the amount of
money circulating in the economy
• The Bank decides and implements
monetary policy
• The Bank issues paper currency and
affect the activities of chartered banks to
adjust the interest rate and the supply of
money
Managing the Money Supply Continued
• The Bank of Canada has three main
goals with managing the money supply
– Minimizing inflation in order to preserve the
purchasing power of the dollar
– Maintaining real output as close as possible to its
potential level
– Regulating the external value of the Canadian
dollar on foreign exchange markets
Acting as the Bankers’ Bank
• The bank holds the deposits of
financial institutions that are
members of the Canadian Payments
Association (CPA)
• CPA includes the chartered banks
and some near banks.
• The association also acts as a
cleaning house for cheques of both
chartered banks and near banks.
Acting as the Bankers’ Bank Continued
• For example, the Depositor A has a chequing
account with Canada Trust. He writes a $50
cheque to Depositor B, who deposits this
cheque in her account at Scotia Bank,
increasing her deposit balance by $50. Scotia
Bank delivers the cheque to Canada Trust, and
receives $50 in return. This payment between
the two banks is actually made by using the
accounts kept by both institutions at the Bank
of Canada. The $50 is transferred from Canada
Trust’s account to Scotia Bank’s account at the
Bank of Canada. To complete the entire
exchange, Canada Trust then cancels the
cheque it has received and reduces Depositor
A’s deposit account by $50. Each day, every
cheque transaction like this is added up by the
Bank of Canada, and the accounts of members
of the CPA are all “cleared” at once.
Acting as the Bankers’ Bank Continued
• Cash reserves from the chartered banks are accounts
held at the Bank of Canada
• When a chartered bank finds that its cash reserves are
too low, it can borrow from the Bank of Canada. The
Bank provides a short-term loan by depositing the
required funds in the chartered bank’s account at the
Bank of Canada.
• Bank rate : the interest rate chartered
banks are charged on advance from the
Bank of Canada
• Because the bank rate is higher then the
interest rates on other available sources of
loans, chartered banks rarely take out Bank of
Canada advances.
Acting as the Federal Government’s Fiscal Agent
• The Federal government needs a
bank to manage its transactions and
financial assets
• The Bank of Canada’s responsibility
as the government’s fiscal agent are
– Holding some of the government’s bank deposits and
decides where other deposits should be held
– Acts as the government banker by clearing federal
government cheques
– Handles the financing of the federal governments debts
by issuing bonds
Acting as the Federal Government’s Fiscal Agent
• Canada Savings Bonds : federal
government bonds that have a set value
throughout their term
– Savers know exactly how much they will receive for the bond
during its entire term
– Increases the attractiveness to Canadian Savings Bonds
• Treasury bills : short-term federal
government bonds that provide no
interest, but are sold at a discount
– Terms of three months to a year
– Usually issued in large denominations
– Sold at a marked down price
Acting as the Federal Government’s Fiscal Agent
• For example, a treasury bill is worth
$100 000 might be bought for $95
000. Once the treasury bill matures,
the holder receives the face vale of
$100 000, thereby earning an income
of $5000.
• The price for federal treasury bills is
decided at an auction conducted
each Tuesday by the Bank of Canada
Ensuring the Stability of Financial Markets
• The Bank of Canada supervises the
operation of financial markets to
ensure the stability of them,
especially for chartered banks.
• This protects the safety of
depositors’ funds and the
soundness of the financial system
The End of Day One
Have a Terrific Tuesday