Macroeconomics Chapter 24 – Money, the Price Level and Inflation – Flashcards
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What is money?
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Any commodity or bill/token that is generally acceptable as a means of payment
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What is a means of payment?
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A method of settling a debt
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What are the functions of money?
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1) A means of payment 2) Medium of exchange 3) Unit of account 4) Store of value
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Explain the role of money as a medium of exchange
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A medium of exchange is an object that is generally accepted for goods and services
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What occurs in the absence of money?
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People would need to exchange goods and services directly in a process called bartering Bartering is costly and requires double coincidence of wants
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Explain the role of money as a unit of account
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A unit of account is an agreed measure for stating the price of goods and services
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Explain the role of money as a store of value
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As a store of value, money can be held for a time and later exchanged for goods and services
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What is currency?
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Notes and coins held by individuals and buisnesses
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What does M1 consist of?
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M1 consists of currency held by individuals and businessess plus chequable deposits owned by individuals and buisnesses
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What does M2 consist of?
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M2 consists of M1 plus all other deposits - non-chequable deposits and fixed term deposits
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Is M1 considered money?
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Yes. All items in M1 are a means of payment and can act as money.
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Is M2 considered money?
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No. Some savings deposits in M2 are not means of payments but are liquid assets
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Define liquidity
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The property of being instantly convertible into a means of payment with little loss of value
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Compare deposits and cheques in terms of being used as money
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Deposits are money but cheques are not A cheque is an instruction to a bank to transfer money
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Is a credit card considered money?
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Credit cards are not money A credit card enables the holder to obtain a loan, which is repaid with money
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Define a depository institution
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A firm that takes deposits from households and firms and makes loans to other households and firms
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What are the three depository institutions in a nation?
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1) Chartered banks 2) Credit unions and caisses populaires 3) Trust and mortgage loan companies
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What is a chartered bank?
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A chartered bank is a private firm that can receive deposits and make loans
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What is a credit union?
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A cooperative organization that receives deposits from and makes loans to its members
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What is the goal of any bank?
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To maximize wealth
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How do banks maximize wealth?
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To maximize wealth, the interest rate at which banks lends must exceed the interest rate it pays on deposits Loans generate profit Depositors must be able to obtain their funds when they want
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What are reserves?
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Notes and coins in a chartered banks vault or the banks deposit at the Bank of Canada
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What are liquid assets?
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Canadian government Treasury bills and commercial bills
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What are securities?
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Longer-term Canadian bonds and other bonds such as mortgage-backed securities
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What are loans?
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Commitments of fixed amounts of money for agreed-upon periods of time
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How do depository institutions make a profit?
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Depository institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans
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What benefits do depository institutions provide?
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1) Create liquidity 2) Pool risk 3) Lower the cost of borrowing 4) Lower the cost of monitoring borrowers
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What is the central bank?
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The public authority that regulates a nation's depository institutions and controls the quantity of money
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What are the roles of the Bank of Canada (central bank)?
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1) Banker to the banks and government 2) Lender of last resort 3) Sole issuer of banks notes
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What does it mean for the central bank to be the banker to the banks and government?
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Accepts deposits from depository institutions that make up the payments system and the government of Canada
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What does it mean for the central bank to be the lender of last resort?
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The central bank stands ready to make loans when the banking system as a whole is short of reserves Banks lend and borrow reserves from other banks in the overnight loans market
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What does it mean for the central bank to be the sole issuer of banks notes?
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Only the central bank is permitted to issue bank notes
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What is the Bank of Canada's Balance sheet?
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The Bank of Canada's assets are government securities (bond) and last resort loans to banks Its liabilities are Bank of Canada notes and deposits of banks and the government
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What is the monetary base?
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Sum of Bank of Canada notes outside the Bank of Canada, banks' deposits at the Bank of Canada, and coins held by households, firms, and banks
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How does the Bank of Canada change the monetary base?
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Conducts open market operation, which is the purchase/sale of government of Canada securities (bonds) by the Bank of Canada in the open market
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What is an open market operation?
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The purchase/sale of government securities by the Bank of Canada from/to a chartered bank When the Bank of Canada buys securities (bonds), it pays for them with newly created reserves held by the banks When the Bank of Canada sells securities (bonds), it is paid for with reserves held by the banks
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What occurs in an open market purchase?
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Open market purchase increases bank reserves This is because in order to buy the securities (bonds), the central bank pays for it with newly created reserves
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What occurs in an open market sale?
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Open market sales decrease bank reserves This is because in order when selling the securities (bonds), the central bank is paid with reserves from banks
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How do banks create deposits?
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Banks create deposits when they make loans and the new deposits created are new money
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What factors limit the quantity of deposits a bank can create?
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1) The monetary base 2) Desired reserves 3) Desired currency holding
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How does the monetary base limit the quantity of deposits a bank can create?
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Monetary base is the sum of bank of Canada notes, coins, and banks' deposits at the Bank of Canada Size of monetary banks limits the total quantity of money that the banking system can create because: 1) Banks have desired reserves 2) Households and firms have desired currency holdings
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What is a bank's actual reserves?
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Consists of notes and coins in its vault and its deposit at the Bank of Canada
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What is the desired reserve ratio?
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Ratio of the bank's reserves to total deposits that a bank plans to hold The desired reserve ratio exceeds the required reserve ratio by the amount that the banks determines prudent for its daily buisnesses
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What is desired currency holding?
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People hold some fraction of their money as currency If total quantity of money increases, so does the quantity of currency that people plan to hold As desired currency holding increases when deposits increase, currency leaves the banks when they make loans and increase deposits
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What is currency drain?
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Ratio of currency to deposits; leakage of reserves into currency
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How do you calculate excess reserves?
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Excess reserves = Actual reserves - desired reserves
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Outline the money creation process
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Money creation process begins with an increase in the monetary base The Bank of Canada conducts an open market operation in which it buys securities from banks The Bank of Canada pays for the securities with newly created bank reserves Banks now have more reserves but the same amount of deposits, so they have excess reserves
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What is the money multiplier?
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Ratio of the change in quantity of money to the change in monetary base Money multiplier = (change in quantity of money)/(change in monetary base)
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What factors influence the quantity of money people plan to hold?
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1) The price level 2) The nominal interest rate 3) Real GDP 4) Financial innovation
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How does the price level influence the quantity of money people plan to hold?
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A rise in price level increases quantity of nominal money but does not change the quantity of real money people plan to hold Quantity of nominal money demanded is proportional to the price level - 10% rise in price level increases quantity of nominal demanded by 10%
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What is nominal money?
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Amount of money measured in dollars
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What is real money?
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Equals nominal money divided by price level
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How does the nominal interest rate influence the amount of money held?
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The nominal interest rate is the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset A rise in the nominal interest rate on other assets decrease the quantity of real money people plan to hold
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How does real GDP influence the amount of money held?
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An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold
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How does financial innovation influence the amount of money held?
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Financial innovation lowers the cost of switching between money and interest-bearing assets, which decreases the quantity of real money that people plan to hold
