Macro CH10
Liquidity (def)
the ease with which an asset can be converted into the economy's medium of exchange.
The Bank of Canada must wrestle with two problems that arise due to fractional-reserve banking. The Bank of Canada does not control the amount of money that...
-households choose to hold as deposits in banks. -commercial bankers choose to lend. (required/excess reserve).
Four Primary Functions of the Bank of Canada
1) Issue currency 2) Act as banker to the commercial banks 3)Act as banker to the Canadian government 4)Control the money supply
Reserve of a commercial bank (2)
1) Vault cash 2) Deposit at central bank (Bank of Canada)
Central Bank's Tools of Monetary Control (3)
1)Open market operations -Domestic market -Foreign exchange market 2)Changing overnight rates 3)Changing reserve requirement
The reserve ratio, R
= fraction of deposits that banks hold as reserves = total reserves as a percentage of total deposits
A bank run occurs when... It reverses the money creation process --> ... Policies (1):
A bank run occurs when depositors suspect that a bank may go bankrupt and "run" to the bank to withdraw. It reverses the money creation process --> disruptive impact on any economy. Policies: Deposit insurance
Bank of Canada can also buy or sell... This will affect...
Bank of Canada can also buy or sell foreign currency in the foreign exchange market. this will affect the money supply in the economy.
What assets should be considered part of the money supply? (2)
Currency: the paper bills and coins in the hands of the (non-bank) public. Demand deposits: balances in bank accounts that depositors can access on demand by writing a check or using a debit card.
(Fractional Reserve System )Balancing act of commercial banks. In order to make money, commercial banks need to _________________ In order to reduce the risk, commercial banks need to ________.
In order to make money, commercial banks need to lend money out --> loan In order to reduce the risk, commercial banks need to keep some deposit.
Example of 2007-2008 financial crisis:
Insolvency
Leverage ratio =
Total Assets/ Capital (owner's equity)
Illiquidity:
a bank does not have enough resources to satisfy its current liability.
Insolvency:
a bank is insolvent when it is unable to pay off its debt holders and depositor in full. -Capital requirement
In a fractional reserve banking system, banks keep
a fraction of deposits as reserves, and use the rest to make loans.
Central bank:
an institution designed to regulate the money supply in the economy. The Bank of Canada: the central bank of Canada.
Medium of exchange:
an item buyers give to sellers when they want to purchase goods and services.
Store of value:
an item people can use to transfer purchasing power from the present to the future.
Change in reserve ratio will
change money multiplier. It also has strong impact on liquidity issues.
Commercial banks include
credit unions, trust companies and others. Big 5 in Canada
Money is the most...
liquid asset available, because it is the medium of exchange.
Bank of Canada has 8 scheduled interest rate announcement in a year (change of overnight rate) Impact: example-
lower interest rate -cheaper for a commercial bank to borrow --> less reserve/liquid assets and more loans -->increase money supply. Most interest rates inside the economy moves with key policy interest rate as well.
3 functions of money:
medium exchange, unit of account, store of value
Fiat money:
money without intrinsic value, used as money because of government decree. Example: the Canadian dollar.
Most developed country choose
not to use required reserve ratio as a policy tool; it is a very strong instrument
Function of Commercial banks:
profit maximization but with risk management.
When Bank of Canada sells, it charges the commercial bank's deposit account at Bank of Canada -->
reserve of the commercial bank decreases.
When Bank of Canada purchases, it credits the commercial bank's deposit account at Bank of Canada -->
reserve of the commercial bank increases.
Key interest rate:
set by Bank of Canada, target rate for the overnight rate -Major policy tool -Operating band ----Bank rate: key interest rate +0.25% ----Deposit rate: key interest rate -0.25%
Commodity money:
takes the form of a commodity with intrinsic value Examples: gold coins, other precious metals, rocks.
The money multiplier is Equals
the amount of money the banking system generates with each dollar of reserves. The money multiplier equals 1/R Example: with $100 cash bill and 10% multiplier = 1/0.1 = 10 and M1 = 10 x $100 = $1000 Assumptions: general public will not hold any currency
Leverage: (Risk):
the borrowed resources to supplement existing funds for purposes of investment Risk: the impact from default on leverage ratio
Overnight rate:
the interest rate at which major financial institutions borrow and lend one-day funds among themselves.
Open market operation:
the purchase or sale of securities (Government of Canada Bond) by the Bank of Canada.
Commercial banks can influence
the quantity of demand deposits in the economy and the money supply.
The money supply (M+) (or money stock):
the quantity of money available in the economy
Money is
the set of assets in an economy that people regularly use to buy goods and services from other people.
Unit of account:
the yardstick people use to post prices and record debts .
