Ch 24 - Money, Deposit Multiplier, Price Level, Inflation

Saturday, April 07, 2012

6:05 PM

    Important Functions of money


    Medium of exchange

    Replaces barter

    Unit of account

    Agreed measure for stating the prices of goods and services

    Store of value




    Notes and coins held by households


    At Bank

    Fiat Money

    Notes not backed by anything tangible (no intrinsic value)


    Important Official Measures of Money



    Chequable deposits (personal & non-personal)
    Currency outside banks


    Fixed term deposits
    Non-chequable deposits (personal & non-personal)



    The property of being instantly convertible into a means of payment with little loss of value

    Deposits are money, but cheques are not

    Cheque is an instruction to a bank to transfer money.
    Deposit is money, it cheque by itself

    Credit cards are not money

    Only enables loan. Must be repaid with money.


    Banking System: Institutions


    Depository institution

    Firm that takes deposits from households and firms and makes loans to other households and firms.

    • Chartered banks
    • Credit unions
    • Trust/Mortgage loan companies


    Goal: Maximize wealth of its owners

    Types of assets:

    • Reserves - deposited in bank of Canada
    • Liquid assets - Gov. Canada treasury bills and commercial bills
    • Securities - Long-term bonds
    • Loans



    • Create liquidity
    • Pool risk
    • Lower cost of borrowing
    • Lower cost of monitoring borrowers

    Bank of Canada

    Central Bank - public authority that regulates a nation's depository institutions and control the quantity of money.

    • Banker to banks and government
    • Last resort lender
    • Sole issuer of bank notes

    Monetary Base


    • Sum of Bank of Canada notes outside of the bank.
    • Banks' deposits at the Bank of Canada
    • Coins held by households, firms, and banks


    Open market operation - purchase or sale of government of Canada securities (by Bank of Canada) in the open market

    Payments System

    Allows banks make payments to each other to settle transactions by their customers.



    Important Desired & Access Reserves


    Reserve ratio

    Fraction of total deposits held as reserves by banks

    Desired reserve ratio

    Ratio that banks wants to have

    Excess reserves

    Currency drain ratio

    Ratio of currency held in cash by people to deposits


    Important Money creation process


    1. Banks have excess reserves
    1. Banks lend them out.
    2. Quantity of money increases
    3. New money is used to make payments
    4. Some new money remain as deposits
    1. Some new money is held as currency
    2. Desired reserves increase (due to increase in deposits)
    1. Excess reserves decrease but remain positive


    Money multiplier



    Currency drain ratio

    Desired reserve ratio




    Quantity of money



    Important Determinants of amount of money people plans to hold


    Price level

    Changes the nominal, but not the real money. (Since change in price level is inflation)

    Nominal interest rate

    Indirect relationship on the quantity of real money people plans hold.

    Real GDP


    Financial innovation

    Lowers the cost of switching between money.


    Demand for money

    X = quantity of real money demanded
    Y = nominal interest rate


    Real GDP (Direct)
    Financial innovation (Indirect)


    Quantity theory of money

    In the long run, an increase in the quantity of money brings an equal percentage increase in the price level.

    Velocity of circulation

    Average number of times per year a dollar is used to purchase goods/services



    Price level

    Real GDP

    Quantity of money

    Velocity of circulation




    Long run:





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