INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

PRINCIPLES OF MACROECONOMICS

Lecture 5: The Monetary System

Instructor: Chi Man Yip

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

ARE THEY LINING UP FOR I-PHONE?American Union Bank, New York City. April 26, 1932.

Source: Wikipedia

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

ARE THEY LINING UP FOR I-PHONE?

United Kingdom, 2007.

Source: http://www.dailymail.co.uk/news/article-2421538/Banks-offer-125-bribes-switch-account-new-rules-allow-money-just-seven-days.html

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

WHAT IS MONEY?

Money: the set of assets in an economy that peopleregularly use to buy goods & services from other people

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

3 FUNCTIONS OF MONEY

1 Medium of Exchange: as item that buyers give to sellerswhen they want to purchase goods or service

2 Unit of Account: the yardstick people use to post prices &record debts

3 Store of Value: as item that people can use to transferpurchasing power from the present to the future

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

MEDIUM OF EXCHANGE

I Who wants my durian? I want 3 pieces of sushi.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

3 FUNCTIONS OF MONEY

1 Medium of Exchange: as item that buyers give to sellerswhen they want to purchase goods or service

2 Unit of Account: the yardstick people use to post prices &record debts

3 Store of Value: as item that people can use to transferpurchasing power from the present to the future

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

3 FUNCTIONS OF MONEY

1 Medium of Exchange: as item that buyers give to sellerswhen they want to purchase goods or service

2 Unit of Account: the yardstick people use to post prices &record debts

3 Store of Value: as item that people can use to transferpurchasing power from the present to the future

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

2 KINDS OF MONEY

1 Commodity Money: Money that takes the form of acommodity with intrinsic value

I Gold was a common form of money

2 Fiat Money: Money without intrinsic value that is used asmoney because of government decree

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

2 KINDS OF MONEY

1 Commodity Money: Money that takes the form of acommodity with intrinsic value

2 Fiat Money: Money without intrinsic value that is used asmoney because of government decree

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

CENTRAL BANK

Central Bank: an institution designed to regulate thequantity of money in the economy

I Bank of Canada is the central bank of Canada.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

CENTRAL BANK

Money Supply: the quantity of money available in theeconomyMonetary Policy: the setting of the money supply bypolicymakers in the central bank

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

COMMERCIAL BANKS & THE MONEY SUPPLY

Reserves: deposits that banks have received but have notloaned outExcess Reserves: reserves that banks hold above the legalminimum

First National BankAssets Liabilities

Reserves $100 Deposits $100

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

COMMERCIAL BANKS & THE MONEY SUPPLY

Fractional-Reserve Banking: a banking system in whichbanks hold only a fraction of deposits as reservesReserve Ratio: the fraction of deposits that banks hold asreserves

First National BankAssets Liabilities

Reserves $10 Deposits $100Loans $90

e.g. Reserve Ratio=ReservesDeposits = 10

100 = 10 percent in this

example.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

THE MONEY MULTIPLIER

I Suppose the borrower from First National Bank uses the$90 to buy the durian from Chi Man

I Chi Man deposits the currency in Second National BankI Second National Bank creates an additional $81 of money

Second National BankAssets Liabilities

Reserves $9 Deposits $90Loans $81

e.g. Reserve Ratio=ReservesDeposits = 9

90 = 10 percent in this

example.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

THE MONEY MULTIPLIER

I Suppose this $81 is eventually deposited in Third NationalBank, which has a reserve ratio of 10 percent

Third National BankAssets Liabilities

Reserves $8.1 Deposits $81Loans $72.9

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

THE MONEY MULTIPLIER

Total money supply= $100 (Deposits in 1st National Bank)

+0.9× $100 (Deposits in 2nd National Bank)+0.9× (0.9× $100) (Deposits in 3rd National Bank)+...

= $1, 000

If 0 < a < 1, then

x + ax + a2x + a3x + ... =x

1− a.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

THE MONEY MULTIPLIER

Money Multiplier: the amount of money the bankingsystem generates with each dollar of reserves

e.g. Money Multiplier= $1000$100 = 10.

I The money multiplier is the reciprocal of the reserve ratio.I Reserve Ratio ↑ → Deposit Banks loan out ↓ →Money

Multiplier ↓

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

THE MONEY MULTIPLIER

Money Multiplier: the amount of money the bankingsystem generates with each dollar of reserves

e.g. Money Multiplier= $1000$100 = 10.

I The money multiplier is the reciprocal of the reserve ratio.I Reserve Ratio ↑ → Deposit Banks loan out ↓ →Money

Multiplier ↓

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

BANK CAPITAL & LEVERAGE

Bank Capital: the resource a bank’s owners have put intothe institutionCapital Requirement: a government regulation specifyinga minimum amount of bank capital

I Goal: Ensure that banks will be able to pay off theirdepositors

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

BANK CAPITAL & LEVERAGE

Leverage: the use of borrowed money to supplementexisting funds for purpose of investmentLeverage Ratio: the ratio of assets to bank capital

e.g. Leverage Ratio= AssetsBank Capital = 1000

50 = 20I For every dollar of capital that the bank owners have

contributed, the bank has $20 of assets.

More Realistic National BankAssets Liabilities

Reserves $200 Deposits $800Loans $700 Debt $150

Securities $100 Capital(Owners′equity) $50

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

3 METHODS OF CONTROLLING THE MONEY SUPPLY

1 Changing the Overnight Rate2 Open-Market Operations3 Changing Reserve Requirements

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

CHANGING THE OVERNIGHT RATE

Bank Rate: the interest rate charged by the Bank ofCanada on loans to the commercial banksOvernight Rate: the interest rate on very short-term loansbetween commercial banks.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

CHANGING THE OVERNIGHT RATE

I Commercial banks never need to pay more than the bankrate because they can always borrow from the Bank ofCanada

I Commercial banks never need to accept less than the bankrate because they can always lend to the Bank of Canada

I The Bank of Canada can alter the money supply bychanging the bank rate, which in turn causes an equalchange in the overnight rate.

I Overnight Rate ↑ → Quantity of Reserves in the BankingSystem ↓ →Money Supply ↓

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

OPEN-MARKET OPERATIONS

Open-Market Operations: the purchase or sale ofgovernment of Canada bonds by the Bank of Canada

I The Bank of Canada buys the bonds→Money inCirculation ↑ →Money Supply ↑

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

CHANGING RESERVE REQUIREMENTS

Reserve Requirements: regulations on the minimumamount of reserves that banks must hold against deposits

I Reserve Requirement ↑ → Banks must hold more reserve→ Reserve Ratio ↑ →Money Multiplier ↓ →MoneySupply ↓

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

EXERCISE 1:

I If the reserve ratio is 1/4 and the central bank increases thequantity of reserves in the banking system by $120, themoney supply increases by what amount?

I A bank has capital of $200 and a leverage ratio of 5. If thevalue of the bank’s assets declines by 10 percent, then itscapital will be reduced to what amount?

I You take $100 you had kept under your mattress anddeposit it in your bank account. If this $100 stays in thebanking system as reserves and if banks hold reservesequal to 10 percent of deposits, by how much does thetotal amount of deposits in the banking system increase?By how much does the money supply increase?

This exercise is obtained from Mankiw, N. Gregory, Ronald D. Kneebone,Kenneth J. Mckenzie (2017). Principles of Macroeconomics.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

EXERCISE 2:

I Suppose that the T-account for First National Bank is asfollows:

More Realistic National BankAssets Liabilities

Reserves $100000 Deposits $500000Loans $400000

I Suppose the Bank of Canada requires banks to hold 5percent of deposits as reserves. Assume that all otherbanks hold only the required amount of reserves. If FirstNational decides to reduce its reserves to only the requiredamount, by how much would the economys money supplyincrease?

This exercise is obtained from Mankiw, N. Gregory, Ronald D. Kneebone,Kenneth J. Mckenzie (2017). Principles of Macroeconomics.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

EXERCISE 3:

I Suppose there is a reserve requirement for private banksset at 10 percent of deposits. Also assume that banks donot hold any excess reserves.

I If the Bank of Canada sells $1 million of government bonds,what is the effect on the economys reserves and moneysupply?

I Now suppose the Bank of Canada lowers the reserverequirement to 5 percent, but banks choose to hold another5 percent of deposits as excess reserves. Why might banksdo so? What is the overall change in the money multiplierand the money supply as a result of these actions?

This exercise is obtained from Mankiw, N. Gregory, Ronald D. Kneebone,Kenneth J. Mckenzie (2017). Principles of Macroeconomics.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

EXERCISE 4:

I Assume there is a reserve requirement of 20 percent. Alsoassume that banks do not hold excess reserves and there isno cash held by the public. The Bank of Canada decidesthat it wants to expand the money supply by $40 million.

I If the Bank of Canada is using open-market operations, willit buy or sell bonds?

I What quantity of bonds does the Bank of Canada need tobuy or sell to accomplish the goal? Explain your reasoning.

This exercise is obtained from Mankiw, N. Gregory, Ronald D. Kneebone,Kenneth J. Mckenzie (2017). Principles of Macroeconomics.

INTRODUCTION MONEY BANK MONETARY POLICY EXERCISE

EXERCISE 5:I The economy of Elmendyn contains 2000 $1 bills.

a. If people hold all money as currency, what is the quantityof money?

b. If people hold all money as demand deposits and banksmaintain 100 percent reserves, what is the quantity ofmoney?

c. If people hold equal amounts of currency and demanddeposits and banks maintain 100 percent reserves, what isthe quantity of money?

d. If people hold all money as demand deposits and banksmaintain a reserve ratio of 10 percent, what is the quantityof money?

e. If people hold equal amounts of currency and demanddeposits and banks maintain a reserve ratio of 10 percent,what is the quantity of money?

This exercise is obtained from Mankiw, N. Gregory, Ronald D. Kneebone,Kenneth J. Mckenzie (2017). Principles of Macroeconomics.