What assets are considered “Money”? What are the functions of money and the types of money? W/o money, the trade would require barter > Exchanging one good/service for another. The medium of exchange: an item buyers give to sellers when they want to purchase g/s. Unit of account: the yardstick ppl use to post prices & record debts. Store of value: an item ppl can use to transfer purchasing power from the present to the future. 2 kinds of Commodity money: commodity with intrinsic value, i. e. gold coins. Fiat money: money w/o intrinsic value, used as money b/c of the gov’t decree, i. e. dollar bills. Money in Can't economy. Money supply (Money stock): the quantity of money available in the economy. Two assets should be considered: Currency: the paper bills & coins in the hands of the general public. Demand deposits: balances in bank accounts that depositors can access on demand by writing a cheque/using debit card. Money Supply = currency + deposits.
What are the bank of Canada and its role? How do banks create money?
Central Bank: an institution designed to regulate the money supply in the economy. Bank of Canada: the central bank of Canada. Established in 1935, nationalized in 1938, owned by Can't gov’t. Managed by a board of directors appointed by the minister of Finance, composed of the governor, the senior deputy governor (7 yr terms), 12 directors (3 yr terms). Four primary functions: Issue currency, act as banker to commercial banks & Can't gov’t, control money supply. Commercial Banks and Money Supply Although Bank of Canada alone is responsible for Canadian monetary policy, the central bank can control the supply of money only through its influence on the entire banking system. Commercial banks include credit unions, caisses populaires, and trust companies. Commercial banks can influence the number of demand deposits in the economy and money supply. Reserves: cash that commercial banks hold. Fractional banking system > Keeps fraction of deposits as reserves, rest is loaned. Banks may hold more than this minimum amt if they choose. The reserve ratio, R Fraction of deposits that banks hold as reserves. Total reserves as % of total deposits. T-account – simplified accounting statement that shows the bank’s Assets & liabilities.
Banks liabilities: deposits(what we put in the bank), Assets: Loans and reserves(What bank keeps). R= Reserves/Deposits. Banks & money supply $100 of currency is in circulation, determining impact on money supply: Calculate in 3 different cases. No banking system Public holds the $100 as currency; Money supply= $100. 100% reserves banking system: banks hold 100% of deposits as reserves make no loans. MS = Currency (loans) + deposits = 0 +100 = 100. Bank does not affect the size of the money supply. Fractional reserve banking system. R=10%: Reserves: 10, Loans: 90, Deposits: 100. MS= $190. When banks make loans > create money. Borrower gets: 90 in currency(asset), 90 in new debt/loan (liability). Money Multiplier: The amt of money the banking system generates with each dollar of reserves. Money multiplier = 1/R R =10, 1/R = 10, 100 x 10 = 1000.
The Bank of Canada’s tools of Monetary Control:
Open-market operations. When it buys gov’t bonds from/ sells to the public. Foreign exchange market operations: when it buys/sells foreign currencies. MS increase when the bank of Canada buys a foreign currency with Canadian Currency, and decrease when BoC sells foreign currency.
Changing the overnight rate. Central banks act as bankers to commercial banks Bank rate: interest rate charged by the bank of Canada on loans to the commercial banks. Since 1998 Bank of Canada as allowed commercial banks to borrow freely at the bank rate, paid commercial banks the bank rate, minus half percent, on their deposits at the bank of Canada. Commercial banks never need to pay more than bank rate for short term loans, b/c they can always borrow from the Bank of Canada instead. Conversely, commercial banks never need to accept less than the bank rate, minus half a percent, when they make short-term loans because they can always lend to the bank of Canada instead. Overnight rate: the interest rate on very short-term loans between commercial banks.
Bank of Canada can alter the money supply by changing the bank rate, which in turn causes an equal chance at the overnight rate. A higher bank rate discourages commercial banks from borrowing from the Bank of Canada. Does a higher overnight rate discourage commercial banks from borrowing from other commercial banks? An increase in the overnight rate reduces the number of reserves in the banking system, which in turn reduces the money supply. Bank of Canada’s control of MS is not precise. Bank of Canada must wrestle w/ 2 problems that come from fractional-reserve banking. Does not control amt of money that: Household chooses to hold as deposits in banks. Commercial bankers choose to lend.
Chapter 11: Money Growth and Inflation How does the money supply affect inflation & nominal interest rates? The quantity theory of money: Price rises when gov’t prints too much money. Most economists believe the quantity theory is a good explanation of the long-run behavior of inflation. Asserts that the quantity of money determines value. 2 approaches: Supply-demand diagram MS determined by the bank of Canada, banking system, consumers. In the model, assume that BoC precisely controls MS & sets it at some fixed amt.
MD (money demand) how much wealth ppl want to hold in liquid form. Depends on P: an increase in P reduces the value of money, so more money is required to buy goods & services. Thus: Quantity of money demanded is –very related to the value of money +vely related to P, other things equal (real income, interest rates, availability of ATMs). Results from Graph: Increasing MS causes P to rise. How does this work? Short version: All nom variables (including prices) will double. All real variables (Including relative prices) will remain unchanged. The neutrality of Money. Monetary neutrality: the proposition that changes in the MS does not affect real variables. Doubling the money supply causes all nominal prices to double, what happens to relative prices? Initially, the relative price of cd in terms of pizza is the price of cd/price of pizza = 15/10 = 1. pizzas per cd. After nominal prices double. 30/20 = 1. 5 pizza per cd. The relative price is unchanged. Monetary neutrality: the proposition that changes in the MS does not affect real variables. Similarly, the real wage W/P remains unchanged, so… Quantity of labor supplied/demanded total employment does not change. The same applies to the employment of capital & other resources. Since the employment of all resources in unchanged, total output is also unchanged by the MS.
The inflation fallacy: most ppl think inflation erodes real income. Inflation is a general increase in the price of the things ppl buy & the things they sell (i. e. labor). In the long run, real incomes are determined by real variables, not the inflation rate. Shoe leather costs: the resources wasted when inflation encourages ppl to reduce their money holdings. Includes the time & transaction costs of more frequent bank withdrawals. Menu costs: the costs of changing prices Printing new menus, mailing new catalogs. Misallocation of resources from relative-price variability. Confusion & inconvenience: inflation changes the yardstick we use to measure transactions, complicates long-range planning & the comparison of dollar amounts over time.
Tax distortions: inflation makes nominal income grow faster than real income, taxes are based on nominal income, & some are not adjusted for inflation, so… inflation causes ppl to pay more taxes even when their real incomes don’t increase. Arbitrary redistributions of wealth Higher-than-expected inflation transfers purchasing power from creditors to debtors: debtors get to repay their debt w/ dollars that aren’t worth as much. Lower-than-expected inflation transfers purchasing power from debtors to creditors. High inflation is more variable & less predictable than low inflation. So, these arbitrary redistributions are frequent when inflation is high. Costs are high for economies experiencing hyperinflation. For economies w/ low inflation ( 0, “Capital outflow”, domestic purchases of foreign assets exceed foreign purchases of domestic assets. Capital is flowing out of the country. When NCO < 0, “Capital inflow”, foreign purchases of domestic assets exceed domestic purchases of foreign assets. Capital is flowing into the country. Variables that Influence NCO.
Real interest rates paid on foreign assets or domestic assets. Perceived risks of holding foreign assets. Gov’t policies affecting foreign ownership of domestic assets. The equality of NX & NCO. An accounting identity: NCO = NX. Arises b/c every transaction that affects NX also affects NCO by the same amt (And vice versa). When a foreigner purchases a good from Canada, Can't export & NX increase The foreigner pay w/ currency or assets, so the Can't acquires some foreign assets, causing NCO to rise. An accounting identity: NCO=NX. Arises b/c every transaction that affects NX also affects NCO the same amt ( & vice versa). When a Can't citizen buys foreign goods. Can't imports rise, NX falls? The Can't buyer pays w/ Can't dollars or assets, so the other country acquires. Can’t assets, causing Can't NCO to fall.
Saving, Investment, & international Flows of Goods & Assets. Y = C + I + G + NX accounting identity. Y – C – G = I + NX rearranging terms. S = I + NX since S = Y – C – G. S = I + NCO since NX = NCO. When S > I, the excess loanable funds flow abroad in the form of positive net capital outflow, NCO >0. When S e =P/P implies that the nom exchange rate between 2 countries should equal the ratio of price levels. If the 2 countries have diff inflation rates, then e will change over time: If inflation is higher in Mexico than in Canada, Then P rises faster than P, so e rises – the dollar appreciates against the peso. If inflation is higher in Canada than in Japan, then P rises faster than P, so e falls- the dollar depreciates against the yen. Limitations of PPP theory, why exchange rates do not always adjust to equalize prices across countries: Many goods cannot easily be traded: i. e. haircuts, going to movies. Price differences on such goods cannot be arbitraged away. Foreign, domestic goods, not perfect substitutes: Price differences reflect taste differences. Nonetheless, PPP works well in many cases, especially as an explanation of long-run trends i. e.
The supply & demand for loanable funds depends on the real interest rate. A higher real interest rate encourages ppl to save & raises the number of loanable funds supplied. The interest rate adjusts to bring the supply & demand for loanable funds into balance. At eq, ’m interested rate, the amt that ppl want to save exactly balances the desired quantities of domestic investment & foreign investment. Loanable funds market diagram. R adjusts to balance supply & demand in the LF market. Both I & NCO depend –very on r, so the D curve is downward-sloping. In small open economy w/ perfect capital mobility, i. e. Canada, the domestic interest rate = the world interest rate. As a result, the quantity of loanable funds made available by the savings of Can't does have to equal the quantity of loanable funds demanded by domestic investment. The difference between these two amts is NCO.
How are the markets for loanable funds & foreign-currency exchange connected? The market for foreign-currency exchange exists b/c ppl want to trade w/ ppl in other countries, but they want to be paid in their own currency. 2 sides of the foreign-currency exchange market are represented by NCO & NX. NCO represents the imbalance between the purchases & sales of capital assets. NX represents the imbalance b/w exports & imports of goods & services. Another identity from preceding chapter: NCO = NX. In the market for foreign-currency exchange, NX is the demand for dollars: foreigners need dollars to buy Can't NX. NCO is the supply of dollars: Can't residents provide/give dollars when they buy foreign assets. S=I + NCO > S – I =NX. What price balances the supply & demand in the market for foreign-currency exchange? * The real exchange rate (E) = e*P/P.
The Can't exchange rate(E) measures the quantity of foreign g/s that trade for one unit of Can't g/s. E is the real value of a dollar in the market for foreign-currency exchange. The demand curve for dollars (NX) is downward sloping b/c a higher exchange rate makes domestic goods more expensive. The supply curve (NCO) is vertical b/c the quantity of dollars supplied for NCO is unrelated to the real exchange rate. An increase in E makes Can't goods more expensive to foreigners, reduces foreign demand for Can't goods & dollars, does not affect NCO/supply of dollars. The real E adjusts to balance the S & D for dollars.
I'm in the open economy. Prices in the loanable funds market & the foreign-currency exchange market adjust simultaneously to balance supply & demand in these two markets. As, they determine the macroeconomic variables of national saving, domestic investment, NCO, and NX How do other policies or events affect the interest rate, exchange rate, and trade balance? The magnitude & variation in important macroeconomic variables depends on the following: Increase in world interest rates. Gov’t budget deficits & surpluses. Trade policies. Political & economic stability.Three steps in using the model to analyze these events. Determine which of the s/d curves e/ event effects. Determine which way the curves shift.
Examine how these shifts alter the economy’s equilibrium. Increase in world interest rates. Events outside Canada that cause world interest rates to change can have important effects on the Can't economy. In a small open economy w/ perfect mobility, an increase in the world interest rate… Crowds out domestic investment, Cause NCO to increase & Causes the dollar to depreciate. The effects of an increase in the gov’t budget deficit.*Gov’t budget deficits & surpluses b/c a gov’t budget deficit represents a negative public saving, it reduces national saving, and therefore reduces… the supply of loanable funds NCO. The supply of Can't dollars in the market for foreign-currency exchange.
Trade Policy: is a gov’t policy that directly influences the quantity of goods services that a country imports/exports. Tariff: a tax on imported goods. Imported quota: a limit on the quantity of a good produces abroad and sold domestically. The initial impact is on imports – which affects NX NX are the sources of demand for dollars in the foreign currency exchange market. Imports are reduced at any exchange rate, & NX will rise. This increases the demand for dollars in the foreign currency exchange market. There is no change in the market for loanable funds, and therefore, no change in NCO. B/c foreigners need dollars to buy Can't NX, there is an increased demand for dollars in the market for foreign-currency. This leads to an appreciation of the real exchange rate. Effect of an import quota. An appreciation of the dollar in the foreign exchange market discourages exports. This offsets the initial increase in NX due to import quota.
Trade policies do not affect the trade balance Political Instability & Capital Flight. Is a large & sudden reduction in demand for assets located in a country. Has its largest impact on the country from which the capital is fleeing, but it also affects other countries. If investors become concerned about the safety of their investments, capital can quickly leave an economy. Interest rates increase & the domestic currency depreciates. When investors around the world observed political problems in Mexico in 1994, they sold some of their Mexican assets and used the proceeds to by assets of the other countries. Most of the macro's quantities fluctuate together. As output falls, unemployment rises to Use the model of AD & AS to study fluctuations. Short-run, changes in nominal variables (Ms or P) can affect real variables (Y/U-rate) How does the model aggregate demand & supply explain economic fluctuations?.
Aggregate-demand curve – shows the quantity of goods & services that households, firms, & the gov’t want to buy each price level. Aggregate-supply curve- shows the number of goods & services that firms choose to produce and sell at each price level. Why does the aggregate-demand curve slope downward? What shifts the AD curve? AD curve shows the quantity of g/s demanded in the economy at any given P Y=C+I+G+NX. Assume G fixed by gov’t policy Increase in P reduces the quantity of g/s demanded b/c: The wealth effect (c falls). The dollars ppl hold buy fewer g/s so real wealth is lower Ppl feel poorer i. e. a stock market boom makes households feel wealthier, Crises, the AD curve shifts right; preferences: consumption, saving tradeoff; tax hikes/cuts. Interest rate effect (I fall). Buying g/s requires more dollars.
If AS is vertical, fluctuations in AD do not cause fluctuations in output/employment. If AS slopes up, then shifts in AD do affect output & employment. Three theories: Sticky wage theory, Imperfection- nominal wages are sticky in the short run, they adjust sluggishly, due to labor contracts; firms & workers set the nominal wage in advance based on Pe, the price level expected to prevail. If P>Pe, revenue is higher, but labor cost is not. Productions are more profitable, so firms increase output & employment. Hence, high P causes higher Y, so the SRAS curve slopes upward. Sticky price theory, Imperfection- many prices are sticky in the short run: due to menu costs, the costs of adjusting prices, i. e. ost of printing new menus, the time required to change price tags. Firms set sticky prices in advance based on Pe. Suppose the BoC increases the MS unexpectedly, in LR P will rise. In SR, firms w/o menu costs can raise their P immediately.