Chapter 8 Money, the Price Level, and Inflation

Defining Money

• Money is any commodity or token generally accepted as a means of payment
• A means of payment is a method of settling a debt
• Money functions as a medium of exchange, unit of account, and store of value

Medium of Exchange

• A medium of exchange is an object generally accepted in exchange for goods and services
• Without money, people would need to exchange goods and services directly through barter
• Barter requires a double coincidence of wants, which is rare and costly

Unit of Account

• A unit of account is an agreed measure for stating the prices of goods and services
• Money simplifies price comparisons

Store of Value

• As a store of value, money can be held for a time and later exchanged for goods and services

Money in Canada Today

• Money in Canada consists of currency and deposits at banks and other depository institutions
• Currency includes notes and coins held by individuals and businesses

Measures of Money

• The two main measures of money in Canada are M1 and M2
• M1 consists of currency held outside banks by individuals and businesses plus chequable deposits owned by individuals and businesses
• M2 consists of M1 plus all other deposits - nonchequable deposits owned by individuals and businesses

M1 and M2

• All items in M1 are means of payment and therefore money
• Chequable deposits can be transferred by e-transfer, cheque, or ATM withdrawal, so they are money
• Non-chequable deposits are transferable by e-transfer, and are not money
• E-transfers and cheques are instructions to a bank to transfer money, not money themselves
• Credit and debit cards and money wallets are not money

Depository Institutions

• A depository institution takes deposits from households and firms and makes loans to others

Types of Depository Institutions

• Deposits at chartered banks, credit unions and caisses populaires, and trust and mortgage loan companies make up the nation's money
• A chartered bank is a private firm, chartered under the Bank Act of 1991, to receive deposits and make loans
• A credit union is a cooperative organization operating under the Cooperative Credit Association Act of 1991 that receives deposits from and makes loans to its members
• A caisse populaire is similar to a credit union but operates in Quebec

Role of Depository Institutions

• The goal of any bank is to maximize the wealth of its owners
• To achieve this, the interest rate at which it lends exceeds the interest rate it pays on deposits
• Banks must balance profit and prudence; loans generate profit, but depositors must access funds when needed

Bank Assets

• A chartered bank puts depositors' funds into reserves, liquid assets, securities, and loans
• Reserves consist of notes and coins in its vault or its deposit at the Bank of Canada
• Liquid assets are Canadian government Treasury bills and commercial bills
• Securities cover longer-term Canadian government bonds and other bonds like mortgage-backed securities
• Loans are commitments of fixed amounts of money for agreed-upon periods

Economic Benefits of Depository Institutions

• Depository institutions provide liquidity, pool risk, lower borrowing costs, and lower borrower monitoring costs

Regulation of Depository Institutions

• Depository institutions are regulated to lessen financial risk, including insolvency and illiquidity
• A bank becomes insolvent if liabilities exceed assets, resulting in negative owner's capital
• Banks must maintain a capital buffer, a required amount of owners' capital as a percentage of total assets, to prevent insolvency
• A bank becomes illiquid if it is solvent but cannot meet sudden demands to repay borrowed funds
• The Bank of Canada ensures that banks and other depository institutions have adequate reserves to avoid illiquidity

Financial Innovation

• Financial innovation, or the development of new financial products, aims to lower deposit costs or increase lending returns
• Financial innovation has changed the composition of money
• Between 1990 and 2020, the percentage of chequable deposits in M2 increased, while non-chequable deposits and currency decreased
• In 1990, currency was 6.5% of M2, falling to 4% in 2020

The Bank of Canada

• The Bank of Canada is Canada's central bank
• A central bank is the public authority that regulates a nation's depository institutions and controls the quantity of money
• The Bank of Canada acts as banker to the banks and government, lender of last resort, and sole issuer of bank notes

Role as Banker

• The Bank of Canada accepts deposits from depository institutions that make up the payments system and the government of Canada

Lender of Last Resort

• The Bank of Canada is the lender of last resort, ready to make loans when the banking system is short of reserves
• Banks lend and borrow reserves from each other in the overnight loans market

Bank Notes and Balance Sheets

• The Bank of Canada exclusively issues bank notes and has a monopoly on this activity
• The Bank of Canada's assets are government securities and last-resort loans to banks
• Liabilities include Bank of Canada notes and deposits of banks and the government

Balance Sheet Assets and Liabilities

• The Bank's main assets are Canadian government securities and loans to banks
• The Bank's main liabilities are Bank of Canada notes in circulation and banks' deposits

Monetary Base

• The liabilities of the Bank of Canada plus coins issued by the Canadian Mint form the monetary base
• The monetary base is the 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
• The Bank of Canada changes the monetary base through open market operations, buying or selling government of Canada securities in the open market

Sources and Uses of Monetary Base

• The Bank of Canada's assets are the sources of monetary base
• The Bank of Canada's liabilities are the uses of monetary base

Bank of Canada's Policy Tools

• The Bank of Canada achieves objectives using open market operations and the bank rate

Open Market Operations

• Open market operations involve the Bank of Canada purchasing or selling government securities to or from a chartered bank or the public
• When the Bank of Canada buys securities, it pays with newly created reserves held by banks
• When the Bank of Canada sells securities, payment is made with reserves held by banks
• Open market operations influence banks' reserves

Bank Rate

• The Bank of Canada makes short-term loans, typically one-day loans, to major depository institutions when the banking system is short of reserves
• The interest rate on these loans is called the bank rate
• The bank rate acts as an anchor for other short-term interest rates and is closely related to the Bank's target for the overnight loans rate

Creating Deposits

• Banks create deposits when they make loans, and the new deposits created are new money

Constraints on Deposit Creation

• The quantity of deposits that banks can create is limited by monetary base, desired reserves, and desired currency holding

Monetary Base and Money Supply

• The monetary base is the sum of Bank of Canada notes, coins, and banks' deposits at the Bank of Canada
• The size of the monetary base limits the total quantity of money the banking system can create because banks have desired reserves and households and firms have desired currency holdings
• Desired holdings of monetary base depend on the quantity of money

Desired Reserves

• A bank's actual reserves consist of notes and coins in its vault and its deposit at the Bank of Canada
• The desired reserve ratio is the 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 bank determines to be prudent for its daily business

Currency Holding

• Because people hold some fraction of their money as currency, the quantity of currency that people plan to hold increases when the total quantity of money increases
• Currency leaves the banks when they make loans and increase deposits as desired currency holding increases, which increases deposits
• This leakage of reserves into currency is called the currency drain
• The ratio of currency to deposits is the currency drain ratio

Money Creation Process

• Money creation begins with an increase in the monetary base
• The Bank of Canada buys securities from banks in an open market operation
• The Bank of Canada pays for the securities with newly created bank reserves
• Banks now have more reserves but the same amount of deposits, resulting in excess reserves
• Excess reserves = Actual reserves – desired reserves

Money Multiplier

• The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base
• For example, if the Bank of Canada increases the monetary base by $100,000 and the quantity of money increases by $250,000, the money multiplier is 2.5
• The quantity of money created depends on the desired reserve ratio and the currency drain ratio
• The smaller these ratios, the larger is the money multiplier

Influences on Money Holding

• The quantity of money that people plan to hold depends on the price level, the nominal interest rate, real GDP, and financial innovation

Price Level

• A rise in the price level increases the quantity of nominal money but doesn't change the quantity of real money that people plan to hold
• Nominal money is the amount of money measured in dollars
• Real money equals Nominal money ÷ Price level
• The quantity of nominal money demanded is proportional to the price level - a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent

Nominal Interest Rate

• 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 decreases the quantity of real money that people plan to hold

Real GDP

• An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold

Financial Innovation

• Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of real money that people plan to hold

Demand for Money

• The demand for money is the relationship between the quantity of real money demanded and the nominal interest rate when all other influences on the amount of money that people wish to hold remain the same

Shifts in Demand

• A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward
• An increase in real GDP increases the demand for money and shifts the demand curve rightward

Market Equilibrium

• Money market equilibrium occurs when the quantity of money demanded equals the quantity of money supplied
• Adjustments that occur to bring about money market equilibrium are fundamentally different in the short run and the long run

Short-Run Equilibrium

• A graph shows the demand for money
• Excess money causes investment in bonds and falling interest rates

Interest Rates

• The quantity of money that people are willing to hold is less than the quantity supplied if the interest rate is exceeds expectations
• They lower their "excess" money by buying bonds
• This action then lowers the interest rate
• The quantity of money that people want to hold exceeds the quantity supplied if the interest rate is below expectations
• They try to get more money by selling bonds, an action raises the interest rate

Supply Effect

• If there is initially the expected interest rate, and the bank increases the quantity of money, people will be holding more money than the quantity demanded
• So they buy some bonds, and the increased demand for bonds raises the bond price and lowers the interest rate

Long-Run Equilibrium

• The loanable funds market determines the real interest rate in the long run
• Nominal interest rate equals the equilibrium real interest rate plus the expected inflation rate
• In the long run, real GDP equals potential GDP, so the price level is the only variable left to adjust

Long-Run Adjustments

• The price level adjusts to make the quantity of real money supplied equal to the quantity demanded
• If the Bank of Canada increases the quantity of money in long-run equilibrium, the price level changes to move the money market to a new long-run equilibrium
• Nothing real has changed in the long run, so Real GDP, employment, quantity of real money, and the real interest rate are unchanged
• The price level rises by the same percentage as the increase in the quantity of money in the long run

Transition

• Adjustment starts in full-employment equilibrium
• If the Bank of Canada increases the quantity of money by 10 percent, the nominal interest rate falls
• As people buy bonds, the real interest rate falls
• As the real interest rate falls, consumption expenditure and investment increase. Aggregate demand increases
• With the economy at full employment, the price level rises

Quantity Theory

• The quantity theory of money states there is an equal percentage increase in the price level when there is more money
• This is based on the velocity of circulation and the equation of exchange

Velocity

• Calling the velocity of circulation V, the price level P, real GDP Y, and the quantity of money M:
  • V = PY ÷ M.

Exchange

• The equation of exchange states that
  • MV = PY.
• The theory of exchange becomes quantitative if M does not influence V or Y
• Change in p is proportional to the change in M

Exchange in Growth

• Expressing the equation of exchange in growth rates:
  • Money growth rate Rate of velocity change + = Inflation rate + Real GDP growth
• Rearranging:
  • Inflation rate = Money growth rate + Rate of velocity change - Real GDP growth
• In the long run, velocity does not change, so
  • Inflation rate = Money growth rate – Real GDP growth

Note Introduction

• To see how the process of money creation works, suppose that the desired reserve ratio is 10 percent and the currency drain ratio is 50 percent of deposits
• The process starts when all banks have zero excess reserves and the Bank of Canada increases the monetary base by $100,000

Lending

• The bank with excess reserves of $100,000 loans them
• $33,333 drains from the bank as currency and $66,667 remains on deposit
• Currency drain is 50 percent of deposits Deposits increase
• The bank's reserves and deposits have increased by $66,667, so the bank keeps $6,667 (10 percent of deposits) as reserves and loans out $60,000
• $20,000 drains off as currency and $40,000 remains on deposit
• Currency drain is 50 percent of deposits
• The process repeats until the banks have created enough deposits to eliminate the excess reserves
• The $100,000 increase in monetary base has created $250,000 of money Equation
• The size of the money multiplier depends on
  • The currency drain ratio (C/D)
  • The desired reserve ratio (R/D)
  • Money multiplier = (1 + C/D) ÷ (C/D + R/D)
• In an example, C/D is 0.5 and R/D is 0.1, so Money multiplier = (1 + 0.5) ÷ (0.1 + 0.5) = (1.5) ÷ (0.6) = 2.5.