Chapter 8 Lecture

MONEY, THE PRICE LEVEL, AND INFLATION

Learning Objectives

• Define Money: Understand what constitutes money and its various functions.

• Structure and Functions of the Bank of Canada: Familiarize with the roles of Canada's central bank.

• Money Creation by Banks: Explain the mechanisms by which banks create money.

• Influencers of the Quantity of Money and Interest Rates: Describe factors that determine money supply and interest rates.

• Relationship Between Money Supply, Price Level, and Inflation: Understand how changes in money supply affect price levels and inflation rates.

What is Money?

• Definition: Any commodity or token widely accepted as payment means.

• Functions of Money:

  • Medium of Exchange: Facilitates transactions; replaces barter, which is inefficient due to the double coincidence of wants.

  • Unit of Account: Standard measurement for pricing goods and services, simplifying comparisons.

  • Store of Value: Maintains purchasing power over time, allowing money to be saved and used later.

Money in Canada Today

• Types of Money:

  • Currency: Physical notes and coins.

  • Deposits: Includes both chequable accounts (can write cheques or e-transfers) and non-chequable accounts (interest-earning).

• Measures of Money:

  • M1+: Contains currency outside banks and chequable deposits.

  • M2+: M1+ plus non-chequable deposits.

• Usage of Measures: M1+ indicates liquid money readily accessible; M2+ offers a broader view of money supply including savings.

The Bank of Canada

• Definition: The central bank that controls the quantity of money and regulates Canadian banks.

• Core Functions:

  • Banker to Banks and Government: Holds deposits from depository institutions and the government.

  • Lender of Last Resort: Provides loans to banks during emergencies or liquidity shortages.

  • Sole Issuer of Bank Notes: Only entity authorized to issue legal tender.

Monetary Policy Tools

• Policy Tools Used by the Bank of Canada:

  • Open Market Operation: Buying and selling government securities to influence reserve levels in banks, affecting money supply.

  • Bank Rate: Interest rate charged on loans to major banks, serving as a benchmark for other interest rates.

How Banks Create Money

• Mechanism: Banks create money through loan-disbursement; new deposits signify new money.

• Influence of Monetary Base:

  • Monetary Base: Total of Bank of Canada notes, coins, and deposits at the central bank.

  • Desired Reserves and Currency Holdings: Banks maintain a reserve ratio and individuals hold a percentage as cash (currency).

• Money Creation Process:

  1. Open market purchase increases monetary base.

  2. Banks lend out excess reserves, creating deposits.

  3. The cycle repeats, expanding the money supply through successive loans.

The Money Multiplier

• Definition: Ratio that depicts the relationship between the change in money supply and the change in the monetary base.

• Calculation: Based on the desired reserve ratio and currency drain ratio. E.g., with a monetary base increase of $100,000 creating a total of $250,000 in new money, the multiplier is 2.5.

Key Influencers on Money Demand

1. Price Level: Increases in price necessitate an increase in nominal money holdings, with real money remaining constant.

2. Nominal Interest Rate: Higher rates diminish the quantity of real money held as opportunity cost rises.

3. Real GDP: Economic expansion raises total expenditure and thus money holdings.

4. Financial Innovations: New financial instruments can shift preferences away from holding money.

Money Market Dynamics

• Equilibrium: Occurs when quantity of money demanded equals quantity supplied; adjustments can vary between short and long run.

• Short-Run Adjustments:

  • If supply exceeds demand, bond demand surges, lowering interest rates.

  • If demand exceeds supply, asset sales drive up interest rates.

Long-Run Adjustments

• Price levels adjust to equalize real money quantities when there's a shift in money supply.

• Quantity Theory of Money: Long-run relationship stipulates that increases in monetary supply proportionately affect price levels, based on the equation MV = PY.

Conclusion

Understanding the interconnections between money, banking operations, and economic indicators is crucial for comprehending broader fiscal policies and their implications on inflation and economic stability.