Macroeconomics 1022 - Midterm #2 - Chapters 8-11

MONEY, THE PRICE LEVEL, AND INFLATION

Overview

• Understanding money and its functions.

• Insight into the Bank of Canada's structure and functions.

• Explanation of how the banking system creates money and its influence on the economy.

• The relationship between money supply, price level, and inflation rate.

What is Money?

Definition

• Money: Any commodity or token widely accepted as a means of payment for goods and services.

• Functions of Money:

  • Medium of exchange

  • Unit of account

  • Store of value

Medium of Exchange

• An object accepted in exchange for goods/services to avoid the inefficiency of barter, which requires a double coincidence of wants.

Unit of Account

• A standard measure to state prices of goods and services, simplifying price comparisons.

Store of Value

• Money holds value over time; it can be held and later exchanged for goods/services.

Money in Canada Today

Types of Money

• Currency: Notes and coins in circulation.

• Deposits: Balances held at banks that can be utilized for transactions.

  • Chequable Deposits: Allow transactions via cheques or e-transfers.

  • Non-chequable Deposits: Earn interest but do not allow withdrawals like chequable deposits.

Measures of Money

• M1+: Includes currency held outside banks and chequable deposits.

• M2+: Combines M1+ with non-chequable deposits.

Are M1+ and M2+ Really Money?

Characteristics

• M1+ includes all means of payment, qualifying as money.

• Chequable deposits can be easily transferred, while non-chequable deposits and other instruments (like credit cards) are not classified as money.

The Bank of Canada

Role

• Central bank of Canada, regulating financial institutions, controlling money supply, and maintaining currency stability.

Functions

• Banker to Banks and Government: Holds accounts for banks and manages government deposits.

• Lender of Last Resort: Provides loans to banks facing liquidity shortages.

• Sole Issuer of Bank Notes: Controls the issuance of banknotes, holding a monopoly.

The Monetary Base

• Comprises Bank of Canada notes, coins, and bank deposits at the Bank of Canada, serving as a foundation for money supply.

Policy Tools Used by the Bank of Canada

• Open Market Operations: Buying/selling government securities to influence bank reserves.

• Bank Rate: Interest rates on loans made to banks to regulate liquidity in the financial system.

How Banks Create Money

Mechanisms of Money Creation

• Creating Deposits by Making Loans: Banks can create new deposits through loans until limited by the monetary base, desired reserves, and currency holding.

Money Creation Process

1. Increase in Monetary Base: Occurs when the Bank buys securities, injecting new reserves into banks.

2. Excess Reserves: Banks can lend more than their required reserves, helping to increase the money supply.

3. Money Multiplier: The ratio of the change in money supply to the change in monetary base;

   • The smaller the reserve and currency holding ratios, the larger the multiplier effect.

The Money Market

Quantity of Money Holding

• Influenced by price level, nominal interest rates, real GDP, and financial innovation.

Demand for Money

• Affected by interest rates—higher rates decrease the quantity of money demanded.

Money Market Equilibrium

• Exists when demand for money equals the quantity supplied; adjustments differ between short and long-term scenarios.

Long-Run and Short-Run Equilibriums

Short-Run Effects

• Changes in money quantity influence GDP and price levels; excess money leads to changes in bond markets impacting interest rates.

Long-Run Adjustments

• Ultimately, the economy reaches a new equilibrium price level; no real change occurs in real GDP, employment, or interest rates.

Quantity Theory of Money

Fundamental Proposition

• In the long run, increasing the money supply leads to a proportional increase in prices; explained by the equation of exchange: MV = PY.

Inflation Rate Equation

• Inflation rate determined by the difference between money growth rate and real GDP growth under stable velocity.

Exchange Rates and the Balance of Payments

Overview

• Exchange rates determined by market dynamics (supply and demand).

Currency Appreciation and Depreciation

• Factors influencing value changes in currencies include trade balance, interest rates, and future expectations.

Determining Exchange Rates

• Influenced by various factors: expectations about future economic conditions, interest rates, and world demand for exports.

Expenditure Multipliers

Multiplier Concept

• Changes in autonomous expenditure lead to amplified changes in equilibrium GDP due to induced expenditure effects.

Calculating the Multiplier

• Multiplier equals the change in real GDP divided by the change in autonomous expenditure, influenced by the slope of the aggregate expenditure curve.