K

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.