In-depth Notes on Money, Price Level, and Inflation

Money and the Price Level

  • What is Money?

    • Medium of exchange, store of value, unit of account

  • Types of Money:

    • M1: Currency held by individuals/businesses + chequable deposits
    • M2: M1 + non-chequable deposits + fixed term deposits

  • Modern Payment Methods:

    • E-transfers, credit cards, debit cards, mobile wallets

The Bank of Canada

  • Balance Sheet: Assets and Liabilities

  • Policy Tools:

    • Open Market Operations: Buying/selling government securities to influence money supply
    • Bank Rate: The interest rate for one-day loans to depository institutions

  • Impact of Bank Rate Changes:

    • Increase in bank rate: higher opportunity cost leads to decreased money supply

Money Creation Process

  • Creation of Money by Banks:

    • Banks create deposits when they make loans
    • Deposits created are considered new money
    • Limited by: monetary base, desired reserves, desired currency holding

  • Monetary Base:

    • Sum of notes, coins, and bank deposits at the central bank

  • Reserve Ratios:

    • Desired reserve ratio: ratio of reserves to deposits planned to be held by banks
    • Currency drain: ratio of currency to deposits

  • Money Multiplier Formula:
    extMoneyMultiplier=(1+CD)(CD+RD)ext{Money Multiplier} = \frac{(1 + \frac{C}{D})}{(\frac{C}{D} + \frac{R}{D})}

Money Market Dynamics

  • Money Market Equilibrium:

    • Determined where supply of money meets demand

  • The Demand for Money:

    • Influenced by interest rates, income level, and economic stability

  • Quantity Theory of Money:

    • Empirical framework showing the relationship between quantity of money in an economy and its price level

Aggregate Demand and Supply

  • Components of Aggregate Demand (AD):

    • Y=C+I+G+X−MY = C + I + G + X - M
    • Where C = consumption, I = investment, G = government spending, X = exports, M = imports

  • Aggregate Supply (AS):

    • Long-Run AS (LAS): Vertical at potential GDP; independent of price level
    • Short-Run AS (SAS): Positively sloped; influenced by price level changes in the short term

  • Factors affecting AS:

    • Technological advancements, productivity, wage rates

Economic Growth and Inflation

  • Economic Growth:

    • Involves shifts in the LAS curve to the right due to increases in labor and capital combined with technological advances

  • Inflation Effects:

    • If money supply increases faster than potential GDP growth, upward pressure on prices occurs, leading to inflation

Practice Problems and Mathematical Notes

  • Example Problem (M1 and M2 Calculation):

    • Sara withdraws $1500, keeps $500 cash; M1 decrease of $1000, M2 unchanged

  • Calculation of Monetary Base and Money Multiplier:

    • If bank deposits are $600 billion and reserves are $60 billion, then
    • extMonetaryBase=60+240=300ext{Monetary Base} = 60 + 240 = 300
    • extMoneyMultiplier=2.8ext{Money Multiplier} = 2.8

  • Various Scenarios in Currency and Interest Rate Changes:

    • Analyze scenarios when GDP increases and its impact on bond prices and interest rates.

Additional Elements: Exchange Rates and the Balance of Payments

  • Exchange rate determination:
    • Dependent on demand and supply dynamics, interest rates, and inflation differentials between countries