Chapter 15

The Monetary System

Outline

o Role of money in the economy o Creation of moneyo Control of supply of money by the

Bank of Canada

Moneyo Money is the set of assets in the

economy that people regularly use to buy goods and services from other people

o Money acts as a medium of exchange and can also serve as a store of value and a unit of account

o Wealth is the sum of all valuable assets owned minus liabilities

The Functions of Money

o Medium of exchange is an item that buyers give to sellers when they purchase goods & services

o A unit of account is the yardstick people use to post prices and record debts

o A store of value is an item that people can use to transfer purchasing power from the present to the future

The Nature of Money

o Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange

o Money is the most liquid asset but it is far from perfect as a store of value

o Trade off between liquidity and store of value determines the type of asset people wish to hold.

The Kinds of Money o Commodity money- money that takes the

form of a commodity with intrinsic valueo Fiat money- money without intrinsic value

that is used as money because of government decree

o Currency- includes the paper bills and coins in the hands of the public

o Deposit money or demand deposits - money held by the public in the form of deposits in commercial banks that can be withdrawn on demand

Measures of Money

o M1= currency+ demand deposits o M2= M1+ savings deposits+

personal term deposits o Term deposit is tied up for a period

of time and has a specified withdrawal time and pays a higher interest rate than demand deposits

Monetary Base, 1955-2003

M1 Supply, 1967-2003

M2 Supply, 1968-2003

The Bank of Canada

o Basic Functions of the Bank: o Banker to the Commercial banks o Banker to the Government o Controller and regulator of money

supplyo Regulator and supporter of money

markets

91- Day Treasury Bill yields, 1946- 2003

Bank Rate- Monthly, 1935-2003

Bond (1-3 year) yields , 1949-2003

Money creation by the banking system

o Assumptions:o Only one kind of asset- loans, and only

one kind of deposit- demand deposit o Fixed reserve ratio= 20% o No cash drain from the banking system

(public holds a fixed amount of currency in circulation)