14.6 SUMMARY

1. Money is any asset that can be used to purchase goods and services easily. Currency in circulation and chequeable (or demand) deposits are both considered part of the money supply. Money plays three roles: it is a medium of exchange used for transactions, a store of value that holds purchasing power over time, and a unit of account in which prices are stated.

2. Over time, commodity money, which consists of goods possessing value aside from their role as money, such as gold and silver coins, was replaced by commodity-backed money, such as paper currency backed by gold. Today the dollar is pure fiat money, whose value derives solely from its official role.

3. The Bank of Canada calculates a number of measures of the money supply. M1 is the narrowest monetary aggregate, containing only currency in circulation and demand deposits, such as chequing accounts, held at chartered banks. M2 and M3 includes a wider range of assets called near-moneys, mainly other forms of chartered bank deposits that can easily be converted into chequing bank deposits.

4. Banks allow depositors immediate access to their funds, but they also lend out most of the funds deposited in their care. To meet demands for cash, they maintain desired (or voluntary) reserve ratios composed of both currency held in their vaults and deposits at the Bank of Canada. Excess reserves refer to any reserves above the desired level of reserves. The reserve ratio is the ratio of bank reserves to bank deposits. A T-account summarizes a bank’s financial position, with loans and reserves counted as assets and deposits counted as liabilities.

5. Banks have sometimes been subject to bank runs, most notably in the early 1930s in the U.S. and briefly just before World War I in Canada. To avert this danger, depositors are now protected by deposit insurance. Although Canadian banks are no longer required to meet minimum reserve requirements, bank owners still face capital requirements that reduce the incentive to make overly risky loans with depositors’ funds.

6. When currency is deposited in a bank, it starts a multiplier process in which banks lend out excess reserves, leading to an increase in the money supply—so private banks create money. If the entire money supply consisted of chequeable bank deposits, the money supply would be equal to the value of reserves divided by the reserve ratio. In reality, much of the monetary base consists of currency in circulation, and the money multiplier is the ratio of the money supply to the monetary base.

7. The monetary base is controlled by the Bank of Canada (BOC), the central bank of Canada. The BOC regulates banks and helps to set overnight interest rates. To meet their desired reserve requirements, banks borrow and lend reserves in the overnight funds market usually at an interest rate very close to the BOC’s target for the overnight rate. When banks are unable to borrow funds in the overnight market, they have the option to borrow from the Bank of Canada at the bank rate. Such a loan is referred to as a lender of last resort loan.

8. The Bank of Canada’s principal tools of monetary policy are open-market operations and deposit switching. To increase the monetary base, the BOC can buy Canadian treasury bills from commercial banks or switch government deposits from itself to banks. To reduce the monetary base, the BOC can sell Canadian treasury bills to banks or switch government deposits from banks to itself.

9. To counteract a poor monetary policy that had worsened the effects of the Great Depression, the Bank of Canada was created. The BOC’s duties were to be the sole issuer of legal tender Canadian banknotes, centralize the holding of reserves, regulate and inspect banks’ books, and make the money supply sufficiently responsive to varying economic conditions.

10. The Great Depression sparked widespread bank runs in the United States, which greatly worsened and prolonged it even further. In response, the American government created federal deposit insurance to reduce the risk of bank runs. Public acceptance of deposit insurance finally stopped the American bank runs of the Great Depression. Canada did not experience significant bank runs during the Depression and, as a result, deposit insurance was not set up in Canada until 1967.

11. During the mid-1990s, the U.S. hedge fund LTCM used huge amounts of leverage to speculate in global financial markets, incurred massive losses, and collapsed. LTCM was so large that, in selling assets to cover its losses, it caused balance sheet effects for firms around the world, leading to the prospect of a vicious cycle of deleveraging. As a result, credit markets around the world froze. The New York Fed coordinated a private bailout of LTCM and revived world credit markets.

12. Sub-prime lending during the U.S. housing bubble of the mid-2000s spread through the world financial system via securitization. When the bubble burst, massive losses by banks and non-bank financial institutions led to widespread collapse in the financial system in the U.S. and elsewhere. To prevent another Great Depression, the U.S. Federal Reserve and the U.S. Treasury expanded lending to banks and non-bank institutions, provided capital through the purchase of bank shares, and purchased private debt. Because much of the crisis originated in non-traditional bank institutions, the crisis of 2008 indicated that a wider safety net and broader regulation are needed in the financial sector. The 2010 Dodd-Frank bill, the biggest American financial reform since the 1930s, is an attempt to prevent another crisis.

13. During the crisis of 2008 and subsequent recession, the Bank of Canada acted much like the Fed, the American central bank. It lowered its target rate for the overnight market, increased lending to Canadian financial institutions, and lengthened the list of securities it would accept as collateral from financial institutions.