The system of fractional-reserve banking creates money, because each dollar of reserves generates many dollars of deposits.
The supply of money depends on the monetary base, the reserve–deposit ratio, and the currency–deposit ratio. An increase in the monetary base leads to a proportionate increase in the money supply. A decrease in the reserve–deposit ratio or in the currency–deposit ratio increases the money multiplier and thus the money supply.
The Bank of Canada changes the money supply using two policy instruments. It can increase the monetary base by making an open-market purchase of bonds or foreign exchange, or by switching government deposits out of the Bank of Canada and into the chartered banks. Both of these operations cause a reduction of interest rates, and so they can be monitored by observing a drop in the Bank Rate.
To start a bank, the owners must contribute some of their own financial resources, which become the bank’s capital. Because banks are highly leveraged, however, a small decline in the value of their assets can potentially have a major impact on the value of bank capital. Bank regulators require that banks hold sufficient capital to ensure that depositors can be repaid.
Portfolio theories of money demand stress the role of money as a store of value. They predict that the demand for money depends on the risk and return on money and alternative assets.
Transactions theories of money demand, such as the Baumol–Tobin model, stress the role of money as a medium of exchange. They predict that the demand for money depends positively on expenditure and negatively on the interest rate.
Financial innovation has led to the creation of assets with many of the attributes of money. These near monies make the demand for money less stable, which complicates the conduct of monetary policy.