ENGR 3360U Winter 2014

Unit 2.3
Money and the Bank of Canada
Dr. J. Michael Bennett, P. Eng., PMP,
UOIT,
Version 2014-I-01

Unit 2.3 Money and the Bank of Canada

Change Record
2014-I-01 Initial Creation

2.3-2

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Course Outline for Part 2

2.1 Microeconomics
2.2 Macroeconomics
2.3 Money and the Bank of Canada

2.3-3

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Unit 2.3 Road Map

2.3.1 Money
2.3.2 Central Banking

2.3-4

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

2.3.1 Money and its uses

Why do people use money?

2.3-5

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Money
Money: Any asset that can be used as a means of payment for purchases and
to settle debts
Historically, many forms have been used such as gold coins, cowrie
shells, unopened gin bottles, playing cards, cacao beans.
In developed countries, money is primarily now Currency and
Checking account balances
Principal uses
Medium of exchange
Unit of account
Store of value
Key Issue is it generally accepted in payment ?

2.3-6

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Medium of Exchange
Medium of exchange:
An asset used in purchasing goods & services
Reduces transaction costs
Barter:
the direct trade of goods or services for other goods or services
E.g. text book writing & house painting? Cars for oranges?
Disadvantages of barter
very high transaction costs (to carry goods to market)
requires double coincidence of wants and impedes specialization
In enabling greater specialization, money increases the productivity of the
entire economy

2.3-7

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Unit of Account and Store of Value

Unit of account
A basic measure / yardstick of economic value
In Canada - unit of account is Canadian dollar
Store of value
An asset that serves as a means of holding wealth
By holding cash rather than spending it now, households can
transfer consumption from today to tomorrow
Note no interest is paid on currency - so why do people hold
cash, other than enough for current transactions ?

2.3-8

Convenience but also

Hide assets from the authorities e.g. drug $ ?
If prices are falling (deflation) then currency gains purchasing power over time

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Measuring the Amount of Money in the Economy

Measures of money
M1
Sum of currency outstanding and balances held in
checking accounts at chartered banks
Narrow definition

M2
All the assets in M1 plus notice & savings deposits
(usable in payments but at greater cost/
inconvenience than currency or cheques)
Broader definition

2.3-9

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

M1, M2, and M3, January 2004 (billions of dollars)

2.3-10

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Determining the Money Supply

The money supply consists of
Currency
Deposit balances held by commercial banks

The determination of the money supply

depends in part on the behavior of
commercial banks

2.3-11

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

What determines the total amount of money

in circulation?

2.3-12

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Banks
Credit ----- credo (I believe)
Bank ---- banco (banci)
Beginnings of our financial structure
7 huggies in CA
Thousands of tinies in USA

2.3-13

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Worlds Oldest Bank (cosi fan tuti!)

Banca Monte dei Paschi di Siena S.p.A. (MPS) is the oldest surviving
bank in the world and Italy's third largest bank. Founded in 1472 by the
magistrate of the city state of Siena, Italy, as a "mountain of piety", it has
been operating ever since. Today it has approximately 3,000 branches,
33,000[ employees and 4.5 million customers in Italy, as well as branches
and businesses abroad. A subsidiary, MPS Finance, handles investment
banking. The bank's main shareholder is the Fondazione Monte dei Paschi di
Siena.
On January 26, 2013, the Banca d'Italia (Bank of Italy) approved a bailout
request from the bank for 3.9 billion ($5.3 billion).
The firm sparked fresh controversy in 2013 when it was accused of
misleading Italy's market regulator in October 2012, shortly before it
received a 4.1-billion euro ($5.47 billion) state bailout.
2.3-14

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Banks Balance Sheet

Assets - What banks own
Liabilities - What banks owe
Bank reserves
Cash or similar assets held by commercial
banks for the purpose of meeting depositor
withdrawals and payments
Not part of the money supply

2.3-15

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Reserve Banking
100 percent reserve banking
Banks reserves = 100 % of their deposits
Banks realized long ago that they dont need to keep reserves = 100 %
deposits
Only a small fraction of deposits are withdrawn on any given day
Profit opportunity !!!
keep just enough reserves on hand to satisfy withdrawals
loan out the rest & charge interest
make money from interest rate differential !!!
Fractional-reserve banking system
A banking system in which bank reserves are less than deposits so that
the reserve-deposit ratio is less than 100%
Reserve-deposit ratio = Bank reserves divided by deposits

2.3-16

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Money Creation
When a bank lends, it creates a chequing account i.e. money
When a borrower spends the loan, the proceeds are deposited at
another bank, creating bank reserves at that bank
Process of expansion of loans and deposits ends when all excess
reserves are loaned out:
The actual ratio of bank reserves to deposits then equals the
desired reserve-deposit ratio

2.3-17

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

2.3.2 Central Banking

What are the special functions and powers
of the Bank of Canada?

2.3-18

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

The Bank of Canada

Opened in 1935 - responsible for administration of
monetary policy
Monetary policy decisions typically involve changes to
interest rates
the key policy rate is announced on 8 pre-specified
dates each year
Since 1988 - sole objective of Bank of Canada has been
keeping inflation low and stable
target range for Core inflation in CPI is 1% - 3%
On average, CPI inflation = 1.7% between 1992 &
2005
2.3-19

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Inflation Performance in Canada

Source: http://www.bank-banque-canada.ca/en/indinf/cpi_graph_en.html

2.3-20

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Average from 2000 is 2.1%

Consumer Price Index, historical summary (1989 to 2008) Year All-items Change from previous year 2002=100 %

1989
1990
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000

2.3-21

74.8
78.4
82.8
84.0
85.6
85.7
87.6
88.9
90.4
91.3
92.9
95.4

2014-I-01

5.1
4.8
5.6
1.4
1.9
0.1
2.2
1.5
1.7
1.0
1.8
2.7

2030
2002
2003
2004
2005
2006
2007
2008
2009
2010
2011
2012

97.8
100.0
102.8
104.7
107.0
109.1
111.5
114.1
115.5
117.8
120.5
122.0

2.5
2.2
2.8
1.8
2.2
2.0
2.2
2.3
1.0
2.0
2.3
1.5

2013 123.2 1.0

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

The Bank of Canada

Other functions of the Bank of Canada
Providing central banking services
Issuing bank notes
Administering the federal debt
Members of the governing council and board of directors are
appointed
Federal government names Governor for 7 year term
agrees then on objectives i.e. target range for inflation
Bank of Canada has independence in meeting those
objectives
2.3-22

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Other Central Banks

U.S. Federal Reserve System
Created in 1913
12 regional Federal Reserve banks
Federal Open Market Committee determines federal
funds rate target
No explicit inflation target
European Central Bank
Created in 1998
Governing council determines the minimum bid rate
Main objective is low and stable inflation
2.3-23

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

More Precise CPI Definitions

Core CPI: The CPI excluding eight of the most volatile
components (fruit, vegetables, gasoline, fuel oil, natural gas,
mortgage interest, inter-city transportation and tobacco products)
as well as the effect of changes in indirect taxes on the remaining
components.
CPI-XFET: The CPI excluding food, energy and the effect of
changes in indirect taxes.
CPIW: CPIW adjusts each CPI basket weight by a factor that is
inversely proportional to the component's variability and is
adjusted to exclude the effect of changes in indirect taxes.

2.3-24

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Trickery
Core
CPI 1

Total CPI
Month

Total
CPI

(seas.
adj.)
2011-12 120.2

2.3-25

2014-I-01

120.8

Percentage change over 1 year ago

(unadjusted)

118.2

2.3

Core
CPI 1

1.9

Alternative
measures of trend
inflation
CPIXFET 2

CPIW 3

1.2

1.9

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco

Unit 2.3 Money and the Bank of Canada

Rates you should know

Overnight lending rate
Prime rate
Mortgage rate
CPI inflation
$CDN
$E
TSE D-J S&P NASDEC FOOTSIE DAX
2.3-26

2014-I-01

Dr. J.M. Bennett, P.Eng., PMP ENGR 3360U Eng Eco