Chapter 10

The Monetary System

SOLUTIONS TO TEXTBOOK PROBLEMS

Quick Quizzes

1. List and describe the three functions of money.

The three functions of money are: (1) medium of exchange; (2) unit of account; and (3) store of
value. Money is used as a medium of exchange because money is the item people use to purchase
goods and services. Money is used as a unit of account because it is the yardstick people use to
post prices and record debts. Money is used as a store of value because it is an item people use to
transfer purchasing power from the present to the future.

2. What is the difference between a central bank like the Bank of Canada and a commercial bank like
the Bank of Montreal?

Commercial banks such as the Bank of Montreal are owned by individual shareholders so their
primary responsibility is to maximize the profits for these shareholders. By comparison, the Bank
of Canada is owned by the government and hands over to the government any profits that are
earned.

3. Describe how banks create money. If the Bank of Canada wanted to use all three of its policy tools
to decrease the money supply, what would it do?

Banks create money when they make loans and hold a fraction of the amount of the loans in
reserves, resulting in an expansion of both money and credit in the economy. If the Bank of
Canada used both of its currently available tools to decrease the money supply, it would: (1) sell
government bonds from its portfolio in the open market to reduce the number of dollars in
circulation and (2) increase the bank rate to discourage banks from borrowing reserves from the
Bank of Canada.

Questions for Review

1. What distinguishes money from other assets in the economy?

Money is different from other assets in the economy because it is the most liquid asset available.
Other assets vary widely in their liquidity.

2. What is commodity money? What is fiat money? Which kind do we use?

Commodity money is money with intrinsic value, like gold, which can be used for purposes other
than as a medium of exchange. Fiat money is money without intrinsic value; it has no value other
than its use as a medium of exchange. Our economy today uses fiat money.

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3. What are demand deposits, and why should they be included in the stock of money?

Demand deposits are balances in bank accounts that depositors can access on demand simply by
writing a cheque. They should be included in the stock of money because they can be used as a
medium of exchange.

4. Who is responsible for setting monetary policy in Canada?

The Bank of Canada is responsible for setting monetary policy in Canada.

5. If the Bank of Canada wants to increase the money supply with open-market operations, what
does it do?

If the Bank of Canada wants to increase the supply of money with open-market operations, it
purchases Canadian government bonds from the public on the open market. The purchase
increases the number of dollars in the hands of the public, thus raising the money supply.

6. Why don’t banks hold 100 percent reserves? How is the amount of reserves banks hold related to
the amount of money the banking system creates?

Banks do not hold 100 percent reserves because it is more profitable to use the reserves to make
loans, which earn interest, instead of leaving the money as reserves, which earn no interest. The
amount of reserves banks hold is related to the amount of money the banking system creates
through the money multiplier. The smaller the fraction of reserves banks hold, the larger the
money multiplier, since each dollar of reserves is used to create more money.

7. Bank A has a leverage ratio of 10, while Bank B has a leverage ratio of 20. Similar losses on bank
loans at the two banks cause the value of their assets to fall by 7 percent. Which bank shows a
larger change in bank capital? Does either bank remain solvent? Explain.

Bank A sees a fall of 10 × 7 = 70 percent in its capital; Bank B sees a 20 × 7 = 140 percent fall in
its capital. Bank A survives, Bank B fails.

8. What is the overnight rate? What happens to the money supply when the Bank of Canada raises
the overnight rate?

The overnight rate is the interest rate on very short-term loans between commercial banks. A
higher overnight rate discourages borrowing from the Bank of Canada, which reduces the money
supply.

9. What are reserve requirements? What happens to the money supply when a central bank raises
reserve requirements?

Reserve requirements are regulations on the minimum amount of reserves that banks must hold
against deposits. An increase in reserve requirements raises the reserve ratio, lowers the money
multiplier, and decreases the money supply.

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10. Why can’t the Bank of Canada control the money supply perfectly?

The Bank of Canada cannot control the money supply perfectly because: (1) the Bank of Canada
does not control the amount of money that households choose to hold as deposits in banks; and
(2) the Bank of Canada does not control the amount that commercial bankers choose to lend. The
actions of households and banks affect the money supply in ways the Bank of Canada cannot
perfectly control or predict.

Quick Check Multiple Choice

1. The money supply includes all EXCEPT which of the following?

a. metal coins
b. paper currency
c. lines of credit accessible with credit cards
d. bank balances accessible with debit cards

2. Chloe takes $100 of currency from her wallet and deposits it into her chequing account. If the bank
adds the entire $100 to reserves, the money supply ___, but if the bank lends out some of the $100,
the money supply ___.
a. increases, increases even more
b. increases, increases by less
c. is unchanged, increases
d. decreases, decreases by less

3. If the reserve ratio is 1/4 and the central bank increases the quantity of reserves in the banking
system by $120, the money supply increases by what amount?
a. $90
b. $150
c. $160
d. $480

4. A bank has capital of $200 and a leverage ratio of 5. If the value of the bank’s assets declines by 10
percent, then its capital will be reduced to what amount?
a. $100
b. $150
c. $180
d. $185

5. Which of the following actions by the Bank of Canada would reduce the money supply?
a. an open-market purchase of government bonds
b. a reduction in banks’ reserve requirements
c. an increase in the interest rate paid on reserves
d. a decrease in the discount rate on Bank of Canada lending

6. In a system of fractional-reserve banking, even without any action by the central bank, the money
supply declines if households choose to hold ___ currency or if banks choose to hold ___ excess
reserves.
a. more, more
b. more, less
c. less, more
d. less, less

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1. c
2. c
3. d
4. a
5. c
6. a

Problems and Applications

1. Which of the following are money in the Canadian economy? Which are not? Explain your answers
by discussing each of the three functions of money.
a. a Canadian dollar coin
b. a Mexican peso
c. a Picasso painting
d. a plastic credit card

a. A Canadian dollar coin is money in the Canadian economy because it is used as a medium
of exchange to buy goods or services, it serves as a unit of account because prices in
stores are listed in terms of dollars and cents, and it serves as a store of value for anyone
who holds it over time.

b. A Mexican peso is not money in the Canadian economy, because it is not used as a
medium of exchange, and prices are not given in terms of pesos, so it is not a unit of
account. It could serve as a store of value, though.

c. A Picasso painting is not money, because you cannot exchange it for goods or services,
and prices are not given in terms of Picasso paintings. It does, however, serve as a store
of value.

d. A plastic credit card is similar to money, but represents deferred payment, rather than
immediate payment. So credit cards do not fully represent the medium of exchange
function of money, nor are they really stores of value, since they represent short-term
loans rather than being an asset like currency.

2. Every month Yankee magazine includes a “Swopper’s [sic] Column” of offers to barter goods and
services. Here is an example: “Will swop custom-designed wedding gown and up to 6 bridesmaids’
gowns for 2 round-trip plane tickets and 3 nights’ lodging in the countryside of England.” Why
would it be difficult to run our economy using a “Swopper’s Column” instead of money? In light of
your answer, why might the Yankee “Swopper’s Column” exist?

a. It would be difficult to run the economy using the “Swopper’s Column” instead of money
because it requires finding a double coincidence of wants. Money works efficiently because
it requires satisfying people’s needs on just one side of each transaction; you buy
something for money and sell something else for money. With money, you do not have to
buy something from someone who wants an item you’re selling.

b. The “Swopper’s Column” probably exists so that people can avoid paying taxes on things
they buy and sell.

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3. What characteristics of an asset make it useful as a medium of exchange? As a store of value?

For an asset to be useful as a medium of exchange, it must be widely accepted (so all transactions
can be made in terms of it), recognized easily as money (so people can perform transactions easily
and quickly), divisible (so people can provide change), and difficult to counterfeit (so people will
not print their own money). That is why nearly all countries use paper money with fancy designs
for larger denominations and coins for smaller denominations.

For an asset to be useful as a store of value, it must be something that maintains its value over
time and something that can be used directly to buy goods and services or sold when money is
needed. In addition to currency, financial assets (like stocks and bonds) and physical assets (like
real estate and art) make good stores of value.

4. Consider how the following situations would affect the economy’s monetary system.
a. Suppose that the people on Yap discovered an easy way to make limestone wheels.
How would this development affect the usefulness of stone wheels as money? Explain.
b. Suppose that someone in Canada discovered an easy way to counterfeit $100 bills. How
would this development affect the Canadian monetary system? Explain.

a. If there were an easy way to make limestone wheels, the people on Yap would make
additional wheels as long as the monetary value of the wheels was greater than the cost
of producing the wheels. The result would be that people would make their own money,
so there would be too much money produced. Most likely, people would stop accepting
the wheels as money and switch to some other asset as a medium of exchange.

b. If someone in Canada discovered an easy way to counterfeit $100 bills, they could flood
the country with counterfeit currency, thus reducing its value. The result might be a switch
to a different type of currency.

5. Go to the website of the Bank of Canada at www.bankofcanada.ca and find the following
information:
a. data on the recent history of the overnight rate
b. the next fixed announcement date
c. the Bank’s latest press release about overnight rates, and why the Bank decided to
change, or not change, its target for the overnight rate

Many answers are possible.

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6. Your uncle repays a $100 loan from Tenth National Bank by writing a $100 cheque on his TNB
chequing account. Use T-accounts to show the effect of this transaction on your uncle and on
TNB. Has your uncle’s wealth changed? Explain.

When your uncle repays a $100 loan from Tenth National Bank (TNB) by writing a cheque from his
TNB chequing account, the result is a change in the assets and liabilities of both your uncle and
TNB, as shown in these T-accounts:

Your Uncle
Assets Liabilities
Before:
Chequing Account $100 Loans $100
After:
Chequing Account $0 Loans $0

Tenth National Bank

Assets Liabilities
Before:
Loans $100 Deposits $100
After:
Loans $0 Deposits $0

By paying off the loan, your uncle simply eliminated the outstanding loan using the assets in his
chequing account. Your uncle’s wealth has not changed; he simply has fewer assets and fewer
liabilities.

7. Beleaguered Provincial Bank (BPB) holds $250 million in deposits and maintains a reserve ratio of
10 percent.
a. Show a T-account for BPB.
b. Now suppose that BPB’s largest depositor withdraws $10 million in cash from her
account. If BPB decides to restore its reserve ratio by reducing the amount of loans
outstanding, show its new T-account.
c. Explain what effect BPB’s action will have on other banks.
d. Why might it be difficult for BPB to take the action described in part (b)? Discuss
another way for BPB to return to its original reserve ratio.

a. Here is BPB’s T-account:

Beleaguered Provincial Bank

Assets Liabilities
Reserves $25 million Deposits $250 million
Loans $225 million

b. When BPB’s largest depositor withdraws $10 million in cash and BPB reduces its loans
outstanding to maintain the same reserve ratio, its T-account is now:

Beleaguered Provincial Bank

Assets Liabilities
Reserves $24 million Deposits $240 million
Loans $216 million

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c. Since BPB is cutting back on its loans, other banks will find themselves short of reserves
and they may also cut back on their loans as well.

d. BPB may find it difficult to cut back on its loans immediately, since it cannot force people
to pay off loans. Instead, it can stop making new loans. But for a time it might find itself
with more loans than it wants. It could try to attract additional deposits to get additional
reserves, or borrow from another bank or from the Bank of Canada.

8. You take $100 you had kept under your mattress and deposit it in your bank account. If this $100
stays in the banking system as reserves and if banks hold reserves equal to 10 percent of deposits,
by how much does the total amount of deposits in the banking system increase? By how much
does the money supply increase?

If you take $100 that you held as currency and put it into the banking system, then the total
amount of deposits in the banking system increases by $1000, since a reserve ratio of 10 percent
means the money multiplier is 1/.10 = 10. Thus, the money supply increases by $900, since
deposits increase by $1000 but currency declines by $100.

9. The Bank of Canada conducts a $10 million open-market purchase of government bonds. If the
required reserve ratio is 10 percent, what is the largest possible increase in the money supply that
could result? Explain. What is the smallest possible increase? Explain.

With a required reserve ratio of 10 percent, the money multiplier could be as high as 1/.10 = 10, if
banks hold no excess reserves and people do not keep some additional currency. So the maximum
increase in the money supply from a $10 million open-market purchase is $100 million. The
smallest possible increase is $10 million if all of the money is held by banks as excess reserves.

10. Suppose that the T-account for First National Bank is as follows:

Assets Liabilities
Reserves $100 000 Deposits $500 000
Loans 400 000

a. If the Bank of Canada requires banks to hold 5 percent of deposits as reserves, how
much in excess reserves does First National now hold?
b. Assume that all other banks hold only the required amount of reserves. If First National
decides to reduce its reserves to only the required amount, by how much would the
economy’s money supply increase?

a. If the required reserve ratio is 5 percent, then First National Bank’s required reserves are
$500 000 × .05 = $25 000. Since the bank’s total reserves are $100 000, it has excess
reserves of $75 000.

b. With a required reserve ratio of 5 percent, the money multiplier is 1/.05 = 20. If First
National lends out its excess reserves of $75 000, the money supply will eventually
increase by $75 000 × 20 = $1 500 000.

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11. Suppose there is a reserve requirement for private banks set at 10 percent of deposits. Also
assume that banks do not hold any excess reserves.
a. If the Bank of Canada sells $1 million of government bonds, what is the effect on the
economy’s reserves and money supply?
b. Now suppose the Bank of Canada lowers the reserve requirement to 5 percent, but
banks choose to hold another 5 percent of deposits as excess reserves. Why might
banks do so? What is the overall change in the money multiplier and the money supply
as a result of these actions?

a. The reserves fall by $1 million and the money supply by $10 million, since the money
multiplier is 10.

b. The banks may choose to hold excess reserves when they are uncertain about future
economic conditions. The money multiplier is still 10. The money supply decreases by $10
million, the same as before. This example shows that the Bank of Canada has only partial
control over the money supply. In times of recession, when banks are reluctant to lend,
monetary policy may become ineffective.

12. Assume there is a reserve requirement of 20 percent. Also assume that banks do not hold excess
reserves and there is no cash held by the public. The Bank of Canada decides that it wants to
expand the money supply by $40 million.
a. If the Bank of Canada is using open-market operations, will it buy or sell bonds?
b. What quantity of bonds does the Bank of Canada need to buy or sell to accomplish the
goal? Explain your reasoning.

a. To expand the money supply, the country’s central bank needs to buy bonds.

b. Since the reserves are 20 percent, the money multiplier is 1/0.2 = 5. In order to obtain an
increase in money supply by $40 million, the country’s central bank needs to buy $40/5 =
$8 million worth of bonds.

13. Suppose that the Bank of Canada sells 100 million pounds sterling from its foreign exchange
reserves, and that the exchange rate is $1.60 Canadian per pound sterling.
a. Explain what happens to the Canadian money supply.
b. Now suppose that the Bank of Canada does not want the money supply to change.
What would it need to do to sterilize its foreign exchange market operation?

a. The Canadian money supply falls by $240 million (100 million pounds sterling × $2.40
Canadian per pound sterling).

b. The Bank of Canada can use the Canadian dollars acquired from the foreign exchange
market to buy Canadian government bonds.

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14. (This problem is challenging.) The economy of Elmendyn contains 2000 $1 bills.
a. If people hold all money as currency, what is the quantity of money?
b. If people hold all money as demand deposits and banks maintain 100 percent reserves,
what is the quantity of money?
c. If people hold equal amounts of currency and demand deposits and banks maintain 100
percent reserves, what is the quantity of money?
d. If people hold all money as demand deposits and banks maintain a reserve ratio of 10
percent, what is the quantity of money?
e. If people hold equal amounts of currency and demand deposits and banks maintain a
reserve ratio of 10 percent, what is the quantity of money?

a. If people hold all money as currency, the quantity of money is $2000.

b. If people hold all money as demand deposits at banks with 100 percent reserves, the
quantity of money is $2000.

c. If people have $1000 in currency and $1000 in demand deposits, the quantity of money is
$2000.

d. If banks have a reserve ratio of 10 percent, the money multiplier is 1/.10 = 10. So if
people hold all money as demand deposits, the quantity of money is 10 × $2000 =
$20 000.

e. If people hold equal amounts of currency (C) and demand deposits (D) and the money
multiplier for reserves is 10, then two equations must be satisfied:

(1) C = D, so that people have equal amounts of currency and demand deposits; and (2)
10 × ($2000 – C) = D, so that the money multiplier (10) times the number of dollar bills
that are not being held by people ($2000 – C) equals the amount of demand deposits (D).
Using the first equation in the second gives 10 × ($2000 – D) = D, or $20 000 – 10 D =
D, or $20 000 = 11 D, so D = $1818.18. Then C = $1818.18. The quantity of money is C
+ D = $3636.36.

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