THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 460

428

PA R T V

Central Banking and the Conduct of Monetary Policy

S U M M A RY
1. There are three players in the money supply process:
the central bank, banks (depository institutions), and
depositors.
2. The monetary base consists of currency in circulation and reserves. Eight factors affect the monetary
base: (1) the Bank of Canada s holdings of securities
and investments, (2) advances, (3) foreign currency
assets, (4) securities purchased under resale agreements, (5) currency outstanding, (6) other Bank of
Canada assets (net), (7) government deposits with
the Bank of Canada, and (8) securities sold under
repurchase agreements. Increases in the first six factors add to the monetary base; increases in the last
two factors reduce the monetary base.
3. The Bank of Canada controls the monetary base
through open market operations and has better control over the monetary base than over reserves.
4. A single bank can make loans up to the amount
of its excess reserves, thereby creating an equal
amount of deposits. The banking system can create
a multiple expansion of deposits because as each
bank makes a loan and creates deposits, the
reserves find their way to another bank, which uses
them to make loans and create additional deposits.
In the simple model of multiple deposit creation in
which banks do not hold on to excess reserves and
the public holds no currency, the multiple increase

in chequable deposits (simple deposit multiplier)
equals the reciprocal of the desired reserve ratio.
5. The simple model of multiple deposit creation has
serious deficiencies. Decisions by depositors to
increase their holdings of currency or of banks to
hold excess reserves will result in a smaller expansion of deposits than the simple model predicts. All
four players the Bank of Canada, banks, depositors, and borrowers from banks are important in
the determination of the money supply.
6. The money supply is positively related to the nonborrowed monetary base MBn, which is determined
by open market operations, and the level of borrowed reserves (advances) from the bank of Canada,
BR. The money supply is negatively related to the
desired reserve ratio, r, and holdings of currency.
The model of the money supply process takes into
account the behaviour of all three players in the
money supply process: the Bank of Canada through
open market operations and lending; depositors
through their decision about their holding of currency; and banks through their decisions about
desired reserves, which are also influenced by
depositors decisions about deposit outflows.
7. The monetary base is linked to the money supply
using the concept of the money multiplier, which
tells us how much the money supply changes when
there is a change in the monetary base.

KEY TERMS
borrowed reserves,

p. 407

high-powered money,

monetary base,

p. 408

p. 405

money multiplier,

p. 422

multiple deposit creation,

p. 414

nonborrowed monetary base,
p. 414
open market purchase,

open market sale, p. 408
required reserves,

p. 407

simple deposit multiplier,

p. 418

p. 408

QUESTIONS

You will find the answers to the questions marked with
an asterisk in the Textbook Resources section of your
MyEconLab.

*3. During the Great Depression years 1930 1933, the
currency ratio c rose dramatically. What do you
think happened to the money supply? Why?

*1. The money multiplier is necessarily greater than 1.
Is this statement true, false, or uncertain? Explain
your answer.

4. During the Great Depression, the desired reserves
ratio r rose dramatically. What do you think happened to the money supply? Why?

2. If the desired reserve ratio on chequable deposits
were set at zero, the amount of multiple deposit
expansion would go on indefinitely. Is this statement true, false, or uncertain? Explain.

*5. Suppose that travellers cheques were included
in the M1* measure of the money supply and
had no reserve requirements. When people travel
during the summer and convert some of their
chequing account deposits into travellers cheques,
what would happen to the money supply? Why?