THE ECONOMICS OF MONEY,BANKING, AND FINANCIAL MARKETS 438

406

PA R T V

Central Banking and the Conduct of Monetary Policy
Unfortunately, neither you nor I can convince people that our IOUs are worth
anything more than the paper they are written on.3
2. Reserves. All banks that participate in the Large Value Transfer System (LVTS),
to be discussed in detail in Chapter 17, have an account at the Bank of Canada
in which they hold deposits (also called settlement balances).4 Reserves consist of settlement balances at the Bank of Canada plus currency that is physically held by banks (called vault cash, because it is held in bank vaults, cash
tills, and automated banking machines). Reserves are assets for the banks but
liabilities for the Bank of Canada because the banks can demand payment on
them at any time and the Bank of Canada is required to satisfy its obligation by
paying Bank of Canada notes. As you will see, an increase in reserves leads to
an increase in the level of deposits and hence in the money supply.
As already noted in Chapter 13, Canadian banks are no longer required to
hold reserves (see the Global box, The Worldwide Decline in Reserve
Requirements). Banks, however, hold some reserves in order to manage their
own short-term liquidity requirements and respond to predictable clearing
drains and across-the-counter and automated banking machine drains. We call
these reserves prudential or desired reserves. For example, banks might desire
that for every dollar of deposits, a certain fraction (say, 5 cents) must be held
as reserves. This fraction (5%) is called the desired reserve ratio. Reserves in
excess of the desired amounts are called unwanted or excess reserves.

Assets

The two assets on the Bank of Canada s balance sheet are important for two reasons.
First, changes in the asset items lead to changes in reserves and consequently to
changes in the money supply. Second, because these assets (government securities
and advances to banks) earn interest while the liabilities (notes in circulation

and settlement balances) in general do not, the Bank of Canada makes millions of
dollars every year its assets earn income and its liabilities cost little. Although it
returns most of its earnings to the federal government, the Bank does spend some of
it on worthy causes, such as supporting economic research.
1. Government securities. This category of assets covers the Bank of Canada s
holdings of securities issued by the Canadian government. As you will see, one
way the Bank of Canada can provide reserves to the banking system is by purchasing government securities, thereby increasing its holdings of these assets.
In fact, the total amount of securities is controlled by open market operations (the

3

The notes item on our balance sheet refers only to notes in circulation that is, the amount in the
hands of the public. Notes that have been printed are not automatically a liability of the Bank. For
example, consider the importance of having $1 million of your own IOUs printed up. You give out
$100 worth to other people and keep the other $999 900 in your pocket. The $999 900 of IOUs does
not make you richer or poorer and does not affect your indebtedness. You care only about the $100
of liabilities from the $100 of circulated IOUs. The same reasoning applies for the Bank of Canada
in regard to its notes.
For similar reasons, the currency component of the money supply, no matter how it is defined,
includes only currency in circulation. It does not include any additional currency that is not yet in the
hands of the public. The fact that currency has been printed but is not circulating means that it is not
anyone s asset or liability and thus cannot affect anyone s behaviour. Therefore, it makes sense not to
include it in the money supply.
4
There are fourteen LVTS participants in addition to the Bank of Canada: the Big Six, Alberta Treasury
Branches, Bank of America National Association, BNP Paribas, Caisse Centrale Desjardins du Qu bec,
Credit Union Central of Canada, HSBC Bank Canada, Laurentian Bank of Canada, and State Street Bank
and Trust Company.