1. Explain two ways by which the Bank of Canada can increase the monetary base. Why is the effect of Bank of Canada actions on bank reserves less exact than the effect on the monetary base?
2. The monetary base increased by 20 percent during the contraction of 1929-1933, but the money supply fell by 25 percent. Explain why this occurred. How can the money supply fall when the base increases?
3. Assume that no banks hold excess reserves, and the public holds no currency. If a bank sells a $100 security to the Bank of Canada, explain what happens to this bank and two additional steps in the deposit expansion process, assuming a 10 percent reserve requirement. How much do deposits and loans increase for the banking system when the process is completed?
Monetary base is the combination of money in the hands of the public and commercial banks deposits held as reserves in the central banks. To increase monetary base, the central bank of Canada can conduct an open market operation: it can buy government securities from the public thus injecting money into circulation in the economy and thus increasing the money in the hands of the public. Secondly, it can also increase the reserve requirement of commercial banks: this increases the amount that is held by commercial banks as reserves in the central banks of Canada thus increasing monetary base. The effect of bank of Canada is less exact on bank reserves than on monetary base because bank reserves determine the level of credit creation in the economy.
Money supply can fall when monetary base increases because of the following reasons: An increase in the reserve requirement thus less money to loan out to the public, high rates of lending rates which makes it expensive for the public to borrow, where the government sells securities to the public thus money supply in the economy.
The bank will get currency in return to selling the security to the bank of Canada. Since the public holds no currency it will borrow from the bank at an interest rate. If it keeps a 10% reserve requirement, it will loan out $90 at the rate of say 10% to person A. person A will give back $99, from this a reserve requirement of 10% is removed and thus loans out $89.1 to person B. After the process is complete person B will give back $98.01. In the end the will have 98.01 plus the reserves (10+9.9) = $117.91