Question

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?

Answer 1

Banks create money through the a multiplier process. This happens through a dynamic chain where the bank lend the excess reserves keeping aside from the deposits it receives. In the next round this loan is deposited by the borrowers in the bank. Here again bank sets aside a portion of this deposit as per cash reserve ratio and lends the excess reserves. This chain develops and ends only when there are no loanable reserves. These aggregate loans that the bank lends is the amount of money created.

The three instrument are (i) repo rate (ii) OMO and (iii) cash reserve rate.

1. Repo rate is the rate at which the central bank of Canada lend the other banks in the country. This imply that if repo rate is increased this means that the cost of borrowing increases. This has the effect of reducing borrowing and thus hampers the money creating process.
2. OMO: open market operations is the selling or buying of Govt securities that impacts the money supply. The selling of govt securities means that bank of Canada gives away the govt securities in exchange of money. This reduces the money supply.
3. Cash reserve ratio: the cash reserve ratio is the ratio that the bank of Canada will announce according to which the banks will keep some cash out of deposits at the central bank. As the cash reserve ratio is increased the reserves that the bank has to keep increases and the reserves that are eligible to lend reduces. Thus an increase in CRR reduces the money supply