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 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, 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 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 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 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 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