Chapter 27: Money and Banking Copyright © 2014 Pearson Canada Inc.

Chapter 27: Money and Banking

Copyright © 2014 Pearson Canada Inc.

Chapter Outline/Learning Objectives

Section Learning ObjectivesAfter studying this chapter, you will be able to

27.1 The Nature of Money 1. describe the various functions of money, and how money has evolved over time.

27.2 The Canadian Banking System

2. see that modern banking systems include both privately owned commercial banks and government-owned central banks.

27.3 Money Creation by the Banking System

3. explain how commercial banks create money through the process of taking deposits and making loans.

27.4 The Money Supply 4. describe the various measures of the money supply.

Copyright © 2014 Pearson Canada Inc. 2Chapter 27, Slide

27.1 The Nature of Money

What is Money?

Money is a medium of exchange.

If there were no money, goods would have to be exchanged in a system of barter.

Barter is very inefficient due to the double coincidence of wants.


What is Money?

Money is also used as a store of value.

• without high inflation, money retains its value well

Finally, money is used as a unit of account.

• used to keep our financial accounts

4Copyright © 2014 Pearson Canada Inc.

LESSONS FROM HISTORY 27-1

Hyperinflation and the Value of Money

Chapter 27, Slide

5

Commodity money:•Can be stored easily•High value densities•Easily portable•Durable

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Weirdest method of payment

The phrase "To pay through the nose" comes from Danes in Ireland, who slit the noses of those who were remiss in paying the Danish poll tax.

The Future of Money

The Kinds of Money

Commodity money: money that takes the form of a commodity with intrinsic value

Fiat money: money without intrinsic value that is accepted as money because of government decree

Copyright © 2014 by Nelson Education Ltd.

10-8

Modern Money: Deposit Money

Money held as deposits with commercial banks and other financial institutions is called deposit money.

Bank deposits are an important part of the money supply.

As in the past, banks create money by issuing more promises to pay (deposits) than they have in cash reserves.

9Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Question

Which of the following best illustrates the unit of account function of money?

a. You list prices for candy sold on your website, www.sweettooth.com, in dollars.

b. You pay for your NHL tickets with dollars.

c. You keep $10 in your backpack for emergencies.

d. You sell a used copy of your textbook for $40.


10-10

Question

What do economists use the word “money” to refer to?

a. income generated by the production of goods and services

b. those assets regularly used to buy goods and services

c. the value of a person’s assets

d. the value of stocks and bonds


10-11

Question

Which of the following has intrinsic value?

a. a golden coin

b. a twenty-dollar bill

c. a bank account

d. a personal cheque


10-12


MyEconLab

www.myeconlab.co

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Any discussion of financial markets and banking systems includesmany terms that you may find unfamiliar. For a brief guide to and description of various financial assets, look for A Quick Introduction to Financial Assets in the Additional Topics section of this book's MyEconLab.

Chapter 27, Slide

27.2 The Canadian Banking System

Most banking systems have:

• a central bank

• many commercial banks

A central bank acts as a bank to the banking system:

• usually a government-owned institution

• and the sole money-issuing authority


The Bank of Canada

Created in 1935.

Formally accountable to the Minister of Finance and Parliament.

System of joint responsibility maintains day-to-day independence.


The basic functions of the Bank of Canada are to:

• act as banker to the commercial banks

• act as fiscal agent of the federal government

• regulate the money supply

• regulate, support, and monitor financial markets

Most of our discussion will focus on the Bank's role in controlling the money supply monetary policy


Table 27-1 Assets and Liabilities of the Bank of Canada


Commercial Banks in Canada

A commercial bank is a privately owned, profit-seeking institution that provides a variety of financial services.

Banks are important "financial intermediaries" and are crucial for the smooth operation of credit markets.

they accept deposits and provide credit

Commercial banks have a number of interbank cooperative relationships.


Table 27-2 Consolidated Balance Sheet of the Canadian Chartered Banks



MyEconLab

www.myeconlab.co

m

The proximate cause of the global recession of 2009–2010 was the collapse of the U.S. housing market beginning in 2007 which, in turn, led to a global financial crisis. For a brief summary of the remarkable events and subsequent policy responses, look for The U.S. Housing Collapse and the Financial Crisis of 2007–2008 in the Additional Topics section of this book's MyEconLab.

Chapter 27, Slide

Reserves

Banks' cash reserves are normally quite small because only a small fraction of depositors want their money at any time.

A bank's reserve ratio is the fraction of its deposit liabilities that it actually holds as reserves

• either vault cash or deposits with the central bank

A bank's target reserve ratio is the fraction of its deposits it wishes to hold as reserves.



MyEconLab

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Although deposit insurance provides benefits to depositors in the form of enhanced security, some economists argue that it encourages excessive risk-taking on the part of the banks themselves. For more details about the debate over deposit insurance, look for The Costs and Benefits of Deposit Insurance in the Additional Topics section of this book's MyEconLab.

Chapter 27, Slide

The Canadian banking system is a fractional-reserve system

• in March 2006 they held less than 1% of their deposits in reserves!

Any reserves in excess of target reserves are called excess reserves

• these are central to the process of "money creation"


27.3 Money Creation by the Banking System

Some Simplifying Assumptions

Suppose:

• banks invest only in loans

• there are only demand deposits

• a fixed target reserve ratio

• no cash drain from the banking system


The Creation of Deposit Money


Table 27-3: The bank initially has a reserve ratio of 20%.

Table 27-4: A new deposit of $100 raises the bank's reserve ratio to 27%.

Chapter 27, Slide

The Creation of Deposit Money


Table 27-5: The bank now has $80 of excess reserves which it can lend.

Table 27-6: The second-round bank receives $80 in new deposits and expands its loans by $64.

Chapter 27, Slide

A single new deposit begins a long sequence of deposit creation.

With the target reserve ratio of 20%, the new deposit of $100 creates a total expansion of deposits of $500.

With no cash drain, a banking system with a target reserve ratio of v will change its deposits by 1/v times any change in reserves (the new deposit).

ΔDeposits = (1/v) ΔReserves


Table 27-7 The Sequence of Loans and Deposits After a Single New Deposit of $100


Excess Reserves and Cash Drains

Deposit creation does not happen automatically; it depends on the decisions of bankers.

A cash drain:

• if households hold a fraction of their deposits in cash, the deposit-creation process is dampened

If c is the currency-deposit ratio, the final change in deposits will be given by:

ΔDeposits = (1/c+v) (New Cash Deposit)


27.4 The Money Supply

The money supply is the total quantity of money that is in the economy at any time.

• several definitions of "money"

In general,

Money supply = Currency + Deposits


Kinds of Deposits

The long-standing distinction between money and other highly liquid assets used to be:

• money was a medium of exchange that did not earn interest

• other assets earned interest but were not a medium of exchange

Today this distinction is very blurred.


Definitions of the Money Supply

A common definition of money is M2:

• M2 = currency + chequable and non-chequable deposits held at the chartered banks

A broader measure is M2+:

• M2+ = M2 + similar deposits held at institutions that are not chartered banks


Table 27-9 M2 and M2+ in Canada


Near Money and Money Substitutes

Near money:

• assets that are a store of value and are readily converted into a medium of exchange

• short-term bonds

• term deposits

Money substitutes:

• things that serve as a temporary medium of exchange but are not a store of value

• credit cards


Choosing a Measure

There is no single timeless or best definition of money.

New financial assets are continually being developed that serve some of the functions of money.

The Role of the Bank of Canada

We have seen how commercial banks can expand reserves into deposit money.

The Bank of Canada has great influence over the amount of reserves in the banking system.


Chapter 27: Money and Banking Copyright © 2014 Pearson Canada Inc.

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