Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Eight Money, Banking, and the Money Supply Macroeconomics by Curtis, Irvine, and Begg Canadian.

Slides are prepared by Dr. Amy Peng, Ryerson University

Chapter EightChapter EightMoney, Banking, and the Money, Banking, and the

Money SupplyMoney SupplyMacroeconomics by Curtis, Irvine, and BeggMacroeconomics by Curtis, Irvine, and Begg

Canadian Edition, Canadian Edition, McGraw-Hill Ryerson, 2007McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd. Chapter 8 2

Learning Outcomes

This chapter explains:This chapter explains:• Money and the functions of money• Modern banking in Canada• Competition among banks• How banks create money• The monetary base, the money multiplier,

and the money supply• Different measures of the money supply in

Canada

©2007 McGraw-Hill Ryerson Ltd. Chapter 8.1 3

Money and the Functions of Money

• The Medium of Exchange– Money is the medium of exchange used to

make payments.– A barter economy has no medium of

exchange. Goods trade direct for goods.

Illustrate…Illustrate…


Money and the Functions of Money

-dbOranges

f-aCoffee

ec-Pizza

OrangesCoffeePizza

• There are six exchange ratios or relative prices for these 3 goods.

• Trade is expensive in a barter economy.


Money and the Function of Money

• Other Functions of Money– Unit of account– Store of value– Standard of deferred payment

• Different Kinds of Money– Money as a commodity– Token money– IOU money– Money supply


Modern Banking in Canada

30 Non-bank trust companies

1100 Credit unions and caisses populaires

Number of near banks:

69 Total

22 Schedule III foreign bank branches

27 Schedule II foreign bank subsidiaries

20 Schedule I domestic banks

Number of chartered banks:

The Bank of Canada

Central Bank:

Banking institutions

The Canadian Banking SystemThe Canadian Banking System


Modern Banking In Canada

• Banks are financial intermediaries

• Bank of Canada– Canada’s central bank

• Commercial banks– Profit-oriented business– Liquidity

• Bank competition and co-operation

• Banking operations and profits


How Banks Create Money

• Two key conditions1. The non-bank public is willing to hold and use

bank deposit as money.– Currency ratio

1. The banks are willing to operate with cash reserves equal to some small fraction of their deposit liabilities.

– Reserve Ratio

depositbank publicbank -non

holdingscash publicbank -noncr

sliabilitiedeposit

assets reserverr



• Banks create money when they: – Make loans– Buy financial securities

• Example– A reserve ratio of 10 percent– A currency ratio of 0– Public has 1000 dollars of cash


How the Banking System Creates Money

Bank loans 0Cash $1,000Deposits 0Cash 0

1. Initial Position

LiabilitiesAssetsLiabilitiesAssets

Non-Bank Private SectorBanks

Bank loans 0Cash 0Deposits $1,000

2. People deposit their cash in the banks.

Cash $1,000

Deposits $1,000

Bank loans $9,000

Cash 0Deposits $10,000

3. Banks make loans of $9,000 in new deposits for customers.

Cash $1,000

Deposits $10,000Loans $9,000



• Banks use their excess reserve to expand their lending.

• Banks balance risk and reward.– Risk: being caught short of cash– Reward: net interest income

• Financial panics


The Monetary Base and the Money Multiplier

• Money supply1. The source of the cash in the economy

2. Cash deposited in the banking system

• Money base– High-powered money– The notes and coins in the economy

• Money multiplier

basemoney

supplymoney multiplierMoney


The Money Multiplier

• Monetary Base (H) = Cash(C)+ Reserves (R)

– Cash (C) = cr x D– Reserves (R) = rr x D

• H = C + R = cr x D + rr x D = (cr + rr)D

• Money Supply (M) = Cash(C)+ Deposits(D)

• M = C + D = cr x D + D = (1+cr)D

rrcr

cr

Drrcr

Dcr

1

)(

)1(

H

M


The Money Multiplier

• Example: Banks hold cash reserves equal to 5 percent and the public holds cash equal to 10 percent of their bank deposits.


• A $1 change in the monetary base results in a change in money supply equal to $7.33.

33.715.0

1.1

)1.005.0(

)1.01(

H

M


How Big is the Money Multiplier?

• Example: Banks hold cash reserves of $4.3 billion against liquid savings and demand deposit of $305.1 billion rr = 4.3 / 305.1 = 1.4%

• Public holds cash balances of $38.7 billion cr = 38.7 / 3.501 = 12.7%


• Each $100 change in the monetary base results in a change in the money supply of about $800.

99.7141.0

127.1

)127.0014.0(

)127.01(

H

M


The Monetary Base and the Money Supply

Monetary Base

Money Supply

Bank Deposits

Banks’ Cash Reserves R = rr X D

Cash in Circulation C = cr X D


How Big is the Money Multiplier?

• Derive the money supply function:– H, H, the monetary base– cr, cr, the public’s cash ratio– rr, rr, the bank’s reserve ratio

• Money supply

• Monetary Policy

Hcrrr

crM

)(

)1(


The Money Supply

00 )(

)1(H

crrr

crM

11 )(

)1(H

crrr

crM

Hcrrr

crM

)(

)1(

Nom

inal

Int

eres

t R

ate

i

M0 M1

ΔM

Money Supply


Measures of the Money Supply

Monetary Base, HMonetary Base, H=

Cash plus bank deposits with the Bank of Canada-

Bank holdings of cash and deposits with the Bank of Canada=

Currency in circulation outside the banks+

Personal chequing accounts and Current accounts=

Money Supply, M1Money Supply, M1+

Non-personal notice deposits and personal savings accounts=

Money Supply, M2Money Supply, M2


Measures of the Money Supply

Money supply, M2Money supply, M2+

Trust and mortgage loan company deposits+

Credit union and caisses populaires deposits+

Life insurance company individual annuities+

Personal deposits in government-owned savings institutions+

Money market mutual funds=

Money Supply, M2+Money Supply, M2+


The Money Supply in Canada in 2004 and 2005 ($billions)

3.9913.2879.3M2+ = M2 +

deposits at other institutions

4.8659.4629.4M2 = M1 +

notice and savings deposits

7.7179.7166.8M1 = currency +

chequable bank deposits

4.544.042.1Currency in circulation C

4.447.845.8Monetary base H

Change (%)20052004

©2007 McGraw-Hill Ryerson Ltd. Chapter 8 22

Chapter Summary

• MoneyMoney has four functions: a medium of exchange, a store of value, a unit of account, and a standard of deferred payment.

• A token moneytoken money is accepted because it is the legal tenderlegal tender.

• A central bankA central bank controls the supply of legal tender.

• Banks create money by making loansmaking loans based on a fractional cash reserve ratio.

• Monetary base, money multiplier, Monetary base, money multiplier, and money money supplysupply

Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Eight Money, Banking, and the Money Supply Macroeconomics by Curtis, Irvine, and Begg Canadian.

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