Slides are prepared by Dr. Amy Peng, Ryerson University Chapter Eight Money, Banking, and the Money Supply Macroeconomics by Curtis, Irvine, and Begg Canadian Edition, McGraw-Hill Ryerson, 2007

©2007 McGraw-Hill Ryerson Ltd.Chapter 82 Learning Outcomes 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 8.13 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…

©2007 McGraw-Hill Ryerson Ltd.Chapter 8.14 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.

©2007 McGraw-Hill Ryerson Ltd.Chapter 8.15 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

©2007 McGraw-Hill Ryerson Ltd.Chapter 8.26 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 System

©2007 McGraw-Hill Ryerson Ltd.Chapter 8.27 Modern Banking In Canada Banks are financial intermediaries Bank of Canada –Canadas central bank Commercial banks –Profit-oriented business –Liquidity Bank competition and co-operation Banking operations and profits

©2007 McGraw-Hill Ryerson Ltd.Chapter 8.38 How Banks Create Money Two key conditions 1.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

©2007 McGraw-Hill Ryerson Ltd.Chapter 8.39 How Banks Create Money 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

©2007 McGraw-Hill Ryerson Ltd.Chapter 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, People deposit their cash in the banks. Cash $1,000 Deposits $1,000 Bank loans $9,000 Cash 0 Deposits $10, Banks make loans of $9,000 in new deposits for customers. Cash $1,000 Deposits $10,000 Loans $9,000

©2007 McGraw-Hill Ryerson Ltd.Chapter How Banks Create Money 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

©2007 McGraw-Hill Ryerson Ltd.Chapter The Monetary Base and the Money Multiplier Money supply 1.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

©2007 McGraw-Hill Ryerson Ltd.Chapter 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

©2007 McGraw-Hill Ryerson Ltd.Chapter 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. Money multiplier A $1 change in the monetary base results in a change in money supply equal to $7.33.

©2007 McGraw-Hill Ryerson Ltd.Chapter 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 / = 1.4% Public holds cash balances of $38.7 billion cr = 38.7 / = 12.7% Money multiplier Each $100 change in the monetary base results in a change in the money supply of about $800.

©2007 McGraw-Hill Ryerson Ltd.Chapter 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

©2007 McGraw-Hill Ryerson Ltd.Chapter How Big is the Money Multiplier? Derive the money supply function: –H, –H, the monetary base –cr, –cr, the publics cash ratio –rr, –rr, the banks reserve ratio Money supply Monetary Policy

©2007 McGraw-Hill Ryerson Ltd.Chapter The Money Supply Nominal Interest Rate i M0M0 M1M1 ΔM ΔM Money Supply

©2007 McGraw-Hill Ryerson Ltd.Chapter Measures of the Money Supply Monetary 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, M1 + Non-personal notice deposits and personal savings accounts = Money Supply, M2

©2007 McGraw-Hill Ryerson Ltd.Chapter Measures of the Money Supply Money 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+

©2007 McGraw-Hill Ryerson Ltd.Chapter The Money Supply in Canada in 2004 and 2005 ($billions) M2+ = M2 + deposits at other institutions M2 = M1 + notice and savings deposits M1 = currency + chequable bank deposits Currency in circulation C Monetary base H Change (%)

©2007 McGraw-Hill Ryerson Ltd.Chapter 822 Chapter Summary MoneyMoney has four functions: a medium of exchange, a store of value, a unit of account, and a standard of deferred payment. token money legal tenderA token money is accepted because it is the legal tender. A central bankA central bank controls the supply of legal tender. making loansBanks create money by making loans based on a fractional cash reserve ratio. Monetary base, money multiplier, money supplyMonetary base, money multiplier, and money supply