© 2003 McGraw-Hill Ryerson Limited. Money, Banking and the Financial Sector

© 2003 McGraw-Hill Ryerson Limited. Introduction u Real goods and services are exchanged in the real sector of the economy. u For every real transaction, there is a financial transaction that mirrors it.

© 2003 McGraw-Hill Ryerson Limited. Introduction u The financial sector is central to almost all macroeconomic debates because behind every real transaction, there is a financial transaction that mirrors it.

© 2003 McGraw-Hill Ryerson Limited. Introduction u All trade in the goods market involves both the real sector and the financial sector.

© 2003 McGraw-Hill Ryerson Limited. Why Is the Financial Sector So Important to Macro? u The financial sector is important to macroeconomics because of its role in channeling savings back into the circular flow.

© 2003 McGraw-Hill Ryerson Limited. Why Is the Financial Sector So Important to Macro? u Savings are returned to the circular flow in the form of consumer loans, business loans, and loans to government.

© 2003 McGraw-Hill Ryerson Limited. Why Is the Financial Sector So Important to Macro? u Savings are channeled into the financial sector when individuals buy financial assets such as stocks or bonds and back into the spending stream as investment. u For every financial asset there is a corresponding financial liability.

© 2003 McGraw-Hill Ryerson Limited. Why Is the Financial Sector So Important to Macro? u Financial assets such as stocks and bonds, are obligations or financial liabilities of the issuer.

© 2003 McGraw-Hill Ryerson Limited. Loans Saving Govt House- holds Corpor- ations Pension funds CDs Savings deposits Chequing deposits Stocks Bonds Government Securities Life insurance Outflow from spending stream The Financial Sector as a Conduit for Savings, Fig. 13-1, p 307 Large business loans Small business loans Venture capital loans Construction loans Investment loans Govt House- holds Corpor- ations Inflow from spending stream Financial sector

© 2003 McGraw-Hill Ryerson Limited. The Role of Interest Rates in the Financial Sector u While price is the mechanism that balances supply and demand in the real sector, interest rates do the same in the financial sector.

© 2003 McGraw-Hill Ryerson Limited. The Role of Interest Rates in the Financial Sector u The interest rate is the price paid for use of a financial asset. u Bonds are promises to pay a certain amount plus interest in the future.

© 2003 McGraw-Hill Ryerson Limited. The Role of Interest Rates in the Financial Sector u When financial assets such as bond make fixed interest payments, the price of the financial asset is determined by the market interest rate.

© 2003 McGraw-Hill Ryerson Limited. The Role of Interest Rates in the Financial Sector u When interest rates rise, the value of the flow of payments from fixed-interest- rate bonds goes down because more can be earned on new bonds that pay the new, higher interest.

© 2003 McGraw-Hill Ryerson Limited. The Role of Interest Rates in the Financial Sector u As the market interest rates go up, price of the bond goes down. u As the market interest rates go down, the price of the bond goes up.

© 2003 McGraw-Hill Ryerson Limited. The Definition and Functions of Money u Money is a highly liquid financial asset. l To be liquid means to be easily changeable into another asset or good. l Social customs and standard practices are central to the liquidity of money.

© 2003 McGraw-Hill Ryerson Limited. The Definition and Functions of Money u Money is generally accepted in exchange for other goods. u Money is used as a reference in valuing other goods. u Money can be stored as wealth.

© 2003 McGraw-Hill Ryerson Limited. The Canadian Central Bank: Bank of Canada u Bank of Canada – The Canadian central bank whose liabilities (bank notes) serve as cash in Canada.

© 2003 McGraw-Hill Ryerson Limited. Bank of Canada u A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms. u Individuals deposits in savings and chequing accounts serve the same function as does currency and are also considered money.

© 2003 McGraw-Hill Ryerson Limited. Functions of Money u Money is a medium of exchange. u Money is a unit of account. u Money is a store of wealth.

© 2003 McGraw-Hill Ryerson Limited. Money As a Medium of Exchange u Without money, we would have to bartera direct exchange of goods and services. u Money facilitates exchange by reducing the cost of trading.

© 2003 McGraw-Hill Ryerson Limited. Money As a Medium of Exchange u Money does not have to have any inherent value to function as a medium of exchange. u All that is necessary is that everyone believes that other people will exchange it for their goods.

© 2003 McGraw-Hill Ryerson Limited. Money As a Medium of Exchange u The Bank of Canadas job is to not issue too much or too little money. u If there is too much money, compared to the goods and services at existing prices, the goods and services will sell out, or the prices will rise.

© 2003 McGraw-Hill Ryerson Limited. Money As a Medium of Exchange u If there is too little money, compared to the goods and services at existing prices, there will be a shortage of money and people will have to resort to barter, or prices will fall.

© 2003 McGraw-Hill Ryerson Limited. Money As a Unit of Account u Money prices are actually relative prices. u A single unit of account saves our limited memories and helps us make reasonable decisions based on relative costs.

© 2003 McGraw-Hill Ryerson Limited. Money As a Unit of Account u Money is a useful unit of account only as long as its value relative to other prices does not change too quickly. u In a hyperinflation, all prices rise so much that our frame of reference is lost and money loses its usefulness as a unit of account.

© 2003 McGraw-Hill Ryerson Limited. Money as a Store of Wealth u Money is a financial asset. u It is simply a government bond that pays no interest.

© 2003 McGraw-Hill Ryerson Limited. Money as a Store of Wealth u As long as money is serving as a medium of exchange, it automatically also serves as a store of wealth.

© 2003 McGraw-Hill Ryerson Limited. Money as a Store of Wealth u Moneys usefulness as a store of wealth also depends upon how well it maintains its value. u Hyperinflations destroy moneys usefulness as a store of value.

© 2003 McGraw-Hill Ryerson Limited. Money as a Store of Wealth u Our ability to spend money for goods makes it worthwhile to hold money even though it does not pay interest.

© 2003 McGraw-Hill Ryerson Limited. Alternative Measures of Money u Since it is difficult to define money unambiguously, economists have defined different measures of money. u They are called M1, M2 and M3, M1+, M2+ and M2++.

© 2003 McGraw-Hill Ryerson Limited. Alternative Measures of Money: M1 u M1 consists of currency in circulation and chequing account balances at chartered banks. u Chequing account deposits are included in all definitions of money.

© 2003 McGraw-Hill Ryerson Limited. Alternative Measures of Money: M2 u M2 is made up of M1 plus personal savings deposits, and non personal notice deposits (that can be withdrawn only after prior notice) held at chartered banks. u Time deposits are also called certificates of deposit (CDs), or term deposits.

© 2003 McGraw-Hill Ryerson Limited. Alternative Measures of Money: M2 u The money in savings accounts is counted as money because it is readily available.

© 2003 McGraw-Hill Ryerson Limited. Alternative Measures of Money: M2 u All M2 components are highly liquid and play an important role in providing reserves and lending capacity for chartered banks.

© 2003 McGraw-Hill Ryerson Limited. Alternative Measures of Money: M2 u The M2 definition is important because economic research has shown that the M2 definition often most closely correlates with the price level and economic activity.

© 2003 McGraw-Hill Ryerson Limited. Beyond M2: The Pluses u Numerous financial assets also have some attributes of money. That is why they are included in some measures of money. u There are measures for M3, M1+, M2+ and beyond.

© 2003 McGraw-Hill Ryerson Limited. Beyond M2: The Pluses u The broadest measure is M2++. u It includes almost all assets that can be turned into cash on short notice. u Broader concepts of asset liquidity have gained greater appeal than the measures of money, because money measures have been rapidly changing.

© 2003 McGraw-Hill Ryerson Limited. Beyond M2: The Pluses u M1, M2 and M3 measures only include deposits held at chartered banks. u Measures containing a + also include deposits at other financial institutions (near banks).

© 2003 McGraw-Hill Ryerson Limited. Distinguishing Between Money and Credit u Credit card balances cannot be money since they are assets of a bank. u In a sense, they are the opposite of money.

© 2003 McGraw-Hill Ryerson Limited. Distinguishing Between Money and Credit u Credit cards are prearranged loans. u Credit cards affect the amount of money people hold. u Generally, credit card holders carry less cash.

© 2003 McGraw-Hill Ryerson Limited. Banks and the Creation of Money u Banks are both borrowers and lenders. l Banks take in deposits and use the money they borrow to make loans to others. l Banks make a profit by charging a higher interest on the money they lend out than they pay for the money they borrow.

© 2003 McGraw-Hill Ryerson Limited. Banks and the Creation of Money u Banks can be analyzed from the perspective of asset management and liability management.

© 2003 McGraw-Hill Ryerson Limited. Banks and the Creation of Money u Asset management is how a bank handles its loans and other assets. u Liability management how a bank attracts deposits and how it pays for them.

© 2003 McGraw-Hill Ryerson Limited. How Banks Create Money u Banks create money because a banks liabilities are defined as money. u When a bank incurs liabilities it creates money. u When a bank places the proceeds of a loan it makes to you in your chequing account, it is creating money.

© 2003 McGraw-Hill Ryerson Limited. The First Step in the Creation of Money u The Bank of Canada creates money by simply printing currency and exchanging it for bonds. u Currency is a financial asset to the bearer and a liability to the Bank of Canada.

© 2003 McGraw-Hill Ryerson Limited. The Second Step in the Creation of Money u The bearer deposits the currency in a chequing account at the bank. u The bank holds your money and keeps track of it until you write a cheque.

© 2003 McGraw-Hill Ryerson Limited. Banking and Goldsmiths u In the past, gold was used as payment for goods and services. u But gold is heavy and the likelihood of being robbed was great.

© 2003 McGraw-Hill Ryerson Limited. From Gold to Gold Receipts u It was safer to leave gold with a goldsmith who gave you a receipt. u The receipt could be exchanged for gold whenever you needed gold.

© 2003 McGraw-Hill Ryerson Limited. From Gold to Gold Receipts u People soon began using the receipts as money since they knew the receipts were backed 100 percent by gold. u At this point, there were two forms of money – gold and gold receipts.

© 2003 McGraw-Hill Ryerson Limited. The Third Step in the Creation of Money u Little gold was redeemed, so the goldsmith began making loans by issuing more receipts than he had gold. u He charged interest on the newly created gold receipts.

© 2003 McGraw-Hill Ryerson Limited. The Third Step in the Creation of Money u When the goldsmith began making loans by issuing more receipts than he had in gold, he created money.

© 2003 McGraw-Hill Ryerson Limited. The Third Step in the Creation of Money u The gold receipts were backed partly by gold and partly by peoples trust that the goldsmith would pay off in gold on demand.

© 2003 McGraw-Hill Ryerson Limited. The Third Step in the Creation of Money u The goldsmith soon realized that he could make more money in interest than he could earn in goldsmithing. u The goldsmith had become a banker.

© 2003 McGraw-Hill Ryerson Limited. Banking Is Profitable u As the goldsmiths became wealthy, others started competing in offering to hold gold for free, or even offering to pay for the privilege of holding the publics gold.

© 2003 McGraw-Hill Ryerson Limited. Banking Is Profitable u That is why most banks today are willing to hold the publics money at no charge – they can lend it out and in the process, make profits.