MACROECONOMICS BY CURTIS, IRVINE, AND BEGG SECOND CANADIAN EDITION MCGRAW-HILL RYERSON, © 2010 Chapter 8 Money, Banking, and the Money Supply

Learning Outcomes ©2010 McGraw-Hill Ryerson Ltd. Chapter 8 2 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

Money & the Functions of Money ©2010 McGraw-Hill Ryerson Ltd. Chapter A Medium of Exchange: Money is the medium of exchange  Anything generally accepted for making payments. Barter economy: No money  Goods trade directly for goods. Barter economy : Trade requires a double coincidence of wants Barter economy: Multiple ‘exchange ratios’Illustrate…

Money and the Functions of Money Barter economy:  Each good has a ‘price’ in terms of every other good  Number of prices = [n x (n – 1)/2], n = number of goods  If n = 25, Price ratios = [25 x (25-1)/2] = 300 Money economy:  Goods trade for money and money for goods  If n = 25, number of money prices = 25 Trade is easier & efficient in money economy ©2010 McGraw-Hill Ryerson Ltd.Chapter 8.1 4

Money and the Function of Money ©2010 McGraw-Hill Ryerson Ltd. Chapter Other Functions of Money Unit of account  Prices quoted & accounts kept in monetary units ($ or ¥) Store of value Carry purchasing power forward in time Standard of deferred payment  Unit of account for future payments

Different Kinds of Money Token Money Legal tender Fiat Money Credit Money Money supply ≡ stock of medium of exchange in circulation ©2010 McGraw-Hill Ryerson Ltd. Chapter 8.1 6

Modern Banking in Canada ©2010 McGraw-Hill Ryerson Ltd. Chapter Canadian Banking System in 2008

Modern Banking in Canada Banks are financial intermediaries Bring borrowers & lenders together Bank of Canada: Canada’s central bank Not profit oriented Regulates money & supports financial markets Responsible for Monetary Policy Banker for commercial banks ‘Lender of last resort’ Banker for Govt Chapter ©2010 McGraw-Hill Ryerson Ltd.

Commercial Banks Commercial Banks: Profit oriented business Provide banking services for public Issue bank deposits & lend to customers Create deposits by their lending activity Deposits are medium of exchange ©2010 McGraw-Hill Ryerson Ltd. Chapter 8.2 9

Bank Competition & Co-operation ©2010 McGraw-Hill Ryerson Ltd. Chapter Competition & Co-operation among banks: Promotes efficiency through: Competition for customer deposits Competition for credit-worth borrowers Co-operation in inter-bank cheque clearing & debit card Interac system Co-operation in consortium lending to jointly fund large projects

Bank Operations & Profits Bank Profits ≡ Interest income from assets – interest cost of deposits = Net interest income x financial assets May be stated:  In absolute $ terms, or  As a % of assets, or  As a % of shareholders’ equity Reported net interest income 2007 Scotiabank Annual Report1.89 % Royal Bank of Canada Annual Report 1.30 % ©2010 McGraw-Hill Ryerson Ltd. Chapter

How Banks Create Money Four key conditions for deposit (money) creation: 1. Non-bank public has confidence in banks, holds & uses bank deposits as money 2. Non-bank public borrows from the banks 3. The banks operate with fractional cash reserves 4. The banks accept risks involved in lending to the non- bank public ©2010 McGraw-Hill Ryerson Ltd. Chapter

©2010 McGraw-Hill Ryerson Ltd.Chapter 8.4 How Banks Create Money Currency ratio (cr)  Ratio of cash balances to deposit balances Reserve ratio (rr)  Ratio of bank cash reserves to deposit liabilities 13

How Banks Create Money ©2010 McGraw-Hill Ryerson Ltd. Chapter Banks create money by issuing deposits to:  make loans to customers  buy financial securities Example of deposit creation, assume:  A reserve ratio of 10 percent, rr = 0.10  A currency ratio of 0, cr = 0  Public has 1000 dollars of cash

How the Banking System Creates Money Banks Non-Bank Private Sector AssetsLiabilitiesAssetsLiabilities 1. Initial Position Cash 0Deposits 0Cash $1,000Bank loans 0 2. People deposit their cash in the banks. Cash $1,000Deposits $1,000Cash 0Bank loans 0 Deposits $1, Banks lend $9,000 by creating $9,000 new customer deposits Cash $1,000 Deposits $10,000 Cash 0Bank loans $9,000 Loans $9,000 Deposits$10,000 ©2010 McGraw-Hill Ryerson Ltd. Chapter

How Banks Create Money Profit oriented banks expand lending & create new deposits when:  They have excess reserves, &  They can find credit-worthy borrowers  They are willing to accept ‘banker’s risk’ of lending & issuing deposits Provided the non-bank public:  Has confidence in the safety of bank deposits, and  Is willing to borrow from banks ©2010 McGraw-Hill Ryerson Ltd. Chapter

Limits on Bank Lending & Deposit Expansion Bank & Non-Bank Behaviour limit deposit expansion Higher rr  lower bank lending & deposit creation  Uncertainty about risks of lending & withdrawals of deposits? Higher cr  lower bank lending & deposit creation  Uncertainty about safety of bank deposits?  Uncertainty about future stability of financial markets? ©2010 McGraw-Hill Ryerson Ltd. Chapter

Limits on Bank Lending and Deposit Expansion Normal conditions:  cr & rr are small & stable Financial crisis like :  concerns re bank deposit safety  ↑ cr  ↑ loan, deposit withdrawals & financial asset risk  ↑ rr  ↑ banks’ costs to raise funds/returns on lending  ↓ numbers of credit worthy borrowers Business access to bank financing ↓ ©2010 McGraw-Hill Ryerson Ltd. Chapter

Financial Panic ©2010 McGraw-Hill Ryerson Ltd. Chapter A Financial Panic involves:  Loss of confidence in bank deposit safety   ‘Run on the bank’ – customers withdraw deposits   Bank calls on central bank for support   Central bank ‘lender of last resort’ action   Evaluation of bank’s assets/liabilities & solvency  Govt take-over &/or orderly liquidation of bank  In the crisis of 2008 & 2009 more than 125 U.S. banks failed compared to just 21 between 2000 & See (

The Monetary Base & the Money Multiplier Money supply (M)  ≡ notes & coin in circulation outside banks + bank deposits Monetary Base (H)  ≡ High-powered money  ≡ notes & coin in circulation & cash held by banks Money Supply  M ≡ money multiplier x monetary base ©2010 McGraw-Hill Ryerson Ltd. Chapter

The Money Multiplier Money Multiplier: ≡ ∆M caused by ∆H, given cr & rr Assume: cr = 0.1 & rr = 0.05 In this example: ∆H = $1  ∆M = $7.33. ©2010 McGraw-Hill Ryerson Ltd. Chapter

The Money Multiplier ©2010 McGraw-Hill Ryerson Ltd. Chapter

How Big is the Money Multiplier? In Canada in early 2008 Bank cash = $5.4 billion Liquid deposits = $494.3 billion rr = 5.4/494.3 = 1.09% Public cash = $47.3 billion Liquid deposits = $494.1 cr = 47.3/494.1 = 9.6% Canadian Money multiplier in 2008 ©2010 McGraw-Hill Ryerson Ltd. Chapter

The Monetary Base and the Money Supply ©2010 McGraw-Hill Ryerson Ltd. Chapter Monetary Base Money Supply Bank Deposits Banks’ Cash Reserves R = rr x D Cash in Circulation C = cr x D

Money Supply Function The money supply function: Three variables: 1. H, the monetary base 2. rr, the bank’s reserve ratio 3. cr, the public’s cash ratio Money supply ©2010 McGraw-Hill Ryerson Ltd. Chapter

The Money Supply Function M0M0 M1M1 Money Supply Interest Rate i H & money multiplier determine M ∆H x money multiplier  ∆M  shift M function ∆M/∆Interest rate = 0 26 Chapter 8.5 ©2010 McGraw-Hill Ryerson Ltd.

Monetary Policy Assume: Constant rr & cr : Money supply function: M = M(rr, cr, H) Central bank controls H  control of M or i Monetary Policy: Objective: affect AD  Y P or P* Central manages H  M 0r i  Y = Y P 0r P = P* ©2010 McGraw-Hill Ryerson Ltd. Chapter

The Money Supply in Canada ($billions) ©2010 McGraw-Hill Ryerson Ltd. Chapter

Chapter Summary ©2010 McGraw-Hill Ryerson Ltd. Chapter 8 29 : Money: Anything generally accepted as means of payment or medium of exchange Other functions of money: a store of value, a unit of account, & a standard of deferred payment. Barter economy trade requires a double coincidence of wants.

Chapter Summary central bank Fiat money is money the government has declared legal tender. The central bank controls the supply of legal tender. token money A token money is a convertible claim on a commodity money. making loans Banks create money by making loans and creating deposits on a fractional cash reserve ratio. Chapter 8 ©2010 McGraw-Hill Ryerson Ltd. 30

Chapter Summary Banks are financial intermediaries. Monetary base (H) is currency in circulation plus banks’ cash reserves. Monetary base (H) is currency in circulation plus banks’ cash reserves. Money multiplier is ∆M/∆H The money supply ©2010 McGraw-Hill Ryerson Ltd.Chapter 831