Lecture notes Prepared by Anton Ljutic

© 2004 McGraw–Hill Ryerson Limited Money and Banking CHAPTER SEVEN

© 2004 McGraw–Hill Ryerson Limited Understand the functions and characteristics of money Recognize the various kinds of money Explain what is included in the money supply Explain what is and is not money Describe the main function of modern banks as money lenders Explain how a small amount of cash can support many loans and create more money This Chapter Will Enable You to:

© 2004 McGraw–Hill Ryerson Limited Functions and Characteristics of Money Medium of exchange –Something that is accepted as payment for goods and services. Store of wealth –The function of money that allows people to hold and accumulate wealth. Unit of account –The function of money that allows us to determine easily the relative value of goods

© 2004 McGraw–Hill Ryerson Limited Characteristics of Money Acceptable Durable Portable Divisible Easily recognized Relatively scarce

© 2004 McGraw–Hill Ryerson Limited Different Kinds of Money Commodity money –A type of money that can also function, and is useful, as a commodity Gold and other precious metals Coins Paper money Chequebook money (deposits)

© 2004 McGraw–Hill Ryerson Limited Fractional Reserve Banking (I) Fractional reserve system –A banking system whereby banks keep only a small fraction of their total deposits on reserve in the form of cash Money –Anything that is widely accepted as a medium of exchange and therefore can be used to buy goods and services and can be used in settlement of debt M1 –Currency in circulation plus demand deposits Demand deposits –Depositors can demand their deposits in cash at any time

© 2004 McGraw–Hill Ryerson Limited Fractional Reserve Banking (II) M2 –M1 plus all notice and personal term deposits Notice deposits –Savings accounts on deposit for an undefined length of time Term deposits –Savings accounts on deposit for a specific term M3 –M2 plus non-personal term deposits known as certificates of deposits

© 2004 McGraw–Hill Ryerson Limited Money Supply in Canada, November 2001 M3=$751B M2=$551B M1=$135B

© 2004 McGraw–Hill Ryerson Limited What is not Money? Currency in vaults or tills of banks Gold Financial securities Debit and credit cards Chequing accounts at near-banks –Near-banks Financial institutions like credit unions or trust companies, which share many of the functions of commercial banks but are not defined as banks under the Bank Act

© 2004 McGraw–Hill Ryerson Limited A Word on Modern Banks Spread –The difference between the rate of interest a bank charges borrowers and the rate it pays savers Target reserve ratio –The portion of deposits that a bank wants to hold in cash

© 2004 McGraw–Hill Ryerson Limited Creation of Money by a Bank Assets –The part of a company’s balance sheet that represents what it owns or what is owed to it Liabilities –The part of a company’s balance sheet that represents what it owes Net worth –The total assets less total liabilities of a company.It is also called equity

© 2004 McGraw–Hill Ryerson Limited Balance Sheet of Saymor Bank (Dec.31,1999) AssetsLiabilities and Equity Reserves$10,000Demand deposits $100,000 Loans to customers $60,000Shareholders’ equity $20,000 Securities$30,000 Fixed Assets$20,000 $120,00 ________ $120,000

© 2004 McGraw–Hill Ryerson Limited Deposit Creation Excess reserves –Reserves in excess of what the bank is required to hold and therefore the amount the bank can lend Following an increase in deposits of $1000, the bank keeps 10% in cash reserves and lends out its excess reserves of $900 If $900 is spent and re-deposited, the bank will keep 10% and lend $810 If $810 is spent and re-deposited, the bank will keep 10% and lend $729 Etc. The money multiplier will determine the increase in total deposits in the banking system

© 2004 McGraw–Hill Ryerson Limited Money Multiplier The increase in total deposits that would occur in the whole banking system as a result of a new deposit in a single bank. The money multiplier also works in reverse Money multiplier =  deposits /  reserves or, Money multiplier = 1 / target reserve ratio

© 2004 McGraw–Hill Ryerson Limited Can Banks Be Short of Reserves? Should it happen, the bank would need to borrow Banks borrow from the Bank of Canada Such (very short term) loans are subject to interest, known as the bank rate –Bank rate The rate of interest that the Bank of Canada charges a commercial bank for a loan Banks would try to avoid such borrowing whenever possible

© 2004 McGraw–Hill Ryerson Limited A Smaller Money Multiplier? The following factors may reduce the size of the multiplier: An increase in the banks target reserves An increase in amount of cash that people hold An insufficient number of credit-worthy applicants for loans A reduced demand for loans by people in times of recession

© 2004 McGraw–Hill Ryerson Limited The functions and characteristics of money The various kinds of money (cash, deposits…) What is included in the money supply (M1, M2…) What is and is not money The main function of modern banks as money lenders How a small amount of cash can support many loans and create more money Chapter Summary: What to Study and Remember