Chapter 27: Money and Banking Copyright © 2014 Pearson Canada Inc.

Chapter Outline/Learning Objectives Section Learning Objectives After studying this chapter, you will be able to 27.1 The Nature of Money describe the various functions of money, and how money has evolved over time. 27.2 The Canadian Banking System see that modern banking systems include both privately owned commercial banks and government-owned central banks. 27.3 Money Creation by the Banking System explain how commercial banks create money through the process of taking deposits and making loans. 27.4 The Money Supply describe the various measures of the money supply. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

27.1 The Nature of Money What is Money? Money is a medium of exchange. If there were no money, goods would have to be exchanged in a system of barter. Barter is very inefficient due to the double coincidence of wants. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Hyperinflation and the Value of Money What is Money? Money is also used as a store of value. without high inflation, money retains its value well Finally, money is used as a unit of account. used to keep our financial accounts LESSONS FROM HISTORY 27-1 Hyperinflation and the Value of Money Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Commodity money: Can be stored easily High value densities Easily portable Durable

Weirdest method of payment The phrase "To pay through the nose" comes from Danes in Ireland, who slit the noses of those who were remiss in paying the Danish poll tax.

The Future of Money

The Kinds of Money Commodity money: money that takes the form of a commodity with intrinsic value Fiat money: money without intrinsic value that is accepted as money because of government decree Copyright © 2014 by Nelson Education Ltd.

Modern Money: Deposit Money Money held as deposits with commercial banks and other financial institutions is called deposit money. Bank deposits are an important part of the money supply. As in the past, banks create money by issuing more promises to pay (deposits) than they have in cash reserves. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Question Which of the following best illustrates the unit of account function of money? a. You list prices for candy sold on your website, www.sweettooth.com, in dollars. b. You pay for your NHL tickets with dollars. c. You keep $10 in your backpack for emergencies. d. You sell a used copy of your textbook for $40. Copyright © 2014 by Nelson Education Ltd.

Question What do economists use the word “money” to refer to? a. income generated by the production of goods and services b. those assets regularly used to buy goods and services c. the value of a person’s assets d. the value of stocks and bonds Copyright © 2014 by Nelson Education Ltd.

Question Which of the following has intrinsic value? a. a golden coin b. a twenty-dollar bill c. a bank account d. a personal cheque Copyright © 2014 by Nelson Education Ltd.

MyEconLab www.myeconlab.com Any discussion of financial markets and banking systems includes many terms that you may find unfamiliar. For a brief guide to and description of various financial assets, look for A Quick Introduction to Financial Assets in the Additional Topics section of this book's MyEconLab. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

27.2 The Canadian Banking System Most banking systems have: a central bank many commercial banks A central bank acts as a bank to the banking system: usually a government-owned institution and the sole money-issuing authority Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

The Bank of Canada Created in 1935. Formally accountable to the Minister of Finance and Parliament. System of joint responsibility maintains day-to-day independence. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

The basic functions of the Bank of Canada are to: act as banker to the commercial banks act as fiscal agent of the federal government regulate the money supply regulate, support, and monitor financial markets Most of our discussion will focus on the Bank's role in controlling the money supply  monetary policy Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Table 27-1 Assets and Liabilities of the Bank of Canada Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Commercial Banks in Canada A commercial bank is a privately owned, profit-seeking institution that provides a variety of financial services. Banks are important "financial intermediaries" and are crucial for the smooth operation of credit markets.  they accept deposits and provide credit Commercial banks have a number of interbank cooperative relationships. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Table 27-2 Consolidated Balance Sheet of the Canadian Chartered Banks Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

MyEconLab www.myeconlab.com The proximate cause of the global recession of 2009–2010 was the collapse of the U.S. housing market beginning in 2007 which, in turn, led to a global financial crisis. For a brief summary of the remarkable events and subsequent policy responses, look for The U.S. Housing Collapse and the Financial Crisis of 2007–2008 in the Additional Topics section of this book's MyEconLab. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Reserves Banks' cash reserves are normally quite small because only a small fraction of depositors want their money at any time. A bank's reserve ratio is the fraction of its deposit liabilities that it actually holds as reserves either vault cash or deposits with the central bank A bank's target reserve ratio is the fraction of its deposits it wishes to hold as reserves. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

MyEconLab www.myeconlab.com Although deposit insurance provides benefits to depositors in the form of enhanced security, some economists argue that it encourages excessive risk-taking on the part of the banks themselves. For more details about the debate over deposit insurance, look for The Costs and Benefits of Deposit Insurance in the Additional Topics section of this book's MyEconLab. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

The Canadian banking system is a fractional-reserve system in March 2006 they held less than 1% of their deposits in reserves! Any reserves in excess of target reserves are called excess reserves these are central to the process of "money creation" Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

27.3 Money Creation by the Banking System Some Simplifying Assumptions Suppose: banks invest only in loans there are only demand deposits a fixed target reserve ratio no cash drain from the banking system Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

The Creation of Deposit Money Table 27-3: The bank initially has a reserve ratio of 20%. Table 27-4: A new deposit of $100 raises the bank's reserve ratio to 27%. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

The Creation of Deposit Money Table 27-5: The bank now has $80 of excess reserves which it can lend. Table 27-6: The second-round bank receives $80 in new deposits and expands its loans by $64. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

A single new deposit begins a long sequence of deposit creation A single new deposit begins a long sequence of deposit creation. With the target reserve ratio of 20%, the new deposit of $100 creates a total expansion of deposits of $500. With no cash drain, a banking system with a target reserve ratio of v will change its deposits by 1/v times any change in reserves (the new deposit). ΔDeposits = (1/v) ΔReserves Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Table 27-7 The Sequence of Loans and Deposits After a Single New Deposit of $100 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Excess Reserves and Cash Drains Deposit creation does not happen automatically; it depends on the decisions of bankers. A cash drain: if households hold a fraction of their deposits in cash, the deposit-creation process is dampened If c is the currency-deposit ratio, the final change in deposits will be given by: ΔDeposits = (1/c+v) (New Cash Deposit) Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Money supply = Currency + Deposits 27.4 The Money Supply The money supply is the total quantity of money that is in the economy at any time. several definitions of "money" In general, Money supply = Currency + Deposits Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Kinds of Deposits The long-standing distinction between money and other highly liquid assets used to be: money was a medium of exchange that did not earn interest other assets earned interest but were not a medium of exchange Today this distinction is very blurred. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Definitions of the Money Supply A common definition of money is M2: M2 = currency + chequable and non-chequable deposits held at the chartered banks A broader measure is M2+: M2+ = M2 + similar deposits held at institutions that are not chartered banks Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Table 27-9 M2 and M2+ in Canada Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

Near Money and Money Substitutes assets that are a store of value and are readily converted into a medium of exchange short-term bonds term deposits Money substitutes: things that serve as a temporary medium of exchange but are not a store of value credit cards Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

The Role of the Bank of Canada Choosing a Measure There is no single timeless or best definition of money. New financial assets are continually being developed that serve some of the functions of money. The Role of the Bank of Canada We have seen how commercial banks can expand reserves into deposit money. The Bank of Canada has great influence over the amount of reserves in the banking system. Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide