1. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 1 Money and Banking SLIDES PREPARED BY JUDITH SKUCE, GEORGIAN COLLEGE

2. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 2 In this chapter you will learn 11.1 The definition and functions of money 11.2 What constitutes the supply of money 11.3 What backs Canada’s money supply 11.4 The components of money demand 11.5 How the equilibrium interest rate is determined in the money market 11.6 About the structure of the Canadian financial system 11.7 About recent developments in money and banking

3. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 3 Chapter 11 Topics 11.1 The Definition & Functions of Money 11.2 The Supply of Money 11.3 What “Backs” the Money Supply? 11.4 The Demand for Money 11.5 Equilibrium in the Money Market 11.6 The Canadian Financial System 11.7 Recent Developments in Money & Banking

4. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 4 The Definition & Functions of Money u Money is what money does

5. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 5 The Definition & Functions of Money u Medium of exchange

6. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 6 u Medium of exchange u Measure of value The Definition & Functions of Money

7. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 7 u Medium of exchange u Measure of value u Store of value The Definition & Functions of Money

8. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 8 Chapter 11 Topics 11.1 The Definition & Functions of Money 11.2 The Supply of Money 11.3 What “Backs” the Money Supply? 11.4 The Demand for Money 11.5 Equilibrium in the Money Market 11.6 The Canadian Financial System 11.7 Recent Developments in Money & Banking

9. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 9 Currency (coins & paper money) plus Demand deposits M1 equals M1 (billions of dollars) December, 2002 The Supply of Money Table 11-1 M1 137.3

10. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 10 The Supply of Money u Currency: Coins + Paper Money token moneytoken money Bank of Canada notesBank of Canada notes u Demand Deposits about ⅔ of M1about ⅔ of M1 u Institutions That Offer Demand Deposits chartered banks are the primary depository institutionschartered banks are the primary depository institutions

11. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 11 The Supply of Money u Near-monies nonchequable savings depositsnonchequable savings deposits term depositsterm deposits

12. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 12 Currency (coins & paper money) plus Demand deposits M1 equals M1 plus Personal savings deposits, plus Non-personal notice deposits M2 equals M2 The Supply of Money Table 11-1 (billions of dollars) December, 2002 M1 137.3 M2 559.8

13. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 13 The Supply of Money u M2+ is M2 plus deposits at trust & mortgage loan companiesdeposits at trust & mortgage loan companies deposits at caisses populaires & credit unions & other non-bank deposit-taking institutionsdeposits at caisses populaires & credit unions & other non-bank deposit-taking institutions money market mutual fundsmoney market mutual funds

14. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 14 Currency (coins & paper money) plus Demand deposits M1 equals M1 plus Personal savings deposits, plus Nonpersonal notice deposits M2 equals M2 plus Deposits: Other intermediaries M2+ equals M2+ M1 M2+ 801.8 M2 The Supply of Money Table 11-1 (billions of dollars) December, 2002 559.8 137.3

15. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 15 The Supply of Money u we will use the narrow M1 definition of money, unless stated otherwise

16. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 16 Chapter 11 Topics 11.1 The Definition & Functions of Money 11.2 The Supply of Money 11.3 What “Backs” the Money Supply? 11.4 The Demand for Money 11.5 Equilibrium in the Money Market 11.6 The Canadian Financial System 11.7 Recent Developments in Money & Banking

17. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 17 What “Backs” the Money Supply? u Money as Debt u Value of Money AcceptabilityAcceptability Legal TenderLegal Tender Relative ScarcityRelative Scarcity

18. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 18 What “Backs” the Money Supply? u Money & Prices The Purchasing Power of the DollarThe Purchasing Power of the Dollar NOTES: Reciprocal Reciprocal relationship between the price level and the value of the dollar D = 1 P

19. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 19 What “Backs” the Money Supply? u Money & Prices The Purchasing Power of the DollarThe Purchasing Power of the Dollar Inflation & AcceptabilityInflation & Acceptability

20. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 20 Chapter 11 Topics 11.1 The Definition & Functions of Money 11.2 The Supply of Money 11.3 What “Backs” the Money Supply? 11.4 The Demand for Money 11.5 Equilibrium in the Money Market 11.6 The Canadian Financial System 11.7 Recent Developments in Money & Banking

21. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 21 The Demand for Money u Transactions Demand, D t demand for money as a medium of exchangedemand for money as a medium of exchange varies directly with GDPvaries directly with GDP u Asset Demand, D a demand for money as a store of valuedemand for money as a store of value varies inversely with the interest ratevaries inversely with the interest rate

22. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 22 The Demand For Money Transactions Demand, D t + Interest Rate Amount of money demanded (billions of dollars) DtDt 10 7.5 5 2.5 0 0 50 100 150 200 250 300 i% Figure 11-1

23. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 23 Transactions Demand, D t Asset Demand, D a += Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DaDa 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) DtDt 10 7.5 5 2.5 0 0 50 100 150 200 250 300 i% Interest Rate The Demand For Money Figure 11-1

24. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 24 Transactions Demand, D t Asset Demand, D a Total demand for money, D m += 10 7.5 5 2.5 0 Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DaDa 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) DtDt 10 7.5 5 2.5 0 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 DmDm i% 100 + 100 = 200 Interest Rate The Demand For Money Figure 11-1

25. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 25 Chapter 11 Topics 11.1 The Definition & Functions of Money 11.2 The Supply of Money 11.3 What “Backs” the Money Supply? 11.4 The Demand for Money 11.5 Equilibrium in the Money Market 11.6 The Canadian Financial System 11.7 Recent Developments in Money & Banking

26. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 26 Equilibrium in the Money Market u demand for money combined with supply of money portrays the money market

27. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 27 Transactions Demand, D t Asset Demand, D a Total demand for money, D m += 10 7.5 5 2.5 0 Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DaDa 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) DtDt 10 7.5 5 2.5 0 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 i% ADD THE MONEY SUPPLY TO FIND THE EQUILIBRIUM RATE OF INTEREST ADD THE MONEY SUPPLY TO FIND THE EQUILIBRIUM RATE OF INTEREST Interest Rate The Demand For Money Figure 11-1 DmDm

28. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 28 Transactions Demand, D t Asset Demand, D a Total demand for money, D m += 10 7.5 5 2.5 0 Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DaDa 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) DtDt 10 7.5 5 2.5 0 0 50 100 150 200 250 300 Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 i% SmSm ieie Equilibrium Interest Rate The Demand For Money Figure 11-1 DmDm

29. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 29 Adjustment to a Decline in the Money Supply u A decline in the supply of money will create a temporary shortage of money & increase the equilibrium interest rate

30. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 30 The Money Market Rate of interest, i (percent) Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 SmSm DmDm ieie Suppose the money supply is decreased from $200 billion, S m, to $150 billion S m1 0 50 100 150 200 250 300 Figure 11-2

31. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 31 Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 10 7.5 5 2.5 0 DmDm ieie SmSm A temporary shortage of money will require the sale of some assets to meet the need S m1 Rate of interest, i (percent) The Money Market Figure 11-2

32. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 32 Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 10 7.5 5 2.5 0 DmDm ieie SmSm A temporary shortage of money will require the sale of some assets to meet the need S m1 Rate of interest, i (percent) The Money Market Figure 11-2 Everyone sells bonds  bond prices fall  interest rates rise illustrated… Everyone sells bonds  bond prices fall  interest rates rise illustrated…

33. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 33 BondsBonds u a $1,000 bond @ 5% pays $50 annually u if you buy this bond for $667, you still receive $50 annually u what is your effective interest rate? u 50/667=7.5% the lower the bond price, the higher the interest rate the lower the bond price, the higher the interest rate

34. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 34 Amount of money demanded (billions of dollars) 0 50 100 150 200 250 300 10 7.5 5 2.5 0 DmDm ieie SmSm A temporary shortage of money will require the sale of some assets to meet the need S m1 Rate of interest, i (percent) The Money Market Figure 11-2 Everyone sells bonds  bond prices fall  interest rates rise until people are happy holding the lower quantity of money Everyone sells bonds  bond prices fall  interest rates rise until people are happy holding the lower quantity of money

35. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 35 Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DmDm ieie After adjustments to asset holdings, a new equilibrium will be seen at a higher level of interest S m1 0 50 100 150 200 250 300 Rate of interest, i (percent) SmSm The Money Market Figure 11-2

36. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 36 Adjustment to an Increase in the Money Supply u An increase in the supply of money will create a temporary surplus of money & decrease the equilibrium interest rate

37. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 37 Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DmDm ieie SmSm 0 50 100 150 200 250 300 Suppose the money supply is increased from $200 billion, S m1, to $250 billion S m2 Rate of interest, i (percent) The Money Market Figure 11-2

38. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 38 Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DmDm SmSm 0 50 100 150 200 250 300 S m2 A temporary surplus of money will require the purchase of some assets to meet the desired level of liquidity Rate of interest, i (percent) The Money Market Figure 11-2

39. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 39 BondsBonds u a $1,000 bond @ 5% pays $50 annually u if you buy this bond for $2000, you still receive $50 annually u what is your effective interest rate? u 50/2000=2.5% the higher the bond price, the lower the interest rate the higher the bond price, the lower the interest rate

40. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 40 Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DmDm SmSm 0 50 100 150 200 250 300 S m2 A temporary surplus of money will require the purchase of some assets to meet the desired level of liquidity Rate of interest, i (percent) The Money Market Figure 11-2 Everyone buys bonds  bond prices rise  interest rates fall until people are happy holding the higher quantity of money Everyone buys bonds  bond prices rise  interest rates fall until people are happy holding the higher quantity of money

41. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 41 Amount of money demanded (billions of dollars) 10 7.5 5 2.5 0 DmDm ieie S m2 0 50 100 150 200 250 300 After adjustments to asset holdings, a new equilibrium will be seen at a lower level of interest Rate of interest, i (percent) SmSm The Money Market Figure 11-2

42. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 42 Chapter 11 Topics 11.1 The Definition & Functions of Money 11.2 The Supply of Money 11.3 What “Backs” the Money Supply? 11.4 The Demand for Money 11.5 Equilibrium in the Money Market 11.6 The Canadian Financial System 11.7 Recent Developments in Money & Banking

43. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 43 The Canadian Financial System u The Evolution of the Canadian Banking System 20032003 –16 domestically owned banks –33 foreign bank subsidiaries –20 foreign bank branches big six banks have 90% of total banking assets & 75% of payments volumebig six banks have 90% of total banking assets & 75% of payments volume mergers may lead to more concentrationmergers may lead to more concentration

44. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 44 Table 11-2 The Balance Sheet of Canadian Chartered Banks December 2002 ($ Billions) AssetsLiabilities Reserves0.5 Demand deposits 97.2 Loans688.8 Savings deposits 131.1 Gov’t. of Canada securities 76.7 Term deposits 240.9 Foreign-currency assets 40.0 Foreign-currency liabilities 76.9 Gov’t of Canada 2.0 Other235.1Other493.0 Total1,041.1Total1.041.1

45. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 45 Assets (Canadian $ billions, 2002) Mizuho Holdings (Japan) $1,876,772 Citigroup (U.S.) 1,674,750 Sumitomo Mitsui (Japan) 1,338,400 Deutsche Bank (Germany) 1,288,926 Mitsubishi Tokyo (Japan) 1,196,957 Royal Bank of Canada 351,042 Canadian Imperial Bank of Commerce 280,447 TD Canada Trust 279,788 Scotiabank276,162 Bank of Montreal 232,362 National Bank of Canada 72,447 GLOBAL PERSPECTIVE 11.1

46. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 46 The Canadian Financial System u Canada’s Chartered Banks fractional reserve systemfractional reserve system u Making Loans u Other Financial Intermediaries u Cheque Clearing

47. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 47 Chapter 11 Topics 11.1 The Definition & Functions of Money 11.2 The Supply of Money 11.3 What “Backs” the Money Supply? 11.4 The Demand for Money 11.5 Equilibrium in the Money Market 11.6 The Canadian Financial System 11.7 Recent Developments in Money & Banking

48. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 48 Recent Developments in Money & Banking u Expansion of Services new productsnew products minibanksminibanks ABMsABMs debit cards, phone banking, Internet bankingdebit cards, phone banking, Internet banking

49. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 49 Recent Developments in Money & Banking u Expansion of Services u Globalization of Financial Markets

50. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 50 Recent Developments in Money & Banking u Expansion of Services u Globalization of Financial Markets u Electronic Transactions

51. © 2005 McGraw-Hill Ryerson Ltd. Macroeconomics, Chapter 11 51 Chapter 11 Topics 11.1 The Definition & Functions of Money 11.2 The Supply of Money 11.3 What “Backs” the Money Supply? 11.4 The Demand for Money 11.5 Equilibrium in the Money Market 11.6 The Canadian Financial System 11.7 Recent Developments in Money & Banking