Mehdi Arzandeh, University of Manitoba PowerPoint Presentation by

14-2 © 2016 McGraw ‐ Hill Education Limited LEARNING OBJECTIVES LO14.1Identify and explain the functions of money. LO14.2List and describe the components of the supply of money in Canada. LO14.3Describe what backs Canada’s money supply, making us willing to accept it as payment. LO14.4Discuss the structure of the Canadian financial system. LO14.5Identify and explain the main factors that contributed to the U.S. financial crisis of 2007–2008. LO14.6Discuss why the Canadian banking system is called a fractional reserve system. LO14.7 Explain the basics of a bank’s balance sheet and the distinction between a bank’s actual reserves and its desired reserves. LO14.8 Describe how a chartered bank can create money. LO14.9 Describe the multiple-deposit expansion of the entire chartered banking system. LO14.10 Define the monetary multiplier, explain how to calculate it, and demonstrate its relevance. 14 Money, Banking, and Money Creation

“Money is what money does” Medium of exchange Measure of value Store of value  Liquidity: the ease with which an asset can be converted to cash with little or no loss of purchasing power. LO1 © 2016 McGraw ‐ Hill Education Limited 14.1 The Functions of Money 14-3

Money Definition M1 Currency: Coins + Paper Money token money Bank of Canada notes Demand Deposits about 3/4 of M1 Institutions That Offer Demand Deposits chartered banks are the primary depository institutions Two Qualifications: currency held by the Bank of Canada and chartered banks is excluded from M1 and other measures of the money supply also excluded from the money supply are any deposits of the federal government or the Bank of Canada that are held by chartered banks LO2 © 2016 McGraw ‐ Hill Education Limited 14.2 The Components of the Money Supply 14-4

Money Definition M2 M1 + Near-monies Near monies are highly liquid financial assets that do not directly function as a medium of exchange but can be readily converted into currency e.g. currency or funds in nonchequable savings accounts Term deposits become available to a depositor only at maturity LO2 © 2016 McGraw ‐ Hill Education Limited 14.2 The Components of the Money Supply 14-5

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 14-1 Components of Money Supply M1, M2, M2+, and M2++ in Canada

Money Definition M2+ and M2++ M2+ deposits at trust and mortgage loan companies deposits at caisses populaires, credit unions and other non-bank deposit- taking institutions money market mutual funds M2++ M2++ is M2 plus Canadian saving bonds and non-money market mutual funds LO2 © 2016 McGraw ‐ Hill Education Limited 14.2 The Components of the Money Supply 14-7

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 14-1 Components of Money Supply M1, M2, M2+, and M2++ in Canada

© 2016 McGraw ‐ Hill Education Limited LO TABLE 14-1 Money in Canada, December 2014 Money Billions of dollars Currency held outside banks $ 68 +Demand deposits at chartered banks held by individuals and businesses 684 =M1 $ 752 +Personal savings deposits and nonpersonal notice deposits at chartered banks 545 =M2 $ Deposits at trust and mortgage companies, credit unions, caisses populaires, and government savings institutions 347 +Money market mutual funds and life insurance annuities 23 =M2+ $1667 +Canada Saving Bonds and other retail instruments 7 +Non–money market mutual funds 863 =M2++ $2,537

Money as Debt Value of Money Acceptability Legal Tender Relative Scarcity LO3 © 2016 McGraw ‐ Hill Education Limited 14.3 What Backs the Money Supply 14-10

Money and Prices THE PURCHASING POWER OF THE DOLLAR D = 1/P If the price level is 1.0, then the value of the dollar is 1 If the price level rises to, 1.20, D falls to A 20% increase in the price level reduces the value of the dollar by 16.67% INFLATION AND ACCEPTABILITY STABILIZING THE PURCHASING POWER OF MONEY LO3 © 2016 McGraw ‐ Hill Education Limited 14.3 What Backs the Money Supply 14-11

Canada’s Chartered Banks A multi-branched, privately owned, chartered financial intermediary that has received a charter by Act of Parliament Fractional reserve banking system A banking system with a reserve ratio that is less than 100 percent of the deposit liabilities of a chartered bank Making Loans Prime rate LO4 © 2016 McGraw ‐ Hill Education Limited 14.4 The Canadian Financial System 14-12

© 2016 McGraw ‐ Hill Education Limited LO TABLE 14-2 The Balance Sheet of Canadian Chartered Banks, December 2014 (billions of dollars) Source: Bank of Canada, AssetsLiabilities Reserves (currency and chartered banks’ deposits with Bank of Canada) 0Demand deposits 232 Loans (determined in Canadian dollars) 879Savings deposits 268 Canadian securities287Term deposits 312 Mortgages 994 Foreign-currency liabilities61 Government of Canada deposit 1 Other assets 166 Other liabilities 1452 Total$2326Total$2326

14.1 GLOBAL PERSPECTIVE The World’s Largest Commercial Banks © 2016 McGraw ‐ Hill Education Limited LO

Other Financial Intermediaries Trust companies, loan companies, credit unions, and caisses populaires Insurance companies  Two basic functions They hold the money deposits of businesses and households They make loans to the public in an effort to make profits. LO4 © 2016 McGraw ‐ Hill Education Limited 14.4 The Canadian Financial System 14-15

Cheque Clearing A cheque is a written order that the drawer uses in making a purchase or paying a debt A cheque is “cleared” when one or more banks transfer part of the drawer’s chequing account to the chequing account of the recipient The Canadian Payments Association (CPA) was set up in 1982 for interbank cheque clearing and electronic payments LO4 © 2016 McGraw ‐ Hill Education Limited 14.4 The Canadian Financial System 14-16

The U.S. Mortgage Default Crisis Subprime mortgage loans High-interest-rate loans to home buyers with higher-than-average credit risk Was promoted by government programs that encouraged home ownership Mortgage-backed securities Bonds backed by mortgage payments LO5 © 2016 McGraw ‐ Hill Education Limited 14.5 The Importance of a Properly Functioning Financial System: The U.S. Financial Crisis of 2007–

Securitization The process of slicing up and bundling groups of loans into new securities As loans defaulted, the system collapsed “Underwater” homeowners abandoned homes and mortgages Shadow banking system Moral hazard The tendency for financial investors and financial services firms to take on greater risks because they are insured against possible losses. LO5 © 2016 McGraw ‐ Hill Education Limited 14.5 The Importance of a Properly Functioning Financial System: The U.S. Financial Crisis of 2007–

The creation of money is done with the help of Canada’s chartered banks The Fractional Reserve System A system in which only a portion of demand deposits and cash reserves is held in chartered bank vaults By issuing loans, depositary institutions create demand deposits LO6 © 2016 McGraw ‐ Hill Education Limited 14.6 Chartered Banks and the Creation of Money 14-19

Illustrating the Idea: The Goldsmiths Goldsmiths accepted gold deposits and issued paper receipts Paper receipts were used as a medium of exchange 100% reserve system LO6 © 2016 McGraw ‐ Hill Education Limited 14.6 Chartered Banks and the Creation of Money 14-20

Significant Characteristics of Fractional Reserve Banking Money creation and reserves Bank panics and regulation LO6 © 2016 McGraw ‐ Hill Education Limited 14.6 Chartered Banks and the Creation of Money 14-21

Balance sheet Assets = Liabilities + Net Worth Both sides balance Formation of a Chartered Bank 1.Creating a Bank 2.Acquiring Property and Equipment 3.Accepting deposits 4.Clearing a Cheque Drawn Against the Bank 5.Granting a Loan 6.Buying Government Securities LO7 © 2016 McGraw ‐ Hill Education Limited 14.7 A Single Chartered Bank 14-22

LO7 © 2016 McGraw ‐ Hill Education Limited 14.7 A Single Chartered Bank Transaction #1 Vault cash: cash held by the bank AssetsLiabilities and Net Worth Creating a Bank Balance Sheet 1: Bank of Vancouver Cash$250,000Capital Stock$250,000

LO7 © 2016 McGraw ‐ Hill Education Limited 14.7 A Single Chartered Bank Transaction #2 Acquiring property and equipment AssetsLiabilities and Net Worth Acquiring Property and Equipment Balance Sheet 2: Bank of Vancouver Cash$10,000Capital Stock$250,000 Property240,000

LO7 © 2016 McGraw ‐ Hill Education Limited 14.7 A Single Chartered Bank Transaction #3 Chartered bank functions Accepting deposits of $100,000 Assets Liabilities and Net Worth Accepting Deposits Balance Sheet 3: Bank of Vancouver Cash $110,000 Demand deposits$100,000 Property 240,000 Capital Stock250,000

LO7 © 2016 McGraw ‐ Hill Education Limited 14.7 A Single Chartered Bank Depositing reserves in the Bank of Canada Desired reserves Desired reserve ratio Desired reserve ratio = Chartered bank’s Desired reserves Chartered bank’s demand-deposit liabilities

Excess reserves Actual reserves - Desired reserves Desired reserves Demand deposits x desired reserve ratio Example: Demand deposits $100,000, actual reserves 110,000 Reserve ratio 20% Excess reserves = $110,000 – ($100,000 x 20%) = 90,000 LO7 © 2016 McGraw ‐ Hill Education Limited 14.7 A Single Chartered Bank 14-27

LO7 © 2016 McGraw ‐ Hill Education Limited 14.7 A Single Chartered Bank Transaction #4 Clearing a cheque $50,000 cheque reduces reserves and demand deposits AssetsLiabilities and Net Worth Clearing a Cheque Balance Sheet 4: Bank of Vancouver Demand Deposits$50,000 Property 240,000 Capital Stock250,000 Cash Reserves $60,000

LO8 © 2016 McGraw ‐ Hill Education Limited 14.8 Money-Creating Transactions of a Chartered Bank Transaction #5a Granting a loan $50,000 loan deposited to chequing AssetsLiabilities and Net Worth When a Loan is Negotiated Balance Sheet 5a: Bank of Vancouver Demand Deposits $100,000 Property240,000 Capital Stock250,000 Cash Reserves$60,000 Loans50,000

LO8 © 2016 McGraw ‐ Hill Education Limited 14.8 Money-Creating Transactions of a Chartered Bank Transaction #5b Using the loan $50,000 loan cashed AssetsLiabilities and Net Worth After a Cheque is Drawn on the Loan Balance Sheet 5b: Bank of Vancouver Demand Deposits $50,000 Property240,000 Capital Stock250,000 Cash Reserves$10,000 Loans50,000 A single bank can only lend an amount equal to its preloan excess reserves

LO8 © 2016 McGraw ‐ Hill Education Limited 14.8 Money-Creating Transactions of a Chartered Bank Transaction #6 Bank buys government securities from a dealer Deposits payment into chequing AssetsLiabilities and Net Worth Buying Government Securities Balance Sheet 6: Bank of Vancouver Demand Deposits $100,000 Property240,000 Capital Stock250,000 Cash Reserves$60,000 Securities50,000

Government Securities Bond purchases from the public by the chartered banks increases the money supply Bond sales to the public decreases the money supply LO8 © 2016 McGraw ‐ Hill Education Limited Money-Creating Transactions of a Chartered Bank

Profits, Liquidity, and the Overnight Lending Rate Bankers have two conflicting goals: 1.Profit 2.Liquidity Overnight loans rate paid on overnight loans to cover temporary shortages of reserves LO8 © 2016 McGraw ‐ Hill Education Limited Money-Creating Transactions of a Chartered Bank

A single bank can lend one dollar for each dollar of excess reserves The banking system can lend (create money) by a multiple of its excess reserves LO9 © 2016 McGraw ‐ Hill Education Limited The Banking System: Multiple-Deposit Expansion

Multiple-deposit expansion Assumptions: 20% desired reserves ratio All banks “loaned up” Banks lend all of their excess reserves A $100 bill is found and deposited Multiple deposits can be created LO9 © 2016 McGraw ‐ Hill Education Limited The Banking System: Multiple-Deposit Expansion

LO9 © 2016 McGraw ‐ Hill Education Limited The Banking System: Multiple-Deposit Expansion Multiple-Deposit Expansion Process Balance Sheet: Chartered Bank A AssetsLiabilities and net worth Cash Reserves $+100 (a 1 ) Demand deposits $+100 (a 1 ) – 80 (a 3 )+ 80 (a 2 ) Loans+ 80 (a 2 )– 80 (a 3 )

LO9 © 2016 McGraw ‐ Hill Education Limited The Banking System: Multiple-Deposit Expansion Multiple-Deposit Expansion Process Balance Sheet: Chartered Bank B AssetsLiabilities and net worth Cash Reserves $+80 (b 1 )Demand deposits$+80 (b 1 ) –64 (b 3 )+64 (b 2 ) Loans+64 (b 2 )–64 (b 3 )

LO9 © 2016 McGraw ‐ Hill Education Limited The Banking System: Multiple-Deposit Expansion Multiple-Deposit Expansion Process Balance Sheet: Chartered Bank C AssetsLiabilities and net worth Cash Reserves $ (c 1 ) Demand deposits $ (c 1 ) –51.20 (c 3 ) (c 2 ) Loans (c 2 )–51.20 (c 3 )

LO9 © 2016 McGraw ‐ Hill Education Limited Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Other Banks Bank (1) Acquired Reserves and Deposits (2) Desired Reserves (Desired Reserve Ratio = 0.2) (3) Excess Reserves (1) - (2) (4) Amount Bank Can Lend; New Money Created = (3) $ $ $ $ $ Total amount of money created (sum of the amounts in column 4) TABLE 14-3 Expansion of the Money Supply by the Chartered Banking System

Definition Maximum demand-deposit creation = excess cash reserves  monetary multiplier D = E × M Reversibility: the multiple destruction of money LO10 © 2016 McGraw ‐ Hill Education Limited The Monetary Multiplier Monetary multiplier = 1 Desired reserve ratio = 1 R

© 2016 McGraw ‐ Hill Education Limited LO FIGURE 14-2 The Outcome of the Money Expansion Process, New Reserves

The LAST WORD Banking, Leverage, and Financial Instability in the U.S. Compared to Canada © 2016 McGraw ‐ Hill Education Limited Leverage boosts banking profits but makes the banking system less stable. Prior to the recession of the banking system in the U.S. may have been over- leveraged. Time to reduce leverage? The use of borrowed money can magnify both profits and losses 95% of the money that a modern chartered bank invests comes from borrowing About 25% by issuing bonds About 70% by taking in demand and saving deposits Banks in Canada were more conservative compared to the U.S. banks, before the financial crisis of ; also Banks were more closely regulated in Canada The U.S. government insured possible payment of banks’ liabilities A possible solution is to require banks to use less leverage The current regulatory system relies on bank supervisors

LO14.1 Identify and explain the functions of money. LO14.2 List and describe the components of the supply of money in Canada. LO14.3 Describe what backs Canada’s money supply, making us willing to accept it as payment. LO14.4 Discuss the structure of the Canadian financial system. LO14.5 Identify and explain the main factors that contributed to the U.S. financial crisis of 2007–2008. LO14.6 Discuss why the Canadian banking system is called a fractional reserve system. LO14.7 Explain the basics of a bank’s balance sheet and the distinction between a bank’s actual reserves and its desired reserves. LO14.8 Describe how a chartered bank can create money. LO14.9 Describe the multiple-deposit expansion of the entire chartered banking system. LO14.10 Define the monetary multiplier, explain how to calculate it, and demonstrate its relevance. Chapter Summary © 2016 McGraw ‐ Hill Education Limited 14-43