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

2. Chapter Outline/Learning Objectives Section Learning Objectives After studying this chapter, you will be able to 27.1The Nature of Money 1.describe the various functions of money, and how money has evolved over time. 27.2The Canadian Banking System 2.see that modern banking systems include both privately owned commercial banks and government-owned central banks. 27.3Money Creation by the Banking System 3.explain how commercial banks create money through the process of taking deposits and making loans. 27.4The Money Supply4.describe the various measures of the money supply. Copyright © 2014 Pearson Canada Inc. 2 Chapter 27, Slide

3. 27.1The Nature of Money Functions of Money 1.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. 3 Chapter 27, Slide

4. Functions of Money 2. Money is also used as a store of value. without high inflation, money retains its value well 3. Finally, money is used as a unit of account. used to keep our financial accounts 4 Copyright © 2014 Pearson Canada Inc. LESSONS FROM HISTORY 27-1 Hyperinflation and the Value of Money Chapter 27, Slide

5. Characteristics of Money 1.Acceptable 2.Durable 3.Portable 4.Divisible 5.Standardized, easily recognized but not easily copied 6.Controlled by central authority 5 © 2014 Pearson Education Canada Inc.

6. The Origins of Money Money has evolved over time, taking various different forms: Metallic money: years ago, the market value of the metal was equal to the face value of the coin this led to debasing  Gresham's Law Paper money: paper money was initially backed by precious metal often referred to as bank notes (issued by banks) 6 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

7. Fractionally backed paper money: goldsmiths and banks began to issue more notes than the amount of gold held in their vaults Fiat money: money that is neither backed by nor convertible into anything else decreed by the government to be legal tender Today, almost all currency is fiat money. 7 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

8. Fractional Reserve Banking People usually write cheques and don’t take out the actual cash (currency) So banks loan excess reserves out at interest They keep a fraction back in case the depositor comes to withdraw it This leverage allows a greater rate of return for the bank (more interest) 8 © 2014 Pearson Education Canada Inc.

9. 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. 9 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

10. 27.2The 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. 10 Chapter 27, Slide

11. 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. 11 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

12. 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 12 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

13. Table 27-1 Assets and Liabilities of the Bank of Canada 13 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

14. 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. 14 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

15. Financial Institutions Act as intermediaries between: households, businesses, and governments that have funds available for lending, and others who want to borrow those funds Two broad categories: Banks Near banks 15 © 2014 Pearson Education Canada Inc.

16. Charter Banks Financial institutions which receive a charter of incorporation under the Bank Act Includes the major commercial banks (RBC, TD Bank, Scotiabank, BMO, CIBC) and several dozen smaller banks 16 © 2014 Pearson Education Canada Inc.

17. Near Banks Financial institutions which share many of the functions of commercial banks Not defined as banks under the Bank Act Includes: Credit unions / caisse populaires Trust companies Mortgage and loan associations 17 © 2014 Pearson Education Canada Inc.

18. Balance Sheet Assets What a company owns or what is owed to it Liabilities What a company owes Net Worth Total assets minus total liabilities Also called equity 18 © 2014 Pearson Education Canada Inc.

19. Balance Sheet – An example 19 © 2014 Pearson Education Canada Inc.

20. Table 27-2 Consolidated Balance Sheet of the Canadian Chartered Banks 20 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

21. 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. 21 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide Target reserves = target reserve ratio  demand deposits

22. 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" 22 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide Excess reserves = actual reserves  target reserves

23. 27.3Money 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. 23 Chapter 27, Slide

24. The Creation of Deposit Money 24 Copyright © 2014 Pearson Canada Inc. 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%. Chapter 27, Slide

25. The Creation of Deposit Money 25 Copyright © 2014 Pearson Canada Inc. 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. Chapter 27, Slide

26. 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 26 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

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

28. 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) 28 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

29. 27.4The 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. 29 Chapter 27, Slide

30. 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. 30 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

31. 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 31 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

32. Table 27-9 M2 and M2+ in Canada 32 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

33. Near Money and Money Substitutes Near money: 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 33 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

34. 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. 34 Copyright © 2014 Pearson Canada Inc. Chapter 27, Slide

35. Review Bank North's Balance Sheet AssetsLiabilities Reserves$300Deposits$2000 Loans$2200Capital $500 Assume that Bank North is operating with no excess reserves. What is their actual reserve ratio? A) 20% B) 12% C) 15% D) 25% E) 13.67% 35 © 2014 Pearson Education Canada Inc.

36. Review Assume that Bank ABC has a target reserve ratio of 10%. If Bank ABC receives a new deposit of $100 000, the largest new loan this bank could initially make, and maintain its target reserve ratio, is________. A)$ 1000. B)$ 10 000. C)$900 000. D)$ 90 000. E)$100 000. 36 © 2014 Pearson Education Canada Inc.