1. Chapter 27 Money and Banking
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2. In this chapter you will learn
1. about the various functions of money, and how money has evolved over time.
2. that modern banking systems include both privately owned commercial banks and government-owned central banks.
3. how commercial banks create money through the process of taking deposits and making loans.
4. the various measures of the money supply.
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3. 27.1 THE NATURE OF MONEY What Is Money?
Money is a medium of exchange - generally acceptable as payment for goods and services.
Characteristics of a medium of exchange
- easily recognizable and accepted by all
- high value for weight
- easily divisible
- durable
- difficult (impossible) to counterfeit
Can we find such a thing?
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4. An economy which uses money to trade is called a
If money did not exist then we would have to exchange goods by bartering - a barter system, or barter economy.
An economy which uses money to trade is called a
monetized, or money economy
A barter system is very inefficient. Exchange (trade among economic agents) is very costly.
Why? Due to the double coincidence of wants - this is not a problem when a medium of exchange is used.
Transaction costs are lower in a money economy
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5. Agents try to minimize the amount of trading that they do.
MONEY IS TECHNOLOGY
What happens in a society in which trading is prohibitively costly? When transaction costs are very high
Agents try to minimize the amount of trading that they do.
This leads to agents trying to be self-sufficient.
No specialization - no division of labour – low productivity.
The doctor grows her own food, repairs her own buggy,
makes her own cloths, repairs her own roof.
Most modern occupations and industries would not exist.
Money is a technology of exchange – it lowers the cost of trading
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6. Money is also used as a store of value.
- without inflation, money retains its value
- money can be used to separate transactions over time
Finally, money is used as a unit of account.
- used to keep our financial accounts
This is how we have used the concept of ‘money’ in this course through Chapter 26
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7. What serves as money in Canada? - Canadian coins
- Canadian paper currency (Bank of Canada notes )
- Bank deposits - transferable by cheque and debit card from buyer to seller
Are the above always acceptable in exchange?
Are other things generally acceptable in exchange?
What about credit cards?
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8. Money is TECHNOLOGY
Money is TRUST
The Origins of Money
Money has evolved over time, taking various forms:
Metallic money (bullion and coinage) WHY?
- during much of the history of money the ‘face value’ of a coin was equal to the market value of the metal contained in the coin
- this led to debasing  Gresham’s Law
NOTE the ‘face’ on the coin sometimes failed to maintain the trust – the money system would then collapse
- clipping – private debasement
Paper money:
- paper money was initially backed by precious metal
- often referred to as bank notes (issued by banks - originally goldsmiths)
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9. MONEY IS CREDIT Fractionally backed paper money:
- goldsmiths and banks issued more notes than the amount of gold held in their vaults. Why? – they lent out the extra notes for interest. Very few notes were redeemed on any given day.
This was the GOLD STANDARD (or STERLING STANDARD)
This system existed in Canada until the early 1930’s
- Private bank notes
- True Bills doctrine – traders
- Bank runs (unit banking vs branch banking)
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10. The next step (relatively modern concept)
Fiat money:
- money that is neither backed by, nor convertible into anything else
- decreed by the government to be legal tender
Absolutely nothing ‘backs’ our Canadian money supply
Today, almost all (all?) currency in the world is fiat money.
Money is TRUST
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11. Modern Money: Deposit Money
Money held as deposits with commercial banks and other financial institutions is called deposit money.
As in the past, banks create money by issuing more promises to pay (deposits) than they have in cash reserves.
What are cash reserves – coins and bills (fiat money)
Why do banks create deposit money? Because they lend it out for interest.
You want a car loan – the bank creates some deposit money and lends it to you and collects interest – what a deal!
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12. Modern Money - two components
Currency in the hands of the non-bank public
- bills and coins
Accounts for about 5% of the total money supply
Deposit with commercial banks and other financial institutions (deposit money)
– chequing accounts, savings accounts, etc.
Accounts for about 95% of the total money supply
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13. Modern Money - 95% of the money supply is electronic
Modern Money - 95% of the money supply is electronic money – records in a computer memory
Our money is highly sophisticated in a technical sense
Very efficient. New technologies such as debit cards – instantaneous electronic access to deposit money - are very efficient technologies.
What is next?
– cell phone money – money implanted in your ear
For those of you who are a bit paranoid, remember:
Big brother effect – poor Elliot Spitzer – they can follow the electronic money
MONEY IS A TECHNOLOGY
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14. What is money? Money is a TECHNOLOGY (of exchange)
Money is TRUST (in the monetary authorities)
Money is CREDIT (created by banks as they create money)
Money is a claim on a goods and services. You get a claim on goods and services by selling (producing) something of value in exchange for money, or someone gives you some of their claims which they got by selling (producing) something of value.
As long as the number of claims grows at the same rate as the output of goods and services produced each period (GDP), then the money is good in the sense that it retains its value – the amount of goods and services that you can get with one unit of the money remains constant.
A Simple Rule The money supply should grow at the same rate as the growth in GDP (not everyone agrees with this rule).
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15. All monetary systems are built on TRUST - they always were and they always will be!
There is nothing sacred about the GOLD STANDARD or any other monetary system based on a single commodity.
Barter - no monetary system at all – eliminates the need for TRUST but it is very costly to trade and leads to low productivity on the production side of the economy.
Any society that uses barter instead of money must be a very simple, low income economy.
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16. Where does the new money go? How does it come into existence?
You want to buy a car you go to the bank and negotiate a loan. The bank agrees to lend you the money. They credit your checking account $30,000. You write a check.
The amount of money in existence has just gone up by $30,000.
Excessive lending could lead to price inflation.
You want to buy some stock/bonds you go to the bank and negotiate a loan. The bank agrees to lend you the money. They credit your checking account $30,000,000. You write a check.
The amount of money in existence has just gone up by $30,000,000. Excessive lending could lead to asset price inflation (bubbles).
The amount of money in existence increases (decreases) when the total size of bank lending increase (decreases)
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17. collapse of the US housing market in 2007-2008 almost resulted
There are two basic forms of risk inherent in a modern monetary system.
The money supply grows faster than the growth in GDP - money’s role as a ‘store of value’ deteriorates and inflation uncertainties result.
If the loans/credit created as part of the money creation process are not repaid then the financial institutions which support our monetary system become suspect – extreme case – the banking system collapses. This is where financial ‘bubbles’ come into play:
collapse of the US housing market in almost resulted
in a collapse of the world monetary system – it could happen.
‘dot com’ bubble of the 1990’s
savings and loan crisis of late 1980’s
Latin America debt crisis of 1970’s/1980’s
Additional risk ? – Dr. Evil finds the computers
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18. 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.
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19. Why we need banks Asymmetric information – again Two groups
Savers (lenders) - have purchasing power (money) they don’t need at this time
Consumers/Investors/Speculators (borrowers) – want to spend money that they don’t have at this time
Lending and borrowing are important utility and output enhancing activities.
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20. Why we need banks Why don’t savers just lend to borrowers?
Asymmetric information – two problems
Adverse selection – the most eager borrowers at the least likely to repay – borrowers have more information on their riskiness then lenders do – recall buying a used car.
Moral Hazard – after the loan/investment, the borrower might have an incentive to act against the interest of the lender – eg. high executive salaries/no dividends –monitoring problem
RESULT – too little lending ‘legitimate’ borrowers cannot get loans and savers do not get a return on their savings.
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21. Why we need banks
Banks arise because they can reduce ‘adverse selection’ and ‘moral hazard’. They specialize in assessing risk and monitoring behaviour – minimize the asymmetric information problems
This is known as ‘financial intermediation’ – or indirect finance
Savers lend to banks and banks lends to borrowers
(Who monitors the banks?? – bank regulators - reputation)
Direct finance – you buy 100 shares of Apple or a government bond. What about the asymmetric information problem? It still exist but reputation also matters and there are securities regulators.
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22. What to do with savings? Primary versus secondary markets Hold cash
Lend to banks (bank account, GIC, etc.)
Buy a bond - Government
- Corporate
Buy equities (stock) - mutual fund
- individual stocks
Private lending - mortgages
- personal loans
Each option differs with respect to ‘adverse selection’ and ‘moral hazard’ problems.
Each differs with respect to the role of the legal system and regulation.
Each differs with respect to the nature of and expected size of the return to the investor.
Primary versus secondary markets
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23. 27.2 THE CANADIAN BANKING SYSTEM
Most modern 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
- the sole money-issuing authority
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24. 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.
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25. 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
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26. OPTIONAL
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27. Commercial Banks in Canada
A commercial bank is a privately owned, profit-seeking institution that provides a variety of financial services:
- accepts deposits
- makes loans
- provides credit-card services
- offers wealth-management services
APPLYING ECONOMIC CONCEPTS 27-1
The Globalization of Financial Markets
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28. OPTIONAL
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29. Reserves
Banks’ cash reserves are normally quite small because only a small fraction of depositors want their money in cash form at any time.
A bank’s reserve ratio is the fraction of 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 deposits it wishes to hold as reserves.
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30. enhanced security, some economists argue that it encourages excessive
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.
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31. The Canadian banking system is a fractional-reserve system
- in March 2006 private banks 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”
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32. 27.3 MONEY CREATION BY THE BANKING SYSTEM Some Simplifying Assumptions
OPTIONAL
Suppose:
- banks invest only in loans
- there are only demand deposits
- all banks have a fixed target reserve ratio
- there is no cash drain from the banking system
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33. The Creation of Deposit Money
The bank initially has a reserve ratio of 20 percent.
OPTIONAL
A new deposit of $100 raises the bank’s reserve ratio to 27 percent.
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34. The bank now has $80 of excess reserves which it can lend.
The $80 in new loans results in a second round of new deposits.
OPTIONAL
The second-round bank receives $80 in new deposits and expands its loans by $64.
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35. A single new deposit begins a long sequence of deposit creation.
With the target reserve ratio of 20%, the new deposit of $100 allows for 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
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36. OPTIONAL
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37. Excess Reserves and Cash Drains
Deposit creation does not happen automatically; it depends on the decisions of bankers. Bankers must find appropriate borrowers to lend their excess reserves to.
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:
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38. Money creation – a very simple example
If v (target reserve ratio) is 5%
and c (currency-deposit ratio – cash drain) is 5%
and if the private banking system gets $1,000,000 in new reserves, then it can create $10,000,000 in deposit money
Δ Deposits = $1,000,000/(5%+5%)
= $1,000,000/(0.10)
= $10,000,000
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39. THE MONEY SUPPLY
The money supply is the total quantity of money that is in the economy at any time
In general,
Money supply = Currency + Deposits
Currency must be (in the hands of the non-bank public)
and deposits must be deposits at commercial banks
- several definitions of “money” which depend on which ‘deposits’ are included.
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40. Kinds of Deposits
The long-standing distinction between money and other highly liquid assets was:
- 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.
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41. Definitions of the Money Supply
The narrowest definition of money is M1:
M1 = currency + chequable deposits
A broader definition is M2:
M2 = M1 + saving deposits at the chartered banks
A still broader measure is M2+:
M2+ = M2 + deposits held at institutions that are not chartered banks
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43. 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
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44. The Role of the Bank of Canada
Choosing a Measure
There is no single, timeless 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.
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