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Chapter 26: Money and Banking (Chapter 27 in 14th edition)Copyright © 2017 Pearson Canada Inc.
Chapter Outline/Learning ObjectivesSection Learning Objectives After studying this chapter, you will be able to 26.1 The Nature of Money 1. describe the various functions of money, and how money has evolved over time. 26.2 The Canadian Banking System 2. see that modern banking systems include both privately owned commercial banks and government - owned central banks. 26.3 Money Creation by the Banking System 3. explain how commercial banks create money through the process of taking deposits and making loans. 26.4 The Money Supply 4. describe the various measures of the money supply. Copyright © 2017 Pearson Canada Inc.
26.1 The Nature of Money What is Money?A medium of exchange is anything that is generally accepted in return for goods and services sold. Money is any generally accepted medium of exchange. Copyright © 2017 Pearson Canada Inc.
Money as a Medium of ExchangeIf there were no money, goods would have to be exchanged by barter, which is a system in which goods and services are traded directly for other goods and services. With barter, each transaction requires a double coincidence of wants. The double coincidence of wants is unnecessary when a medium of exchange is used. Copyright © 2017 Pearson Canada Inc.
Money as a Store of ValueTo be a satisfactory store of value, money must have a relatively stable value. When the price level is stable, the purchasing power of a given sum of money is also stable. When the price level is highly variable, so is the purchasing power of money, and the usefulness of money as a store of value is undermined. Money as a Unit of Account Money is used for accounting, and its use for such purpose does not rely on its physical existence. Copyright © 2017 Pearson Canada Inc.
Characteristics of MoneyLO1 acceptable durable portable divisible standardized, easily recognized but not easily copied controlled by central authority © 2012 McGraw-Hill Ryerson Limited
The Origins of Money Metallic MoneyBefore the invention of coins, it was necessary to carry the metals in bulk. The invention of coinage eliminated the need to weigh the metal at each transaction. But coins often could not be taken at their face value because of the practice of clipping a thin slice off the edge of the coin. Gresham’s Law is the theory that “bad,” or debased, money drives “good,” or undebased, money out of circulation. Copyright © 2017 Pearson Canada Inc.
Modern Money: Deposit MoneyMoney held by the public in the form of deposits with commercial banks is deposit money. Bank deposits are money. Today, just as in the past, banks create money by issuing more promises to pay (deposits) than they have cash reserves available to pay out. Copyright © 2017 Pearson Canada Inc.
26.2 The Canadian Banking SystemSeveral types of institutions make up a modern banking system. The central bank is a bank that acts as banker to the commercial banking system and often to the government as well, and is usually the sole money-issuing authority. Financial intermediaries are privately owned institutions that serve the general public. They are the intermediaries between savers, from whom they accept deposits, and borrowers, to whom they make loans. We use the term “commercial banks” to refer to all financial intermediaries. Copyright © 2017 Pearson Canada Inc.
The Bank of Canada The Bank of Canada commenced operations on March 11, The organization of the Bank of Canada is designed to keep the operation of monetary policy free from day-to-day political influence. The Bank of Canada has considerable autonomy, but the ultimate responsibility for the Bank’s actions rests with the government. This system is known as “joint responsibility.” Copyright © 2017 Pearson Canada Inc.
The Bank of Canada The basic functions of the Bank of Canada are to:act as banker to the commercial banks act as banker to the federal government regulate the money supply support financial markets Copyright © 2017 Pearson Canada Inc.
Table 26-1 Assets and Liabilities of the Bank of Canada December 2014 (millions of dollars)Copyright © 2017 Pearson Canada Inc.
Commercial Banks in CanadaA commercial bank is a privately owned, profit-seeking institution that provides a variety of financial services, such as accepting deposits from customers and making loans and other investments. Commercial banks act as essential intermediaries in the credit market. Commercial banks undertake interbank activities. Multibank systems make use of a clearing house, which is an institution in which interbank indebtedness, arising from the transfer of cheques between banks, is computed and offset and net amounts owing are calculated. Commercial banks also act as profit seekers. Copyright © 2017 Pearson Canada Inc.
Table Consolidated Balance Sheet of the Canadian Chartered Banks, January 2015 (millions of dollars) Copyright © 2017 Pearson Canada Inc. Chapter 27, Slide
Commercial Bank ReservesThe reserves needed to ensure that depositors can withdraw their deposits on demand will normally be quite small. The Canadian banking system is a fractional-reserve system, which is a banking system in which commercial banks keep only a fraction of their deposits in cash or on deposit with the central bank. A bank’s reserve ratio is the fraction of its deposits that it holds as reserves in the form of cash or deposits with the central bank. A bank’s target reserve ratio is the fraction of its deposits it would ideally like to hold as reserves. Any reserves in excess of the target level are called excess reserves. Copyright © 2017 Pearson Canada Inc.
26.3 Money Creation by the Banking SystemSome Simplifying Assumptions To focus on the essential aspects of how commercial banks create money, suppose that banks can invest in only one kind of asset— loans—and they have only one kind of deposit. We assume that all banks have the same target reserve ratio, which does not change, and that there is no cash drain from the banking system. Copyright © 2017 Pearson Canada Inc.
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
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 SystemSome 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
Assets Liabilities Net Worth Creating MoneyLO4 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 © 2012 McGraw-Hill Ryerson Limited
Balance Sheet of Saymor Bank Ltd. as of December 31, 2011Creating Money LO4 Net worth of Saymor Bank is $20,000 (million): Balance Sheet of Saymor Bank Ltd. as of December 31, 2011 Assets Liabilities and Equity Reserves $ Demand deposits $ Loans to customers 60 000 Shareholders’ equity 20 000 Securities 30 000 Fixed assets 20 000 $ © 2012 McGraw-Hill Ryerson Limited
Target reserves = target reserve ratio demand depositsCreating Money LO4 Target Reserve Ratio the portion of deposits that a bank wants to hold in cash Target reserves = target reserve ratio demand deposits © 2012 McGraw-Hill Ryerson Limited
Balance Sheet of Saymor Bank Ltd. as of December 31, 2011Creating Money LO4 Reserve ratio = 10,000/100,000 = 10% Balance Sheet of Saymor Bank Ltd. as of December 31, 2011 Assets Liabilities and Equity Reserves $ Demand deposits $ Loans to customers 60 000 Shareholders’ equity 20 000 Securities 30 000 Fixed assets 20 000 $ © 2012 McGraw-Hill Ryerson Limited
Excess reserves = Actual reserves target reservesCreating Money LO4 Excess Reserves reserves in excess of what the bank wants to hold as its target reserves Excess reserves = Actual reserves target reserves © 2012 McGraw-Hill Ryerson Limited
Balance Sheet of Saymor Bank Ltd. as of December 31, 2011Creating Money LO4 New deposit of $1,000: Target reserves = 10% x 101,000 = $10,100 Excess reserves = 11,000 – 10,100 = $900 Balance Sheet of Saymor Bank Ltd. as of December 31, 2011 Assets Liabilities and Equity Reserves $ Demand deposits $ Loans to customers 60 000 Shareholders’ equity 20 000 Securities 30 000 Fixed assets 20 000 $ 11 000 © 2012 McGraw-Hill Ryerson Limited
The Creation of Deposit MoneyTable 26-3: The bank initially has a reserve ratio of 20%. Table 26-4: A new deposit of $100 raises the bank's reserve ratio to 27%. Copyright © 2017 Pearson Canada Inc.
The Creation of Deposit MoneyTable 26-5: The bank now has $80 of excess reserves which it can lend. Table 26-6: The second-round bank receives $80 in new deposits and expands its loans by $64. Copyright © 2017 Pearson Canada Inc.
If ν is the target reserve ratio, a new deposit to the banking system will increase the total amount of deposits by 1/ν times the new deposit. In our example, ν = 0.2 and the new deposit is $100. So total deposits eventually increase by $100×1/0.2 = $500. With no cash drain from the banking system, a banking system with a target reserve ratio of ν can change its deposits by 1/v times any change in reserves. ΔDeposits = ΔReserves/ν Copyright © 2017 Pearson Canada Inc.
Table 26-7 The Sequence of Loans and Deposits After a Single New Deposit of $100Copyright © 2017 Pearson Canada Inc.
Excess Reserves and Cash DrainsDeposit creation does not happen automatically; it depends on the decisions of bankers. If commercial banks do not choose to lend their excess reserves, there will not be a multiple expansion of deposits. If people decide to hold an amount of cash equal to a fixed fraction of their bank deposits, any multiple expansion of bank deposits will be accompanied by a cash drain. If c is the ratio of cash to deposits that people want to maintain, the final change in deposits will be given by: ΔDeposits = (New Cash Deposit)/(c + ν) Copyright © 2017 Pearson Canada Inc.
Money Multiplier = 1 / Target Reserve RatioLO4 the increase in total deposits that would occur in the whole banking system as a result of a new deposit in a single bank Money Multiplier = 1 / Target Reserve Ratio © 2012 McGraw-Hill Ryerson Limited
Self-Test 7 LO4 Assume that the nation’s banking system is over-reserved by $20 M. What is the value of the money multiplier and what is the maximum possible expansion in the money supply if the target reserve ratio is: a) 10% b) 2% c) 5% © 2012 McGraw-Hill Ryerson Limited
26.4 The Money Supply The money supply is the total quantity of money that is in the economy at any time. Economists use several alternative definitions for the money supply. Each definition includes the amount of currency in circulation plus some types of deposit liabilities of the financial institutions. Money supply = Currency + Bank deposits Copyright © 2017 Pearson Canada Inc.
Kinds of Deposits For many years, the distinction lay between demand deposits, which earned little or no interest but were transferable on demand (by cheque) and savings deposits, which earned a higher interest return but were not easily transferable. Today that distinction is blurred. The deposit that is genuinely tied up for a period of time now takes the form of a term deposit, which has a specified withdrawal date a minimum of 30 days into the future, and which pays a much reduced interest rate in the event of early withdrawal. Copyright © 2017 Pearson Canada Inc.
Definitions of the Money SupplyTwo commonly used measures of money in Canada today are M2 and M2+. M2 is currency plus demand and notice deposits at the chartered banks. M2+ is M2 plus similar deposits at other financial institutions. Copyright © 2017 Pearson Canada Inc.
Table 26-9 M2 and M2 + in Canada, February 2015 (millions of dollars)Copyright © 2017 Pearson Canada Inc.
Near Money and Money SubstitutesNear money is liquid assets that are easily convertible into money without risk of significant loss of value. Near money can be used as short-term stores of value but are not themselves media of exchange. Term deposits are an example of near money. A money substitute is something that serves as a medium of exchange but is not a store of value. An example of a money substitute is a credit card. Copyright © 2017 Pearson Canada Inc.
The Role of the Bank of CanadaWe have seen how the commercial banking system, when presented with a new deposit, can create a multiple expansion of bank deposits. This shows how the reserves of the banking system are systematically related to the money supply. In Chapter 28, we will see the details of how the Bank of Canada conducts its monetary policy and how its actions influence the total amount of reserves in the banking system. Copyright © 2017 Pearson Canada Inc.
Review Consider a new deposit of $ to the Canadian banking system. Assuming that all Canadian banks have a target reserve ratio of 2 percent, and that there is no cash drain, the banking system as a whole could create ________ as a result of this single new deposit. A) $ of new deposits B) $ of new deposits C) $ of new deposits D) $ of additional loans E) $ of additional loans © 2014 Pearson Education Canada Inc.
Review Bank North's Balance Sheet Assets Liabilities Reserves $300 Deposits $2000 Loans $2200 Capital $500 $2500 $2500 Refer to Table Assume that Bank North is operating with no excess reserves. What is their actual reserve ratio? A) 12% B) 15% C) 13.67% D) 25% E) 20% © 2014 Pearson Education Canada Inc.
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