Money, Banking and the
Financial Sector
Chapter 13
© 2003 McGraw-Hill Ryerson Limited.
13 - 2
Laugher Curve
A central banker walks into a pizzeria to
order a pizza.
When the pizza is done, he goes up to
the counter to get it.
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13 - 3
Laugher Curve
The clerk asks him: “Should I cut it into
six pieces or eight pieces?”
The central banker replies: “I’m feeling
rather hungry right now.
You’d better cut it into eight pieces.”
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13 - 4
Introduction
Real goods and services are exchanged
in the real sector of the economy.
 For every real transaction, there is a
financial transaction that mirrors it.

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13 - 5
Introduction

The financial sector is central to almost
all macroeconomic debates because
behind every real transaction, there is a
financial transaction that mirrors it.
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13 - 6
Introduction

All trade in the goods market involves
both the real sector and the financial
sector.
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13 - 7
Why Is the Financial Sector
So Important to Macro?

The financial sector is important to
macroeconomics because of its role in
channeling savings back into the
circular flow.
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13 - 8
Why Is the Financial Sector
So Important to Macro?

Savings are returned to the circular flow
in the form of consumer loans, business
loans, and loans to government.
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13 - 9
Why Is the Financial Sector
So Important to Macro?

Savings are channeled into the financial
sector when individuals buy financial
assets such as stocks or bonds and
back into the spending stream as
investment.
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13 - 10
Why Is the Financial Sector
So Important to Macro?
For every financial asset there is a
corresponding financial liability.
 Financial assets such as stocks and
bonds, are obligations or financial
liabilities of the issuer.

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13 - 11
The Financial Sector as a
Conduit for Savings, Fig. 13-1, p 307
Pension funds
CDs
Savings
deposits
Chequing
deposits
Stocks
Bonds
Government
Securities
Life insurance
Outflow
from
spending
stream
Inflow
from
spending
stream
Gov’t
Households
Corporations
Gov’t
Saving
Loans
Financial sector
Households
Corporations
Large business
loans
Small business
loans
Venture capital
loans
Construction
loans
Investment
loans
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13 - 12
The Role of Interest Rates in
the Financial Sector

While price is the mechanism that
balances supply and demand in the real
sector, interest rates do the same in the
financial sector.
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13 - 13
The Role of Interest Rates in
the Financial Sector
The interest rate is the price paid for
use of a financial asset.
 Bonds are promises to pay a certain
amount plus interest in the future.

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13 - 14
The Role of Interest Rates in
the Financial Sector

When financial assets such as bond
make fixed interest payments, the price
of the financial asset is determined by
the market interest rate.
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13 - 15
The Role of Interest Rates in
the Financial Sector

When interest rates rise, the value of
the flow of payments from fixed-interestrate bonds goes down because more
can be earned on new bonds that pay
the new, higher interest.
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The Role of Interest Rates in
the Financial Sector
As the market interest rates go up, price
of the bond goes down.
 As the market interest rates go down,
the price of the bond goes up.

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13 - 17
Savings That Escape the
Circular Flow

Some economists believe that the
interest rate does not balance the
demand and supply of savings, causing
macroeconomic problems.
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Savings That Escape the
Circular Flow

In order to make sense of the problem,
macroeconomics divides the flows into
two types of financial assets.
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13 - 19
Savings That Escape the
Circular Flow

In order to make sense of the problem,
macroeconomics divides the flows into
two types of financial assets.
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13 - 20
Savings That Escape the
Circular Flow
The first type include bonds and loans
which work their way into the system.
 The second type, money held by
individuals, is not necessarily assumed
to work its way back into the flow.

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13 - 21
The Definition and Functions
of Money

Money is a highly liquid financial asset.
 To
be liquid means to be easily changeable
into another asset or good.
 Social customs and standard practices are
central to the liquidity of money.
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13 - 22
The Definition and Functions
of Money
Money is generally accepted in
exchange for other goods.
 Money is used as a reference in valuing
other goods.
 Money can be stored as wealth.

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13 - 23
The Canadian Central Bank:
Bank of Canada

Bank of Canada – The Canadian
central bank whose liabilities (bank
notes) serve as cash in Canada.
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13 - 24
Bank of Canada

A bank is a financial institution whose
primary function is holding money for,
and lending money to, individuals and
firms.

Individuals’ deposits in savings and
chequing accounts serve the same
function as does currency and are also
considered money.
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13 - 25
Functions of Money
Money is a medium of exchange.
 Money is a unit of account.
 Money is a store of wealth.

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Money As a Medium of
Exchange
Without money, we would have to
barter—a direct exchange of goods and
services.
 Money facilitates exchange by reducing
the cost of trading.

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Money As a Medium of
Exchange
Money does not have to have any
inherent value to function as a medium
of exchange.
 All that is necessary is that everyone
believes that other people will exchange
it for their goods.

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13 - 28
Money As a Medium of
Exchange

The Bank of Canada’s job is to not
issue too much or too little money.

If there is too much money, compared to
the goods and services at existing
prices, the goods and services will sell
out, or the prices will rise.
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13 - 29
Money As a Medium of
Exchange

If there is too little money, compared to
the goods and services at existing
prices, there will be a shortage of
money and people will have to resort to
barter, or prices will fall.
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13 - 30
Money As a Unit of Account
Money prices are actually relative
prices.
 A single unit of account saves our
limited memories and helps us make
reasonable decisions based on relative
costs.

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Money As a Unit of Account
Money is a useful unit of account only
as long as its value relative to other
prices does not change too quickly.
 In a hyperinflation, all prices rise so
much that our frame of reference is lost
and money loses its usefulness as a
unit of account.

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13 - 32
Money as a Store of Wealth
Money is a financial asset.
 It is simply a government bond that
pays no interest.

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Money as a Store of Wealth

As long as money is serving as a
medium of exchange, it automatically
also serves as a store of wealth.
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13 - 34
Money as a Store of Wealth
Money’s usefulness as a store of wealth
also depends upon how well it
maintains its value.
 Hyperinflations destroy money’s
usefulness as a store of value.

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13 - 35
Money as a Store of Wealth

Our ability to spend money for goods
makes it worthwhile to hold money even
though it does not pay interest.
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13 - 36
Alternative Measures of
Money
Since it is difficult to define money
unambiguously, economists have
defined different measures of money.
 They are called M1, M2 and M3, M1+,
M2+ and M2++.

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Alternative Measures of
Money: M1
M1 consists of currency in circulation
and chequing account balances at
chartered banks.
 Chequing account deposits are included
in all definitions of money.

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13 - 38
Alternative Measures of
Money: M2
M2 is made up of M1 plus personal
savings deposits, and non personal
notice deposits (that can be withdrawn
only after prior notice) held at chartered
banks.
 Time deposits are also called
certificates of deposit (CDs), or term
deposits.

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13 - 39
Alternative Measures of
Money: M2

The money in savings accounts is
counted as money because it is readily
available.
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13 - 40
Alternative Measures of
Money: M2

All M2 components are highly liquid and
play an important role in providing
reserves and lending capacity for
chartered banks.
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13 - 41
Alternative Measures of
Money: M2

The M2 definition is important because
economic research has shown that the
M2 definition often most closely
correlates with the price level and
economic activity.
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13 - 42
Beyond M2: “The Pluses”
Numerous financial assets also have
some attributes of money. That is why
they are included in some measures of
money.
 There are measures for M3, M1+, M2+
and beyond.

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13 - 43
Beyond M2: “The Pluses”
The broadest measure is M2++.
 It includes almost all assets that can be
turned into cash on short notice.
 Broader concepts of asset liquidity have
gained greater appeal than the
measures of money, because money
measures have been rapidly changing.

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13 - 44
Beyond M2: “The Pluses”
M1, M2 and M3 measures only include
deposits held at chartered banks.
 Measures containing a “+” also include
deposits at other financial institutions
(near banks).

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13 - 45
Components of M2 and M1,
Fig . 13-2, p 313
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13 - 46
Measures of Money in
Canada: M1, M2 and M2+, Fig.
13-3, p 314
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13 - 47
Distinguishing Between
Money and Credit
Credit card balances cannot be money
since they are assets of a bank.
 In a sense, they are the opposite of
money.

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13 - 48
Distinguishing Between
Money and Credit
Credit cards are prearranged loans.
 Credit cards affect the amount of money
people hold.
 Generally, credit card holders carry less
cash.

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13 - 49
Banks and the Creation of
Money

Banks are both borrowers and lenders.
 Banks
take in deposits and use the money
they borrow to make loans to others.
 Banks make a profit by charging a higher
interest on the money they lend out than
they pay for the money they borrow.
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13 - 50
Banks and the Creation of
Money

Banks can be analyzed from the
perspective of asset management and
liability management.
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13 - 51
Banks and the Creation of
Money
Asset management is how a bank
handles its loans and other assets.
 Liability management how a bank
attracts deposits and how it pays for
them.

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13 - 52
How Banks Create Money
Banks create money because a bank’s
liabilities are defined as money.
 When a bank incurs liabilities it creates
money.

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13 - 53
How Banks Create Money

When a bank places the proceeds of a
loan it makes to you in your chequing
account, it is creating money.
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13 - 54
The First Step in the Creation
of Money
The Bank of Canada creates money by
simply printing currency and exchanging
it for bonds.
 Currency is a financial asset to the
bearer and a liability to the Bank of
Canada.

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13 - 55
The Second Step in the
Creation of Money
The bearer deposits the currency in a
chequing account at the bank.
 The bank holds your money and keeps
track of it until you write a cheque.

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13 - 56
Banking and Goldsmiths
In the past, gold was used as payment
for goods and services.
 But gold is heavy and the likelihood of
being robbed was great.

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13 - 57
From Gold to Gold Receipts
It was safer to leave gold with a
goldsmith who gave you a receipt.
 The receipt could be exchanged for gold
whenever you needed gold.

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13 - 58
From Gold to Gold Receipts
People soon began using the receipts
as money since they knew the receipts
were backed 100 percent by gold.
 At this point, there were two forms of
money – gold and gold receipts.

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13 - 59
The Third Step in the
Creation of Money
Little gold was redeemed, so the
goldsmith began making loans by
issuing more receipts than he had gold.
 He charged interest on the newly
created gold receipts.

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13 - 60
The Third Step in the
Creation of Money

When the goldsmith began making
loans by issuing more receipts than he
had in gold, he created money.
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The Third Step in the
Creation of Money

The gold receipts were backed partly by
gold and partly by people’s trust that the
goldsmith would pay off in gold on
demand.
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13 - 62
The Third Step in the
Creation of Money
The goldsmith soon realized that he
could make more money in interest than
he could earn in goldsmithing.
 The goldsmith had become a banker.

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13 - 63
Banking Is Profitable

As the goldsmiths became wealthy,
others started competing in offering to
hold gold for free, or even offering to
pay for the privilege of holding the
public’s gold.
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13 - 64
Banking Is Profitable

That is why most banks today are
willing to hold the public’s money at no
charge – they can lend it out and in the
process, make profits.
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13 - 65
The Money Multiplier
Banks lend a portion of their deposits
keeping the balance as reserves.
 Reserves are cash and deposits a bank
keeps on hand, or at the central bank,
enough to manage the normal cash
inflows and outflows.

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13 - 66
The Money Multiplier

The desired reserve ratio is the ratio of
reserves to total deposits.
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The Money Multiplier
Banks used to be required by the Bank
of Canada to hold a percentage of
deposits - the required reserve ratio.
 If banks chose to hold an additional
amount, this was called the excess
reserve ratio.

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13 - 68
The Money Multiplier

Banks “hold” currency for people and in
return allow them to write checks for the
amount they have on deposit at the
bank.
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13 - 69
Determining How Many
Demand Deposits Will Be
Created

To determine the total amount of
deposits that will eventually be created,
the original amount that is deposited is
multiplied by 1/r, where r is the reserve
ratio.
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13 - 70
Determining How Many
Demand Deposits Will Be
Created

For an original deposit of $100 and a
reserve ratio of 10 percent, the formula
would be:
1/r = 1/0.10 = 10
10 X $100 = $1,000
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13 - 71
Determining How Many
Demand Deposits Will Be
Created

This means that $900 of new money
was created ($1,000 -$100).
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13 - 72
Calculating the Money
Multiplier

The ratio 1/r is called the simple money
multiplier.
 The
simple money multiplier is the
measure of the amount of money
ultimately created per dollar deposited in
the banking system, when people hold no
currency.
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13 - 73
Calculating the Money
Multiplier

The higher the reserve ratio, the smaller
the money multiplier, and the less
money will be created.
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13 - 74
An Example of the Creation
of Money
The first 10 rounds of the money
creation process is illustrated in the
following table.
 Assume a deposit of $10,000 and a
desired reserve ratio of 20 percent.

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13 - 75
An Example of the Creation
of Money, Table 13-1, p 319
Bank Gets
Initial deposit
Second stage
Third stage
Fourth stage
Fifth stage
Sixth stage
Seventh stage
All other stages
TOTAL
10,000
8,000
6,400
5,120
4,096
3,277
2,621
10,486
50,000
Bank Keeps
(Reserve Ratio: 20%)
2,000
1,600
1,280
1,024
819
656
524
2,097
10,000
Bank Loans (80%) =
Person Borrows
8,000
6,400
5,120
4,096
3,277
2,621
2,097
8,389
40,000
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13 - 76
An Example of the Creation
of Money

If banks keep excess reserves for safety
reasons, the money multiplier
decreases.
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13 - 77
Calculating the Approximate
Real-World Money
Multiplier

The approximate real-world money
multiplier in the economy is:
1/(r +c)
r = the percentage of deposits banks desire to hold in
reserve
c = the ratio of money people hold in cash to the
money they hold as deposits
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13 - 78
Calculating the Approximate
Real-World Money
Multiplier

Assume banks keep 10 percent in
reserve and the ratio of individuals’ cash
holdings to their deposits is 25 percent.
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13 - 79
Calculating the Approximate
Real-World Money
Multiplier

The approximate real-world money
multiplier is:
1/(0.1 +0.25) = 1/0.35 = 2.9
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13 - 80
Faith as the Backing of Our
Money Supply
Promises to pay underlie any financial
system.
 All that backs the modern money supply
are promises by borrowers to repay
their loans and government guarantees
that banks’ liabilities to depositors will
be met.

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13 - 81
Regulation of Banks and the
Financial Sector

The banking system’s ability to create
money presents potential problems.
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13 - 82
Financial Panics
The financial history of the world is filled
with stories of financial upheavals and
monetary problems.
 In the 1800s, banks were allowed to
issue their own notes, which often
became worthless.

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Anatomy of a Financial Panic
Financial systems are based on trust
that expectations will be fulfilled.
 Banks borrow short and lend long,
which means that if people lose faith in
banks, the banks cannot keep their
promises.

© 2003 McGraw-Hill Ryerson Limited.
13 - 84
Government Policy to
Prevent Panic
To prevent panics, various levels of
government guarantee the obligations
of many financial institutions.
 The Canada Deposit Insurance
Corporation (CDIC) was created in 1967
to guarantee limited amounts of
deposits at chartered banks and trust
and mortgage loan companies.

© 2003 McGraw-Hill Ryerson Limited.
13 - 85
Government Policy to
Prevent Panic

Financial institutions pay a small
premium for each dollar of deposit to
the government-organized insurance
company.

That company puts the premium into a
fund used to bail out banks
experiencing a run on deposits.
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Government Policy to
Prevent Panic

These guarantees have two effects:
 They
prevent the unwarranted fear that
causes financial crises.
 They
prevent warranted fears.
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13 - 87
The Benefits and Problems of
Guarantees

The fact that deposits are guaranteed
does not serve to inspire banks to make
certain deposits are covered by loans in
the long run.
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13 - 88
Costly Failures of the 1980s
and 1990s

Since its inception, the CDIC has been
called on to provide assistance to
depositors in more than 20 failed
financial institutions.

In the late 70s and early 80s, a number
of new institutions in Alberta and British
Columbia faced difficult times when oil
prices fell and economy went into
recession.
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Costly Failures of the 1980s
and 1990s
In the 1990s the CDIC settled the
claims of over a million depositors, most
due to the collapse of Central Guaranty
Trust Company.
 This put the CDIC in a difficult financial
position, because the rates they had
been charging for insurance were not
enough to cover the losses.

© 2003 McGraw-Hill Ryerson Limited.
Money, Banking and the
Financial Sector
End of Chapter 13