Prof. Gustavo Indart
Department of Economics
University of Toronto
ECO 100Y
INTRODUCTION TO ECONOMICS
Lecture 15. MONEY, BANKING, AND PRICES
15.1
WHAT IS MONEY?
15.1.1 Classical and Modern Views
For the Classical school, there exists a clear dichotomy between the real sector and
the monetary sector of the economy.
For this school, the allocation of resources and the determination of real national
income depend exclusively on relative prices, and thus these are determined in the
real sector of the economy and not in the monetary sector.
In their view, an increase in the nominal supply of money leads to a proportional
increase in all prices and to no change in relative prices. Therefore, an increase in the
nominal supply of money will not affect the allocation of resources or the level of real
national income. For that reason, money is said to be neutral in the determination of
real national income (GDP).
The modern view of money, on the other hand, accepts the neutrality of money in
the long-run but not during the adjustment process.
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15.1.2 The Definition of Money
The definition of money depends on the function of money we are referring to. The most
common definition, however, considers money as a medium of exchange.
A medium of exchange is anything that is generally acceptable in exchange for goods
and services.
Without a medium of exchange, it would be necessary to exchange goods directly for
other goods − an exchange known as barter. Barter is the direct exchange of goods for
goods.
Barter can take place only when there is a double coincidence of wants. A double
coincidence of wants is a situation that occurs when person A wants to buy what
person B is selling and person B wants to buy what person A is selling.
15.1.3 The Functions of Money
Money has four functions. It serves as a: 1) medium of exchange; 2) unit of account; 3)
standard of deferred payment; and 4) store of value.
1) Medium of Exchange
Any commodity or asset that serves as a generally acceptable medium of exchange is
money. Money makes unnecessary the double coincidence of wants. People with
something to sell will always accept money in exchange for it, and people who want to
buy will always offer money in exchange.
2) Unit of Account
An agreed measure for stating the prices of goods and services is a unit of account. In
this way, the opportunity cost of a commodity can easily be stated in terms of any other
commodity.
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Without money as a unit of account, the price of a commodity would have to be stated in
terms of each and every commodity in the economy.
3) Standard of Deferred Payment
An agreed measure that enables contracts to be written for future receipts and
payments is called a standard of deferred payment. If you borrow money to finance
your college education, your future commitment will be agreed to in dollars and cents.
Money is used as the standard for a deferred payment.
4) Store of Value
Any commodity that can be held and exchanged later for some other commodity or
service is a store of value. Most physical objects are stores of value. Financial assets
(e.g., bonds, treasury bills, etc.) are also stores of value.
There are no stores of value that are completely safe and predictable. The value of any
physical object, paper security, and even of money fluctuates overtime.
The more stable and the more predictable the value of a commodity, the better can it
act as a store of value. Thus the higher and the more unpredictable the inflation rate,
the less useful is money as a store of value.
It is essential that money be a store of value. Otherwise, it would not be accepted as a
medium of exchange.
15.1.4 The Different Forms of Money
Money can take four different forms: 1) commodity money; 2) convertible paper money;
3) fiat money; and 4) private debt money.
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1) Commodity Money
Commodity money is a physical commodity valued in its own right and also used as a
medium of exchange.
Many commodities have served as commodity money at different times and places. The
most common commodity money has been coins made from metals such as gold,
silver, and copper.
The main advantage of commodity money is that the commodity is valued for its own
sake and can be used in ways other than as a medium of exchange. This fact provides
a guarantee of the value of the money.
The main advantages of precious metals as commodity money were that their quality
was easily verified, and that they were easily divisible into smaller units.
The main disadvantages of precious metals as commodity money were that it was also
easy to cheat on the value of the money through clipping and debasement.
Clipping is reducing the size of coins by an imperceptible amount. Debasement is
creating a coin with a lower-than-standard silver or gold content.
2) Convertible Paper Money
A paper claim to a commodity that circulates as a medium of exchange is called
convertible paper money.
That is, convertible paper money is a promise to pay on demand a certain amount of
gold. The first issuers of convertible paper money were goldsmiths, followed by banks.
In particular, bank notes (banks' promises to pay) remained an important part of the
money supply in Canada until 1950.
When a country's money is convertible into gold, the country is said to be on a gold
standard.
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Once the convertible paper money system was operating, it became apparent that it
was not necessary to keep an equal amount of commodity money to back the
convertible paper money in circulation.
As long as a sufficient deposit were kept, more convertible paper money was possible
to be created and lent for a profit. This type of money is called fractionally backed
paper money.
3) Fiat Money
Fiat money is an intrinsically (almost) worthless commodity that serves the function of
money. The term "fiat" means "by order of the authority".
Examples of fiat money are the bank notes and coins we use in Canada today.
People are willing to accept fiat money in exchange for the goods and services they sell
only because they know it will be honoured when they go to buy goods and services.
The replacement of commodity money by fiat money enables the commodities
themselves to be used productively.
4) Private Debt Money
Private debt money is a loan that the borrower promises to repay in currency on
demand. By transferring the entitlement to be repaid from one person to another, such a
loan can be used as money.
The most important example of private debt money is chequing deposits at chartered
banks and other financial institutions.
A chequing deposit is a loan by a depositor to a bank, the ownership being
transferable from one person to another by writing an instruction to the bank -a chequeasking the bank to alter its records. Chequing deposits may then be called deposit
money.
Note that chequing deposits are money, but cheques are not. When you pay with a
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cheque you don't increase the quantity of money in the economy. You just transfer the
amount written on the cheque from your account to the account of the person who
receives the cheque.
Credit cards are not money either. A credit card is only an ID card, as your driver's
licence, which allows you to purchase something with the promise of repaying later.
When you make a purchase, you sign a credit-card sales slip that creates a debt in your
name.
15.1.5 Money in Canada Today
There are three main economic measures of money in current use: M1, M2, and M3.
M1 = currency held outside banks + privately held demand deposits at chartered
banks and all other financial institutions
M2 = M1 + personal and non-personal notice deposits at chartered banks and all
other financial institutions
M3 = M2 + personal and non-personal fixed-term deposits at chartered banks
and all other financial institutions
In our analysis we are going to treat all forms of deposits as only one (D), and thus
money (M) will be
M = CUP + D,
where CUP is currency in circulation outside the banking system.
Note that the total currency in the economy (CU) is equal to the currency held by the
public (CUP) plus the currency held by the banks in their vaults (CUB):
CU = CUP + CUB.
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15.2
THE BANKING SYSTEM
15.2.1 The Bank of Canada
The Bank of Canada is Canada's central bank. A central bank is a public authority
charged with regulating and controlling a country's monetary and financial institutions
and markets.
The Bank of Canada is also responsible for the nation's monetary policy. Monetary
policy is the attempt to control inflation and the foreign exchange value of the Canadian
currency, and to moderate the business cycle by changing the quantity of money in
circulation and adjusting interest rates.
The Bank of Canada is relatively independent from the central government. Only when
there is a strong disagreement about monetary policy between the government and the
Bank does the governor of the Bank resign.
The main functions of the Bank of Canada are:
1) Banker to the Chartered Banks
The Bank of Canada accepts deposits from the chartered banks and will, on order,
transfer them to the account of another bank.
The deposits of the chartered banks with the Bank of Canada are an asset from the
point of view of the chartered banks, but a liability from the point of view of the Bank of
Canada.
2) Lender of Last Resort to Chartered Banks
The Bank of Canada finances settlement payments between banks when banks
reserves (i.e., deposits of the chartered banks at the Bank of Canada) are not sufficient.
3) Banker to the Government
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The government keeps its chequing deposits at the Bank of Canada. The government
also borrows from the Bank of Canada by selling government securities (bonds) to the
Bank.
4) Controller and Regulator of the Money Supply
The Bank of Canada controls the money supply, mainly through the purchase and sale
of government securities (bonds).
The balance sheet of the Bank of Canada is a statement that lists the Bank’s assets
and liabilities. Assets are things of value that the Bank owns. Liabilities are things that
the Bank owes to other institutions.
Bank of Canada’s assets are, for instance, the government securities (bonds) it owns,
loans to chartered banks, and foreign-currency reserves.
Bank of Canada’s liabilities are, for instance, the total currency in circulation outside and
inside the banking system, the deposits of the chartered banks, and the deposits of the
Government of Canada.
Note that what is an asset for the Bank of Canada is at the same time a liability to
someone else, and what is a liability to the Bank of Canada is at the same time an asset
to someone else.
15.2.2 Financial Intermediaries
A financial intermediary is a firm that takes deposits from households and firms and
makes loans to other households and firms.
There are three types of financial intermediaries whose deposits are components of the
nation's money:
1) chartered banks
2) trust and mortgage loan companies
3) local credit unions and caisses populaires.
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The differences between these three types of financial institutions have been reduced in
recent times, and thus we are going to talk about chartered banks when referring to the
banking system in general.
The balance sheet of a chartered bank is a statement that lists the banks' assets and
liabilities. Assets are things of value that the bank owns. Liabilities are things that the
bank owes to households and firms.
A chartered bank's assets are, for instance, its deposits with the Bank of Canada, the
government securities (bonds) it owns, the currency in its vault, the loans made to its
customers, etc.
A chartered bank's liabilities are, for instance, the deposits of its customers, the deposits
of the Government of Canada, etc.
Note that what is an asset for the chartered bank is at the same time a liability to
someone else, and what is a liability to the chartered bank is at the same time an asset
to someone else.
For instance, both the chartered bank's deposits with the Bank of Canada and the
currency it holds represent liabilities to the Bank of Canada. Similarly, the public's
deposits with the chartered bank represent an asset from the point of view of the public.
15.3
HOW BANKS CREATE MONEY
15.3.1 Reserves
Banks need to keep some cash in their vaults in order to meet depositors' day-to-day
requirements for cash. They also need to keep some deposits with the Bank of Canada
to settle accounts with other banks (transfers of deposits to other banks).
The sum of the cash held by the chartered banks in their vaults (CUB) and their deposits
with the Bank of Canada (DBC) constitute the chartered banks' reserves (RE):
RE = CUB + DBC.
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However, Banks don't need to have $100 in cash or on deposit at the Bank of Canada
for every $100 that people have deposited with them. As a matter of fact, banks today
have about $1 in cash or on deposit at the Bank of Canada for every $100 deposited in
it. Banks have learned from experience that these reserve levels are adequate for
ordinary business needs.
The fraction of a bank's total deposits that are held in reserves is called the reserve
ratio (v):
v = RE/D,
where D represents customers' deposits with the chartered banks.
All banks have a desired reserve ratio. The desired reserve ratio is the ratio of
reserves to deposits that banks regard as necessary in order to be able to conduct their
business.
Before 1994, the desired reserve ratio was determined partly by regulation and partly by
what the banks regarded as the minimum safety level for their reserve holdings.
Government regulation used to set the minimum required reserve ratio. Banks,
however, could choose to hold a reserve ratio above this minimum. This implied that the
required reserves may differ from the desired reserves.
At any point in time, banks may hold reserves at a level different from the desired level.
The difference between actual reserves and desired reserves is excess reserves or
insufficient reserves.
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15.3.2 The Creation of Money
Whenever banks have excess reserves, they are able to create money.
Remember that money is equal to currency outside the banking system (CUP) plus
deposits (D):
M = CUP + D.
Banks can't affect the component CUP of the money supply (it depends on the public's
preference between cash and deposits), but they can affect the component D of the
money supply.
Banks can create deposits (D) by making loans to their customers. Let's have a look at
an example.
Suppose that there is only one chartered bank with a desired reserve ratio of 20 percent
(v = 0.20). Suppose that a customer of this bank decides to reduce her holdings of
currency and deposits $100 in her account. The changes in the balance sheets of the
public and of the chartered bank are as follows:
Public
Assets
CUP
D
Chartered Bank
Liabilities
–100
+100
Assets
CUB
+100
Liabilities
D
+100
After this first step, the money supply (M) has not changed yet. Any change in the
money supply would be equal to:
∆M = ∆CUP + ∆D.
And since ∆CUP = –100 and ∆D = +100, then ∆M = 0.
Note that since deposits have increased by $100, the chartered bank should increase
its reserves by $20 in order to keep the desired reserve ratio of 20%.
However, the actual reserves of the chartered bank have increased by $100 since
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reserves (RE) are equal to:
RE = CUB + DBC.
That is, actual RE have increased by the increase in CUB.
Since the change in actual reserves ($100) is greater than the change in desired
reserves ($20), the chartered bank is now holding excess reserves of $80.
What the chartered bank will do now is to lend these excess reserves of $80 to some of
its customers, thus increasing these customers' deposits at the bank by $80. The
corresponding changes in the balance sheets are as follows:
Public
Assets
CUP
D
D
Chartered Bank
Liabilities
–100
+100
+80
L
Assets
+80 CUB
D
+100
+80
Liabilities
D
D
+100
+80
After this second step, the money supply has increased:
∆M = ∆CUP + ∆D
= –100 + (100 + 80)
= 80.
But this is not the end of the story. The chartered bank desired change in reserves is
20% of the change in deposits of $180, that is, $36. The actual change in reserves,
however, is still $100. Therefore, after the second step, the chartered bank reduced its
excess reserves but still holds $64 in excess reserves.
Once again, the chartered bank will lend out this excess reserves to some of its
customers, thus increasing D by $64. The accumulated changes in the balance sheets
are as follows:
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Public
Assets
CUP
D
D
D
–100
+100
+80
+64
Chartered Bank
Liabilities
L
L
Assets
+80 CUB
+64 L
L
+100
+80
+64
Liabilities
D
D
D
+100
+80
+64
After this third step, the money supply has increased by $144: ∆CUP = –100 and ∆D =
+244.
The chartered bank desired change in reserves is 20% of the change in deposits of
$244, that is, $48.80. The actual change in reserves, however, is still $100. Therefore,
after the third step, the chartered bank has reduced its excess reserves but still holds
$51.20 in excess reserves.
Once again, the chartered bank will lend out this excess reserves and the process will
continue. The process will come to an end when all excess reserves have been
eliminated. At this time, the banking system would have increased the money supply by
the initial change in reserves times the money multiplier (mm):
∆M = mm ∆RE.
15.3.3 The Simple Money Multiplier
The money multiplier (mm) is equal to the change in money supply divided by the
change in reserves:
∆M
mm =
∆RE
And assuming no cash drain from the banking system, then ∆M = ∆D and
mm = ∆D / ∆RE.
Now, if the desired reserve ratio (v) is fixed and there is no cash drain from the banking
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system, then v = ∆RE / ∆D, and
mm = ∆D / ∆RE = 1 / v.
In our example, v is 0.20 and thus the corresponding money multiplier is 5. Hence, at
the end of the multiplying process the money supply will have increased by 5 times the
initial change in reserves, that is, by $500. Therefore, the total change in the money
supply will be equal to the summation of this increase in deposits ($500) minus the
initial decrease in cash holdings ($100), or a total of $400.
Indeed, since mm = ∆D / ∆RE = 1 / v,
∆D = mm ∆RE = 5 ($100) = $500.
This analysis suggests that there must be an increase in reserves (RE) in order to have
an increase in the money supply (M).
15.4
THE BANK OF CANADA'S CONTROL OVER THE MONEY SUPPLY
We indicated that one of the main functions of the Bank of Canada was to control or
regulate the supply of money.
In order to achieve this goal, that is, in order to alter the supply of money, the Bank of
Canada must affect the reserves of the chartered banks.
The main instrument used by the Bank of Canada to affect the chartered banks'
reserves and thus control the money supply is open market operations.
An open market operation is a purchase or sale of Government of Canada securities
(treasury bills and bonds) by the Bank of Canada. When the Bank of Canada buys
Government Bonds from the public or the chartered banks, the supply of money
increases. When the Bank of Canada sells Government Bonds to the public or the
chartered banks, the supply of money decreases.
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15.4.1 An Open Market Purchase
Let’s assume that there is no cash drain in banking system (i.e., ∆CUP = 0) and that the
desired reserve ratio is fixed at 0.20 (and thus mm = 5). Let’s further assume that there
is only one chartered bank.
Suppose that the Bank of Canada buys $100 worth of Government Bonds from the
public. The changes in the balance sheets of the public, the chartered banks, and the
Bank of Canada are as follows:
Public
Assets
GB
D
–100
+100
Liabilities
Chartered Bank
Assets
DBC
+100
Bank of Canada
Liabilities
D
+100
Assets
GB
Liabilities
+100 DBC
+100
The public sells an asset in the form of Government Bonds, and the Bank of Canada
acquires an asset in the form of Government Bonds. Therefore, the item "Government
Bonds" in the assets column decreases by $100 in the public's balance sheet and
increases by the same amount in the Bank of Canada's balance sheet.
The Bank of Canada buys these bonds by writing a cheque which the public deposits at
the chartered bank. Therefore, the item "deposits" in the assets column of the public
increases by $100. These deposits represent a liability from the point of view of the
chartered bank, and thus the liabilities column of the bank increases by $100.
Now the chartered bank has the cheques written by the Bank of Canada and thus holds
a claim on the Bank. The chartered bank deposits these cheques at the Bank of
Canada, and thus its deposit increases by $100.
After the Bank of Canada's purchase of the bonds, the money supply increased by $100
(equal to the change in deposits).
Also, since the chartered bank’s deposits with the Bank of Canada are part of the
chartered bank’s reserves, the reserves increased by $100.
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Now, through the multiplying mechanism, the money supply will increase by the money
multiplier times the change in reserves:
∆M = mm ∆RE = 5 ($100) = $500.
Therefore, the final changes in the balance sheets (i.e., after the chartered bank
eliminates all excess reserves) would be as follows:
Public
Assets
GB
D
D
Chartered Bank
Liabilities
–100 L
+100
+400
Assets
+400 DBC
L
Liabilities
+100 D
+400 D
+100
+400
Bank of Canada
Assets
GB
Liabilities
+100 DBC
+100
We could have obtained the same result had the Bank of Canada bought the bonds
from the chartered banks instead that from the public. In this case, the changes in the
balance sheets would have been as follows:
Public
Assets
D
+500
Chartered Bank
Liabilities
L
Assets
+500 GB
DBC
L
Liabilities
–100 D
+100
+500
+500
Bank of Canada
Assets
GB
Liabilities
+100 DBC
+100
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15.4.2 An Open Market Sale
Suppose that the Bank of Canada sells $100 worth of Government Bonds to the public.
The changes in the balance sheets of the public, the chartered banks, and the Bank of
Canada are as follows:
Public
Assets
GB
D
Liabilities
+100
–100
Chartered Bank
Assets
DBC
–100
Bank of Canada
Liabilities
D
–100
Assets
GB
Liabilities
–100 DBC
–100
The public buys an asset in the form of Government Bonds, and the Bank of Canada
sells an asset in the form of Government Bonds. Therefore, the item "Bonds" in the
assets column increases by $100 in the public's balance sheet and decrease by this
amount in the Bank of Canada's balance sheet.
The public buys these bonds by writing cheques. Therefore, the item "deposits" in the
assets column of the public decreases by $100. These deposits represent a liability
from the point of view of the chartered bank, and thus the liabilities column of the bank
decreases by $100.
Now the Bank of Canada has the cheques written by the public and thus holds a claim
on the chartered bank. The chartered bank’s deposits with the Bank of Canada thus
decrease by $100.
After the Bank of Canada's sale of bonds, the money supply has decreased by $100
(equal to the change in deposits).
Also, since the chartered bank’s deposits with the Bank of Canada are part of the
chartered bank’s reserves, the reserves decreased by $100.
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Now, through the multiplying mechanism, the money supply will decrease by the money
multiplier times the change in reserves:
∆M = mm ∆RE = 5 (–$100) = –$500.
In order to decrease the public's deposits by $500 (i.e., by an additional $400), the
chartered bank will have to recall $400 in loans.
Therefore, the final changes in the balance sheets would be as follows:
Public
Assets
GB
D
D
Chartered Bank
Liabilities
+100 L
–100
–400
–400
Assets
DBC
L
–100
–400
Liabilities
D
D
–100
–400
Bank of Canada
Assets
GB
Liabilities
–100 DBC
–100
We could have obtained the same result had the Bank of Canada sold the bonds to the
chartered banks instead of to the public. The changes in the balance sheets would have
been as follows:
Public
Assets
D
–500
Chartered Bank
Liabilities
L
–500
Assets
GB
DBC
L
Liabilities
+100 D
–100
–500
–500
Bank of Canada
Assets
GB
Liabilities
–100 DBC
–100