PowerPoint Presentation by
Mehdi Arzandeh, University of Manitoba
Money, Banking, and
Money Creation
14
LEARNING OBJECTIVES
LO14.1
LO14.2
LO14.3
LO14.4
LO14.5
LO14.6
LO14.7
LO14.8
LO14.9
LO14.10
Identify and explain the functions of money.
List and describe the components of the supply of money in Canada.
Describe what backs Canada’s money supply, making us willing to accept it as payment.
Discuss the structure of the Canadian financial system.
Identify and explain the main factors that contributed to the U.S. financial crisis of 2007–2008.
Discuss why the Canadian banking system is called a fractional reserve system.
Explain the basics of a bank’s balance sheet and the distinction between a bank’s actual
reserves and its desired reserves.
Describe how a chartered bank can create money.
Describe the multiple-deposit expansion of the entire chartered banking system.
Define the monetary multiplier, explain how to calculate it, and demonstrate its relevance.
© 2016 McGraw‐Hill Education Limited
14-2
14.1 The Functions of Money
“Money is what money does”
• Medium of exchange
• Measure of value
• Store of value
Liquidity: the ease with which an asset can be converted to
cash with little or no loss of purchasing power.
LO1
© 2016 McGraw‐Hill Education Limited
14-3
14.2
The Components of the
Money Supply
• Money Definition M1
• Currency: Coins + Paper Money
• token money
• Bank of Canada notes
• Demand Deposits
• about 3/4 of M1
• Institutions That Offer Demand Deposits
• chartered banks are the primary depository institutions
• Two Qualifications:
• currency held by the Bank of Canada and chartered banks is excluded from
M1 and other measures of the money supply
• also excluded from the money supply are any deposits of the federal
government or the Bank of Canada that are held by chartered banks
LO2
© 2016 McGraw‐Hill Education Limited
14-4
14.2
The Components of the
Money Supply
• Money Definition M2
• M1 + Near-monies
• Near monies are highly liquid financial assets that do not directly function
as a medium of exchange but can be readily converted into currency
• e.g. currency or funds in nonchequable savings accounts
• Term deposits become available to a depositor only at maturity
LO2
© 2016 McGraw‐Hill Education Limited
14-5
FIGURE 14-1
LO2
Components of Money Supply M1, M2, M2+, and
M2++ in Canada
© 2016 McGraw‐Hill Education Limited
14-6
14.2
The Components of the
Money Supply
• Money Definition M2+ and M2++
• M2+
• deposits at trust and mortgage loan companies
• deposits at caisses populaires, credit unions and other non-bank deposittaking institutions
• money market mutual funds
• M2++
• M2++ is M2 plus Canadian saving bonds and non-money market mutual
funds
LO2
© 2016 McGraw‐Hill Education Limited
14-7
FIGURE 14-1
LO2
Components of Money Supply M1, M2, M2+, and
M2++ in Canada
© 2016 McGraw‐Hill Education Limited
14-8
TABLE 14-1
Money in Canada, December 2014
Billions of
dollars
Money
Currency held outside banks
$ 68
+ Demand deposits at chartered banks held by individuals and businesses
= M1
+ Personal savings deposits and nonpersonal notice deposits at chartered
banks
= M2
+ Deposits at trust and mortgage companies, credit unions, caisses
populaires, and government savings institutions
+ Money market mutual funds and life insurance annuities
= M2+
+ Canada Saving Bonds and other retail instruments
+ Non–money market mutual funds
= M2++
LO2
© 2016 McGraw‐Hill Education Limited
684
$ 752
545
$ 1297
347
23
$1667
7
863
$2,537
14-9
14.3
What Backs the Money
Supply
• Money as Debt
• Value of Money
• Acceptability
• Legal Tender
• Relative Scarcity
LO3
© 2016 McGraw‐Hill Education Limited
14-10
14.3
What Backs the Money
Supply
• Money and Prices
• THE PURCHASING POWER OF THE DOLLAR
•
•
•
•
D = 1/P
If the price level is 1.0, then the value of the dollar is 1
If the price level rises to, 1.20, D falls to 0.833
A 20% increase in the price level reduces the value of the dollar by
16.67%
• INFLATION AND ACCEPTABILITY
• STABILIZING THE PURCHASING POWER OF MONEY
LO3
© 2016 McGraw‐Hill Education Limited
14-11
14.4
The Canadian Financial
System
• Canada’s Chartered Banks
• A multi-branched, privately owned, chartered financial
intermediary that has received a charter by Act of
Parliament
• Fractional reserve banking system
• A banking system with a reserve ratio that is less than 100 percent of the
deposit liabilities of a chartered bank
• Making Loans
• Prime rate
LO4
© 2016 McGraw‐Hill Education Limited
14-12
TABLE 14-2
The Balance Sheet of Canadian Chartered
Banks, December 2014 (billions of dollars)
Assets
Liabilities
Reserves (currency and chartered
banks’ deposits with Bank of Canada)
0
Demand deposits
Loans (determined in
Canadian dollars)
879
Savings deposits
Canadian securities
287
Term deposits
Mortgages
Other assets
Total
994
166
$2326
Foreign-currency liabilities
232
268
312
61
Government of
Canada deposit
1
Other liabilities
1452
Total
$2326
Source: Bank of Canada, 2012.
LO4
© 2016 McGraw‐Hill Education Limited
14-13
14.1 GLOBAL PERSPECTIVE
The World’s Largest Commercial Banks
LO4
© 2016 McGraw‐Hill Education Limited
14-14
14.4
The Canadian Financial
System
• Other Financial Intermediaries
• Trust companies, loan companies, credit unions, and
caisses populaires
• Insurance companies
Two basic functions
• They hold the money deposits of businesses and
households
• They make loans to the public in an effort to make profits.
LO4
© 2016 McGraw‐Hill Education Limited
14-15
14.4
The Canadian Financial
System
• Cheque Clearing
• A cheque is a written order that the drawer uses in making a
purchase or paying a debt
• A cheque is “cleared” when one or more banks transfer part of the
drawer’s chequing account to the chequing account of the recipient
• The Canadian Payments Association (CPA) was set up in 1982 for
interbank cheque clearing and electronic payments
LO4
© 2016 McGraw‐Hill Education Limited
14-16
14.5
The Importance of a Properly Functioning
Financial System: The U.S. Financial Crisis of
2007–2008
• The U.S. Mortgage Default Crisis
• Subprime mortgage loans
• High-interest-rate loans to home buyers with higher-than-average
credit risk
• Was promoted by government programs that encouraged home
ownership
• Mortgage-backed securities
• Bonds backed by mortgage payments
LO5
© 2016 McGraw‐Hill Education Limited
14-17
14.5
The Importance of a Properly Functioning
Financial System: The U.S. Financial Crisis of
2007–2008
• Securitization
• The process of slicing up and bundling groups of loans into new
securities
• As loans defaulted, the system collapsed
• “Underwater” homeowners abandoned homes and mortgages
• Shadow banking system
• Moral hazard
• The tendency for financial investors and financial services firms to take on
greater risks because they are insured against possible losses.
LO5
© 2016 McGraw‐Hill Education Limited
14-18
14.6
Chartered Banks and the
Creation of Money
• The creation of money is done with the help of Canada’s
chartered banks
• The Fractional Reserve System
• A system in which only a portion of demand deposits and
cash reserves is held in chartered bank vaults
• By issuing loans, depositary institutions create demand
deposits
LO6
© 2016 McGraw‐Hill Education Limited
14-19
14.6
Chartered Banks and the
Creation of Money
• Illustrating the Idea: The Goldsmiths
• Goldsmiths accepted gold deposits and issued paper receipts
• Paper receipts were used as a medium of exchange
• 100% reserve system
LO6
© 2016 McGraw‐Hill Education Limited
14-20
14.6
Chartered Banks and the
Creation of Money
• Significant Characteristics of Fractional Reserve Banking
• Money creation and reserves
• Bank panics and regulation
LO6
© 2016 McGraw‐Hill Education Limited
14-21
14.7 A Single Chartered Bank
• Balance sheet
• Assets = Liabilities + Net Worth
• Both sides balance
• Formation of a Chartered Bank
1.
2.
3.
4.
5.
6.
LO7
Creating a Bank
Acquiring Property and Equipment
Accepting deposits
Clearing a Cheque Drawn Against the Bank
Granting a Loan
Buying Government Securities
© 2016 McGraw‐Hill Education Limited
14-22
14.7 A Single Chartered Bank
Transaction #1
Vault cash: cash held by the bank
Creating a Bank
Balance Sheet 1: Bank of Vancouver
Assets
Cash
LO7
Liabilities and Net Worth
$250,000
Capital Stock
© 2016 McGraw‐Hill Education Limited
$250,000
14-23
14.7 A Single Chartered Bank
Transaction #2
Acquiring property and equipment
Acquiring Property and Equipment
Balance Sheet 2: Bank of Vancouver
Assets
Cash
Property
LO7
Liabilities and Net Worth
$10,000 Capital Stock
240,000
© 2016 McGraw‐Hill Education Limited
$250,000
14-24
14.7 A Single Chartered Bank
•
Transaction #3
Chartered bank functions
Accepting deposits of $100,000
Accepting Deposits
Balance Sheet 3: Bank of Vancouver
Assets
Cash
Property
LO7
Liabilities and Net Worth
$110,000
240,000
Demand deposits
$100,000
Capital Stock
250,000
© 2016 McGraw‐Hill Education Limited
14-25
14.7 A Single Chartered Bank
Depositing reserves in the Bank of Canada
•
•
Desired reserves
Desired reserve ratio
Desired reserve
=
ratio
LO7
Chartered bank’s
Desired reserves
Chartered bank’s
demand-deposit liabilities
© 2016 McGraw‐Hill Education Limited
14-26
14.7 A Single Chartered Bank
• Excess reserves
• Actual reserves - Desired reserves
• Desired reserves
• Demand deposits x desired reserve ratio
• Example:
• Demand deposits $100,000, actual reserves 110,000
• Reserve ratio 20%
• Excess reserves = $110,000 – ($100,000 x 20%)
= 90,000
LO7
© 2016 McGraw‐Hill Education Limited
14-27
14.7 A Single Chartered Bank
•
Transaction #4
Clearing a cheque
$50,000 cheque reduces reserves and demand deposits
Clearing a Cheque
Balance Sheet 4: Bank of Vancouver
Assets
LO7
Liabilities and Net Worth
Cash Reserves
$60,000
Demand Deposits
$50,000
Property
240,000
Capital Stock
250,000
© 2016 McGraw‐Hill Education Limited
14-28
14.8
Money-Creating Transactions of a
Chartered Bank
Transaction #5a
Granting a loan
• $50,000 loan deposited to chequing
When a Loan is Negotiated
Balance Sheet 5a: Bank of Vancouver
Assets
LO8
Liabilities and Net Worth
Cash Reserves
$60,000
Loans
Property
50,000 Demand Deposits
240,000 Capital Stock
© 2016 McGraw‐Hill Education Limited
$100,000
250,000
14-29
14.8
•
Money-Creating Transactions of a
Chartered Bank
Transaction #5b
Using the loan
$50,000 loan cashed
After a Cheque is Drawn on the Loan
Balance Sheet 5b: Bank of Vancouver
Assets
Liabilities and Net Worth
Cash Reserves
$10,000
Loans
Property
50,000 Demand Deposits
240,000 Capital Stock
$50,000
250,000
A single bank can only lend an amount
equal to its preloan excess reserves
LO8
© 2016 McGraw‐Hill Education Limited
14-30
14.8
Money-Creating Transactions of a
Chartered Bank
Transaction #6
Bank buys government securities from a dealer
•
Deposits payment into chequing
Buying Government Securities
Balance Sheet 6: Bank of Vancouver
Assets
LO8
Liabilities and Net Worth
Cash Reserves
$60,000
Securities
Property
50,000 Demand Deposits
240,000 Capital Stock
© 2016 McGraw‐Hill Education Limited
$100,000
250,000
14-31
14.8
Money-Creating Transactions of a
Chartered Bank
• Government Securities
• Bond purchases from the public by the chartered banks
increases the money supply
• Bond sales to the public decreases the money supply
LO8
© 2016 McGraw‐Hill Education Limited
14-32
14.8
Money-Creating Transactions of a
Chartered Bank
• Profits, Liquidity, and the Overnight Lending Rate
• Bankers have two conflicting goals:
1. Profit
2. Liquidity
• Overnight loans rate paid on overnight loans to cover
temporary shortages of reserves
LO8
© 2016 McGraw‐Hill Education Limited
14-33
14.9
The Banking System:
Multiple-Deposit Expansion
• A single bank can lend one dollar for each dollar of excess
reserves
• The banking system can lend (create money) by a multiple of
its excess reserves
LO9
© 2016 McGraw‐Hill Education Limited
14-34
14.9
The Banking System:
Multiple-Deposit Expansion
• Multiple-deposit expansion
• Assumptions:
• 20% desired reserves ratio
• All banks “loaned up”
• Banks lend all of their excess reserves
• A $100 bill is found and deposited
• Multiple deposits can be created
LO9
© 2016 McGraw‐Hill Education Limited
14-35
14.9
The Banking System:
Multiple-Deposit Expansion
Multiple-Deposit Expansion Process
Balance Sheet: Chartered Bank A
Assets
Cash
Reserves
Loans
LO9
Liabilities and net worth
$+100 (a1)
Demand deposits
$+100 (a1)
– 80 (a3)
+ 80 (a2)
+ 80 (a2)
– 80 (a3)
© 2016 McGraw‐Hill Education Limited
14-36
14.9
The Banking System:
Multiple-Deposit Expansion
Multiple-Deposit Expansion Process
Balance Sheet: Chartered Bank B
Assets
Cash
Reserves
Loans
LO9
Liabilities and net worth
$+80 (b1)
Demand deposits
$+80 (b1)
–64 (b3)
+64 (b2)
+64 (b2)
–64 (b3)
© 2016 McGraw‐Hill Education Limited
14-37
14.9
The Banking System:
Multiple-Deposit Expansion
Multiple-Deposit Expansion Process
Balance Sheet: Chartered Bank C
Assets
Cash
Reserves
Loans
LO9
Liabilities and net worth
$+64.00 (c1)
Demand
deposits
$+64.00 (c1)
–51.20 (c3)
+51.20 (c2)
+51.20 (c2)
–51.20 (c3)
© 2016 McGraw‐Hill Education Limited
14-38
TABLE 14-3
Bank
Bank A
Bank B
Bank C
Bank D
Bank E
Bank F
Bank G
Bank H
Bank I
Bank J
Other Banks
Expansion of the Money Supply by the
Chartered Banking System
(1)
Acquired
Reserves
and Deposits
$100.00
80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
53.68
(2)
Desired
Reserves
(Desired Reserve
Ratio = 0.2)
(3)
Excess
Reserves
(1) - (2)
$20.00
16.00
12.80
10.24
8.19
6.55
5.24
4.20
3.36
2.68
10.74
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
42.94
Total amount of money created (sum of the
amounts in column 4)
LO9
© 2016 McGraw‐Hill Education Limited
(4)
Amount Bank Can
Lend; New Money
Created = (3)
$80.00
64.00
51.20
40.96
32.77
26.21
20.97
16.78
13.42
10.74
42.94
$400.00
14-39
14.10 The Monetary Multiplier
• Definition
Monetary
multiplier
=
1
Desired reserve ratio
=
1
R
• Maximum demand-deposit creation =
excess cash reserves  monetary multiplier
•D=E×M
• Reversibility: the multiple destruction of money
LO10
© 2016 McGraw‐Hill Education Limited
14-40
FIGURE 14-2
LO10
The Outcome of the Money Expansion Process,
New Reserves
© 2016 McGraw‐Hill Education Limited
14-41
The LAST
WORD
Banking, Leverage, and Financial Instability
in the U.S. Compared to Canada
• Leverage boosts banking profits but makes the banking system less stable. Prior to
the recession of 2007-2009 the banking system in the U.S. may have been overleveraged. Time to reduce leverage?
• The use of borrowed money can magnify both profits and losses
• 95% of the money that a modern chartered bank invests comes from
borrowing
• About 25% by issuing bonds
• About 70% by taking in demand and saving deposits
• Banks in Canada were more conservative compared to the U.S. banks,
before the financial crisis of 2007-2009; also
• Banks were more closely regulated in Canada
• The U.S. government insured possible payment of banks’ liabilities
• A possible solution is to require banks to use less leverage
• The current regulatory system relies on bank supervisors
© 2016 McGraw‐Hill Education Limited
14-34
Chapter Summary
LO14.1
LO14.2
LO14.3
LO14.4
LO14.5
LO14.6
LO14.7
LO14.8
LO14.9
LO14.10
Identify and explain the functions of money.
List and describe the components of the supply of money in
Canada.
Describe what backs Canada’s money supply, making us willing to
accept it as payment.
Discuss the structure of the Canadian financial system.
Identify and explain the main factors that contributed to the U.S.
financial crisis of 2007–2008.
Discuss why the Canadian banking system is called a fractional
reserve system.
Explain the basics of a bank’s balance sheet and the distinction
between a bank’s actual reserves and its desired reserves.
Describe how a chartered bank can create money.
Describe the multiple-deposit expansion of the entire chartered
banking system.
Define the monetary multiplier, explain how to calculate it, and
demonstrate its relevance.
© 2016 McGraw‐Hill Education Limited
14-43