Download EDITragan_12ce_ch27

1 of 39
Chapter 27
Money and Banking
03/01/10
Copyright © 2008 Pearson Education Canada
2 of 39
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.
03/01/10
Copyright © 2008 Pearson Education Canada
3 of 39
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?
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
4 of 39
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
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
5 of 39
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
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
6 of 39
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
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
7 of 39
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?
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
8 of 39
The Origins of Money
Money is TECHNOLOGY
Money is TRUST
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)
03/01/10
Copyright © 2008 Pearson Education Canada
9 of 39
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)
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
10 of 39
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
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
11 of 39
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!
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
12 of 39
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
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
13 of 39
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.
MONEY IS A TECHNOLOGY
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
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
14 of 39
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).
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
15 of 39
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.
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
16 of 39
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)
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
17 of 39
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 2007-2008 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
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
18 of 39
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.
www.myeconlab.com
03/01/10
Copyright © 2008 Pearson Education Canada
19 of 39
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.
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
20 of 39
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.
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
21 of 39
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.
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
22 of 39
What to do with savings?
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
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
23 of 39
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
03/01/10
Copyright © 2008 Pearson Education Canada
24 of 39
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.
03/01/10
Copyright © 2008 Pearson Education Canada
25 of 39
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
03/01/10
Copyright © 2008 Pearson Education Canada
26 of 39
OPTIONAL
03/01/10
Copyright © 2008 Pearson Education Canada
27 of 39
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
03/01/10
Copyright © 2008 Pearson Education Canada
28 of 39
OPTIONAL
03/01/10
Copyright © 2008 Pearson Education Canada
29 of 39
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.
03/01/10
Copyright © 2008 Pearson Education Canada
30 of 39
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.
www.myeconlab.com
03/01/10
Copyright © 2008 Pearson Education Canada
31 of 39
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”
03/01/10
Copyright © 2008 Pearson Education Canada
32 of 39
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
03/01/10
Copyright © 2008 Pearson Education Canada
33 of 39
The Creation of Deposit Money
The bank initially
has a reserve
ratio of 20
percent.
Assets
Cash and
other reserves
Loans
200
900
1100
Liabilities
Deposits
Capital
1000
100
1100
OPTIONAL
Assets
Cash and
other reserves
Loans
03/01/10
300
900
1200
Liabilities
Deposits
Capital
1100
100
1200
Copyright © 2008 Pearson Education Canada
A new deposit of
$100 raises the
bank’s reserve
ratio to 27
percent.
34 of 39
The bank now has
$80 of excess
reserves which it
can lend.
Assets
Cash and
other reserves
Loans
220
980
1200
Liabilities
Deposits
Capital
1100
100
1200
The $80 in new loans results in a second round of new
deposits.
OPTIONAL
Assets
Cash and
other reserves
Loans
03/01/10
+16
+64
+80
Liabilities
Deposits
Capital
+80
+0
80
The second-round
bank receives $80
in new deposits
and expands its
loans by $64.
Copyright © 2008 Pearson Education Canada
35 of 39
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
03/01/10
Copyright © 2008 Pearson Education Canada
36 of 39
OPTIONAL
03/01/10
Copyright © 2008 Pearson Education Canada
37 of 39
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:
 Re serves
Deposits 
c v
03/01/10
Copyright © 2008 Pearson Education Canada
38 of 39
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
 Re serves
Deposits 
cv
Δ Deposits
03/01/10
= $1,000,000/(5%+5%)
= $1,000,000/(0.10)
= $10,000,000
Copyright © 2008 Pearson Education Canada
39 of 39
27.4 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.
03/01/10
MFC2007MFC2007,MFC2007,MFC2007MFC2007MFC2007
Copyright © 2008 Pearson Education Canada
40 of 39
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.
03/01/10
Copyright © 2008 Pearson Education Canada
41 of 39
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
03/01/10
Copyright © 2008 Pearson Education Canada
42 of 39
03/01/10
Copyright © 2008 Pearson Education Canada
43 of 39
Near Money and Money Substitutes
Near money:
- 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
03/01/10
Copyright © 2008 Pearson Education Canada
44 of 39
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.
03/01/10
Copyright © 2008 Pearson Education Canada
45 of 39
03/01/10
Copyright © 2008 Pearson Education Canada