Download Econ 204 Topic 7 - University of Alberta

Topic 7
Money and Banking
27.a Money
27.b Banking in Canada
27.c Money Creation
27.d Money Supply
28.a Compound Interest and PV
28.b Money Demand
28.c Money Equilibrium
29 Canadian Monetary Policy
27.a Money’s Role
Money fulfills three roles:
1) Medium of Exchange
 Money is accepted in return for goods and
services
 Without money, exchanges would be made
with trades and barter, which requires 2
agents wanting each other’s goods
 A dentist would have to find an Apple
employee that needs a filling
 Money makes the economy more efficient
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27.a Money’s Role
2) Store of Value
 Goods and services can be sold for money
today, and then that money can be traded for
goods and services in the future
 Inflation weakens money’s role as a store of
value
3) Unit of Account
 Money can be used for accounting (sales,
expenses, allocations, etc)
 Physical money doesn’t need to even exist for
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this purpose
27.a History of Money
1) Metallic Money
 Gold and other precious metals were rare and
divisible, and originally used as money
 Metals could be shaved down to cheat
 Coins could be re-minted less pure and
cause inflation
2) Paper Money
 Based on gold held by a private or central
bank
 Banks could “create” money by printing more
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notes than they had gold
27.a History of Money
3) Fiat Money
 After WWI and WWII, money was controlled
by central banks an no longer tradable for
gold
 Government establishes the money as legal
tender
4) Deposit Money
 Entries in bank accounts are money without
physical form
 These entries are transferred between bank
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accounts through transactions
27.a Money Now
 Deposit Money far exceeds physical coin and
paper (fiat) money
 Banks can still create money by issuing more
deposit money than they have reserves to pay
out
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27.b Bank of Canada
Bank of Canada – Canada’s CENTRAL BANK – A
bank that acts as banker to commercial banks
and the governments.
 Government owned, run by a Governor
 Sole money-issuing authority
 Works with the government, but is separate
from the government (free of politics)
 In THEORY, the Minister of Finance could
issue a directive to the bank, forcing the
bank to follow it or the Governor to resign
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 This has NEVER happened
27.b Bank of Canada
The Bank of Canada has 4 roles:
1) Banker to Commercial Banks
 Commercial banks have accounts and loans
with Bank of Canada
 Funds are moved between these accounts as
people make payments between banks
2) Banker to the Federal Government
 Federal Government has an account with the
Bank of Canada
 Bank of Canada buys government bonds when
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the government requires money
Table 27-1
Assets and Liabilities of the Bank of Canada
Role 1
Role 2
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Copyright © 2014 Pearson
Canada Inc.
Chapter 27, Slide
27.b Bank of Canada
3) Regulator of Money Supply
Bank of Canada can change its assets and
liabilities to affect the Money Supply (chapter 29)
4) Supporter of Financial Markets
Keeps financial institutions stable by:
Controlling the interest rate (chapter 29)
Making sure credit is available
Maintaining citizen confidence
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27.b Commercial Banks
Commercial banks (banks owned by the private
sector), as well as other financial institutions
(such as trust companies and credit unions) have
3 features:
1) Providers of Credit
 Banks act as a FINANCIAL INTERMEDIARY,
borrowing from individuals who have extra
money and lending to individuals who need
credit
 This allows businesses to operate day-to-day
and households to make big purchases 11
27.b Commercial Banks
2) Interbank Activities
Banks work together for “pool loans” and credit
cards
Banks allow for cheque and electronic transfer
clearing between institutions (through the Bank
of Canada accounts when needed)
3) Banks are Profit Seekers
Banks compete for investments, and make
profits by lending these investments
Also make profits from bank fees for a range
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of financial services
27.c Creation of Money
To see how banking activities create money, we
need the following definitions:
Reserves – money a commercial bank keeps on
hand (or at the central bank) to pay
out to investors if required
(banks can always take a loan from the central
bank if more money is required – hence
consumer confidence remains)
Reserve ratio – fraction of its deposits that a
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commercial bank holds as reserves
27.c Creation of Money
Assumptions:
1) Banks keep a fixed 20% reserve ratio (actual
is closer to 1%)
2) No cash drain
Bob invests $100 in TD bank.
TD keeps $20 as a reserve and loans $80
That $80 is invested in another bank B
Bank B keeps $16 and loans $64
There is now $244 in the system
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27.c Money Creation Formula
NewDeposit s
Money 
v
v=reserve ratio
From our example,
100
Money 
0.2
Money  500
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Table 27-7
The Sequence of Loans and Deposits
After a Single New Deposit of $100
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Chapter 27, Slide
27.c Money Creation w/cash Drain
NewDeposit s
Money 
vc
v=reserve ratio
c=cash drain
From our example, if people keep 10% of new
loans as cash on hand,
100
Money 
0.2  0.1
Money  333
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27.d Money Supply
Money Supply  Currency  Cash Deposits
Two calculations of Money Supply are M2 and
M2+:
M2: Currency, plus demand and notice deposits
at chartered banks
M2+: M2, plus demand and notice deposits at
other financial institutions
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Table 27-9
M2 and M2+ in Canada
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Chapter 27, Slide
28.a PV Calculations
Given a choice between 2 investments, you
need to be able to compare them
2 investment’s can’t be compared if they
come due at different times
ie: $120,000 next year or $155,000 in 3
years
We need to be able to examine the
PRESENT VALUE (value today) of a future
amount of money
28.a Annual Compounding
Investment: $100
Interest rate: 2%
Derived Formula:
S = P (1+r)t
S = value after t
years
P = principle
amount
r = interest rate
t = years
Year
Calc.
1
Amount
100
100.00
2 100*1.02
102.00
3 100*1.022
104.04
4 100*1.023
106.12
5 100*1.024
108.24
28.a Present Value
How much do I have to invest now to
have a given sum of money in the
future?
PV = S/[(1+r)t]
PV = present value (money invested
now)
S = sum needed in future
r = real, compound interest rate
t = years
28.a Tuition Example
You and your spouse just got pregnant,
and will need to pay for university in
20 years. If university will cost
$30,000 in real terms in 20 years, how
much should you invest now? (long
term GIC’s pay 5%)
PV = S/[(1+r)t]
= $30,000/[(1.05)20]
= $11,307
28.b Money Demand
People have 2 choices:
A) Hold BONDS – any investment that gives a
payout in the future and has a present value
B) Hold MONEY – any instrument that can be
used to buy goods and services but does not
give returns
More Money = Less Bonds
More Bonds = Less Money
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28.b Money Demand
People and firms hold money for 3 reasons
A) Transaction Demand – people and firms need
money to buy things
B) Precautionary Demand – people and firms
hold money in case they need to buy things
C) Speculative Demand – firms (mostly) hold
money if they think interest rates will increase
in the future, making bonds more profitable
 Uncertainty is part of money demand
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28.b Money Demand
Money Demand Depends on 3 Variables:
1) the interest rate (-)
Higher interest rates mean more bonds are
bought (therefore less money)
2) real GDP (+)
Higher output means higher wages,
meaning more money is needed
3) the price level (+)
Higher prices means more money is
needed to buy the same amount
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Fig. 28-1 Money Demand as a Function of the
Interest Rate, Real GDP, and the Price Level
• This money demand
(MD) curve is
sometimes called
the liquidity
preference function.
• Changes in Y or P
cause
the MD curve to shift.
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Copyright © 2014 Pearson
Canada Inc.
• Changes in the
interest rate cause
movements along the
MD curve.
Chapter 28, Slide
Money Demand—Summing Up
- + +
MD = MD (i, Y, P)P)
• Remember there are two assets—bonds and
money.
• The decision to hold money is the same as
the decision not to hold bonds.
28.c Money Equilibrium
• Monetary
Equilibrium
Fig. 28-2
Monetary Equilibrium
• Monetary equilibrium
occurs when the
quantity
of money demanded
equals the quantity of
money supplied:
•  equilibrium interest
rate
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Chapter 28, Slide
Fig. 28-3
•
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Changes in the Equilibrium Interest Rate
Shifts in the MS or MD curves cause the
equilibrium interest rate to change.
Chapter 28, Slide
Money Neutrality v. Hysteresis
Money neutrality is the idea that changes
in the money supply do not have real
LONG-RUN effects on the economy.
Technology and preferences affect GDP,
relative prices, employment etc. in the long
run
Money Supply only affects absolute price
levels
Money Neutrality v. Hysteresis
Hysteresis: the growth rate of Y* may be
affected by the short run path of real GDP.
Money Supply affects interest rates
Interest rates MAY affect aggregate
investment rates
Investment rates affect growth
Monetary shifts can accompany
unemployment, which deteriorates skills
(human capital) therefore reduces growth
Keynes v. Friedman
John Maynard Keynes:
1) Money Supply Changes have little effect on
the interest rate (Money Demand is
relatively flat)
2) Interest rates have little effect on
investment
Therefore fiscal policy is a better tool than
monetary policy
Friedman (Monetarist)
Milton Friedman:
1) Money Supply Changes have large effects
on the interest rate (Money Demand is
relatively steep)
2) Interest rates have big effects on
investment
Therefore monetary policy is a great tool.
Keynes v. Friedman Results
Studies show:
1) Money Demand is relatively steep
(Friedman/Monetarists were right)
BUT
2) The AGGREGATE impact of interest rates on
investment is unknown
 Investors may expect the interest rate to
go higher
 Investment may be in different areas
Monetary Policy Debate
Economists debate the following:
1) Monetary policy can only affect the price
level
OR
2) Monetary policy can lessen the effect of
shocks
OR
3) Monetary policy can influence long-run
growth
29 Canadian Monetary Policy – How?
The Bank of Canada’s Monetary policy consists
of
INTEREST RATE TARGETTING
Where the Bank of Canada
1) Announces a desired interest rate,
2) Money demand of banks and individuals
change
3) The Bank of Canada allows Money Supply to
change as needed
4) The new equilibrium gives the target rate 37
29 Canadian Monetary Policy – How?
A) Bank of Canada announces its TARGET RATE,
and the BANK RATE 0.25% above its target
Bank Rate = Target Rate +0.25%
B) The Bank of Canada will lend to banks at the
BANK RATE and borrow from banks at 0.5%
below the BANK RATE
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29 Canadian Monetary Policy – How?
C) Since Banks compete, no bank can offer a
sure loan or borrow at a rate not within 0.25%
of the target rate
D) All bank loans (mortgages, etc) proceed from
this Bank Rate, increased slightly for bank
profit, and to different degrees according to
uncertainty.
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29 Canadian Monetary Policy – How?
The Bank of Canada’s Monetary policy targets
interest rates to
MAINTAIN A TARGET INFLATION RATE
In an inflationary gap, inflation is too high and
needs to be decreased
Increasing interest rates slows the economy
and reduces inflation
In a recessionary gap, low inflation
accompanies unemployment and low wages
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Decreasing interest rates boosts the economy
29 Canadian Monetary Policy – WHY?
High inflation is costly:
People with fixed income (ie: Seniors) are
unable to meet their current needs
People with investments have lower real
returns
Prices become poor signals to producers and
consumers
Uncertainty increases, making firms less willing
to innovate
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29 Canadian Monetary Policy Complications
1) Core Inflation
 Some sources of inflation (ie: international gas
prices) are unaffected by Canadian targetting
 Therefore Canada targets CORE INFLATION
(with food, energy, and indirect tax effects
removed)
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29 Canadian Monetary Policy Complications
2) Time Lag
 Changing interest rates will affect GDP
(through investment) in 9 to 12 months
 Affecting prices and inflation can take a
further 9 to 12 months
 The BANK has to react to output gaps BEFORE
they occur
 They therefore only react to large,
foreseeable changes
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 Sometimes there is error and destabilization
Topic 7 Summary
 The role of money has evolved over the years
 There is currently much more deposit (virtual)
money that fiat (actual) money
 The Bank of Canada has accounts for the big
banks and the government of Canada
 The Bank of Canada has control over the money
supply and supports the Canadian financial
system
 Charter banks provide credit (together and
separate)
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Topic 7 Summary
 Charter banks can create money, depending on
their reserve
 Money supply is currency plus deposits
 Money demand is based on the decision to hold
cash or hold bonds (investment), which depends
on the interest rate
 Equilibrium in money demand and supply
determines the interest rate
 The Bank of Canada targets the interest rate
through an announced Bank Rate
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Topic 7 Summary
 The Bank of Canada’s monetary policy serves to
target inflation
 Slowing down the economy in an inflationary
gap
 Helping spur the economy in a recessionary
gap
 The Bank of Canada can only target Core Interest
Rates
 This adjustment takes time, and errors can lead to
destabilization
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