The Banking System -There are three types of institutions in Canada: -Depository institutions -The Bank of Canada -The payments systems

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1 What is Money? -A means of payment is a method of settling a debt -Money serves three other functions: -Medium of exchange -Unit of account -Store of Value Medium of Exchange -A medium of exchange is any object that is generally accepted in exchange for goods and services -Without a medium of exchange, goods and services must be exchanged directly for other goods and services bartering -A medium of exchange overcomes the need for a double coincidence of wants which rarely occurs -Money isn t the only medium of exchange, you can buy with a credit card Unit of Account -A unit of account is an agreed measure for stating the prices of goods and services -If the price of a movie is $8, and the price of a pop is $4, you know right away that seeing one movie costs you 2 cases of pop -Though it would be confusing to state that, so we use money to state the cost of goods Store of Value -Money is a store of value in the sense that it can be held and exchanged later for goods and services -If money were not a store of value, it could not serve as a means of payment Money in Canada Today -Consists of: -Currency the notes and coins held by individuals and businesses -Deposits trust and mortgage companies, credit unions, and caisses populaires are also counted as money Cheques are not considered money Credit cards are not money -Official measures of money M1 consists of currency and chequable deposits and M2 consists of M1 and all other deposits. M1 is considered money Most forms of M2 are counted of money, the ones that are not are called liquidity assets The Banking System -There are three types of institutions in Canada: -Depository institutions -The Bank of Canada -The payments systems Depository Institutions -A private firm that takes deposits from households and firms and makes loans to other households and firms -Chartered Banks a private firm chartered under the Bank Act of 1992 to receive deposits and make loans. The largest institution of banking systems -Credit Unions and Caisses populaires a cooperative organization that operates under the Cooperative Credit Association Act of 1992 and that receives deposits from and makes loans to

2 its members. A caisse populaire is the French version -Trust and Mortgage Loan Companies a privately owned depository institution that operates under the Trust and Loan Companies Act of They make deposits, loans and act as trustee for pension funds and for estates -Depository institutions provide services such as cheque clearing, account management, credit cards, and Internet banking, provided from an income of service fees -A chartered bank puts the funds it receives into four types of assets: -Reserves notes and coins in a bank s vault of in a deposit account at the Bank of Canada -Liquid assets government of Canada Treasury bills and commercial bills -Securities government of Canada bonds and other bonds such as mortgage-backed securities -Loans commitments of funds for an agreed-upon period of time -Economic benefits provided by depository institutions: -Create liquidity they create liquidity -Pool risk if you lend to one person who defaults, you lose the entire amount loaned -Lower the cost of borrowing -Lower the cost of monitoring borrowers a lender can encourage good decision that prevent defaults Bank of Canada -Canada s central bank -It is the: -Banker to banks and government the Bank of Canada has a restricted list of customers -Lender of last resort makes loans to banks it is the lender of last resort, which means that it stands ready to make loans when the banking system as a whole is short of reserves -Sole issuer of bank notes only bank that is permitted to issue bank notes -The Bank of Canada s balance sheet: -The Bank of Canada s Assets: government securities treasure bills, and loans to depository institutions -The Bank of Canada s Liabilities: Bank of Canada notes are the dollar bills that we use in our daily transactions, and depository institution deposits are part of the reserves of these institutions -The Bank of Canada s liabilities together with coins issued by the Royal Canadian Mint make up the monetary base it is the sum of the Bank of Canada notes, coins, and depository institution deposits at the Bank of Canada -To change the monetary base, the Bank of Canada conducts an open market operation which is the purchase or sale of government of Canada securities treasury bills and bonds The Payments System -The system in which banks make payments to each other to settle transactions by their customers -Large Value Transfer System (LVTS) an electronic payments system that enables financial institutions and their customers to make large payments instantly and with the sure knowledge that the payment has been made -Automated Clearing Settlement System (ACSS) the system through which all payments not processed by the LVTS are handled

3 How Banks Create Money Creating Deposits by Making Loans -If you swipe your credit card, the store in which you do that to increases the size of its deposit and you increase the size of your loan -The quantity of deposits that the banking system can create is limited by three factors: -Monetary base- the size of the monetary base limits the total quantity of money that the banking system can create -Desired reserves- Banks don t have $100 of reserves for every $100 that people have deposited. The fraction of a bank s total deposits that are held in its reserves is called the reserve ratio. The quantity of reserves that a bank plans to hold is its desired reserves expressed as a percentage of total deposits called the desired reserve ratio. A bank s excess reserves are its actual reserves minus its desired reserves -Desired currency holdings- The proportion of money held as currency isn t constant but at any given time, people have a definite view as to how much they want to hold in each form of money. We call the leakage of currency from the banking system the currency drain, and we call the ratio of currency to deposits the currency drain ratio The Money Creation Process -The process begins when the monetary base increases and the banking system has excess reservces 1. Banks have excess reserves 2. Banks lend excess reserves 3. The quantity of money increases 4. New money is used to make payments 5. Some of the new money remains on deposit 6. Some of the new money is a currency drain 7. Desired reserves increase because deposits have increased 8. Excess reserves decrease but remain positive The Money Multiplier -The ratio of the change in the quantity of money to the change in monetary base The Market for Money The Influences on Money Holding -Price level the quantity of nominal money demanded is proportional to the price level, other things remaining the same -Nominal Interest Rate Money loses value because of inflation -Real GDP the quantity of money that households and firms plan to hold depends on the amount they are spending, the quantity of money demanded in the economy as a whole depends on real GDP -Financial Innovation financial innovations include: daily interest chequable deposits, automatic transfers between chequable deposits and saving deposits, automatic teller machines, credit and debit cards, internet banking and bill paying The Demand for Money -The relationship between the quantity of real money demanded and the nominal interest rate when all

4 other influences on the amount of money that people wish to hold remain the same -A change in real GDP or financial innovation changes eh demand for money and shifts the demand for money curve Money Market Equilibrium -Occurs when the quantity of money demanded equals the quantity of money supplied -Short run equilibrium each day, the Bank of Canada adjusts the quantity of money to hit its interest rate target -Long run equilibrium supply and demand in the loanable funds market determines the real interest rate The Quantity Theory of Money -The proposition that in the long run, an increase in the quantity of money brings an equal percentage increase in the price level -The velocity of circulation is the average number of times a dollar of money is used annually to buy the goods and services that make up GDP P = price level Y= real GDP M=quantity of money V=velocity of circulation GDP = PY V= PY MV = PY P= M (V/Y) M Money growth rate + Rate of velocity change = Inflation rate + Real GDP growth rate Inflation rate = Money growth rate + Rate of velocity change Real GDP growth rate In the long run: Inflation rate = Money growth rate Real GDP growth rate Mathematical Note The Money Multiplier Al (1 L) MB = Desired currency holding + Desired reserves M = Deposits + Desired currency holding Desired currency holding = a x Deposits Desired reserves = b x Deposits MB = (a+b) x Deposits M = (1 + a) x Deposits

5 MB = (a+b) x Change in deposits M = (1 + a) x Change in deposits Money multiplier = (1+a) (a+b)