Topic 7 Money and Banking

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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

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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

this purpose

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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

notes than they had gold

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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

accounts through transactions

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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

 This has NEVER happened

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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

the government requires money

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Table 27-1 Assets and Liabilities of the Bank of Canada

Canada Inc.

Chapter 27, Slide

Role 1

Role 2

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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

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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

of financial services

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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

commercial bank holds as reserves

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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

v=reserve ratio

From our example,

v

s NewDeposit Money 



500 2 . 0

100 







Money

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Table 27-7 The Sequence of Loans and Deposits After a Single New Deposit of $100

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27.c Money Creation w/cash Drain

v=reserve ratio c=cash drain

From our example, if people keep 10% of new loans as cash on hand,

c v

s NewDeposit Money

 



333 1 . 0 2

. 0

100 



 



Money

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27.d Money Supply

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

Deposits Cash

Currency

Supply  

Money

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Table 27-9 M2 and M2+ in Canada

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 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 PV Calculations

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28.a Annual Compounding

Investment: $100 Interest rate: 2%

Year Calc. Amount

1 100 100.00

2 1001.02 102.00 3 1001.02

²

104.04 4 100*1.02

³

106.12 5 100*1.02

⁴

108.24 Derived Formula:

S = P (1+r)

^t

S = value after t years

P = principle amount

r = interest rate

t = years

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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

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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

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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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 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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28.b Money Demand

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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 (M

_D

) curve is sometimes called

the liquidity

preference function.

• Changes in Y or P cause the M

_D

curve to shift.

• Changes in the interest rate cause movements along the M

_D

curve.

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Money Demand—Summing Up

• Remember there are two assets—bonds and money.

• The decision to hold money is the same as the decision not to hold bonds.

- + +

M

_D

= M

_D

(i, Y, P)P)

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• Monetary Equilibrium

• Monetary equilibrium occurs when the

quantity

of money demanded equals the quantity of money supplied:

 equilibrium interest rate

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Fig. 28-2 Monetary Equilibrium

28.c Money Equilibrium

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Fig. 28-3 Changes in the Equilibrium Interest Rate

• Shifts in the M

_S

or M

_D

curves cause the equilibrium interest rate to change.

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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

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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

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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

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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.

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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

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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

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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

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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

 Decreasing interest rates boosts the economy

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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

 Sometimes there is error and destabilization

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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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