Economics 12

1. Economics 12 [The Money Market] Part 1 – Money and Banking

2. Money Humanity’s greatest invention and its greatest curse.

3. Money • Is it possible to be extremely wealthy but literally have no money?

4. Money Increases Wealth A society possessing no money would be very simple and materially very poor. This is because exchange would be difficult and time consuming. Imagine a person possessing a pound of honey but wanting a package of medium-sized, flat-head screws. How long might it take to find someone with the right screws who just happened to want some honey? In short, what we are saying here is that almost everybody would be forced to produce most of the necessities of survival for themselves. Few could earn a livelihood by specializing in producing just one product and then trading it for other products. This lack of specialization, along with the high cost of exchange, would ensure an existence in which a minimal quantity of goods and services was exchanged. Thus, the use of money increases a nation's wealth.

5. Functions of Money What is money good for? To spend, of course! • Prime function of money – acts as a medium of exchange • Something that is accepted as payment for goods and services. • Without money, barter is required. • The function of money that allows people to hold and accumulate wealth is called store of wealth.

6. Functions of Money • Money also used as a unit of account or measure of value. Assume, for instance, that a suit of clothes is worth 10 litres of beer, that a litre of beer is worth 2 loaves of bread, and that you need 100 loaves of bread to buy a table-how many suits of clothes does it take to buy a table? Given the clothes-table example above, how many suits of clothes would it cost to buy a table if a litre of beer is worth only one loaf of bread?

7. Characteristics of Money Money needs to be all of the following: • acceptable • durable • portable • divisible • standardized, easily recognized but not easily copied • controlled by central authority

8. Different Kinds of Money • Commodity money is a type of money that can also function, and is useful, as a commodity • Fiat money is anything that is declared as money by government order.

9. Different Kinds of Money • Commodity money • Gold and other precious metals • Coins • Paper money • Chequebook money (deposits)

10. Fractional Reserve Banking • A fractional reserve system is a banking system in which banks keep only a small fraction of their total deposits on reserve in the form of cash.

11. A Definition • Money is anything that is widely accepted as a medium of exchange and therefore can be used to buy goods or settle debts.

12. M1 Definition • Simplest, most basic definition • Includes currency in circulation (coins and paper bank notes) plus demand deposits in the chequing accounts of all commercial banks. • The word demand in demand deposits refers to the fact that depositors can demand their deposits in cash at any time. The money supply (in $ billions) in Canada in November 2007 was: M1 = currency plus demand deposits 189 = 49 + 140 (26% ) (74%)

13. M2 Definition • includes all of M1 plus all notice deposits (savings accounts on deposit for an undefined length of time) and what are called personal term deposits, which are on deposit for a specific term, such as six months. The money supply (in $ billions) in Canada in November 2007 was: M2 = M1 plus notice deposits and personal term deposits 769 = 189 + 580 (25% ) (75%)

14. M3 Definition • includes M2 but adds to it term deposits of businesses (known as certificates of deposits), which are easily convertible into chequable deposits. The money supply (in $ billions) in Canada in November 2007 was: M3 = M2 plus certificates of deposits 1191 = 769 + 422 (65% ) (35%)

15. The 3 Measures of Money

16. What is Not Money? • Only the portion of currency issued by the Bank of Canada that is in circulation is included as money. • The currency in the vaults or tills of banks is not included in any definition of money. • A new bank deposit of currency changes the composition of the money supply but does not change its total. • Also excluded: • Gold • Financial securities such as stocks and bonds • Accounts at near-banks (nonbank financial institutions)

17. Canada’s Big Banks

18. Practice • If David deposits $240 cash into his chequing account at a commercial bank, has the money supply changed? • If, later on, David transfers this $240 from his chequing account to a saving account in the same bank, has M1 changed? Has M2? • Given the following data (all in billions of Canadian$): • Coins 13 • Certificates of deposit 137 • Demand deposits 72 • Notice and personal term deposits 215 • Notes 27 What are the values of M1, M2, and M3?

19. Stop Here for Day 1

20. Modern Banks and the Creation of Money • Banks are in the business to make money. • Major source of profit comes from using any excess deposits productivity be lending them out. • Profit comes from the spread – the difference between the interest rate a bank charges to borrowers and the interest rate it pays to depositors.

21. Modern Banks and the Creation of Money • Not much difference in spread between different banks. • Total profits come from total volume rather than differences in spreads. • Banks do not carry excess inventory (money). • No return on idle money balances • Reserves kept to a minimum • Target reserve ratio is the proportion of demand deposits that a bank wants to hold in the form of cash.

22. Modern Banks and the Creation of Money • Canadian banking system is remarkably secure. • Branch banking system • Dominated by a few large banks each with many branches operating across the country • Size and geographical diversity spreads risk and minimizes possibility of bank failure

23. Modern Banks and the Creation of Money • Pro • Security • Con • Only six big banks so competition within the system is weak • Inconveniences like long lineups, hours of operation • Size of spread is wider • Loan policies unfavourable to small business • Canadian banking system is very secure and stable, but also very conservative.

24. Assets, Liabilities and Balance Sheets • Assets represent what a company owns or what others owe it. • Liabilitiesrepresent what a company owes to others. • The difference between the two is the net worthof the company (equity).

25. Assets, Liabilities and Balance Sheets Transaction 1: Fred, a customer of the bank, deposits $200 cash in the bank. The reserves of the bank would therefore increase by $200. The other entry? Fred's bank balance will increase by $200. (An asset for Fred, of course, but a liability for the bank, since it now owes Fred $200 more.) So, demand deposits increase by $200. In sum, both assets and liabilities have increased. Transaction 2: Penny withdraws $500 cash from her account. This is straightforward, since it is just the reverse of transaction 1. The bank's reserves are reduced by $500, and the demand deposits go down by $500. So, both assets and liabilities are reduced accordingly. Transaction 3: The bank buys some securities for $200 cash. In this case, reserves decrease by $200, and securities increase by $200. Therefore, one asset decreases, and another increases; the net effect on total assets is zero.

26. Assets, Liabilities and Balance Sheets • Each time that a bank issues a loan, it creates money. Transaction 4: Suppose that the bank grants you a loan. What exactly does this imply? Generally speaking, it does not mean that the bank gives you cash. Instead, in exchange for your written acceptance of the terms and conditions for repayment of the loan, the bank will give you immediate credit in your chequing account for the amount of the loan. Now, whether you actually draw out cash or, instead, write a cheque for the whole or part of the amount is up to you. But what the bank has given you is "direct and immediate access to goods and services" and the ability to settle a debt. It has, in other words, by a single bookkeeping entry, created money for you. The two accounts affected, therefore, are: an increase in loans (an asset) and an increase in demand deposits (a liability). Cash reserves are unaffected.

27. Assets, Liabilities and Balance Sheets • Now, having been granted the loan you might do one of three things: Transaction 4a: You decide that you are going to withdraw some or all of it in cash. In which case, the bank's reserves decrease by the amount of the withdrawal and the demand deposits are decreased by the same amount.

28. Assets, Liabilities and Balance Sheets • Now, having been granted the loan you might do one of three things: Transaction 4b: You decide to write a cheque to buy an airline ticket. Suppose that the airline company also does its banking at the same bank. In that case, your demand deposit balance is reduced by the amount of the cheque, and that of the airline company is increased by the same amount. Here, the total amount of demand deposits remains unchanged. In addition, note that the bank's reserves were unaffected.

29. Assets, Liabilities and Balance Sheets • Now, having been granted the loan you might do one of three things: Transaction 4c: You write a cheque to buy a new sofa from the Sogood Sofa company. Sogood Sofa deposits your cheque at its bank, which is a different bank from yours. At the end of the day, its bank will come to yours for payment of the cheque. The cheque is then cleared against your bank, whose reserves will drop as a result. Therefore, your bank's reserves and demand deposits will be reduced, while the other bank's reserves and demand deposits will increase.

30. Practice • Give the necessary bank bookkeeping entries for each set of circumstances below. • The bank makes a $2000 loan to Fadia. • Fadia writes a $2000 cheque to Middle East Travel, which has its accounts at a different bank.

31. The Money Multiplier • An example to start • Target reserves set at 10 percent • Target Reserves = Target Reserve Ratio x Demand Deposits Target Reserves = 10% x $100 000 = $10 000

32. The Money Multiplier • Tom finds $1000 to deposit in bank. • Target Reserves = 10% x $101 000 = $10 100 • Excess Reserves = Actual Reserves – Target Reserves • $11 000 – 10 100 = $900 (over-reserved) • Bank keeps only 10% of deposit for cash reserves, therefore has 90% to lend out • 90% of $1000 deposit = $900 Reserves $11 000 Demand Deposits $101 000

33. The Money Multiplier • Wing Lee requires a $900 loan • Buys a car from New Star Car Company who deposits cheque into another bank, J.M.K. • After J.M.K. clears cheque against Saymor • J.M.K. keeps only 10% of deposit for cash reserves, therefore has 90% to lend out • Excess Reserves = 90% of $900 = $810 Reserves + $900 Demand Deposits + $900

34. The Money Multiplier • Sue needs $810 to pay off some debt • Negotiates loan from J.M.K. to pay Sarbjit by cheque • Sarbjit deposits cheque into M.P.C. • After M.P.C. clears cheque against J.M.K. • J.M.K. keeps only 10% of deposit for cash reserves, therefore has 90% to lend out • Excess Reserves = 90% of $810 = $729 Reserves + $810 Demand Deposits + $810

35. The Money Multiplier • Although the cash moves from bank to bank, the banking systemseems unable to get rid of this additional cash. • A bank lends it out, but each time it returns to some other bank. • Each time it returns, the receiving bank retains 10 percent of that new deposit in additional reserves. Reserves Loans Deposits +1000 +1000 (Tom) +900 (to Wing Kee) +900 (New Star) +810(to Sue) +810 (Sarbjit) +729 +729 … …

36. Entire Banking System • Target Reserves = 10% of Demand Deposits therefore Demand Deposits = 10 x Target Reserves • Tom deposits $1000 so Reserves become $101 000 • Demand Deposits can rise to 10 x $101 000 or $1 010 000 Reserves $100 000 Demand Deposits $1 000 000 Loans $900 000

37. deposits 1 reserves target reserve ratio The Money Multiplier • The money multiplier is the increase in total deposits that would occur in the whole banking system as a result of a new deposit in a single bank. • Money Multiplier = Or Money Multiplier =

38. Can Banks Ever Be Short of Reserves • At the end of the day, bank might find that it has less reserves than it targeted. • Borrow from the Bank of Canada • The bank rate is the rate of interest that the Bank of Canada charges a commercial bank for a loan.

39. Money Multiplier in Reverse • If a single bank finds itself under-reserved, it will have to increase its reserves in some more permanent way. • Doing so will be at the expense of some other bank's reserves. • The total loans in the whole banking system will decrease and, as a result, deposits also reduce by an amount determined by the money multiplier. • Banks can neither create nor destroy currency. • What they can do is create or destroy loans and demand deposits, and this is what they do whenever they are over- or under­reserved.

40. A Smaller Money Multiplier Factors that May Reduce the Size of the Multiplier • An increase in the banks' target reserves • An increase in amount of cash that people hold (currency drain) • An insufficient number of creditworthy applicants for loans • A reduced demand for loans by people in times of recession