Money and Banking: Principles of Macroeconomics Study Notes

Money and Banking

Introduction to Money

Money is a fundamental concept in macroeconomics, serving as the backbone of modern economies. It facilitates transactions, enables economic calculation, and supports the functioning of financial systems.

• Definition of Money: Anything that people generally accept in exchange for goods and services and as a settlement for debt.

Examples of Money

Throughout history, various items have served as money, depending on their acceptability and value within societies.

Examples of Money
Boar tusk, Boats, Cigarettes, Copper, Corn, Cows, Feathers, Glass, Goats, Gold, Horses, Iron, Molasses, Polished heads (wampum), Pots, Red woodpecker scalps, Rice, Round stones with centers removed, Rum, Salt, Silver, Tobacco, Tortoise shells, Whale teeth

Additional info: These examples illustrate that money can take many forms, from commodities with intrinsic value to objects valued for their scarcity or utility.

The Functions of Money

Core Functions

Money performs several essential functions in an economy:

1. Medium of Exchange: Sellers accept money as payment in market transactions and as settlement for debt. This function eliminates the inefficiencies of barter, which requires a double coincidence of wants.

2. Unit of Account: Money provides a standard measure for pricing goods and services, facilitating comparison of value.

3. Store of Value: Money retains value over time, allowing individuals to transfer purchasing power into the future.

4. Standard of Deferred Payment: Money is used to settle debts that mature in the future, making it desirable for credit transactions.

Liquidity

Liquidity refers to the ease with which an asset can be converted into cash without significant loss of value or incurring high transaction costs. Money is considered the most liquid asset.

• Low Liquidity: Assets like antique furniture, commercial buildings, and paintings.

• High Liquidity: Certificates of deposit, chequable accounts, cash.

Types of Money

Commodity Money

Commodity money has intrinsic value; it can be used for purposes other than as a medium of exchange (e.g., gold, silver, cigarettes).

Fiduciary (Fiat) Money

• Currency issued by the government, whose value is based solely on public confidence that it represents command over goods and services.

• Fiat money is declared legal tender by the government and has no intrinsic value.

Credit Cards and Bank Cards

• Credit cards: Defer payment rather than complete transactions; not considered money.

• Bank cards: Used to instruct banks to transfer funds; facilitate access to money but are not money themselves.

Defining the Money Supply

Narrow and Broad Measures

• M1 (Narrowest measure): Currency outside banks and demand deposits.

• M2 (Broader measure): M1 plus personal savings deposits (fixed term and non-chequable deposits) and non-personal notice deposits.

• Other measures include M1+, M2+, M3, etc.

Composition of the Canadian Broad Money Supply (2020)

Aggregate	Main Components	Proportion of Total
M1+	Chequable (transaction) deposits	~67%
M2+	Personal savings deposits, non-personal notice deposits	~54%

Additional info: The Bank of Canada tracks these aggregates to monitor monetary policy and economic activity.

The Financial System

Financial Intermediaries

Financial intermediaries are institutions that transfer funds between ultimate lenders (savers) and ultimate borrowers.

• Examples: Chartered banks, trust companies, credit unions, insurance companies, pension funds, mutual funds, investment dealers, finance companies.

Process of Financial Intermediation

Financial intermediation involves accepting savings from households, businesses, and governments, and lending these funds to other households, businesses, and governments.

• Ultimate Lenders: Households, businesses, governments

• Ultimate Borrowers: Households, businesses, governments

Links between Money Supply and Economic Variables

Changes in the money supply are important determinants of the level of economic activity (GDP) and the price level (inflation) in the economy.

Money Creation

Who Creates Money?

• Money is created by both the central bank and commercial banks through the process of deposit creation and lending.

• Money Supply Formula:

$MS = CU + D$

• Where MS is the money supply, CU is currency in circulation, and D is demand deposits.

Fractional Reserve Banking

In a fractional reserve banking system, depository institutions hold reserves that are less than the amount of total deposits. This system allows banks to create money through lending.

• Historical Note: Goldsmiths issued notes exceeding the value of gold and silver on hand, laying the foundation for modern banking.

Reserves and Reserve Ratios

• Reserves: Deposits held by chartered banks at the central bank and vault cash.

• Desired Reserve Ratio: The percentage of total deposits that banks wish to hold as reserves.

Excess Reserves

Excess reserves are the amount by which actual reserves exceed desired reserves.

$\text{Excess reserves} = \text{actual reserves} - \text{desired reserves}$

• When excess reserves are positive, the money supply can increase.

• When excess reserves are negative, the money supply contracts.

Simple Banking Model

This model assumes:

• Desired reserve ratio is fixed

• No excess reserves

• No currency drain

• Banks can lend all they want at the current rate

• Assets: Reserves and loans only; Liabilities: Deposits only

Bank Balance Sheets

Assets	Liabilities
Reserves, Loans	Deposits

$\text{Net Worth} = \text{Assets} - \text{Liabilities}$

Money Creation Process

When a deposit is made, banks keep a fraction as reserves and lend out the rest, creating new deposits in the process. This cycle continues across multiple banks, expanding the money supply.

Bank	New Deposits (Reserves)	New Desired (Excess Reserves)	Maximum New Loans plus Investments
1	$10,000	$1,000	$9,000
2	$9,000	$900	$8,100
3	$8,100	$810	$7,290
4	$7,290	$729	$6,561
All other banks	$65,610	$6,561	$59,049
Totals	$100,000	$10,000	$90,000

The Money Multiplier

The money multiplier quantifies the maximum amount of money the banking system can generate with each dollar of reserves, assuming no leakages.

$\text{Potential money multiplier} = \frac{1}{\text{desired reserve ratio}}$

Actual change in money supply:

$\text{Actual change in money supply} = \text{actual money multiplier} \times \text{change in total reserves}$

• Leakages: Currency drains and excess reserves in the system reduce the actual multiplier effect.

Deposit Insurance and Bank Regulation

Bank Runs

Bank runs occur when many depositors attempt to withdraw their funds simultaneously due to fears about a bank's solvency.

Canada Deposit Insurance Corporation (CDIC)

• A government agency that insures deposits held in federally incorporated financial institutions in Canada.

• Created to assure depositors that their funds are safe and can be converted into cash when needed, even though banks do not hold 100% of deposits as cash.

Deposit Insurance, Adverse Selection, and Moral Hazard

Asymmetric Information

• Occurs when one party in a transaction has more or better information than the other, creating an advantage.

Adverse Selection

• A problem arising from asymmetric information before a transaction occurs.

• Individuals most likely to engage in undesirable activities (from the lender's perspective) are also most likely to seek loans.

Moral Hazard

• Occurs after a transaction, when one party has an incentive to take actions that are undesirable from the other party's perspective (e.g., riskier behavior by insured banks).