The Monetary System: Money, Banking, and Policy in Macroeconomics

The Monetary System

Introduction

The monetary system is a fundamental component of macroeconomics, influencing the functioning of economies through the creation, management, and regulation of money. This section explores the definition of money, its various forms, the process of money creation by banks, and the role of government institutions in controlling the money supply.

The Meaning of Money

Definition of Money

• Money is the set of assets in the economy that people regularly use to buy goods and services from other people.

Functions of Money

• Medium of exchange: An item buyers give to sellers when purchasing goods or services.

• Unit of account: The yardstick people use to post prices and record debts.

• Store of value: An item that allows people to transfer purchasing power from the present to the future.

• Liquidity: The ease with which an asset can be converted into a medium of exchange. Money is the most liquid asset.

Kinds of Money

• Commodity money: Money that takes the form of a commodity with intrinsic value (e.g., gold, cigarettes in prisons).

• Fiat money: Money without intrinsic value that is accepted as money because of government decree (e.g., paper currency).

• Bitcoin: A form of money that exists only in electronic form. Bitcoins are neither commodity nor fiat money and have no intrinsic value. Their success depends on their ability to perform the functions of money.

Money in the Canadian Economy

The Money Stock

• The money stock is the quantity of money circulating in the economy, influencing many economic variables.

• Measures of the money stock include currency (paper bills and coins) and demand deposits (bank account balances accessible on demand).

• Credit cards are not considered money; they represent a method of payment, not a store of value or medium of exchange.

Measures of Money: M1+ and M2

There are different measures of the money stock, such as M1+ and M2. M2 is larger but less liquid than M1+.

Measure	Components	Liquidity
M1+	Currency + Chequable deposits	High
M2	M1+ + Non-chequable deposits and other savings	Lower

The Bank of Canada

Role and Definition

• Bank of Canada (BoC): The central bank of Canada, responsible for regulating the quantity of money in the economy.

• Central bank: An institution designed to regulate the money supply.

The Bank of Canada Act

• Prior to the 1930s, bank notes were issued by the Department of Finance and commercial banks; Canada was on the gold standard.

• The collapse of the gold standard during the Great Depression led to the need for controlling fiat money.

• The Bank of Canada Act (1934) established the BoC, which was nationalized in 1938.

• The BoC is managed by a board of directors (governor, senior deputy governor, up to 12 directors, including the deputy minister of finance).

• The BoC is independent of the government in practice.

Main Functions of the Bank of Canada

• Issue currency

• Act as banker to commercial banks

• Act as banker to the Canadian government

• Control the money supply

Money Supply and Monetary Policy

• Money supply: The quantity of money available in the economy.

• Monetary policy: The setting of the money supply by policymakers in the central bank.

• The BoC can increase or decrease the number of dollars in the economy, affecting inflation and unemployment.

Commercial Banks and the Money Supply

Role of Commercial Banks

• Commercial banks (including credit unions, caisses populaires, and trust companies) play a key role in the monetary system by influencing the supply of money through their lending activities.

100 Percent-Reserve Banking

• In a 100 percent-reserve banking system, banks hold all deposits as reserves and do not loan out any money.

• Reserves are deposits that banks have received but not loaned out.

Assets	Liabilities
Reserves: $100	Deposits: $100

In this system, banks do not influence the supply of money.

Fractional-Reserve Banking and Money Creation

• Fractional-reserve banking: Banks hold only a fraction of deposits as reserves and lend out the rest.

• Reserve ratio: The fraction of deposits that banks hold as reserves.

• When banks lend out a portion of deposits, new money is created in the economy.

Assets	Liabilities
Reserves: $10 Loans: $90	Deposits: $100

Money supply (currency + deposits) = $100 + $90 = $190

The Money Multiplier

• Money multiplier: The amount of money the banking system generates with each dollar of reserves.

• In the example, $100 of reserves generates $1000 of money, so the money multiplier is 10.

• The money multiplier is the reciprocal of the reserve ratio:

$ext{Money Multiplier} = rac{1}{R}$

• The higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier.

Example of the Money Multiplier Process

Bank	Reserves	Loans	Deposits
First National	$10	$90	$100
Second National	$9	$81	$90
Third National	$8.10	$72.90	$81

Total money supply increases as loans are redeposited and re-lent, up to $1000 in the example.

Summary Table: Key Terms and Concepts

Term	Definition
Money	Set of assets used to buy goods/services
Medium of exchange	Item used for transactions
Unit of account	Standard for pricing/recording debts
Store of value	Asset for transferring purchasing power
Commodity money	Money with intrinsic value
Fiat money	Money by government decree
Money supply	Total money in circulation
Monetary policy	Central bank's control of money supply
Fractional-reserve banking	Banks hold fraction of deposits as reserves
Money multiplier	Amount of money created per dollar of reserves

Key Equations

• Money Multiplier: $ext{Money Multiplier} = rac{1}{R}$

Example Application

If the reserve ratio is 10% ($R = 0.1$), the money multiplier is $rac{1}{0.1} = 10$. Thus, $100 in reserves can support $1000 in total money supply through the banking system.

Quick Quiz Review

• The money supply includes all EXCEPT:

  • metal coins

  • paper currency

  • lines of credit accessible with credit cards (not included)

  • bank balances accessible with debit card

Conclusion

The monetary system is essential for understanding macroeconomic policy, the creation and regulation of money, and the role of banks and central banks in influencing economic outcomes such as inflation, unemployment, and growth.