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ECON 1102 - REVIEW PART 3
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This is the 3rd part (and last) of the notes for ECON 1102. It contains the last few chapters, and if you pair it with part 1 and 2, you'll be good to go for the exam.
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Principles of Macroeconomics 3Chapter 11- Money and Banking
What is the Nature of Money?
- For money to be considered an asset, it must fulfill three functions:
1. It must serve as a medium of exchange, something that could be accepted for goods and services. An
alternative would be barter, which requires a double coincidence of wants.
2. It must be able to be used as a store of value, used to transport purchasing power. An advantage of
holding money is that it is liquid, making it portable and ready to use. The disadvantage is that its
value falls over time due to inflation.
3. It is a unit of account, meaning that money is a standard way of quoting prices.
Coinage and Goldsmiths
- The invention of coinage eliminated the need to weigh the metal at each transaction, but coins often
could not be taken at their face value because people would clip them.
- Gresham’s Law is the theory that bad money derives good money out of circulation.
- Goldsmiths would give their depositors receipts, promising to return the gold on demand so buyers
began to transfer the goldsmith's receipts when making a purchase, and the transferring of paper
receipts, rather than gold was the invention of paper money, which was backed by precious metal and
convertible on demand into this metal.
- Goldsmiths and banks discovered that it was not necessary to keep 1 ounce of gold in the vaults for
every claim to 1 ounce circulating as paper money, we say that such a currency is fractionally backed
by the reserves.
- Currency issued by private banks became rare and central banks took control of issuing currency.
- Money today is fiat money because it is decreed by the government to be legal tender.
- Money held by the public as deposits with commercial banks are deposit money, and banks create
money by issuing more promises to pay deposits than they have cash reserves available to pay out
What is the Canadian Banking System?
- The central bank acts as a banker to the commercial banking system, and often to the government as
well, and is usually the sole money-issuing authority.
- Financial intermediaries are privately owned institutions that serve the general public. They are the
intermediaries amid savers, from whom they take deposits, and borrowers, to whom they make loans.
- The organization of the Bank of Canada is designed to keep the operation of monetary policy, free
from day-to-day political influence. (1935)
- The Bank of Canada’s basic functions is to act as a banker to commercial banks to act as banker to the
federal government to regulate the money supply, and to support financial markets.
- A commercial bank is a privately owned profit-seeking institution that provides a variety of financial
services, such as accepting deposits from customers and making loans and other investments.
What are Bank Reserves?
- Bank reserves are the deposits a commercial bank has made with the Bank of Canada plus its cash on
hand, vault cash.
- 100% reserve banking is a situation in which banks’ reserves equal 100% of their deposits.
- The way that banks earn a profit is by making loans at higher interest rates than what they pay the
depositors for using their money.
- The modern banking system is therefore a fractional-reserve banking system, a banking system in
which bank reserves are less than deposits.
, - A bank’s reserve ratio is a fraction of the deposits, that it holds as reserves in the form of cash or
deposits with the central bank. Reserves/Deposits = Reserve Ratio = v
- The Banks target reserve ratio is the fraction of its deposit. It would ideally like to hold as reserves.
Any reserves in excess of the target level are called excess reserves. Excess = Actual – Target
How is Money Created in the Banking System?
- We assume that all banks have the same target reserve ratio, unchangeable, that there is no cash
drain from the banking system, & that the public holds all money in the form of deposits, not currency
- Assuming that the target reservation is 10% for every $100 deposit the bank will hold $10 as reserves,
making them lend out the extra $90 by creating a $90 deposit for the borrower. Banks will create
money, as long as their actual reserves are different from their target reserves.
Example: A $100 Cash Deposit
Reserves = 100 Deposits = 100
Reserves = 100 Loans = 90 Deposits = 190
Reserves = 100 Loans = 171 Deposits = 271
Reserves = 100 Loans = 244 Deposits = 344...
Reserves = 100 Loans = 900 Deposits = 1000
- The bank will keep making loons until it is holding exactly 10% of the deposits as reserves. If the
desired reserve ratio is 10%, then the level of deposits corresponding to a 10% desired reserve a shoe
in the beginning point of $100 must be $1000.
Changes in Deposits
- The money supply equals currency plus deposits. If (v) is the target reserve ratio, a new deposit to the
banking system will increase the total amount of the deposit by 1/v times the new deposit.
- If v = 0.1 and the new deposit = $100… 100 x 1/0.1 = $1000.
- With no cash drain from the banking system, a banking system with a target reserve ratio of ‘v’ can
change the deposit by 1/v times any change in reserves. (Change in Deposits = Change in Reserves/v)
- If commercial banks do not choose to lend excess reserves, there will not be a multiple expansion of
deposits. If people decide to hold an amount of cash equal to a fixed fraction of their bank deposits,
any multiple expansion of bank deposits will be accompanied by a cash drain.
- If ‘c’ is the ratio of cash to deposits that people want to maintain, the final change in deposits will be:
Change in Deposits = (New Cash Deposit)/(c+v) = 100 / (0.05+0.1) = $667, not 1000.
- If the Central Bank wishes is to increase the money supply, it can start the process of deposit creation
by purchasing a Government of Canada bond from an individual or firm on the public market. This
individual will then deposit these funds in the banking system and this new deposit will lead to further
increases in the money supply.
What is the Money Supply?
- The money supply is the total quantity of money that is in the economy at any time. There is more
than one way to find the money supply, and each definition includes the amount of currency in
circulation, plus some types of deposit liabilities of financial institutions.
- A distinction lies between demand deposits, which earned little or no interest but were transferrable
on demand as cheques, and savings or notice deposits which earned a higher interest rate but were
not easily transferrable.
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