1. WHAT IS MONEY? (151-157)

2. HOW THE BANKING SYSTEM CREATES AND DESTROYS MONEY (158-167)

3. HOW THE CENTRAL BANK CREATES AND DESTROYS MONEY(text:402-8) (168-175)

WHAT IS MONEY?

WITHOUT MONEY, TRADE REQUIRES BARTER:

GOODS & SERVICES EXCHANGED FOR GOODS & SERVICES.
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PROBLEM WITH BARTER: REQUIRES COINCIDENCE OF WANTS.

TRADE WITHOUT MONEY IS VERY DIFFICULT - HIGH TRANSACTIONS COSTS.

EXISTENCE OF MONEY REDUCES THESE COSTS. THE MONETARY SYSTEM IS A TYPE OF PUBLIC GOOD.

MONEY: ANY ASSET WHICH IS GENERALLY ACCEPTED IN EXCHANGE FOR GOODS & SERVICES.

ONCE ACCEPTED AS A MEANS OF EXCHANGE, MONEY USUALLY BECOMES:
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1. UNIT OF ACCOUNT: STANDARD FOR QUOTING PRICES; MEASURE OF VALUE.

&

2. STORE OF VALUE: ASSET USED TO CARRY WEALTH FROM ONE PERIOD TO THE NEXT.

NOTE: MONEY IS A STOCK, LIKE OTHER ASSETS (BONDS, SHARES, HOUSES)

BENEFIT OF HOLDING WEALTH IN MONEY:

LIQUIDITY - CAN QUICKLY BE TRANSFORMED INTO ANY GOOD OR SERVICE.

COST OF HOLDING MONEY: OPPORTUNITY COST OF FOREGONE NOMINAL INTEREST.
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TYPES OF MONEY?

1. COMMODITY: HAS VALUE IN NON-MONETARY USE.

E.G., CATTLE, CIGARETTES, GOLD, SILVER.

GOLD IS DURABLE, PORTABLE AND SCARCE.

2. FULLY-BACKED PAPER MONEY: GOLDSMITHS STORE GOLD, ISSUE CERTIFICATES WHICH ARE USED AS MONEY.

3. PARTIALLY-BACKED PAPER MONEY: GOLDSMITHS ISSUE MORE CERTIFICATES THAN GOLD STORED, BECAUSE ONLY A FRACTION OF CERTIFICATES REDEEMED FOR GOLD AT ANY ONE TIME.
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EVENTUALLY:

4. PURE FIAT MONEY: NOT REDEEMABLE FOR ANY COMMODITY, IT HAS VALUE BECAUSE PEOPLE BELIEVE IT HAS VALUE. "CURRENCY"

"VALUE" OF MONEY = GOODS & SERVICES IT CAN BUY. INVERSELY RELATED TO THE PRICE LEVEL.

E.G., $1 TODAY BUYS WHAT $0.729 BOUGHT IN 1986.

BY 19TH CENTURY:

5. CHEQUING DEPOSITS: TRANSFER OF OWNERSHIP OF A DEPOSIT OF CURRENCY IN A BANK. BANKS ISSUE MORE DEPOSITS THAN CURRENCY HELD - FRACTIONAL RESERVES
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STOCK OF MONEY IN CANADA

1. CURRENCY (NOTES&COINS) HELD BY PUBLIC (CU)

2. CHEQUING DEPOSITS IN BANKS (D)

M1= 1 + 2

M2= M1 + NOTICE DEPOSITS + PERSONAL TERM DEPOSITS

M3= M2 + BUSINESS CERTIFICATES OFDEPOSIT

NOTE: THESE INCLUDE ONLY DEPOSITS AT CHARTERED BANKS. M2+ INCLUDES DEPOSITS AT "NEAR BANKS" - EG, CREDIT UNIONS.
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WHICH MEASURE IS "MONEY"?

THINK OF A CONTINUUM OF ASSETS, FROM MOST TO LEAST "LIQUID":

CURRENCY,CHEQUING DEPOSITS

SAVINGS DEPOSITS,GOV'T TREASURY BILLS,GOV'T BONDS

MUTUAL FUNDS,SHARES,CARS, CAPITAL GOODS, HOUSES...

MONEY IS MOST LIQUID ASSET

FOR SIMPLICITY, ASSUME:

MONEY = CURRENCY + CHEQUING DEPOSITS

M = CU + D
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THE BANKING SYSTEM

BANKS, CHARTERED BY PARLIAMENT:

1. TAKE DEPOSITS AT ZERO (OR LOW) INTEREST AND LEND AT (HIGHER) INTEREST.

SPREAD= LOAN RATE - DEPOSIT RATE

2. CHANNEL FUNDS FROM SAVERS (LENDERS) TO INVESTORS (BORROWERS). REDUCE RISKS BY "POOLING".

3. PROVIDE A SAFE ASSET IN WHICH TO HOLD WEALTH.

4. PROVIDE A PAYMENTS MECHANISM - CHEQUING.
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BANKS CAN CREATE/DESTROY MONEY BECAUSE OF:

FRACTIONAL RESERVE BANKING

BANKS DO NOT HOLD 100% OF A DEPOSIT AS VAULT CASH (RESERVES, R).

THEY HOLD A FRACTION AND USE REMAINDER TO MAKES LOANS, LN.

ONLY A SMALL FRACTION OF THE PUBLIC DEMANDS CASH WITHDRAWLS AT ONE TIME.

WHY DO BANKS NOT HOLD ZERO RESERVES?

1. BECAUSE FLOW OF NEW DEPOSITS        WITHDRAWLS
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2. BECAUSE BANKS ARE VULNERABLE TO "RUNS".

BANK RUN: EVERYONE TRIES TO WITHDRAW AT ONCE.

WHY REGULATE BANKS?

TO PREVENT COLLAPSE OF PAYMENTS MECHANISM, A PUBLIC GOOD.

REGULATION?

1. REQUIRE MINIMUM RESERVE/DEPOSIT RATIOS.

2. INSURE DEPOSITS (CDIC)

PROBLEM: MORAL HAZARD

3. REQUIRE BANK OWNERS TO INVEST SIGNIFICANT AMOUNT OF OWN CAPITAL
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CREATION OF MONEY

FIRST:

BANKS' BALANCE SHEETS:

ASSETS LIABILITIES

RESERVES (R) DEPOSITS (D)

LOANS (LN) SHAREHOLDERS

EQUITY (NW)

(SECURITIES)

(FIXED ASSETS)

DOUBLE-ENTRY BOOK-KEEPING:

EVERY TRANSACTION REQUIRES TWO ENTRIES; TWO SIDES OF SHEET MUST BALANCE. (9.3)
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BANKS HAVE TARGET RESERVE RATIO: rr* = (R/D)*

E.G., rr* = 0.05

TARGET RESERVES = rr* x D

EXCESS RESERVES = ACTUAL RESERVES - TARGET RESERVES

= R - (rr* x D)

= R - R*

IF EXCESS RESERVES > 0, BANKS TRY TO MAKE LOANS.

IF EXCESS RESERVES < 0, BANKS TRY TO REDUCE LOANS.

NOW: MONEY CREATION

YOU FIND $1000 CASH, DEPOSIT IN A BANK.
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M = CU + D ; NO CHANGE

BALANCE SHEET CHANGES?

BANK:

A               L + NW

LN            D +1000

R +1000

    +1000       +1000

PUBLIC (YOU):

A                 L + NW

CU    -1000 LN

D       +1000
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SUPPOSE rr* = 0.1

TARGET RESERVES? + 100

ACTUAL RESERVES? +1000 EXCESS RESERVES? + 900

BANK MAKES NEW LOAN TO YOUR FRIEND OF $900 CASH, DEPOSITS IT IN SAME BANK.

BALANCE SHEET CHANGES?

BANK:

A                     L + NW
LN +900         D +1000
R +1000              + 900

PUBLIC (YOU & YOUR FRIEND)

A                           L + NW

CU -1000            LN +900
D +1000
    + 900

MONEY? M = CU + D

CU HAS DECREASED BY 1000

D HAS INCREASED BY 1900

M HAS INCREASED BY 900

TARGET RESERVES? + 190

ACTUAL RESERVES? +1000 EXCESS RESERVES? + 810

BANK MAKES NEW LOAN OF $810 ...
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ON ROUND t, BANKS CREATE $1000 x (1 - rr*)t IN NEW DEPOSITS (MONEY).

ACTUAL RESERVES HAVE INCREASED BY $1000.

WITH TARGET RESERVE RATIO (rr*) OF 0.1, DEPOSITS IN TOTAL INCREASE BY $10,000!

CHANGE IN D / CHANGE IN R = THE MONEY MULTIPLIER

= 1/rr*

EXERCISE: SHOW FINAL BALANCE SHEET CHANGES FOR BANKS AND PUBLIC.

HOW MUCH DID THE MONEY SUPPLY INCREASE?

CHANGE IN M = -1000 +10000
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-PUBLIC DECIDES HOW MUCH M TO HOLD AS CU AND D.

-BANK DETERMINES rr*.

-IF PUBLIC INCREASES CURRENCY HOLDINGS, M FALLS

(PROCESS ABOVE IN REVERSE)

-MONEY MULTIPLIER IS REALLY SMALLER BECAUSE SOME NEW DEPOSITS ARE WITHDRAWN AS CASH.

-IF BANKS INCREASE rr*:

1. M FALLS

2. REDUCES MULTIPLIER

-IF PUBLIC DOESN'T WANT NEW LOANS, MONEY CREATION STALLS.
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CENTRAL BANK CONTROL OF THE MONEY SUPPLY (402-8)

IN CANADA, THE BANK OF CANADA (b. 1935) IS THE CENTRAL BANK:

-SOLE ISSUER OF CURRENCY

-BANK FOR THE CHARTERED BANKS ("LENDER OF LAST RESORT")

-REGULATOR OF THE BANKS

-CONDUCTS MONETARY POLICY

EXPANSIONARY POLICY: (FASTER) INCREASE IN M

AND DECREASE IN "THE" INTEREST RATE.
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CONTRACTIONARY POLICY: SLOWER INCREASE OR DECREASE IN M; INCREASE IN THE INTEREST RATE.

INSTRUMENT?

OPEN MARKET OPERATIONS:

PURCHASE AND SALE OF GOV'T SECURITIES FROM THE PUBLIC

GOV'T SECURITIES: STOCK OF OUTSTANDING FEDERAL GOV'T DEBT.

-A PURCHASE OF GOV'T SECURITIES ADDS RESERVES TO THE BANKS AND CREATES A MULTIPLE INCREASE IN M.

-A SALE OF GOV'T SECURITIES DECREASES M.
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OPEN MARKET PURCHASE OF $1000 IN GOV'T SECURITIES.

B of C PAYS WITH CHEQUE TO YOU.

YOU DEPOSIT CHEQUE IN YOUR BANK.

YOUR BANK CLEARS CHEQUE WITH B of C, GETS $1000 IN RESERVES (VAULT CASH).

BALANCE SHEET CHANGES?

B of C:

A                              L + NW

GOV'T                    R +1000
SEC'S +1000         CU

BANKS:

A                            L + NW

R +1000                D +1000
LN

PUBLIC:

A                           L + NW

CU                        LN
D                         +1000
GOV'T
SEC'S                   -1000

NOW: BANKS HAVE +900 IN EXCESS RESERVES (rr*= .1)

SAME MULTIPLIER PROCESS AS BEFORE. CHANGE IN M?
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M INCREASES BY $10,000 (NEW DEPOSITS CREATED BY INITIAL $1000 ADDITION TO RESERVES OF BANKS).

NOTE:

1. LIABILITIES OF CENTRAL BANK ARE THE MONETARY BASE

2. THE CENTRAL BANK CONTROLS THE MONETARY BASE BY BUYING AND SELLING GOV'T SECURITIES.

3. THE CENTRAL BANK DOES NOT CONTROL THE MONEY SUPPLY COMPLETELY.

4. THE PUBLIC AFFECTS THE MONEY SUPPLY BY:
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i. CONTROLLING THE RATIO OF CURRENCY TO DEPOSITS

ii. DECIDING WHETHER OR NOT TO TAKE OUT LOANS.

5. THE BANKS AFFECT THE MONEY SUPPLY BY CONTROLLING THE TARGET RESERVE RATIO.

FOR SIMPLICITY, ASSUME:

rr* IS KNOWN AND CONSTANT.

THE PUBLIC DOES NOT ADJUST ITS CURRENCY HOLDINGS WHEN THE MONEY SUPPLY CHANGES.

BANKS CAN ALWAYS FIND LOAN CUSTOMERS.
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EXERCISES:

A. What would be the effect on the money supply of:

i. A decline in the public's confidence in banks.

ii. An increase in the banks' target reserve ratios.

iii.The increased use of credit cards.

B. Assume the target reserve ratio is 0.4:
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i. The Bank of Canada buys a government security from Maria for $1000.

Explain what will happen to the money supply, using balance sheets for the B of C and the banking system.

ii. Answer the same question assuming that Maria (and only Maria) takes the payment from the B of C as follows:

$500 cash (which she hides under her mattress) and a $500 cheque.
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