Introduction To Economics

ECO 100Y

Introduction to Economics Topic 15: Money and Banking

Source: LR 12, LR11 Chapter 27; LR10 Chapter 26. Note that Lecture emphasizes balance sheets (sometimes called T-accounts).

ECO 100 W.G. Wolfson

Topic 15: Money and Banking

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Definition and Functions of Money 

Money is a medium of exchange A medium of exchange is anything that is accepted in exchange for goods and services o In history: precious metals (gold, silver) o In prisoner of war camps: cigarettes

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Functions of money: A medium of exchange A unit of account A store of value

ECO 100 W.G. Wolfson

Topic 15: Money and Banking

Does Money Matter?  

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So far, our Simple Keynesian Model of income and output determination does not include money! Does money matter?  i.e., can changes in the amount of money affect national income and output (GDP)? Two views:  Classical: Money is neutral (does not affect real output), but only the price level  Modern: Money can affect real output in the short run

ECO 100 W.G. Wolfson

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What Constitutes Money Today? A Class Discussion 1 2 3 4 5 6 7 8 9 10 ECO 100 W.G. Wolfson

Topic 15: Money and Banking

Definition of Money For ECO 100 

For ECO 100 purposes, we use the “narrow definition” of Money, called M1 M1=Currency in Circulation + Demand Deposits M1 = CIC + DD CIC = notes and coins held by the public (households and firms) DD = Deposits available to depositors on demand o Assume chartered banks only DD are “fiat” money (and CIC too?)

ECO 100 W.G. Wolfson

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Definition of M1 Money    

M1 = CIC + DD Demand Deposits are by far the larger of the two To understand how M1 behaves, we need to understand how DD behave We do this via the use of Balance Sheets for Banks and the Public  Based on equation: Net Worth = Assets - Liabilities  LHS of balance sheet shows Assets  RHS of balance sheet shows Liabilities (+ Net Worth)  LHS = RHS (double entry bookkeeping)

ECO 100 W.G. Wolfson

Topic 15: Money and Banking

Understanding Banking: The Ancient Saga of the Goldsmith 

In the old days, when gold was used as money, the goldsmith provided a safekeeping service  100% of deposits backed by gold

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Then, people realized commerce could be facilitated through swapping gold “deposit receipts”, rather than gold  Ownership of deposits transferable  100% of deposits backed by gold

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Next, goldsmiths realized that not every depositor asked to withdraw his/her deposit (i.e., gold) on the same day  Goldsmith can make loans create new deposits  Less than 100% of deposits now backed by gold  Called fractional reserve system

ECO 100 W.G. Wolfson

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Understanding Banking: The Modern Banking System 

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Financial intermediaries Chartered banks (and others) Central Bank In Canada, the Bank of Canada In the U.S., the Federal Reserve Reserves no longer in the form of gold A Bank’s Reserves =Vault Cash + The Bank’s Deposits at the Central Bank

ECO 100 W.G. Wolfson

Topic 15: Money and Banking

Chartered Banks  

The modern version of goldsmiths Assets  Currency in its vault (VCCB)  Deposits with the Bank of Canada (DBC)  Loans made to its customers (L)  Government Bonds (GB)

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Liabilities  Deposits of its customers (DDP)  Deposits of the Government of Canada (DDG)

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Reserves (R) of Chartered Banks 

R = VCCB + DBC

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VCCB  to meet customers’ needs

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DBC  to settle accounts with other banks Target (or desired) reserves established by each bank  Used to be regulated by the Bank of Canada Assumption is that banks operate always to be at the target Reserve Ratio (rr)  Excess reserves are loaned out  There are always willing borrowers

ECO 100 W.G. Wolfson

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Multiple Deposit Creation

(The Apocryphal Wolfson Airplane Experiment) 

Simplifying Assumptions:  Bank Assets = Reserves + Loans  Bank Liabilities = DDP only  Reserve Ratio: rr = 10%  Reserves are VC only  Loans provided in cash at one bank and deposited in another  Initial level of DDP for Banks A, B, C, D etc. = $400 The Airplane Experiment: $100 bill falls from an airplane in your yard; you deposit it in Bank A. What happens to Total R, DD, M1?

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Multiple Deposit Creation (The Simple Math) 

We assume “no currency drain”  The current level of CIC remains the same  Excess reserves in Bank A become additional reserves in Bank B (and so on for C, D, etc.)

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The Math:  R = rr * DD  DD = R / rr  ∆DD = ∆R / rr

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The Example:  ∆DD = ∆R / rr = $100 / .10 = $1,000  The “Money Multiplier” = 1 / rr = 1 / .10 = 10

ECO 100 W.G. Wolfson

Topic 15: Money and Banking

Changing the Money Supply 

Altering the Reserves of the banking system can affect the level of DD and the Money Supply (M1)  Increase Reserves  DD increases; M1 increases  Decrease Reserves  DD decreases; M1 decreases

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How can Reserves be increased or decreased?  Done by the Bank of Canada (monetary policy)  Via “Open Market Operations”  Via “Swap of the Government’s deposits from/to the Bank of Canada to/from the chartered banks

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The Roles of The Bank of Canada    

Banker to the chartered banks Lender of last resort to chartered banks Banker to the Government of Canada Controller of the money supply  i.e., executes monetary policy  By increasing / decreasing reserves of the banks

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Note that currency is a liability of the B of C  But, currency no longer convertible to gold

ECO 100 W.G. Wolfson

Topic 15: Money and Banking

Balance Sheet of Bank of Canada 

Assets  Government Bonds (GB)  Loans to chartered banks (LCB)  Foreign-currency reserves (discussed later)

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Liabilities  Currency (C = CIC + VCCB)  Deposits of the Government of Canada (DG)  Deposits of the chartered banks (DCB)  DCB = DBC

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Open Market Operations 

There is a “bond market” in Canada  Brings together buyers and sellers  Bank of Canada can participate in this “open market”

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The Bank of Canada can affect the money supply by being a buyer or a seller in the bond market  Buy or sell Government Bonds from/to the Public or from/to the Chartered Banks

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Examples (rr = 10%; no currency drain, etc.)  Show that an open market purchase of $100M of GBs from the public will increase the money supply  Show that an open market sale of $100M of GBs to the

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Swap of Government Deposits 

The Government holds deposits in chartered banks and in the Bank of Canada

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Demonstrate the following:

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 If the Government’s deposits were held only at the B of C, the reserves of the banking system would change with every tax receipt and every government expenditure. Having deposits in the banking system avoids the above issue, while opening up a tool of monetary policy Example:  Show that a swap of $10M of DG from the B of C to the chartered banks increases DD and M1.

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List of Useful Equations 

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Money supply: M1 = CIC + DD Currency: C = CIC + VCCB

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Bank Reserves: R = VCCB + DBC

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Money Multiplier: MM = 1 / rr

ECO 100 W.G. Wolfson

Topic 15: Money and Banking

The Impact of Gov’t Spending on the Money Supply

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How can (federal) government spending be financed?  i.e., How can the government acquire a bank balance in order to draw on its deposits for spending? There are 3 ways:  Tax-financed spending  Bond-financed spending  Money-financed spending

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Demonstrate :

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 How each are implemented (use T- accounts)  How each impact on M1 and on GDP (assume Y < YF) ECO 100 W.G. Wolfson

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Advances By Bank of Canada to Chartered Banks 

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One of the roles of the central bank is to be a “banker to the banks”  This includes providing loans to the banks  A loan might be needed if reserves are “low” A loan from the Bank of Canada is not free!  There is an interest rate, called the Bank Rate  The Bank Rate is an “administered rate”, set by the B of C Other interest rates:  Overnight Rate  Prime Rate Begs the question of what is the impact of changes in interest rate(s) on the real economy e.g. real GDP?

ECO 100 W.G. Wolfson

Topic 15: Money and Banking