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8/11/2019 Economics Banking

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Chapter 24

Money, the Price Level and Inflation

What is Money?

Moneyis any commodity or token that is generally acceptable as the means of payment.

A means of paymentis a method of settling a debt.

When payment has been made, there is no remaining obligation between the parties to a

transaction.

Money performs three other functions:

o Medium of exchange

o Unit of account

o Store of value

A medium of exchangeis any object that is generally acceptable in exchange for goods and

services. Without money, it would be necessary to exchange goods and services directly for other goods

and services an exchange called barter.

A unit of accountis an agreed measure for stating the prices of goods and services.

In the absence of a standardized unit of account, keeping track of prices and comparing prices

would be difficult.

A store of valueis any commodity or token that can be held and exchanged later for goods and

services.

The more stable the value of a commodity or token, the better it can act as a store of value and

the more useful it is as money.

Money in Canada today consists of currency and deposits at banks and other financial

institutions.

The coins and Bank of Canada notes that we use today are known as currency.

The two main measures of money are called:

o M1

o M2

M1consists of currency held outside the banks and chequable deposits of individuals and

businesses.

M1 does not include currency held by banks, and it does not include currency and bank

deposits owned by the government of Canada.

M2consists of M1 plus all other deposits.

Deposits are money but cheques are not money.

A cheque transfers a deposit from one account to another.

Credit cards and debit cards are not money.


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The Banking System

A depository institutionis a private firm that takes deposits from households and firms and

makes loans to other households and firms.

The deposits of three types of depository institutions make up the nations money:

o

Chartered banks

o Credit unions and caisses populaires

o Trust and mortgage companies

To provide security for its depositors, a bank holds reserves, which are currency in a banks vault

plus its deposit at the Bank of Canada.

A bank has four types of assets: overnight loans, liquid assets, securities, and loans.

Banks provide four services for which people are willing to pay: create liquidity, minimize the

cost of borrowing, minimize the cost of monitoring borrowers, and pool risk.

The Bank of Canada is Canadas central bank, a public authority that supervises other banks and

financial institutions, financial markets, and the payments system and conducts monetary

policy.

The Bank of Canada makes loans to banks and serves as the lender of last resort, which means

that it stands ready to make loans when the banking system as a whole is short of reserves.

How Banks Create Money

We will use the work bank to refer to any depository institution.

Banks create money by making loans.

We will start by looking at a one-bank economy.

The fraction of a banks total deposits that are held in reserves is called the reserve ratio. The desired reserve ratiois the ratio of reserves to deposits that banks wish to hold.

A banks desired reservesare equal to deposits multiplied by the desired reserve ratio.

Actual reserves minus desired reserves are excess reserves.

When a bank has excess reserves it makes loans.

We call the leakage of currency from the banking system the currency drain, and we call the

ratio of currency to deposits the currency drain ratio.

There are nine steps in the sequence of money creation:

1. Banks have excess reserves.

2. Banks lend excess reserves.

3. The quantity of money increases.4. New money is used to make payments.

5. Some of the new money remains on deposit.

6. Some of the new money is a currency drain.

7. Desired reserves increase because deposits have increased.

8. Excess reserves decrease, but remain positive.


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The process repeats until the banks have created enough deposits to eliminate their excess

reserves.

The monetary baseis the sum of Bank of Canada notes outside the Bank of Canada, banks

deposits at the Bank of Canada, and coins held by households, firms, and banks.

The money multiplier is the ratio of the change in the quantity of money to the change in

monetary base. So for example, if reserves increase by $100,000 and the quantity of money

increases by $300,000 then the money multiplier is 3.

Read pp. 586-587 in your textbook to work through the formula for the money multiplier.

The Market for Money

The quantity of money that people choose to hold depends on four main factors:

o The price level

o The nominal interest rate

o Real GDP

o

Financial innovation

The quantity of money measured in dollars is nominal money.

The quantity of nominal money that people plan to hold isproportionalto the price level.

The quantity of money measured in constant dollars is called real money.

Real money is equal to nominal money divided by the price level.

The quantity of real money held is independentof the price level.

The quantity of real money that people plan to hold depends on the interest rate.

The reason is that the interest rate is the opportunity cost of holding money.

The higher the interest rate, the greater the opportunity cost of holding money and the smaller

is the quantity of money that people plan to hold.

The quantity of real money that people plan to hold depends on real GDP.

The reason is that money is held to enable people to undertake transactions, and the larger the

amount transacted, the greater is the amount of money that people hold.

The quantity of real money that people plan to hold depends on financial innovation.

Five financial innovations have changed the quantity of real money that people hold:

o Daily interest chequable deposits

o Automatic transfers between chequable deposits and savings deposits

o Automatic teller machines

o Debit cards and credit cards

o

Internet banking and bill paying The demand for money curveis the relationship between the quantity of real money demanded

and the interest rate when all other influences on the amount of money that people wish to

hold remain the same.


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The figure shows the demand for money curve.

A change in the interest rate brings a movement along the demand curve.

The figure below shows a change in the demand for money.

A change in real GDP brings a shift of the demand curve.

Financial innovation also shifts the demand for money curve.

Money Market Equilibrium

The interest rate is the amount received by a lender and paid by a borrower expressed as a

percentage of the amount of the loan.

The interest rate on a bond varies inversely with the price of the bond.


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The Quantity Theory of Money

The quantity theory of moneyis the proposition that in the long run, an increase in the quantity

of money brings an equal percentage increase in the price level.

The velocity of circulationis the average number of times a dollar of money is used annually to

buy the goods and services that make up GDP.

GDP equals the price level (P) multiplied by real GDP (Y).

Call the quantity of money M.

Then V= PY/M

Rearranging this equation, gives the equation of exchange: MV = PY.

We can also express the equation of exchange in growth rates: Money growth rate + Rate of

velocity change = Inflation rate + Real GDP growth rate

Solving this equation for the inflation rate gives: Inflation rate = Money growth rate + Rate of

velocity change - Real GDP growth rate

In the long run, the rate of velocity change is approximately zero, so: Inflation rate = Moneygrowth rate - Real GDP growth rate

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