Chapter 27
Money and Banking

1

Two Perspectives on Money
The Classical View of Money
• Relative prices and real GDP determined only by real things
• technology and preferences
•Money is neutral
• change in the money supply causes no change in real variables
• change in the money supply does lead to a proportionate change in the price level

2

The Modern View
Short run:
• changes in money do generate changes in output and other real variables
Long run:
• money is neutral
•changes in money and the price level are closely linked countries with high inflation rates often have higher rates of growth of the money supply
3

The Nature of Money
Money is a medium of exchange
• acceptable as payment for goods and services.
• without money, would need a system of barter
•barter is inefficient
•requires double coincidence of wants
Not a problem when a general medium of exchange is used. 4

Money is a store of value
• without high inflation, money retains its value
Alternative media of exchange -- ice cream?
-- do not necessarily hold their value well.
Money is a unit of account
• the unit of measure we use to keep our financial accounts

5

The Origins of Money
Metallic money
• Coin worth market value of metal
• Led to debasing
Gresham’s Law:
• “bad money drives out good” when two types of money used
• one with greater intrinsic value will be driven out of circulation
6

Paper money
• backed by precious metal
• convertible on demand
• referred to as bank notes because it was issued by private banks

7

Fractionally backed paper money
• goldsmiths (banks) found they didn’t need to keep 1 oz. of gold in vaults for every receipt for 1 oz.
• issued more “receipts” than the gold in their vaults
Fiat money
• paper money or coinage
• neither backed by nor convertible into anything else
• decreed by the government to be acceptable as legal tender Today most currency is fiat money.
8

Modern Money
Deposit Money:
• money held by the public in form of deposits with commercial banks and other financial institutions
• bank deposits are money

Money Creation:
• banks create money by issuing more promises to pay
(deposits) than they have available in their cash reserves

9

The Canadian Banking System
Consists of:
• commercial banks
• a central bank
Central bank:
• acts as a bank to commercial banking system
• usually government-owned
• sole money-issuing authority
Bank of Canada [ BOC ] is central bank in Canada
10

BOC
• operates under system of joint responsibility - 1967
• operates monetary policy on a day-to-day basis
• free of political influence
• ultimately answerable to Parliament

11

Basic functions of BOC:
1) banker to commercial banks
2) banker to federal government
3) regulate money supply
4) regulate, support, and monitor financial markets

12

1) Banker to commercial banks:
• Accepts deposits (commercial bank reserves)
• Transfers funds to other commercial banks to settle debts
• Lends to commercial banks (lender of last resort)
Assets (March, 1999)
Government of Canada
Securities
Advances to banks
Foreign-currency assets
Other assets

Total ($millions)

Liabilities (March,1999)
30,042 Notes in circulation
737 Government deposits
323 Deposits of banks
(reserves)
1,696 Foreign-currency liabilities and capital
Other liabilities and capital 32,798 Total ($ millions)

30,882
12
1,115
159
630
32,798
13

2) Banker to Federal Government
• Holds some government deposits
• May lend to federal government by buying treasury bills
(short term bonds) or regular bonds

Important for conduct of monetary policy

14

3) Regulator of Money Supply
• Controls money supply
• Two main liabilities of BOC are:
• Currency in circulation
• Chartered bank reserves

• Controlling liabilities, controls money supply

15

4) Regulate and Support Money Markets
• Financial institutions
• banks, borrow short and lend long
Problems:
• unexpected interest rate rise
• banks must pay higher interest rates to keep deposits • funds loaned out a lower rates