ECN204 MODULE 10 CHAPTER 15

Money functions as a medium of exchange…

Facilitating transactions between buyers and sellers. In the past, before the advent of money, societies relied on barter systems where goods and services were directly exchanged.

• However, this system was cumbersome and inefficient due to the requirement of a double coincidence of wants.

• For instance, if a farmer wanted to exchange wheat for shoes, they needed to find a shoemaker who not only had the desired shoes but also wanted wheat in return.

• The solution to this problem was the emergence of a universally accepted medium of exchange. Historically, various commodities like seashells, salt, and precious metals such as gold and silver served as money because they were universally accepted in transactions.

Unit of Account

Money also serves as a unit of account, providing a common measure for expressing the value of goods and services. Once a medium of exchange is established, it naturally becomes a unit of account because prices are quoted in terms of that currency.

• For instance, if gold coins are used as money, prices of goods and services would be denominated in terms of gold coins. Similarly, in a modern context, prices are quoted in terms of fiat currencies like CAD.

Having a standard unit of account

Facilitates economic calculations, comparisons, and planning.

• It allows individuals and businesses to easily assess the relative value of different goods and make informed decisions about spending and investment.

Store of Value

Money functions as a_______, allowing individuals to save wealth for future use.

• When an object is widely accepted as a medium of exchange, individuals have confidence that it will retain its value over time, enabling them to store their wealth in that form.

For Example, if CAD is widely accepted…. (Store of Value)

In an economy, individuals can hold their savings in the form of CAD. They may keep physical cash in safes or bank accounts.

• The ability of money to serve as a store of value depends on factors like stability, liquidity, and the confidence of the public in its purchasing power.

• Central banks play a crucial role in maintaining the stability of fiat currencies through monetary policy.

The capability of the medium of exchange to retain…

Its value over time is an important factor in determining how willing the public are in storing their income as money.

• Imagine a situation where the Canadian dollar is losing its value rapidly due to inflation.

• Would you be willing to hold your savings in the form of cash in your vault, or as deposits in a chequing account – which does not pay interest?

• This highlights the role of monetary authorities – i.e., the central banks in modern economies – in maintaining a stable monetary system. This argument also goes to the core of how monetary policy can affect the economy by balancing the demand for and supply of money, as you will see later on.

Liquidity

Is a concept that plays a crucial role in monetary economics.

• It refers to the ease and speed with which an asset can be converted into the socially accepted medium of exchange, typically currency or money.

• For instance, in the Canadian economy where CAD serves as the socially accepted money, liquidity measures how quickly one can convert assets such as government bonds into CAD.

• If you own government bonds and need to access cash, the speed at which you can sell those bonds and obtain CAD reflects the liquidity of those bonds.

M1+ is compromised of two principal components:

• Currency

• Demand Deposits

Currency (M1+ Components)

This category includes all the coins and paper money that actively circulate within the Canadian economy, representing the most physical and tangible form of money.

• When we talk about currency, we’re referring to the actual cash that you can hold in your hand, spend at a local market, or stash away for a rainy day.

Demand Deposits (M1+ Components)

A somewhat less tangible but equally crucial component, demand deposits represent the total deposits in chequable accounts across Canada.

• Unlike holding a bill or a coin, demand deposits are digital figures that represent an individual’s or entity’s balance in an account accessible by cheques.

First, any currency held in vaults of the Bank of Canada or charter banks.. (Exceptions to the two components of M1+)

The second exception are the deposits made by the federal government or the bank of Canada (Exceptions to the two components of M1+)

At first glance, one might wonder why the funds of such central pillars of our financial system would be omitted.

• The answer lies in the delineation between the private and public sectors.

• The focus of M1+ is on capturing the liquidity available to the private sector – the individuals, businesses, and organizations that operate within the economy.

• The government’s deposits, representative of the public sector, play a different role, underpinning fiscal policies and national economic strategies rather than participating in the market in the same way private sector funds do.

M2

M1+ is the narrowest measure of “money stock.” If we broaden this definition slightly, we arrive at our second measure of money, __.

• Encompasses all elements of M1+ but ventures further to include what is known as near money.

• This term, evocative of liquidity's essence, refers to any financial asset that can swiftly be converted into currency (or demand deposits).

• In this light, near money represents the pinnacle of liquidity outside of cash itself – assets that, while not immediately usable as currency, can quickly don the mantle of money with minimal effort or delay

Savings Account Deposits (Near Demand)

Picture the funds in personal savings accounts.

• While these cannot be directly handed over in a transaction like cash, they stand at the ready, able to be transformed into demand deposits with ease and speed.

Term Deposits (Near Demand)

These are the funds deposited with a bank or financial institution that agree to stay put until a specified maturity date.

• While locked in, they are not accessible without incurring a penalty.

• However, once maturity is reached, they effortlessly transition into the realm of currency. Guaranteed Investment Certificates (GICs) are a prime example.

Notice Deposits (Near Demand)

Unique to the business world, these deposits are accessible swiftly but require a heads-up – a notice – before withdrawal.

• This feature positions them as highly liquid, yet distinct from the immediate availability of cash.

These forms of near money…

Though not directly usable in transactions, embody a critical characteristic: the ability to be converted into a medium of exchange at breakneck speed.

• This quality is why they are included in the more lenient measure of money, M2.

• It's a recognition of their potential to act, adapting quickly to fulfill the role of money when needed.

An important distinction to remember Is that M2 doesn’t just add to M1+; it envelops it.

• By incorporating M1+, M2 inherently represents a larger measure of the money stock at any given moment.

• This hierarchical structure not only broadens our comprehension of what constitutes money but also highlights the spectrum of liquidity within financial assets.

• M2, in essence, serves as a bridge between the stringent liquidity of M1+ and the broader liquidity landscape.

M2+ is….

The deposits at credit unions, caisses populaires, trust companies, mortgage and loan companies, and other non-bank depository institutions, and also money market mutual funds.

• If we add Canadian saving bonds and non-money market mutual funds to , we arrive at M2++.

Chartered Banks (M2+)

Examples: RBC, TD, BMO, CIBC, Scotiabank.

You:

Deposit money → bank holds it → bank lends/invests money → you can use your account.

They are generally for-profit corporations owned by shareholders.

Credit Unions (M2+)

is basically a member-owned alternative to a traditional bank.

Instead of being owned by outside shareholders, the customers are generally also members/owners.

Example:

You join a credit union → deposit money → use its financial services → potentially participate in member ownership.

They offer many of the same services as banks:

• Chequing accounts

• Savings accounts

• Mortgages

• Loans

• Credit cards

Caisses Populaires (M2+)

is essentially the French/Quebec cooperative version of a credit union.

• The most famous example is Desjardins.

Trust Companies (M2+)

A trust company is a financial institution that can handle things like:

• Investments

• Estates

• Trusts

• Financial management

Historically, they also took deposits and made loans, so they can be part of the broader financial system.

Mortgage and Loan Companies

These specialize more heavily in lending.

For example:

You deposit money with the institution → the institution uses funds to make loans or mortgages.

They are essentially specialized financial intermediaries.

Intrinsic Value (Money as Debt)

The evolution of money is indeed a captivating tale. In its early history, people traded using items of _______, such as gold coins, seashells, or even cigarettes in certain contexts like prisons.

• These items were valued not just as currency but also for their own worth: even if one did not accept them in an exchange, they still had their own intrinsic value.

Gold Standard (Money as Debt)

As the banking systems developed, particularly with the establishment of central banks – such as the Bank of Canada in Canada, or the Federal Reserve System in the U.S. – paper currency began to be backed by precious metals, like gold (stored in places such as Fort Knox).

• This meant, in theory, you could exchange a dollar for its equivalent in gold. However, by the mid-20th century, this _______ was abandoned due to its inefficiency and high costs, not to mention the security risks of storing vast amounts of gold.

Today bank issues currency like a $1 bill from the bank of Canada… (Money As Debt)

Symbolizes a promise to the bearer but not in the form of gold or any physical asset.

• Instead, it’s a declaration of debt, an assurance that the bank owes you a dollar.

• This system works based on a collective agreement – call it a non-written social contract – and trust in the currency’s value as a medium of exchange and a unit of account.

• We accept currency and deposits because we trust that others will do the same, allowing us to exchange these notes for goods and services.

• The seller accepts your money, knowing it can be used in future transactions, perpetuating a cycle of trust and acceptability

Fractional Reserve System

A foundational aspect of these chartered banks is their operation within a fractional reserve banking system.

• This model permits banks to hold a smaller amount of assets compared to their liabilities. In simpler terms, banks are not required to keep the full amount of depositors’ funds in reserve.

• Instead, they maintain a fraction of these deposits as reserves, enabling the remainder to be loaned out or invested.

• This system plays a crucial role in money creation and circulation within the economy, amplifying the impact of demand deposits on the overall money supply.

Stage 1 (Stages in the lifecycle of chartered bank)

Creating a bank

Stage 2 (Stages in the lifecycle of chartered bank)

Creating a bank

Stage 3 (Stages in the lifecycle of chartered bank)

Accepting Deposits

Stage 4 (Stages in the lifecycle of chartered bank)

Clearing a Cheque Drawn Against The Bank

Stage 5 (Stages in the lifecycle of chartered bank)

Granting a Loan

Stage 6 (Stages in the lifecycle of chartered bank)

Buying Government Securities

Creating a Bank

Begins with a foundational step: securing a charter from the Canadian Parliament.

• This legal recognition is essential, as it grants the institution the authority to operate within the Canadian banking system.

• Following this, the next critical phase involves capitalization, where the founding members must gather the necessary funds to operationalize the bank.

• This is typically achieved by offering shares to the public, with founders often participating in this initial round of investment themselves.

Let’s consider a scenario where through this initial public offering ….. (IPO)

The new chartered bank successfully raises $250,000 in cash. This sum represents the bank’s initial capital, provided by its investors or shareholders, who in return own a piece of the bank proportionate to their investment.