Macroeconomics Chapter 14

Chapter 14: Money, Banking, and Money Creation

Learning Objectives

LO14.1 Explain the functions of money.
LO14.2 Describe the components of the Canadian money supply.
LO14.3 Describe what “backs” the money supply.
LO14.4 Discuss the structure of the Canadian financial system.
LO14.5 Explain the main factors that contributed to the U.S. financial crisis of 2007–2008.
LO14.6 Explain the fractional reserve system used by Canadian chartered banks.
LO14.7 Explain the basics of a bank’s balance sheet and distinguish between a bank’s actual reserves and its desired reserves.
LO14.8 Describe how a chartered bank creates money.
LO14.9 Describe the multiple expansion of loans and money by the entire chartered banking system.
LO14.10 Define and calculate the monetary multiplier.

Functions of Money (14.1)

Medium of exchange: Money serves as an intermediary in trade, facilitating transactions and eliminating the complications and inefficiencies associated with a barter system, where goods and services are exchanged directly.

Unit of account: Money provides a standard measurement of value, allowing for the consistent pricing of goods and services and enabling economic calculations and comparisons between values in monetary units (e.g., dollars).

Store of value: Money allows individuals and businesses to preserve purchasing power over time, maintaining value so that it can be used for future transactions, despite factors like inflation potentially eroding its value.

Liquidity: Liquidity refers to the ease with which an asset can be converted into cash without significantly affecting its value. Money is the most liquid asset available, meaning it can be quickly and easily used for transactions.

Components of the Money Supply (14.2)

Definition of M1

Currency: This encompasses all physical forms of money, including coins and paper money, known as token money, which is issued by the Bank of Canada.
Demand deposits: Representing about 75% of M1, this includes checking accounts where funds can be withdrawn at any time without any prior notice.
Primary institutions: Chartered banks act as the main depository institutions providing demand deposits.

Definition of M2

M1 + Near-monies: This category incorporates M1 along with near-monies, which are highly liquid financial assets that can be easily converted into cash, such as savings accounts.
Term deposits: These are savings accounts that restrict access to funds until a set maturity period, contributing to the broader money supply only upon maturation.

Broader Definitions

M1+: This is a narrower definition that includes more components, specifically currency in circulation and demand deposits.
M2+: Expanded to include deposits at trust and mortgage companies, mutual funds, and other financial institutions.
M2++: This extends the M2 definition to encompass Canadian savings bonds and various non-money market mutual funds, reflecting a broader view of available funds in the economy.

What Backs the Money Supply (14.3)

Money as Debt: In modern economies, most money, including paper currency and demand deposits, is essentially treated as a debt owed by the banking system to the holders of the money.

Value of Money Factors: The value of money is influenced by its acceptability among the public, its legal tender status (meaning it must be accepted if offered in payment of a debt), and its relative scarcity, which affects supply and demand dynamics.

The Canadian Financial System (14.4)

Chartered Banks

Chartered banks are multi-branched, privately-owned financial institutions that operate under the authority of an Act of Parliament in Canada and are crucial to the banking system.
They adhere to a fractional reserve banking system, which means they maintain a reserve ratio that is less than 100%, allowing them to lend out a portion of deposits received from customers.

Chartered Bank Balance Sheets

Example assets and liabilities (in billions):
- Reserves: $318
- Loans: $517
- Mortgages: $1369
- Total assets: $3,879
The balance sheet serves as a vital tool for assessing a bank's financial position, showing how much it owes relative to what it owns.

The U.S. Financial Crisis of 2007-2008 (14.5)

Key Terms

Subprime mortgage loans: These are high-interest loans extended to borrowers with poor credit histories, making them riskier for lenders.
Mortgage-backed securities: These are investment products backed by mortgage payments, which became widely traded before the crisis.

Causes of the Crisis

Government programs that aimed to promote home ownership inadvertently led to increased risk-taking in mortgage lending.
The impending burst of the real estate market bubble resulted in plummeting property values, culminating in widespread defaults.
Incentives associated with mortgage-backed bonds encouraged excessive borrowing, driving up risk in the financial system.
The outcome was a significant rise in foreclosures that jeopardized the stability of the financial system, leading to a global economic downturn.

Fractional Reserve Banking (14.6)

Under the fractional reserve banking system, banks retain only a fraction of demand deposits and reserves within the bank's vaults while the remainder is available for loans, creating a multiplier effect in the money supply.
Chartered banks create money by issuing loans, effectively increasing the total money supply within the economy by lending more than they hold in actual cash.

Characteristics of Fractional Reserve Banking

Money Creation: By loaning out excess reserves, banks can generate more money in circulation, which is vital for stimulating economic growth.
Bank Panics: Despite its advantages, this system is vulnerable to bank panics, situations where worried depositors withdraw their funds en masse. Deposit insurance can help mitigate the risk of bank runs.

Bank Balance Sheet Fundamentals (14.7)

Balance sheets are crucial financial documents summarizing a bank's financial position using the equation: Assets = Liabilities + Net Worth.
Main operations include accepting customer deposits, issuing loans, and adhering to required reserve levels for liquidity.

Multiple-Deposit Expansion Criteria (14.9)

The banking system is capable of lending multiple times its excess reserves due to the fractional reserve system, allowing for greater leverage and economic stimulation.
Monetary Multiplier Calculation: The formula to determine how much money is created in the banking system is:
- Money Multiplier = 1 / Desired Reserve Ratio. For example, if the reserve ratio is set at 20%, the monetary multiplier equals 5, meaning for every dollar held as reserves, a total of $5 can be circulating in the economy.

Conclusion on Monetary Response (COVID-19)

The Bank of Canada, in response to the economic downturn caused by COVID-19, implemented strategies which included effectively setting the monetary multiplier to infinity, thereby providing chartered banks with ample reserves for versatile lending options.
Recognizing the importance of qualifying borrowers is critical for overall stabilization and managing inflation risk during periods of slow economic activity.

Chapter Summary

A thorough review of the learning objectives and key concepts discussed throughout the chapter highlights the integral role of money, the banking system, and their implications in both everyday transactions and broader economic conditions.