Engineering Economics: Money and Banking

Money

  • Money is any asset people accept for goods, services, or debt repayment.
  • Asset: Anything of value owned.

First Money - Barley

  • Barley was likely the first commodity used as money (Sumerian Barley money).
  • Used around 3000-3500 BC in Sumer.
  • Measurement: sila (approx. 0.82 litre).
  • Problem: Inconvenient (mold, mice, large purchases).

Early Non-intrinsic Money

  • Silver shekel appeared in Mesopotamia around 2500-3000 BC.
  • 8. 33 grams of silver, easier to store/transport than barley.

Coins

  • Sumerians were the first to use coins.
  • First written word was likely for accounting.

Functions of Money

  • Medium of exchange: Accepted as payment.
  • Unit of account: Standard measure of value.
  • Store of value: Allows deferred consumption; liquid.
  • Standard of deferred payment: Facilitates exchanges across time.

Fiat Money

  • Paper money issued by banks/governments, not exchangeable for commodities.
  • Fiat money is authorized by a central bank/government.
  • Acceptable if people believe it will retain value.

Banks and Money

  • Banks create money through checking accounts.
  • Banks are profit-making firms.

Bank Balance Sheets

  • Assets (left) = Liabilities + Stockholders’ Equity (right).
  • Banks use deposits to make loans/buy securities.
  • Largest liabilities: deposit accounts.

Reserves

  • Deposits kept as cash or with the Bank of Canada.
  • Banks lend/invest deposited money to make profit.
  • In 2018, banks kept 5% as reserves.

T-Accounts

  • Simplified balance sheet showing transaction changes.
  • Example: $1,000 deposit increases reserves and deposits.
  • No net change in money supply initially.

Simple Deposit Multiplier

  • Formula: 1/rd where rd is the desired reserve ratio.
  • With 10% reserve ratio, multiplier is 10.

Real-World Deposit Multiplier

  • Lower than simple multiplier because:
    • Banks may hold excess reserves.
    • Consumers hold currency outside banks.
  • During the 2007-2009 financial crisis, the multiplier fell close to 1 in the US.

Banks and the Money Supply

  • Banks gain reserves: make new loans, money supply expands.
  • Banks lose reserves: reduce loans, money supply contracts.

Bank Runs and Bank Panics

  • Fractional reserve banking system: banks keep a fraction of deposits as reserves.
  • Bank run: depositors lose confidence and withdraw money.
  • Bank panic: many simultaneous bank runs.
  • Central bank (e.g., Bank of Canada) acts as lender of last resort to prevent panics.

Bank of Canada

  • Created in 1934.
  • Monetary policy decisions by governing council (governor, senior deputy governor, 4 deputy governors).
  • The federal government approves governor choice and has ultimate responsibility.

BoC Operating Band and Overnight Rate

  • Bank of Canada targets the overnight interest rate (banks' rate for 24-hour loans).
  • Sets an operating band of 50 basis points (0.5%).
  • Bank rate (lending rate) is the upper limit; deposit rate is the lower limit.

Implementing Monetary Policy

  • Open market operations: buying/selling government securities to control money supply.
    • Purchase and resale agreement: increase money supply.
    • Sale and repurchase agreement: decrease money supply.
  • Lending to financial institutions: banks borrow from the Bank of Canada to meet reserve needs.
  • Bank of Canada acts as a lender of last resort.

BoC Approach to Monetary Policy

  • Goal: keep inflation between 1% and 3%, aiming for 2%.
  • Lowers overnight rate target if the economy slows (prevent inflation below 1%).
  • Increases overnight rate target if the economy overheats (prevent inflation above 3%).

Quantity Theory of Money (QTM)

  • Equation: M ims V = P ims Y
  • M = Money supply; V = Velocity of money; P = Price level; Y = Real output.
  • Inflation rate = Growth of money supply – Growth rate of real output.
  • If money supply grows faster than real GDP, there is inflation.
  • If money supply grows slower than real GDP, there is deflation.

Hyperinflation

  • Very high inflation (over 50% per month).
  • Results from central banks increasing the money supply excessively.
  • Associated with slow growth or recession.

German Hyperinflation (1920s)

  • Germany printed money to pay WWI reparations.
  • Led to massive inflation, rendering the mark worthless.

Common Misconceptions

  • Money is not the same as income or wealth.
  • Assets for depositors are liabilities for the bank.