Lecture 11: Money and the Banking System

Money and the Banking System

• What is Money?

  • Generally accepted in exchange for goods/services.

  • Commodities (e.g., furs, cigarettes) used historically, but often not durable.

• Functions of Money:

  • Medium of exchange

  • Measure of value

  • Store of value

  • Means of deferred payment

• Measuring Money:

  • M1 = Currency + Demand Deposits.

  • Currency = Legal tender (fiat money).

• Types of Deposits:

  • Demand deposits = accessible funds.

  • Savings deposits = not for direct payments.

• Liquidity:

  • Money is the most liquid asset, easily converted to goods/services.

• Money Creation by Banks:

  • Banks take deposits and provide loans, profiting from interest rate differentials.

  • Fractional reserve system: banks keep a reserve fraction of deposits.

• Balance Sheet of a Bank:

  • Assets: Things of value (loans, cash).

  • Liabilities: Financial obligations (deposits).

  • Capital: Difference between assets and liabilities.

• Reserve and Leverage Ratios:

  • Desired reserve ratio: percentage of deposits held in reserve.

  • Leverage ratio: total assets to bank capital.

• Money Multiplier:

  • Measures potential demand deposit creation from reserves.

  • Multiple expansion due to lending.

• Bank of Canada (BoC):

  • Central bank controlling money supply, established in 1935.

  • Appointed governor and board manage operations.

• Inflation Control Target:

  • Objective: maintain inflation at 1–3% for economic efficiency.

• BoC Responsibilities:

  • Currency issuance, fund management, financial system oversight, monetary policy making.