Notes on Chapter 14: Money, Banking, and Money Creation

Chapter Overview

  • Importance of Money:
    • Money is a significant invention akin to the wheel in human history.
    • Unlike the wheel, money has evolved over time to meet societal needs.
  • Objective:
    • Discuss the function of money in macroeconomics.
    • Explain how money creation occurs in modern economies (e.g., by commercial banks).
    • Explore the use of monetary policy via the Aggregate Supply-Aggregate Demand (AS-AD) model.

Functions of Money

  • Money is defined by its functions, which are:
    1. Medium of Exchange: Facilitates transactions between buyers and sellers.
      • Historical Context: Barter system was inefficient due to the requirement of mutual wants.
      • Examples of Mediums: Commodities like seashells, gold, silver, and modern fiat currencies (e.g., CAD).
      • Cigarettes in WWII: Used as money in German prisons.
    2. Unit of Account: Provides a common measure of value for goods and services.
      • Prices are denominated in terms of the established medium of exchange (e.g., CAD).
    3. Store of Value: Allows individuals to save wealth over time.
      • Must retain value and be stable for effective storage (e.g., holding CAD).
      • Stability and Trust: Central banks work to maintain currency stability, as inflation can erode purchasing power.

Liquidity

  • Definition:
    • Refers to the ease with which an asset can be converted into cash (the socially accepted medium of exchange).
    • Examples: Government bonds are liquid; houses are relatively illiquid.
    • A high degree of liquidity is advantageous as it allows quick access to cash.

Components of Money Supply

  • Definitions of Money Supply:
    • M1+: Most liquid forms of money.
      • Components:
      1. Currency: Coins and paper money circulating in the economy.
      2. Demand Deposits: Chequable accounts with banks.
    • Exclusions from M1+:
      • Vault cash held by the central banks.
      • Deposits by the federal government or central banks (focused on private sector liquidity).
  • Broader Measures:
    1. M2: Includes M1+ and near money (assets that can quickly convert to currency).
    2. M2+: M2 plus other deposits at non-bank institutions.
    3. M2++: M2+ plus other financial instruments like saving bonds.

Money Supply Analysis

  • Cash in circulation is a smaller portion of the total money supply compared to digital forms.
  • The infrastructure of banking allows management of liquidity and encourages digital currency use.

The Nature of Money

  • Evolution:
    • Historical reliance on intrinsic value items to a modern currency system backed by trust.
    • Money today lacks intrinsic value; it is a declaration of debt and relies on universal acceptance.
  • Inflation and Prices:
    • Inflation erodes money's purchasing power.
    • Calculation Example:
      • If inflation is at 5%, the purchasing power drops; could quantify the decrease using price indices.

The Financial System and Banking Dynamics

  • Banking Operations:
    • Can create money through fractional reserve banking (holding reserves and loaning excesses).
    • Each deposit leads to a cycle of lending creating more demand deposits.
    • Example Calculation:
      • Desired reserve ratio, excess reserve operations, and the impact on M1+.
  • Depositor Confidence:
    • The banking system relies on public trust; systems like deposit insurance protect against bank runs.
    • Profit maximization drives banks to navigate between liquidity and investment.

Monetary Policy and Financial Crisis Case Study

  • The importance of regulation and the risks associated with money creation by banks.
  • Historical Context: The U.S. financial crisis in 2007-2008 showcased the dangers of subprime mortgages and banking failures due to a lack of trust, leading to widespread economic turmoil.
  • Need for effective regulation to mitigate risks associated with excessive lending and speculative financial practices.