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Chapter 11

Money and Banking

11.1 The Nature of Money

• Functions of Money

– Medium of exchange

– Store of Value

– Unit of account

Money Need Not Be Physical

• Money need not have a physical presence to serve as a medium of exchange, a store of value, and a unit of account.

• Most Canadians hold much more money in their bank accounts, and they can easily make a transaction with a debit card.

• In the overall economy, there is much more money in the form of bank deposits than there is in the form of physical money.

The Origins of Money

• Metallic Money

• Milling/Debasing the currency

• Gresham’s Law

Paper Money

• The role of goldsmiths

• Banknotes – convertible on demand

• Fractionally backed paper money

• Fiat money

• Gold standard
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Modern Money: Deposit Money

• Money held by the public in the form of deposits with commercial banks is deposit money.

• Bank deposits are considered money.

• Today, just as in the past, banks create money by issuing more promises to pay (deposits) than they have cash reserves available to pay out.

• Another modern form of money is “cryptocurrencies” such as Bitcoin, Ethereum, and Ripple.

11.2 The Canadian Banking System

• Two types of institutions make up a modern banking system:

1. Central bank (Bank of Canada)

2. Financial intermediaries

• “Commercial banks” refer to financial intermediaries that are deposit accepting and loan granting.

The Bank of Canada

• The Bank of Canada commenced operations on March 11,1935.

• The organization of the Bank of Canada is designed to keep the operation of monetary policy free from day-to-day political influence.

• The Bank of Canada has considerable autonomy, but the ultimate responsibility for the Bank’s actions rests with the government.

• This system is known as “joint responsibility.”

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• The basic functions of the Bank of Canada:

– Banker to the commercial banks

– Banker to the federal government

– Regulator of the money supply

• Table 11-1 shows the Bank of Canada’s balance sheet from December 2019, just before the pandemic began.

Table 11-1 Assets and Liabilities of the Bank of Canada, December 2019 (millions of dollars)

The balance sheet of the Bank of Canada shows that it serves as banker to the commercial banks and to the government of Canada, and as issuer
of our currency; it also suggests the Bank’s role as regulator of the money supply. The principal liabilities of the Bank are the basis of the money
supply. Bank of Canada notes are currency, and the deposits of the commercial banks give them the reserves they need to create deposit money.
The Bank’s holdings of Government of Canada securities arise from its operations designed to regulate the money supply.
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The Bank’s Balance Sheet During the COVID-19 Pandemic

• Beginning early in 2020, the Government of Canada issued a massive amount of new securities to provide financial relief to unemployed workers
and businesses whose revenue had collapsed.

• The Bank of Canada played an important role by purchasing a large amount of these newly issued securities, thereby expanding the amount of
money in the banking system.

• With the arrival of vaccines in early 2021 and the swift recovery of the economy that followed, it is expected that the Bank of Canada’s balance
sheet to return to a more normal situation by 2022 or soon thereafter.

Commercial Banks in Canada

• Commercial bank ‒ a privately owned, profit-seeking institution that provides a variety of financial services, such as accepting deposits from
customers and providing loans, mortgages, and other financial products.

– Essential intermediaries in the credit market.

– Undertake interbank activities.

– Multibank systems make use of a clearing house.

– Commercial banks also act as profit seekers.

Commercial Bank Reserves

• Fractional-reserve system

• Reserve ratio

• Target reserve ratio

• Excess reserves.

• At the core of any commercial banking system lies both confidence and risk.

• Applying Economic Concepts 11-2 ‒ examines some of the key Canadian banking regulations designed to maintain confidence and manage risks.

11.3 Money Creation by the Banking System

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• Some Simplifying Assumptions

– To focus on the essential aspects of how commercial banks create money, suppose that banks can invest in only one kind of asset—loans—and
they have only one kind of deposit.

– We assume that all banks have the same target reserve ratio, which does not change, and that there is no cash drain from the banking system.

The Creation of Deposit Money

• The bank initially has a reserve ratio of 20 percent.

Table 11-3: The Initial Balance Sheet of TD

TD has reserves equal to 20 percent of its deposit liabilities. The commercial bank earns profits by finding profitable investments for much of the
money deposited with it. In this balance sheet, loans are its income-earning assets.

• A new deposit of $100 raises the bank’s reserve ratio to 27%.

Table 11-4: TD’s Balance Sheet Immediately After a New Deposit of $100

The new deposit raises liabilities and assets by the same amount. Because both reserves and deposits rise by $100, the bank’s actual reserve ratio,
formerly 0.20, increases to 0.27. The bank now has excess reserves of $80.
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• The bank now has $80 of excess reserves which it can lend. Table 11-5: TD’s Balance Sheet After Making a New Loan of $80.

Table 11-5: TD’s Balance Sheet After Making a New Loan of $80

TD converts its excess cash reserves into new loans. The bank keeps $20 as a reserve against the initial new deposit of $100. It lends the remaining
$80 to a customer, who writes a cheque to someone who deals with another bank. Comparing Table 11-3 and 11-5 shows that the bank has
increased its deposit liabilities by the $100 initially deposited and has increased its assets by $20 of cash reserves and $80 of new loans. It has also
restored its target reserve ratio of 0.20.

• The second-round bank receives $80 in new deposits and expands its loans by $64.

Table 11-6: Changes in the Balance Sheets of Second-Round Banks

Second-round banks receive cash deposits and expand loans. The second-round banks gain new deposits of $80 as a result of the loan granted by
TD. These banks keep 20 percent of the cash that they acquire as their reserve against the new deposit, and they can make new loans using the
other 80 percent.

Table 11-7 The Sequence of Loans and Deposits After a Single New Deposit of $100
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The Creation of Deposit Money

• If ν is the target reserve ratio, a new deposit to the banking system will increase the total amount of deposits by 1/ν times the new deposit.

• In our example, ν = 0.2 and the new deposit is $100. So total deposits eventually increase by $100 × 1/0.2 = $500.

• With no cash drain from the banking system, a banking system with a target reserve ratio of ν can change its deposits by 1/v times any change in
reserves.

ΔDeposits = ΔReserves/ν

• The total change in the combined balance sheets of the entire banking system is shown in Table 11-8
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Table 11-8: Change in the Combined Balance Sheets of All the Banks in the System Following the Multiple Expansion of Deposits.

The reserve ratio is returned to 0.20. The entire initial deposit of $100 ends up as additional reserves of the banking system. Therefore, deposits
rise by (1/0.2) times the initial deposit – that is, by $500.

Excess Reserves and Cash Drains

• Deposit creation depends on the decisions of bankers.

• If commercial banks must choose to lend their excess reserves, otherwise, no deposit expansion.

• If people decide to hold an amount of cash equal to a fixed fraction of their bank deposits, any multiple expansion of bank deposits will be
accompanied by a cash drain.

• If c is the ratio of cash to deposits that people want to maintain, the final change in deposits will be given by:

ΔDeposits = (New Cash Deposit)/(c + ν)

11.4 The Money Supply

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• The money supply is the total quantity of money that is in the economy at any time.

• Economists use several alternative definitions for the money supply.

• Each definition includes the amount of currency in circulation plus some types of deposit liabilities of the financial institutions.

Money supply = Currency + Bank deposits

Kinds of Deposits

• Demand deposits

• Savings deposits

• Term deposit

• Money market mutual funds

• Money market deposit accounts

Definitions of the Money Supply

• Two commonly used measures of money in Canada today are M2 and M2+.

• M2 is currency plus demand and notice deposits at the chartered banks.

• M2+ is M2 plus similar deposits at other financial institutions.

Near Money and Money Substitutes

• Near money is liquid assets that are easily convertible into money without risk of significant loss of value.

• Near money can be used as short-term stores of value but are not themselves media of exchange.

• Term deposits are an example of near money.

• A money substitute is something that serves as a medium of exchange but is not a store of value.

• An example of a money substitute is a credit card.

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The Role of the Bank of Canada

• We have seen how the commercial banking system, when presented with a new deposit, can create a multiple expansion of bank deposits.

• This shows how the reserves of the banking system are systematically related to the money supply.

• In Chapter 13, we will see the details of how the Bank of Canada conducts its monetary policy and how its actions influence the total amount of
reserves in the banking system.