Chapter 12

Money

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Learning Objectives
After this chapter you will be able to:

 Outline various definitions of money

 Explain main functions of money
 Identify the demand for and supply of money
 Define the equilibrium in the money market
 Explain how money is created
 Define the money multiplier

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Sea Shell or Money?

● Is this an image of a sea shell or money? The answer is: both.

● For centuries, people used the durable sea shells as a medium of exchange.
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Commodity Backed Money
● Commodity money - an item that is used as money, but whic

● Currencies backed by commodity – e.g. dollar bills or other c

● During much of its history, gold and silver backed the money
A Silver Certificate and a Modern U.S. Bill

“In silver payable

to the bearer on
demand”

● Until 1958, the US dollar was commodity-backed money - backed

by silver, as indicated by the words at the bottom.
Fiat Money
● All contemporary currencies are not backed by gold or any ot
● Now, government simply declares (i.e. guarantees) that all pa
● Fiat money – money that has no intrinsic value but is declare
● The only backing of our money is universal faith and trust tha
 Main Financial Institutions in Canada

 The four traditional pillars of the Canadian financial system:

 Chartered banks which are allowed by law (charter) to offer a
wide range of financial services
 Near banks (trust companies, credit unions) which offer a more

narrow and specialized services

 Insurance companies which collect premiums from insurance

holders and pay claims in case of loss/damage

 Investment dealers which invest clients’ money and collect fees

 In the last few decades, financial deregulation reduced differences

among these institutions.

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Takers of Money Deposits
Deposit-takers (e.g. banks):
 accept funds provided by savers and pay them interest
 lend funds to borrowers and charge them interest

 hold cash reserves to meet the needs of depositors

withdrawing funds

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Discussion questions:
What is the main source of banks’ profits?

Can a bank be unprofitable or go bankrupt?

What can happen if depositors suspect that a bank will

go bankrupt?

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Bank Run

Bank run - when depositors race to the bank to withdraw their deposits
for fear that the bank will go bankrupt.
Bank runs during the Great Depression of 1930s were frequent.
The most recent one: Silicon Valley Bank in the US in March 2023 (16 th
largest US bank; $20 billion loss).
National Chartered Banks in Canada

The “Big Six” hold the lion’s share of Canadian chartered bank assets. Other
banks, trusts, credit uinions, etc. usually operate on a regional basis.

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The Functions of Money
 There are three main functions that money
performs in the economy:
1. A means of exchange (it overcomes the need
for barter)
2. A store of purchasing power
3. A measure of value (unit of account)

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Components of Money Supply
There are three common definitions of money in
Canada (and most other countries):

 M1 includes currency (cash) and regular deposits

at banks.
 M2 consists of M1 plus personal term deposits at

banks.
 M3 consists of M2 plus various non-personal term

deposits and foreign currency deposits.

 Note: credit cards are not counted as money as they are
short-term (up to one month) loans.
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The Canadian Money Supply

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Transaction Size and Type of Payment

For transactions under $15, cash makes up over half of total payments. For transactions
between $15 and $25, the shares for cash, debit cards, and credit cards are roughly
equal. Credit cards become important for transactions in the $25 and $50 range and
dominate for transactions above $50. 15
Money Demand
There are two types of money demand:
 Transactions demand is related to money’s use as
a means of exchange
 Transaction demand for money varies directly

with output (GDP) and the price level.

 Asset demand is related to money’s use as a
store of purchasing power.
 Total money demand is the sum of the
transaction demand and asset demand.

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The Demand for Money

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The Supply of Money
The size of the money supply in the economy is
determined by the government via its central bank.

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Equilibrium in the Money Market
 Equilibrium in the money market occurs at the
intersection of the demand and supply curves.
 The equilibrium point determines the price of money
– interest rate.
 As government determines money supply, it controls

interest rates.
 A rise in money supply lowers the interest rate (price
of money).
 A decrease in money supply pushes the interest rate

up.
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Equilibrium in the Money Market

In case of surplus (the quantity of money supplied exceeds the quantity demanded), the
government can decrease money supply in order to push interest rate down. When the
interest rate is below its equilibrium value, the opposite occurs.

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Money Creation
 Deposit-takers (banks) keep minimum cash reserves in
order to satisfy anticipated withdrawal demands.
 Minimum cash reserves are defined by the central bank

as a percentage of total deposits.

 The reserve ratio equals minimum (desired, required)

reserves divided by total deposits.

 Excess reserves equal total actual cash at the bank minus

minimum (desired) reserves.

 Whenever excess reserves exist, new money is being

created.

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First Transaction

If minimum reserve is 10%...

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Second Transaction

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Third Transaction

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Fourth Transaction

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Fifth Transaction

And money creation process continues…

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The Money Multiplier
 When banks issue multiple rounds of loans, the total amount of
money created in the economy is determined by using the money
multiplier.
 Money multiplier is simply the number of times an initial loan is
“multiplied” as it is spent and re-deposited in other banks.
 Money multiplier formula = 1 / reserve ratio
Example: if minimum reserve is 5% (i.e. the reserve ratio is 0.05),
money multiplier is equal to: 1/5% or 1/0.05 = 20
 In case of new deposits: by multiplying new deposits with the
money multiplier, we can determine the total additional amount
of money created in the banking system.

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Example: Increase in MoneySupply
 Initial position at a bank: actual reserves = required
reserves (no excess reserves)
 The reserve requirement = 8% (reserve ratio is 0.08)

 Bank receives new deposit = $10 million

 Minimum reserve @8% = $0.8 million
 Excess reserve (available for lending) = $9.2 million
 As excess reserves do not earn interest, bank lends it out to borrowers
who deposit it in their banks and the multiplication process continues.

 Money multiplier = 1/0.08 = 12.5

 Increase in money supply = $9.2m x 12.5 = $115 mill.
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The Importance of Money
 Monetarist theory: money supply determines overall price
level (inflation).
 Changes in money supply (M) should reflect changes in

output (GDP). If M rises at a higher rate then GDP, the result

is a rise in prices (inflation).
 According to monetarists, central banks should not use

expansionary or contractionary policies but follow a rule:

M = GDP
 The logic of monetarism was first questioned by Keynes after

WWI who argued that government should use M as a tool of

managing the economy (e.g. getting it out of recession).
 To be discussed in the Monetary Policy chapter.

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Conclusion
Defined main functions of money
Defined main components of money (M1, M2, M3).
Identified the demand and supply of money and the
equilibrium in money market.
Showed the money creation process
Defined Money Multiplier

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