Engineering

Economics
MONEY AND BANKING
Hubbard: Selected portions of chapter 10
 Money

Money is one of the most important inventions of mankind.

Economists consider money to be any asset that people are generally willing to accept in
exchange for goods and services, or for payment of debts.
Asset: Anything of value owned by a person or a firm.

We will begin by considering what role money serves, and what can be used as money.
Then we will consider modern forms of money and the roles of banks and the government
in creating and managing money.
Finally, we will create a model that relates prices to the amount of money.
First Money - Barley
According to many scholars, it is widely agreed that barley was first commodity to be used as
money. It is known as Sumerian Barley money, which was used about 3000 - 3500 BC in Sumer,
which is now part of Turkey.

(It is interesting to note that the Sumerians are credited with the first written word and the
invention of the wheel.)

Barley money was simply barley, where fixed amount of barley grains were used for the
purchase of goods and services. The most common measurement was the sila (approx. 0.82 of a
litre) and even wages were set in silas.

Problem: Inconvenient. Mold, mice and making large purchases would be difficult.
Early Non-intrinsic money – shekels and
coins
The real gain in monetary history took place when people gained trust in money
that lacked intrinsic value, (i.e. eat it, drink it or wear it) but was easier to store
and transport. That was the silver shekel.
 The silver shekel appeared in Mesopotamia around 2500 to 3000 BC.
 The silver shekel was not a coin but rather 8.33 grams of silver.
 This was much easier than handling barley and shekels were used for
thousands of years.
Coins
 Sumerians, the first known culture to use
coins as money. Interestingly, the first
written word was most-likely used for
accounting purposes; this was pointed out in
Yuval Harari’s excellent book titled Sapiens

 Lydian Lion and an ancient Lydian coin

 The Functions of Money
Money fulfills four primary functions:
Medium of exchange
Money is acceptable to a wide variety of parties as a form of payment for goods and services.
Unit of account
Money allows a way of measuring value in a standard manner.
Store of value
Money allows people to defer consumption till a later date by storing value. Other assets can do this too, but
money does it particularly well because it is liquid, easily exchanged for goods.
Standard of deferred payment
Money facilitates exchanges across time when we anticipate that its value in the future will be predictable.
Fiat Money (1 of 2)
Beginning in China in the 10th century and spreading throughout the world, paper money was
issued by banks and governments. The paper money was exchangeable for some commodity,
typically gold, on demand.
In modern economies, paper money is generally issued by a central bank run by the government.
The Bank of Canada is the central bank of Canada. However, money issued by the Bank of
Canada is no longer exchangeable for gold; nor is any current world currency. Instead, the Bank
of Canada issues currency known as fiat money.
Fiat money refers to any money, such as paper currency, that is authorized by a central bank or
governmental body, and that does not have to be exchanged by the central bank for gold or some
other commodity money.
Fiat Money (2 of 2)
Fiat money: Money, such as paper currency, that is authorized by a central bank
or governmental body and that does not have to be exchanged by the central bank
for gold or another commodity money.
It is more flexible for central banks to create money.
However it also creates a potential problem: fiat money is only acceptable as long
as households and firms have confidence that if they accept paper dollars in
exchange for goods and services, the dollars will not lose much value during the
time they hold them.
If people stop “believing” in the fiat money, it will cease to be useful.
 Apply the Concept Your Money Is No Good Here!

If you want “simple, seasonal, healthy

In 2017, a US restaurant required customers to pay online before
picking up their orders using credit card of mobile wallet. food” from Sweetgreen, don’t bring cash.
The restaurant chain implemented these changes to eliminate the
cash management and it will also deter robberies.

Many other countries have started discouraging cash transactions.

Will Canada eventually become largely a cashless economy?
Drawbacks are that some older people will not be able to use
smartphone apps, people with vision problems won’t be able to
use apps and low-income people may not afford smartphones or
credit cards.
Maurice Savage/Alamy Stock Photo
There are also some privacy concerns with the use of credit cards.
 Are Bitcoins Money?
When we think of money, we typically think of currency issued Bitcoins are created by computer calculations,
by a government. not by central banks.
But currency is only a small part of the money supply.

Over the last decade or so, consumers have come to trust forms of
e-money such as PayPal.
Bitcoins are a new form of e-money, owned not by a government or
firm, but a product of a decentralized system of linked computers.
Bitcoins (cryptocurrency) can be traded for other currencies on
web sites.
Some web sites accept Bitcoins as a form of payment.
Should Bitcoins be included in a measure of the money supply?
For now, they are not; if they get more popular, maybe they
should. Tomohiro Ohsumi/Bloomberg/Getty Images
Banks and Money
Banks play a critical role in the money supply.
Recall that there is more money held in checking accounts than there is actual currency in the
economy.
So money is being created by banks.
Further, banks are profit-making private firms: among the largest corporations in the country.
Their activities are designed to allow themselves to make a profit.

In order to understand the role that banks play, we will first try to understand how banks operate as
a business.
 Bank Balance Sheets (1 of 2)

On a balance sheet, a firm’s assets are listed Figure 10.2 Balance Sheet for Royal Bank, September
on the left, and its liabilities (and 30, 2018
stockholders’ equity, or net worth) are listed
on the right. The left and right sides must
add to the same amount.
Banks use money deposited with them to
make loans and buy securities
(investments).
NOTE: SOME ENTRIES HAVE BEEN COMBINED TO SIMPLIFY THE
Their largest liabilities are their deposit BALANCE SHEET.

accounts: money they owe to their SOURCE: DATA FROM THE OFFICE OF THE SUPERINTENDENT OF
FINANCIAL INSTITUTIONS, ACCESSED ON NOVEMBER 21, 2018,
depositors. HTTP://WWW.OSFI-BSIF.GC.CA/ENG/PAGES/DEFAULT.ASPX.
 Bank Balance Sheets (2 of 2)

Reserves are deposits that a bank keeps Figure 10.2 Balance Sheet for Royal Bank,
September 30, 2018
as cash in its vault or on deposit with the
Bank of Canada.
Notice that the bank does not keep
enough deposits on hand to cover all
of its deposits. This is a big part of
how the bank makes a profit: lending
NOTE: SOME ENTRIES HAVE BEEN COMBINED TO
out or investing money deposited with SIMPLIFY THE BALANCE SHEET.
it. SOURCE: DATA FROM THE OFFICE OF THE SUPERINTENDENT OF
FINANCIAL INSTITUTIONS, ACCESSED ON NOVEMBER 21, 2018,
In 2018, banks kept 5% as reserves. HTTP://WWW.OSFI-BSIF.GC.CA/ENG/PAGES/DEFAULT.ASPX.
Using T-Accounts to Show Money Creation

A T-account is a stripped-down version of a

balance sheet, showing only how a
transaction changes a bank’s balance sheet.
When you deposit $1,000 in currency at
Bank of Montreal (BMO), its reserves
increase by $1,000 and so do its deposits:

The currency component of the money supply

decreases by the $1,000, since that $1,000 is no longer
in circulation; but the checking deposits component
increases by $1,000. So there is no net change in the
money supply—yet.
 T-Accounts
But BMO needs to make a profit; so it keeps 10% (for
example) of the deposit as reserves, and lends out the rest,
creating a $900 checking account deposit.
The $900 initially appears in a BMO checking account but
will soon be spent; and BMO will transfer $900 in
currency to the bank at which the $900 check is deposited.
When Will It End?
Bank Increase in Chequing Account Deposit
Each “round”, the additional checking
account deposits get smaller and smaller. Bank of Montreal $1000
Every round, 10% of the deposits are Royal Bank + 900 (= 0.9 × $1000)
kept as reserves. This allows us to tell Third Bank + 810 (= 0.9 × $ 900)
by how much the checking deposits
Fourth Bank + 729 (= 0.9 × $ 810)
will eventually increase: the $1,000
• +•
in currency will become the 10%
required reserves for all of the • +•

checking deposits, so a total of • +•

$10,000 in checking deposits can be Total change in = $10 000
chequing account
created. deposits
 Simple Deposit Multiplier
An alternative way to find out how much money the original $1,000 in currency will create is to add up all of the
checking account deposits.
$1000  0.9  $1000   0.9  0.9   $1000   0.9  0.9  0.9   $1000   
$1000  0.9  $1000   0.9 2  $1000   0.9 3  $1000  
$1000  1  0.9  0.9 2  0.9 3  

The expression in the parentheses can be rewritten as:

1 1
  10
1  0.9 0.10
So the total increase in deposits is $1,000(10) = $10,000.
The “10” here is the simple deposit multiplier: the ratio of the amount of deposits created by banks to
the amount of new reserves.
General Form for the Simple Deposit
Multiplier
In general, we can write the simple deposit multiplier as:
1
Simple deposit multiplier =
rd
So with a 10% desired required reserve ratio (rd), the simple deposit multiplier is 10.

With a 20% desired required reserve ratio, the simple deposit multiplier is 5.
1
Change in chequing account deposits = Change in bank reserves 
rd
For example, $100,000 in new deposit, with a 10% desired reserve ratio, results in:
1
Change in checking account deposits  $100, 000 
0.10
 $100,000  10  $1,000,000
 Real-World Deposit Multiplier
With a 10% desired reserve ratio, the simple deposit multiplier tells us that a currency deposit will
be multiplied 10 times.
But in reality, we do not observe this.
Why this difference?
Banks may not lend out as much as we predict, either because they want to keep excess
reserves, or they cannot find credit-worthy borrowers.

Consumers keep some currency out of the bank; that currency cannot be used as required
reserves.
Note: during the financial crisis of 2007–2009, research suggests that the real-world multiplier fell
to close to 1 in the US.
Conclusions About Banks and the Money
Supply

In general, we can assume that the real-world deposit multiplier is greater than 1. So
we conclude that:
1. When banks gain reserves, they make new loans, and the money supply expands.
2. When banks lose reserves, they reduce their loans, and the money supply
contracts.

This is enough to establish the important relationship between banks and the money
supply.
 Bank Runs and Bank Panics
In Canada, banks are not required to keep any deposits as reserves, but good business practice
means they keep about 5%. This is known as a fractional reserve banking system, and is in a
system shared by nearly all countries.
But what if depositors lost confidence in a bank, and tried to withdraw their money all at
once? This situation is known as a bank run; if many banks simultaneously experience bank
runs, a bank panic occurs.

A central bank, like the Bank of Canada, can help to prevent bank runs and panics by acting as a
lender of last resort, promising to make loans to banks in order to pay off depositors.
This assurance helps make people confident in being able to eventually receive their money
and prevents the panic.
The Establishment of the Bank of Canada (1
of 2)
The Bank of Canada was created in 1934 as a result of Royal Commission (a federal government sponsored
study).
The overall responsibility for the Bank of Canada rests with the 15 member board of directors.
The board of directors consists of:
The governor of the Bank of Canada
The senior deputy governor of the Bank of Canada
The deputy minister of finance
12 outside directors
Monetary policy decision are taken by the governing council which consists of the governor, the
senior deputy governor, and the 4 deputy governors.
The Establishment of the Bank of Canada (2
of 2)

The Bank of Canada carries out monetary policy and has a high degree of
independence.
However, the federal government approves the choice of governor and has the
ultimate responsibility for monetary policy.
The objectives of monetary policy are determined jointly by the Bank of Canada
and the minister of finance and the government has the right to override the Bank
of Canada decisions.
 The BoC Operating Band and Overnight
Rate (1 of 2)
Figure 10.3 Operating Band for the Overnight
The Bank of Canada signals its stance on
Interest Rate.
monetary policy by announcing a target for the
overnight interest rate.

The overnight interest rate is the interest rate

banks charge each other for overnight (24 hour)
loans.

The Bank of Canada sets an operating band for

this interest rate of 50 basis points (half a
percent).

The upper limit of the operating band for the overnight interest rate defines the bank rate (or lending rate), and the lower limit of the operating band defines
the deposit rate.
The BoC Operating Band and Overnight
Rate (2 of 2)
The Bank of Canada is willing to lend to banks
Figure 10.3 Operating Band for the Overnight
at the bank rate, ib (upper limit of the band) Interest Rate.

The Bank of Canada will pay ib − 0.5 on banks

deposits they make at the Bank of Canada.

By being ready to lend and borrow at either end

of the operating band, the Bank of Canada
ensures the overnight rate will remain in that
range.

The upper limit of the operating band for the overnight interest rate defines the bank rate (or lending rate), and the lower limit of the operating band
defines the deposit rate.
 Implementing Monetary Policy (1 of 2)

The Bank of Canada uses two main monetary policy tools:

1. Open market operations refers to the buying and selling of government securities by the
Bank of Canada in order to control the money supply.

To increase the money supply, the Bank of Canada buys government securities (and then sells
them back at a later date). This is called a purchase and resale agreement.
To decrease the money supply, the Bank of Canada sells its securities (and buys them back
later). This is called a sale and repurchase agreement.
These open market operations can occur very quickly.
Implementing Monetary Policy (2 of 2)

2. Lending to Financial Institutions is the Bank of Canada’s other main policy tool.

Financial institutions can borrow from the Bank of Canada to meet their reserve
requirements needs. When the bank rate is low, financial institutions will borrow from the
Bank of Canada and use the funds to make new loans, which increases deposits and thus
increases the supply of money.
Additionally, the Bank of Canada acts as a lender of last resort to financial institutions. The
Bank of Canada will make loans (against collateral) to help solvent (but illiquid) banks deal
with unexpectedly high withdrawals. This helps prevent bank and financial panics.
The BoC Approach to Monetary Policy (1 of 2)

Figure 10.4 How the Bank of Canada Keeps the Rate of

The Bank of Canada’s goal is to
Inflation from Falling Below the Target Range.
keep inflation between 1 and 3
percent – aiming for 2 percent.

If the Bank of Canada expects

the economy to slow down, it
lowers the target and operating
band for the overnight interest
rate. This prevents the inflation
rate from falling below 1
percent.
SOURCE: From The Bank of Canada. Reprinted with permission.
 The BoC Approach to Monetary Policy (2 of 2)

Figure 10.5 How the Bank of Canada Keeps the Rate

The Bank of Canada’s goal is to keep
of Inflation from Moving Above the Target Range .
inflation between 1 and 3 percent –
aiming for 2 percent.

If the Bank of Canada expects the

economy to exceed its capacity, it
increases the target and operating
band for the overnight interest rate.
This prevents the inflation rate from
rising above 3 percent.
SOURCE: From The Bank of Canada. Reprinted with permission.
 The Quantity Theory Explanation of
Inflation
When variables are multiplied together in an equation, we can form the same equation
with their growth rates added together.
So the quantity equation:
M V  P  Y
generates:

Growth rate of the money supply + Growth rate of velocity

= Growth rate of the price level  or the inflation rate 
+ Growth rate of real output

We can rewrite the equation to help understand what determines inflation by assuming that
velocity of money is constant, we obtain:
Infaltion rate
= Growth rate of the moneysupply  Growth rate of realoutput
The Inflation Rate According to the Quantity
Theory
Inflation rate = Growth of the money supply – Growth rate of real output

This equation provides the following predictions:

1. If the money supply grows faster than real GDP, there will be inflation.
2. If the money supply grows slower than real GDP, there will be deflation (a decline in the price
level).
3. If the money supply grows at the same rate as real GDP, there will be neither inflation nor
deflation: the price level will be stable.
Is velocity truly constant from year to year? The answer is no.
But the quantity theory of money can still provide insight:
In the long run, inflation results from the money supply growing at a faster rate than real GDP.
 How Accurate Are Estimates of Inflation from
the QTM? (1 of 2)
Figure 10.7a The Relationship between Money Growth and
Real GDP growth has been relatively Inflation over Time and around the World
consistent over time.
So based on the quantity theory of
money (QTM), there should be a
predictable, positive relationship
between the annual rates of inflation
and growth rates of the money supply.
There is a positive relationship, more
stronger in the long run.

SOURCES: PANEL (A): DATA FOR 1870 TO 1960, M.C. URQUHART, “CANADIAN ECONOMIC GROWTH 1870-1985,” INSTITUTE FOR ECONOMIC
RESEARCH, QUEENS UNIVERSITY: KINGSTON, ONTARIO, DISCUSSION PAPER NO. 734; AND SINCE 1961 STATISTICS CANADA CANSIM II SERIES
V3860248 AND V41552796; PANEL (B): INTERNATIONAL MONETARY FUND, INTERNATIONAL MONETARY STATISTICS.
 How Accurate Are Estimates of Inflation from
the QTM? (2 of 2)
Figure 10.7b The Relationship between Money Growth and Inflation over Time and

We see a similar story when we compare around the World

average rates of inflation and growth rates

of the money supply across different
countries.
Although the relationship is not entirely
predictable, countries with higher growth
in the money supply do have higher rates
of inflation.

SOURCES: Panel (a): Data for 1870 to 1960, M.C. Urquhart, “Canadian Economic Growth 1870-1985,” Institute for Economic Research, Queens University: Kingston,
Ontario, Discussion Paper No. 734; and since 1961 Statistics Canada CANSIM II series V3860248 and V41552796; Panel (b): International Monetary Fund,
International Monetary Statistics.
 High Rates of Inflation

Very high rates of inflation—in excess of 50 percent per month—are known as hyperinflation.
Hyperinflation results when central banks increase the money supply at a rate far in excess
of the growth rate of real GDP.

This might happen when governments want to spend much more than they raise through
taxes, so they force their central bank to “buy” government bonds.

Recently, hyperinflation has occurred in Zimbabwe; the inflation rate became high enough, people
stop using paper currency.
Hyperinflation tends to be associated with slow growth, if not severe recession.
Apply the Concept The German Hyperinflation of the Early
1920s
After Germany lost WWI, the Allies forced Germany During the hyperinflation of the 1920s, people in
to pay reparations. Germany used paper currency to light their stoves.
Unable to cover both its regular spending and the
reparations, the German government sold bonds to
its central bank, the Reichsbank.
The value of the German mark started to fall, and
the Allies demanded payment in their own
currencies; so Germany was forced to buy their
currency with its own. This required massive
expansion of the money supply.
From 1922–1923, the German price index rose
from 1,440 to 126,160,000,000,000, making the
German mark (and any savings held in German
currency) worthless.
Germany
1920’s

Hyperinflation is generally defined

as inflation that exceeds 50% per
month.
 Common Misconceptions to Avoid
Money is not the same as income or wealth, though the latter two concepts are
often denominated in money.
“Assets” and “liabilities” can be confusing, especially as a checking account
deposit. An asset for the depositor is a liability for the bank. Remember in this
chapter to consider things from the bank’s perspective.