Money and Banking

The Nature of Money

Money is a fundamental concept in macroeconomics, serving as the backbone of modern economies. Understanding its functions and evolution is essential for analyzing economic systems.

• Medium of Exchange: Money facilitates transactions by eliminating the inefficiencies of barter, which requires a double coincidence of wants (both parties must want what the other offers).

• Store of Value: Money allows individuals to transfer purchasing power over time. If inflation is low, money retains its value well.

• Unit of Account: Money provides a common measure for valuing goods and services, making it easier to keep financial accounts and compare prices.

Example: Without money, a baker wanting shoes would need to find a shoemaker who wants bread, illustrating the inefficiency of barter.

Origins of Money

The development of money has evolved through several stages, each improving the efficiency and reliability of economic transactions.

Metallic Money

• Before coins, people used metal as a medium of exchange, requiring weighing for each transaction.

• The invention of coinage standardized value and eliminated the need for weighing.

• Problems such as clipping (removing small pieces from coins) reduced trust in coins.

• Gresham's Law: "Bad money drives out good"—debased coins circulate while full-value coins are hoarded or disappear.

Paper Money

• Goldsmiths provided safekeeping for gold and issued receipts, which became transferable and functioned as early paper money.

• Banks later issued bank notes backed by precious metals and convertible on demand.

Fractional-Reserve Money

• Banks realized they did not need to keep 100% reserves for all notes issued, leading to fractional-reserve banking.

• Over time, central banks became the sole issuers of currency.

Fiat Money

• Modern money is fiat money: not backed by a physical commodity but declared legal tender by government.

• Fiat money is accepted as a medium of exchange, a store of value, and a unit of account as long as its purchasing power remains stable.

Modern Money: Deposit Money and Cryptocurrencies

• Deposit Money: Balances held at commercial banks and other financial institutions, forming a major part of the money supply.

• Banks can create money by issuing more promises to pay (deposits) than they have in cash reserves.

• Cryptocurrencies: Digital forms of money such as Bitcoin, Ethereum, and Ripple, representing a new development in the evolution of money.

The Canadian Banking System

Modern banking systems are composed of central banks and various financial intermediaries, each playing a distinct role in the economy.

• Central Bank: The primary government-owned institution responsible for regulating the money supply and acting as a bank to commercial banks. In Canada, this is the Bank of Canada.

• Commercial Banks: Privately owned, profit-seeking institutions that accept deposits and make loans. They are key financial intermediaries in the credit market.

Example: The Bank of Canada issues currency and regulates monetary policy, while commercial banks provide everyday banking services to individuals and businesses.

Functions of the Central Bank

• Acts as banker to commercial banks

• Acts as fiscal agent for the federal government

• Regulates the money supply

• Regulates, supports, and monitors financial markets

Additional info: The Bank of Canada is designed to operate independently from day-to-day political influence, but is ultimately accountable to the government.

Summary Table: Key Types of Money

Key Terms and Definitions

• Medium of Exchange: An asset used to facilitate the sale, purchase, or trade of goods between parties.

• Store of Value: An asset that can be saved, retrieved, and exchanged at a later time, and is predictably useful when retrieved.

• Unit of Account: A standard numerical unit of measurement of the market value of goods, services, and other transactions.

• Fiat Money: Currency that a government has declared to be legal tender, but it is not backed by a physical commodity.

• Fractional-Reserve Banking: A banking system in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal.

• Gresham's Law: The principle that "bad money drives out good" in circulation.

• Cryptocurrency: A digital or virtual currency that uses cryptography for security and operates independently of a central bank.