Money, Banks, and the Bank of Canada

Chapter Overview

This chapter explores the nature and functions of money, how money is measured in Canada, the process by which banks create money, the role of the Bank of Canada, and the quantity theory of money. Understanding these concepts is essential for analyzing the broader financial system and monetary policy.

What Is Money, and Why Do We Need It?

Definition and Functions of Money

• Money is 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.

Before money, trade required barter, which depends on a double coincidence of wants. The invention of money allowed for easier trade and economic specialization.

• Commodity money: Goods used as money that also have value independent of their use as money (e.g., animal skins, precious metals).

The Four Functions of Money

• Medium of exchange: Accepted as payment for goods and services.

• Unit of account: Provides a standard measure of value.

• Store of value: Can be saved and used for future purchases; money is especially effective because it is liquid.

• Standard of deferred payment: Facilitates transactions over time, assuming stable value.

Characteristics of Good Money

• Acceptable to most people

• Standardized quality

• Durable

• Valuable relative to weight

• Divisible for various transaction sizes

Types of Money

Commodity Money

• Examples: Cowrie shells (Asia), gold/silver, beaver pelts (Canada), cigarettes (prisons).

Fiat Money

• Authorized by a central bank or government; not backed by a commodity.

• Modern Canadian currency is fiat money, issued by the Bank of Canada.

• Relies on public confidence for value.

How Is Money Measured in Canada Today?

Definitions of the Money Supply

• The Bank of Canada uses several measures, from narrow to broad:

Additional info: M1+ is most relevant for analyzing money as a medium of exchange.

Credit and Debit Cards

• Debit cards access checking accounts (the account balance is money, not the card).

• Credit cards are short-term loans; not considered money until paid off with funds from a deposit account.

Cryptocurrencies

• Examples: Bitcoin (not issued by central banks, not currently included in money supply measures).

How Do Banks Create Money?

The Role of Banks

• Banks hold more money in checking accounts than there is physical currency, indicating money creation.

• Banks are profit-making firms that use deposits to make loans and investments.

Bank Balance Sheets

• Assets: Reserves, loans, securities

• Liabilities: Deposits (owed to depositors), borrowings, other liabilities

Reserves

• Cash in vault or on deposit with the Bank of Canada.

• Canada does not require a specific reserve ratio, but banks typically keep about 5% (desired reserve ratio, ).

Money Creation Process

• When a deposit is made, banks keep a fraction as reserves and lend out the rest, creating new deposits in the banking system.

Example: Deposit Expansion

Simple Deposit Multiplier

• The total increase in deposits from an initial deposit can be calculated as:

Where is the desired reserve ratio. For , the multiplier is 10.

Real-World Deposit Multiplier

• In practice, the multiplier is less than the simple model predicts due to banks holding excess reserves and people holding currency outside banks.

The Bank of Canada

Role and Structure

• Canada's central bank, established in 1934.

• Responsible for monetary policy, managed by a board of directors and a governing council.

• Objectives set jointly with the federal government, which can override decisions.

Monetary Policy Tools

• Open market operations: Buying and selling government securities to control the money supply.

• Lending to financial institutions: Providing loans to banks, especially as lender of last resort.

Interest Rate Targeting

• The Bank of Canada sets a target for the overnight interest rate within an operating band (typically 0.5 percentage points wide).

• The upper limit is the bank rate; the lower limit is the deposit rate.

The Quantity Theory of Money

The Quantity Equation

The relationship between money, prices, and output is formalized as:

• = Money supply

• = Velocity of money

• = Price level

• = Real output (real GDP)

Velocity is calculated as:

Quantity Theory and Inflation

• If velocity is constant, the growth rate of the money supply determines the inflation rate.

• If money supply grows faster than real GDP, inflation occurs.

• If money supply grows slower than real GDP, deflation occurs.

• If both grow at the same rate, the price level is stable.

Hyperinflation

• Very high inflation (over 50% per month), usually caused by excessive money supply growth.

• Example: Germany in the 1920s, Zimbabwe in the 2000s.

Common Misconceptions

• Money is not the same as income or wealth.

• Assets and liabilities are relative: a deposit is an asset for the depositor, a liability for the bank.