Money and Banking

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Money and Banking

• Lecture 12-B

Part II
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Overview

• Money Creation by Banks
• Measuring the Money Supply
• Near Money and Money Substitutes

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Money Creation
Some Simplifying Assumptions
To simplify things, suppose that banks can invest
in only one kind of asset loans and there is
only one kind of deposit a demand deposit.
Two other simplifying assumptions are

• a fixed target reserve ratio, and
• no cash drain from the banking system.

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The Creation of Deposit Money
The bank initially has a reserve ratio of 20
percent that is, the ratio of reserves to
deposits is 0.20.
A single new deposit of 100 raises liabilities
and assets by the same amount, and the banks
reserve ratio initially increases to 27 percent.
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The bank can now lend the excess reserves of 80
it will then return to its 20 percent reserve
ratio.
The 80 in new loans results in a second bank
receiving new deposits of 80. This is the second
round of new deposits.
The second-round bank receives cash deposits and
expands its loans by 64, or 80 percent of the
new deposits.
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A single new deposit begins a long sequence of
deposit creation. In this example, with the
target reserve ratio of 20 percent, the new
deposit of 100 creates a total expansion of
deposits equal to 500.
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If v is the target reserve ratio, the ultimate
expansion of deposits in the banking system will
be 1/v times the new deposit.
With no cash drain from the banking system, a
banking system with a target reserve ratio of v
will change its deposits by 1/v times any change
in reserves.
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Excess Reserves and Cash Drains
Deposit creation does not happen automatically
it depends on the decisions of bankers. If
bankers do not lend out their excess reserves,
deposits will not expand.
If households keep a fixed fraction of their
deposits in cash a cash drain the
deposit-creation process will be dampened.
If c is the ratio of cash to deposits that people
want to maintain, the final change in deposits
will be given by
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Exercise 1
If a deposit of 1000 is made and the target
reserve ratio is 15, then the first loan will be
made for 850 and the reserves will initially
increase by 150.
If people hold 5 of their money in cash, cash
drain is 5, the person receiving the loan of
850 will only deposit 807.50 into the banking
system and hold 42.50 in cash.
Part of the deposit of 807.50 will be held in
reserves by the banks and the rest will be
loaned. This process will continue until the bank
has its desired reserve ratio and no more
deposits are made. Total Deposits created
1000/(0.150.05) 5000
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Exercise 2
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A
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B
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The larger the target-reserve ratio and the
percentage of cash-drain, the less the amount of
money created by a given deposit.
The change in the publics cash-holdings
where c is the percentage cash drain.
In the case of Example B, the change in cash is
equal to (0.10)(5000) 500.
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Measuring Money Supply

• Money supply (or Money Stock)
• The amount of money in an economy that is easily
  available for use in payments.
• Not just money in circulation

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Types of Banks and Deposits

• Current Accounts and Personal Chequable Accounts
  (Demand deposits)
• Funds in accounts that can be removed without
  notice and usually pay little or no interest.
• Savings Deposits
• Bank deposits that typically earn a rate of
  return and require a stipulated amount of notice
  to be withdrawn.
• Term Deposits
• Bank deposits paying a market rate of return
  which are deposited for a fixed term and thus
  have limited liquidity.
• Money Market Mutual Funds (MMMFs)
• Funds that issue shares to holders backed by
  high-quality short-term assets such as Treasury
  bills.

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Cheques and Cheque-Clearing

• Cheque a written order for a bank to transfer a
  specific amount of funds from the writers
  account to someone else.
• A clearinghouse is needed to sort out net
  inter-bank payments. The clearinghouse for
  Canadian banks is operated by the Canadian
  Payments Association (CPA).
• There has been a noted shift from paper-based to
  electronic transactions.

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The Measurement of Money

• Considerations
• chartered vs. other types of financial
  institutions
• types of deposits and their evolution the growth
  of electronic transactions
• types of financial assets

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Monetary Aggregates

• Currency in circulation currency outside the
  banking system.
• M1 currency in circulation plus current accounts
  and personal chequable accounts. This definition
  most closely specifies money as it fulfils its
  medium of exchange function.
• M2 M1 plus notice deposits of firms and personal
  savings deposits at chartered banks.
• M1 M1 plus personal chequable savings deposits
  at banks and near banks and non-personal
  chequable notice deposits at banks and near
  banks.
• M2 M2 plus notice and term deposits at
  near-banks. Significantly larger than M2,
  signaling the increasing importance of financial
  institutions other than banks.
• M3 M2 plus non-personal fixed term deposits and
  the Canadian dollar value of chartered bank
  deposits denominated in foreign currencies but
  owned by Canadian residents.

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More Monetary Aggregates

• M1 M1 plus non-chequable notice deposits
  held at chartered banks plus all non-chequable
  deposits at trust and mortgage loan companies,
  credit unions and caisses populaires less
  interbank non-chequable notice deposits.
• M2M2 plus Canada Savings Bonds and other
  retail instruments plus cumulative net
  contributions to mutual funds other than Canadian
  dollar money market mutual funds (which are
  already included in M2 (gross)).

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Major Canadian Money Supply Aggregates
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Near Money and Money Substitutes
Assets that are a store of value and are readily
converted into a medium of exchange but are not
themselves a medium of exchange are called near
money.
In general, whether it pays to convert cash or
chequable deposits into higher interest-earning
term deposits for a given period will depend on
the inconvenience and other transaction costs of
shifting funds, and on the amount of interest
that can be earned.
Things that serve as a temporary medium of
exchange but not a store of value are sometimes
called money substitutes.
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Choosing a Measure
There is no single timeless definition of money,
or what qualifies as near money or a money
substitute.
New financial assets are continually being
developed that serve some, if not all, of the
functions of money.
The Role of the Bank of Canada
The commercial banking system, when confronted
with a new deposit, can create a multiple
expansion of bank deposits. This expansion shows
how the reserves of the banking system are
related to the money supply.
It is the Bank of Canadas job to control those
reserves.
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Exercise 3
Consider a withdrawal of 5000 from the Canadian
Banking system.
Suppose that the target reserve ratio for all
commercial banks is 8 and there is no cash drain.
A withdrawal has the opposite effect of a deposit.
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Note that for any round, the change in reserves
plus the change in loans exactly equals the
change in deposits.
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Total change in Deposits
Total change in Reserves
Total change in Loans