Money and Banking

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Money and Banking

• Lecture 12-A

Part I
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Overview

• Barter vs. Money
• Functions of Money
• The Evolution of Money
• The Importance of Money
• The Banking System and Reserves

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Barter
The direct exchange of goods and services for
other goods and services.

• Disadvantages of Barter
• Variable Value of Assets
• Time-consuming Negotiation of Price
• Large number of transactions
• Double Coincidence of Wants

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Money vs. Barter

• Money improves social welfare by
• Reducing transaction costs
• Simplifying trades

Money is not necessarily the bills and coins we
carry around in our pockets.
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The Functions of Money
Medium of Exchange How transactions are
conducted Something that is generally
acceptable in exchange for goods and services. In
this function money removes the need for double
coincidence of wants by separating sellers from
buyers. By doing so it also facilitates division
of labour. This is the main function of money.
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Unit of Account How the value of goods
services are denominated Something that
circulates and provides a standardized means of
evaluating the relative price of goods and
services.
Store of value How the value of goods services
are maintained in monetary terms The ability of
money to command purchasing power in the future
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Legal Tender

• Legal tender is something specified by the
  government that must be accepted in settlement of
  transactions.

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The Importance of Money

• Economists have found links between money in
  circulation and inflation, interest rates, stock
  prices and economic activity.

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Money and Price Level Movements since 1913
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Money and Real Income since 1913
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Inflation and Interest Rates since the end of
World War II
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Liquidity and Transaction Costs
Liquidity refers to the availability of funds to
meet claims or the ease and low cost with which
an asset can be sold. An asset that is the medium
of exchange is said to be perfectly liquid.
Transaction costs the financial and
non-financial cost of completing some economic
transaction (excluding the purchase price of the
item in question)
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Monetary Standards

• Commodity Standard
• In this case the monetary unit is some physical
  asset in a specified quantity and often quality.
• The circulating medium is what people actually
  use as money in exchanges (e.g. paper notes
  backed by the commodity).
• Specie refers to metals minted into coins
• The most often used commodity has been gold

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The Gold Standard

• Gold is a scarce but available commodity with
  intrinsic value.
• Under this standard the market for gold dictates
  the value of money.
• At one point in time, much of the Western world
  used the gold standard which
• Fixed the price of gold and held exchange rate
  fluctuations within narrow limits.
• The Canadian dollar was fixed in terms of gold
  and on par with the US dollar

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Gold Standard (contd)

• The End of the Gold Standard
• Recession in the Western world and discretionary
  monetary policy by varying the degree in which
  notes were backed by gold.

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Bimetallism

• This monetary system is based on the value of two
  precious metals usually with a fixed exchange
  rate between them.
• Problems Variations in relative market value
  and Greshams Law
• Greshams Law Bad money drives out good money.

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Fiat Money
The circulating medium - notes and coins (made in
metal with virtually non-monetary uses) that are
worth whatever the issuing agent dictates. The
value of the currency is not guaranteed by some
precious commodity.
The value of the medium of exchange is guaranteed
only by the taxation and borrowing power of the
government. Coins and notes reflect a debt of the
government accepted by the public.
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Fiat Money (contd)

• Paper Money in Canadian History
• Playing cards and cardboard
• Token money issued by banks
• Provincial Notes
• Dominion notes and the end of the Gold Standard
• Bank of Canada Notes and Bank Cheques

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Deposit Money
Money held by the public in the form of deposits
with commercial banks and other financial
institutions is called deposit money.
Bank deposits are money. Today, just as in the
past, banks create money by issuing more promises
to pay (deposits) than they have cash reserves
available to pay out.
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The Banking System
Most banking systems are made up of a central
bank plus many commercial banks.
A central bank acts as a bank to the commercial
banking system. It is usually a government-owned
institution and is the sole money-issuing
authority.
The Bank of Canada is Canadas central bank.
The system of joint responsibility keeps the
conduct of monetary policy free from day-to-day
political influence but ensures that it is
ultimately answerable to Parliament.
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The Bank of Canada
The basic functions of the Bank of Canada are to

• act as banker to the commercial banks,
• act as banker to the federal government,
• regulate the money supply, and
• regulate, support, and monitor financial markets.

The nature of the relationship between money and
economic activity is greatly influenced by the
state of the financial sector of the economy.
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• Deregulation
• Gradual reduction in the role of the government
  in the financial sector resulting in a blurring
  of the divisions between the main categories of
  financial institutions due to
• Financial Innovation
• Increased competition
• Advancement of computer technology
• Perception of increased volatility in the
  financial sector

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Commercial Banks A commercial bank is a privately
owned, profit-seeking institution that provides a
variety of financial services, such as accepting
deposits and making loans.
Other Financial Institutions

• Trust Companies
• Mortgage Loan Companies
• Credit Unions (caisses populaires in Quebec)
• Insurance Companies
• Investment Dealers

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• Special role of Banks
• Despite the eroding of banks dominant position
  in the financial sector banks remain special
  because of their unique functions
• Liquidity
• Consumption Reallocation
• Comparative advantage in Complex Transactions
• Reduce the problem of Asymmetric Information
• Risk Management Tools

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Globalization

• Canadas economy is relatively small and open
• Investors have easier access to foreign markets
• The growing integration of financial transactions
  and regulations worldwide means that
  international financial considerations may have a
  huge impact on domestic financial conditions.

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Reserves
The reserves needed to assure that depositors can
withdraw their deposits on demand are normally
quite small because only a small fraction of
depositors want their money at any time.
A banks reserve ratio is the fraction of its
deposit liabilities that it actually holds as
reserves, either as vault cash or as deposits
with the central bank.
A banks target reserve ratio is the fraction of
its deposits it wishes to hold as reserves.
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Commercial banks strive to maintain some target
ratio of reserves to deposits. In the past, this
target ratio was legally imposed today, it is
determined by the banks themselves.
For example, if a bank has 1000 in deposit
liabilities and has a target deposit ratio of
15, it would like to keep vault cash and
deposits and the central bank of 150.
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Fractional Reserve System
The Canadian banking system is a
fractional-reserve system, with commercial banks
holding reserves of much less than 100 percent of
their deposits.
Any reserves in excess of target reserves are
called excess reserves.
For example if a bank has 1000 in deposit
liabilities, reserves of 200 and its target
reserve ratio is 15, then its excess reserves
are (200 150) 50.