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ParkinBade Chapter 25


Money today is no longer backed by gold or is convertible to gold at a fixed rate. ... A trust and mortgage loan company is a privately owned depository institution ... – PowerPoint PPT presentation

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Title: ParkinBade Chapter 25

Money, Banking, and Interest Rates Ratna K.
Money Makes the World Go Around
  • Money has taken many forms what is money now?
  • What do banks do, and can they create money?
  • What determines the amount of money that people
    stuff into their wallets and keep in the bank?
  • What determines interest rates and what makes
    them rise and fall?

What Is Money?
  • Money is any commodity or token that is generally
    acceptable as a means of payment.
  • Fiat Money Money in the world today is called
    fiat money, because the law orders them to be
    money. Money today is no longer backed by gold or
    is convertible to gold at a fixed rate. Many
    countries, including Canada, have abandoned gold
  • Money has three other functions
  • Medium of exchange
  • Unit of account
  • Store of value

What Is Money?
  • Medium of Exchange
  • A medium of exchange is an object that is
    generally accepted in exchange for goods and
  • In the absence of money, people would need to
    exchange goods and services directly, which is
    called barter.
  • Barter requires a double coincidence of wants,
    which is rare, so barter is costly.
  • Unit of Account
  • A unit of account is an agreed measure for
    stating the prices of goods and services.

What Is Money?
  • Store of Value
  • As a store of value, money can be held for a time
    and later exchanged for goods and services.
  • Money in Canada Today
  • Money in Canada consists of
  • Currency
  • Deposits at banks and other financial
  • Currency is the general term for bills and coins.

What Is Money?
  • Official Measures of Money
  • The two main official measures of money in Canada
    are M1 and M2.
  • M1 consists of currency outside banks and demand
    deposits at chartered banks that are owned by
    individuals and businesses.
  • M2 consists of M1 plus personal savings deposits
    at chartered banks, non-personal notice deposits
    at chartered banks, deposits at trust and
    mortgage loan companies, deposits at credit
    unions and deposits at other financial

What Is Money?
  • Figure 25.1 illustrates the composition of these
    two measures in June 2005 and shows the relative
    magnitudes of the components of money.

What Is Money?
  • The items in M1 clearly meet the definition of
    money the items in M2 do not do so quite so
    clearly but still are quite liquid.
  • Liquidity is the property of being instantly
    convertible into a means of payment with little
    loss of value.
  • Chequeable deposits are money, but cheques are
    not cheques are instructions to banks to
    transfer money.
  • Credit cards are not money. Credit cards enable
    the holder to obtain a loan quickly, but the loan
    must be repaid with money.

The Banking System
  • The banking system consists of private and public
    institutions that create money and manage the
    nations monetary and payments system.
  • The institutions in the banking system divide
  • Depository institutions
  • The Bank of Canada
  • The payments system

The Banking System
  • Depository Institutions
  • A depository institution is a firm that accepts
    deposits from households and firms and uses the
    deposits to make loans to other households and
  • The deposits of three types of depository
    institution make up Canadas money
  • Chartered banks
  • Credit unions and caisses populaires
  • Trust and mortgage loan companies

The Banking System
  • Chartered Banks
  • A chartered bank is a private firm that is
    licensed to receive deposits and make loans.
  • A chartered banks balance sheet summarizes its
    business and lists the banks assets,
    liabilities, and net worth.
  • The objective of a chartered bank is to maximize
    the net worth of its stockholders (owners).

The Banking System
  • Credit Unions and Caisses Populaires
  • A credit union is a co-operative organization
    that operates under the Co-operative Credit
    Association Act of 1992 and that receives
    deposits from and makes loans to its members.
  • A caisse populaire is a credit union that
    operates in Quebec.
  • In 2001, these institutions had deposits of 115

The Banking System
  • Trust and Mortgage Loan Companies
  • A trust and mortgage loan company is a privately
    owned depository institution that operates under
    the Trust and Loan Companies Act of 1992.
  • These institutions receive deposits, make loans,
    and act as trustees for pension funds and
  • In 2001, these institutions had deposits of 8
    billion included in M2.

The Banking System
  • Profit and Prudence A Balancing Act
  • To goal of any bank is to maximize the wealth of
    its owners. To achieve this objective, interest
    rate at which it lends exceeds the interest rate
    paid on deposits.
  • But the banks must balance profit and prudence
    loans generate profit, but depositors must be
    able to obtain their funds when they want them.
  • If depositors perceive the risk associated with
    lending and if they rush to withdraw their
    deposits, there might be bank runsleading to
    banks collapse. So to avoid such a situation,
    banks must be prudent in the way it uses its
    depositors funds.

Run On A Bank
What's going on in these pictures? It's an
old-fashioned run on a bank! In Nov 2007, over 4
billion was withdrawn from Northern Rock Bank in
England. More recently, the criminal
investigation of cricket tycoon Sir Allen Stanrod
sowed panic in the Caribbean and Latin America,
especially Antigua on Feb 17, 2009.
The Banking System
  • Reserves and Loans
  • To achieve security for its depositors, a bank
    divides its funds into two parts reserves and
  • Reserves are the cash in a banks vault and
    deposits at the Bank of Canada.
  • Bank lending takes the form of
  • Overnight loans
  • Liquid assets
  • Investment securities
  • Loans

The Banking System
  • The Economic Functions of Banks
  • Depository institutions make a profit from the
    spread between the interest rate they pay on
    their deposits and the interest rate they charge
    on their loans.
  • This spread exists because depository
  • Create liquidity.
  • lower the cost of lending and borrowing.
  • Pool risk.
  • Make payments.

  • 1. Create Liquidity
  • A bank creates liquid assets by borrowing short
    and lending long.
  • Borrowing short means accepting deposits and
    standing ready to repay them on depositors
  • Lending long means making loan commitments for a
    long term.
  • Banks earn profits by being able to charge higher
    interest rates on their loans than on deposits
    they receive.

  • 2. Lower Costs
  • Banks lower the cost of lending and borrowing.
  • People with funds to lend can easily find the
    type of bank deposit that matches their plans.
  • People who want to borrow can do so by using the
    facilities offered by banks.
  • Without bank services, borrowing and lending can
    be costly in terms of search costs (search for
    lenders and borrowers).

  • 3. Pool Risk
  • By lending to a large number of businesses and
    individuals, a bank lowers the average risk of
    default it faces.
  • The interest rate on a bank loan is set to
    ensure that the amount earned on the loans that
    do get repaid is sufficiently high to pay for
    ones that dont get repaid.
  • This provides a significant security for the
    depositors, which is not possible without a
    banking system.

  • 4. Make Payments
  • Banks provide the payments system.
  • For example,
  • (a) the cheque-clearing system.
  • (b) The credit card payment system
  • Banks collect fees for these services.

The Banking System
  • Bank of Canada
  • The Bank of Canada is Canadas central bank.
  • A central bank is the public authority that
    supervises financial institutions and markets and
    conducts monetary policy.
  • The Bank of Canada is
  • a Banker to the banks and government
  • Lender of last resort
  • Sole issuer of bank notes

How Banks Create Money
  • Banker to Banks and Government
  • The Bank of Canada accepts deposits from
    depository institutions that make up the payments
    system and the government of Canada.
  • Lender of Last Resort
  • The Bank of Canada is the lender of last resort,
    which means that it stands ready to make loans
    when the banking system as a whole is short of
  • If some banks have surplus reserves and others
    are short of reserves, the overnight loans market
    moves funds from one bank to another.

How Banks Create Money
  • Sole Issuer of Bank Notes
  • The Bank of Canada is the only bank that is
    permitted to issue bank notes. The BOC has a
    monopoly on this activity.
  • The Bank of Canadas Balance Sheet
  • The Bank of Canadas assets are government
    securities and last-resort loans to banks.
  • Its liabilities are Bank of Canada notes and
    deposits of banks and the government.

The Banking System
  • The Payments System
  • The payments system is the system through which
    banks make payments to each other to settle
    transactions by their customers.
  • The payments system is owned by the Canadian
    Payments Association (CPA) and it operates two
    national payments systems
  • Large Value Transfer System
  • Automated Clearing Settlement System

The Banking System
  • Large Value Transfer System
  • The Large Value Transfer System (LVTS) is an
    electronic payments that enables financial
    institutions and their customers to make large
    payments instantly and with sure knowledge that
    the payment has been made.
  • Automated Clearing Settlements System
  • The Automated Clearing Settlements System (ACSS)
    is the system through which all payments not
    processed by the LVTS are handled. These payments
    include debit card and ABM transactions.

How Banks Create Money?
  • Creating Deposits by Making Loans
  • Banks create deposits when they make loans and
    the new deposits created are new money.
  • The quantity of deposits that banks can create is
    limited by three factors
  • The monetary base
  • Desired reserves
  • Desired currency holding

How Banks Create Money
  • Monetary Base
  • The liabilities of the BOC (plus coins issued by
    the Canadian Mint) form the monetary base.
  • The monetary base is the sum of BOC notes and
    coins outside the Bank of Canada (held by
    households, firms, and banks) and banks deposits
    at the BOC.

How Banks Create Money
  • Reserves
  • The fraction of a banks total deposits held as
    reserves is the reserve ratio.
  • The desired reserve ratio is the ratio of
    reserves to deposits that banks want to hold.
    Reserves are not required, so bank are free to
    determine the prudent level of reserves. Reserves
    are held so that banks can stay ready to pay in
    case depositors want to withdraw their deposits.
  • Excess reserves equal actual reserves minus
    desired reserves. Banks can loan all of excess

How Banks Create Money
  • Desired Currency Holding
  • We hold money in the form of currency and bank
    deposits and people hold some fraction of their
    money as currency.
  • The fraction of deposits held as currency is
    called the currency drain ratio and is the ratio
    of currency to deposits.

  • When a bank receives deposits, it keeps v in
    reserves (desired reserve) and lends the
    remaining excess reserve (1 v) . The amount
    loaned becomes a new deposit at another bank.
  • The next bank in the sequence keeps v of the
    deposits and lends (1-v) , and the process
    continues until the banking system has created
    enough deposits to eliminate its excess reserves.
  • At the end of the process, an additional 100,000
    of reserves creates an additional 400,000 of
    deposits (loans reserves) at the desired
    reserve ratio v 25. as shown in the running
    tally of the next slide.

Multiple Creation of Bank Deposits
  • At each stage the new loan/deposit is (1 v)
    of the previous loan/deposit.
  • If L is that proportion then the complete
    sequence is 1 L L2 L3 and so on.
  • The total increase in deposits
  • initial deposits x (1 L L2 L3 )
  • initial deposits/(1 L)
  • (Note the above series is called convergent
    geometric series. Let S (1 L L2 L3 )
    then LS L L2 L3 .. Now S LS 1 which
    proves that S 1/(1 L))
  • In this example ?D 100,000/(1 0.75)
  • 400, 000

  • The Deposit Multiplier
  • If v desired reserve ratio, then a new deposit
    in the banking system will increase the total
    deposit by 1/v times the initial new deposits
    (?R), provided that there is no cash/currency
    drain. That is,
  • Where, 1/v 1/(1 L) is the Deposit Multiplier.
  • ? Loan ?Deposits - ?Reserve

  • The two simplifying assumptions in our previous
    example of deposit creation are
  • (1) banks loan all of their excess reserves and
  • (2) there exists no Currency Drain.
  • If banks dont choose to lend their excess
    reserves, there will be no expansion of deposits.

How Banks Create Money?
  • In the presence of currency drain, the money
    creation will be slower (than in its absence).
  • To see how the process of money creation works,
    suppose that the desired reserve ratio is 10
    and the currency drain ratio is 50 .
  • The process starts when all banks have zero
    excess reserves except one bank and it has excess
    reserves of 100,000.
  • Figure 25.3 in the next slide illustrates the
    process and keeps track of the numbers.

How Banks Create Money
  • The bank with excess reserves of 100,000 loans
  • Of the amount loaned, 33,333 (50 of deposits)
    drains from the bank as currency and 66,667
    remains on deposit.

How Banks Create Money
  • The banks reserves and deposits have increased
    by 66,667, so the bank keeps 6,667 (10 ) as
    reserves and loans out the remaining excess
    reserve of 60,000.

How Banks Create Money
  • 20,000 (50) drains off as currency and 40,000
    remain on deposit.

How Banks Create Money
  • The process repeats until the banks have created
    enough deposits to eliminate the excess reserves.
  • 100,000 of excess reserves creates 250,000 of

How Banks Create Money
  • The Money Multiplier
  • The money multiplier is the ratio of the change
    in the quantity of money to the change in the
    monetary base.
  • In our example, when the monetary base increased
    by 100,000, the quantity of money increased by
    250,000, so the money multiplier is 2.5.
  • Monetary base, MB Currency Desired Reserve.
  • Money or Loan, M Currency Deposits.
  • Let currency drain ratio a and desired reserve
    b, then Currency a X Deposits and Desired
    Reserve b X Deposits.

How Banks Create Money
  • So, MB (a b) X deposits and
  • M (1 a) X Deposits.
  • From the above two equations,
  • M (1 a)/(a b) X MB
  • In our example, a 0.5 and b 0.1, so
  • New Money, M (1 0.5)/(0.5 0.1) x MB
  • 2.5 x MB.
  • The money multiplier (1 a)/(a b)

The Demand for Money
  • How much money do people want to hold?
  • The Influences on Money Holding
  • The quantity of money that people plan to hold
    depends on four main factors
  • The price level
  • The interest rate
  • Real GDP
  • Financial innovation

The Demand for Money
  • The Price Level
  • A rise in the price level increases the nominal
    quantity of money (but doesnt change the real
    quantity of money) that people plan to hold.
  • Nominal money is the amount of money measured in
  • The quantity of nominal money demanded is
    proportional to the price levela 10 rise in
    the price level increases the quantity of nominal
    money demanded by 10.

The Demand for Money
  • The Interest Rate
  • The interest rate is the opportunity cost of
    holding money that you could have earned on other
    assets such as saving deposits, bonds (that you
    could have bought with money).
  • The opportunity cost of holding money nominal
    interest rate, not real interest rate, Why?
  • This is because when you hold money you give up
    not only the real interest you could have earned
    in an alternative asset but also lose the buying
    power due to inflation. A rise in the nominal
    interest rate decreases the quantity of money
    that people plan to hold.

The Demand for Money
  • Real GDP
  • An increase in real GDP increases the volume of
    expenditure, which increases the quantity of real
    money that people plan to hold.
  • Financial Innovation
  • Financial innovation that lowers the cost of
    switching between money and interest-bearing
    assets decreases the quantity of money that
    people plan to hold. For example, credit cards,
    ATM, etc.. reduces the amount of money people
    want to hold.

The Demand for Money
  • Figure 25.4 illustrates the demand for money
  • A rise in the interest rate brings a decrease in
    the quantity of money demanded.

A fall in the interest rate brings an increase in
the quantity of money demanded.
The Demand for Money
  • Shift in Demand Curve
  • A decrease in real GDP or a financial innovation
    decreases the demand for money and shifts the
    demand curve leftward.
  • An increase in real GDP increases the demand for
    money and shifts the demand curve rightward.

Interest Rate Determination
  • An interest rate is the amount received by a
    lender and paid by a borrower expressed a s
    percentage of the amount of the loan.
  • The price of a bond (a financial asset) and the
    interest rate on it are inversely related.
  • If the price of a bond falls, the interest rate
  • If the price of a bond rises, the interest rate
  • We can study the forces that determine the
    interest rate in the market for money.

Bond Price and Interest Rate An example
  • If the government issues a bond that pays 100
    each year, what is the interest rate, r, on this
  • The answer depends on the price, p, you pay for
    the bond.
  • If p 1,000, then r 10 a year.
  • If p 500, then r 20 a year.
  • In the market for bonds, an increase in the
    demand for bonds will raise its price and lower
    the interest rate.

Interest Rate Determination
  • Money Market Equilibrium
  • The supply of and the demand for money determine
    the interest rate.
  • The actions of the BOC and the banking system
    determine the supply of money.
  • The BOC is the sole supplier of monetary base and
    it can choose the terms on which currency and
    reserves for the banks are supplied.

Interest Rate Changes with Money Supply
Interest Rate Determination
  • The BOC can choose to
  • Target the quantity of money
  • Target the interest rate
  • Quantity of Money Target
  • If the Bank of Canada targets the quantity of
    money, then the quantity of money supplied is
    fixed and the money supply curve is the vertical.

Interest Rate Determination
  • With a fixed quantity of money, the interest rate
    adjusts to make the quantity of money demanded
    equal to the quantity supplied.

Interest Rate Determination
  • If the interest rate is above the equilibrium,
    the quantity of money that people are willing to
    hold is less than the quantity supplied.
  • They try to get rid of their excess money they
    are holding by buying bonds.
  • This action raises the price of a bond, which
    lowers the interest rate.

Interest Rate Determination
  • If the interest rate is below the equilibrium,
    the quantity of money that people want to hold
    exceeds the quantity supplied.
  • They try to get more money by selling bonds.
  • This action lowers the price of a bond, which
    raises the interest rate.

Interest Rate Determination
  • Interest Rate Target
  • If the Bank of Canada targets the interest rate,
    then the quantity of money supplied by the
    banking system must equal the quantity of money
    demanded at the chosen interest rate.
  • To achieve this quantity of money supplied, the
    BOC adjusts the monetary base.

Interest Rate Determination
  • With a 5 interest rate target, the quantity of
    money demanded is 600 billion and BOC sets the
    monetary base so that the quantity of money
    supplied by the banking system is 600 billion.

Interest Rate Determination
  • If the Bank of Canada wants to lower the interest
    rate to 4, the Bank of Canada must increase the
    monetary base such that the quantity of money
    supplied by the banking system increases to 650
    billion equal to the quantity of money demanded.