Money and Banking 03-18-2013
Side note: In-Class Documentary
Original proposal: Buy all the toxic assets (at the taxpayers expense) to remove
responsibility from the banks.
What actually happened: Capital injection
Why bail out all major banks and not just the ones that are suffering?
If you only bail out the ones that are in trouble, the public will know which ones
they have to take out their money of. If this happens, the suffering banks will
fail anyway and due to the interconnectedness of all these big banks, the whole
system is at risk to fail.
Mortgage backed security?
The Canadian Banking System
Two main players:
Financial Intermediaries – ex. commercial banks, credit unions, insurance
o Firms that take deposits from people and then lend it to people who need
Bank of Canada
Owned by the government – only shareholder
o Federal Reserve System of the US is privately owned by the private banks
Operated by an appointed Governor (Mark Carney)
o Deputy of Finance Minister is only involved in bigger decisions
o Mark Carney’s agenda: stable inflation of 2%
Semi-independent from government: day-to-day autonomy
o They don’t have to answer to the government with what decisions they
make ex. when they decide to change the interest rate
o BUT the gov’t does have the power to appoint and dismiss who the
governor is – must dismiss the governor before they can intervene on any
Functions of BOC
1. Banker to Commercial Banks
a. Accepts deposits from commercial banks
b. “Lender of last resort”
2. Banker to the Federal Government a. Buys government securities ex. bonds (“IOU”)
3. Regulator of the Money Supply
a. Chapter 29
4. Regulator and Supporter of Financial Markets
a. To prevent potentially catastrophic banking system failure
b. Financial stability
Balance Sheet of BOC
Main asset: Government of Canada bonds (securities)
o Notes in circulation – involves currency - guarantee that your money is
o Government of Canada deposits
o “Other liabilities and capital”
Capital – what the business is worth after paying off all the
Example: Euro debt crisis – one central bank that makes monetary policy for all
Greece wasn’t able to pay back their bonds – value of these assets fell
liabilities > assets
Why would you buy a bond from the government? They “don’t” go bankrupt
Greece in trouble European central bank in trouble every other country in
Europe in trouble
Privately owned, profit-seeking institution
Main function: accepts deposits and makes loans
Solves major information friction in savings/investment markets
o Acts as an intermediary between those who have funds and those who
o Credit is required for:
Large household purchases ex. homes
Investment by firms
Banks must have money on hand in case depositors want to make a withdrawal
How much do they need? Only a fraction.
What if they don’t have enough? o Lender of last resort (borrow from BOC)
o CDIC – Canadian Deposit Insurance Corporation – if your bank fails, they
will compensate for up to $100,000
Fractional Reserve System
Target and Excess Reserves
Reserve ratio – fraction of its deposits that a commercial bank holds as
o Reserves are held in the form of cash or deposits with the central
Target reserve ratio – fraction of its deposits that a bank wants to hold as
Excess reserves – deposits in excess of the target reserve rati
Commercial Banks’ Collective Balance Sheet
Reserves (including deposits with BOC)
Canadian securities (corporate and provincial and municipal governments)
No stocks – regulation that BOC has: not allowed to invest in other companies
because they’re only allowed to invest in safe assets (low risk)
Foreign currency assets
Shareholders’ equity Money Supply and Money Demand 03-20-2013
What is Money?
Three Principle Functions:
Medium of Exchange (most important)
o Solves “Double Coincidence of Wants” Problem
o Eliminates inconvenience/inefficiency of barter trade (searching for a
Store of Value
o Spend some of it today for the things I want today, and spend some of
next month on things I want next month.
o Create value in the present and store it for the future for when you
actually want to spend it.
Unit of Account
o Way of measuring the quantity of the object we’re talking about
What makes good money?
A “good” medium of exchange should have the follow characteristics:
Easily recognizable and readily acceptable
High value relative to weight
Difficult to counterfeit
Some examples from the past: precious metals, shells, beads, etc.
Modern money has no intrinsic value
Instead, its value is derived from people’s willingness to accept it as a
medium of exchange
Called Fiat Money – because the money is derived by fiat
Currency is created when the Bank of Canada decides to print more bills. But deposits
are also considered money. Commercial banks “create” money by lending out deposits.
So how are deposits created?
Assumptions for this model:
Fixed target reserve ratio
No “cash drain” – all money goes to the bank right away New Deposits
A new deposit occurs for one of three reasons: (How new money comes to life)
An individual may immigrate and deposit their cash in a Canadian bank
An individual may have cash “hidden under their bed” – it wasn’t existing for a
long period of time (goes back into the system/flow)
The BOC purchases government bonds from a firm or individual. Money is then
deposited in a commercial bank.
o When money is in the Bank of Canada, we assume that it is out of
circulation. When BOC takes money out of their vaults, it goes back into
circulation and will therefore be considered a “new deposit”.
If someone makes a deposit of x, how much new money will actually be made?
More or less? The same?
Target Reserve ratio = 20%.
What happens to the quantity of deposits if another 100$ is deposited into this
Deposit of $100 increases deposits and reserves reserve ratio is now 27%
Bank loans out excess reserves restores reserve ratio to target
New loan is deposited at another bank new process starts
Deposit and Loan cycle goes on indefinitely
Amount of initial deposit = Amount of physical currency = Addition to New
The initial deposit of $100 results in a total increase in deposits of $500
o It is as if money was created out of thin air
Define the reserve ratio:
o v = Reserves/Deposits
We have a simple formula: Money Multiplier
o Δ Deposits = (1/v) x Initial Deposits
Note: the money creation process is partially determined by the behavior of
banks and so is not under the complete control of the BOC
o BOC no longer mandates the reserve ratio
o Commercial banks can choose what their target reserve ratio is
Cash drain – situation where households choose to deposit only a fraction of
their money and hold on to the rest in the form of cash o Less money is circulated through the banks Dampens the money
o Define the currency-deposit ratio:
c = Currency/Deposits
o New formula:
Δ Deposits = (1/c+v) x Initial Deposits
Would be smaller because cash drains minimize the money creation
Money Supply (Chapter 27!)
Money Supply = Currency in Circulation + Deposits
We would like to model the market for money in a supply and demand
framework. But what is the “price” of money?
Assumption: All individual (disposable) income is used to purchase either
money (non-interest bearing assets) or bonds (interest bearing assets).
o Buy bonds when they want to save money
Hence, the opportunity cost of holding money is the return (interest)
from holding bonds.
o Price of money = interest rate = rate of return on bonds
Question: Would you prefer $100 today or $100 in one year’s time?
Principle: People prefer money today over the same amount in the
Why? Money received today can be saved and earn interest.
o Put in savings account and acquire interest $100 + interest
o Inflation will erode purchasing power of that $100
o $100 in the future will be able to buy less goods and services
How much do we value money received in the future relative to the present?
Example: If the annual interest rate is 8%, how much money will you have if
you deposit $100 for 1 year?
o Answer: $108
o This is more than you would have if you received the $100 in one year’s
o Hence, money promised in the future is worth less than money received
o How much less? Question: How much would you be willing to accept today in lieu of receiving
$100 in one year?
o Obviously, this should be less than $100 (because you can earn interest)
o Tells us how much the future payment is worth today
o This is called the present value and it depends on the interest rate
(or opportunity cost)
Consider an asset that pays $X in one year’s time. If the interest rate is i% per
year, the PV of the asset is
In general, an asset that pays $X in t years time has a present value of:
o Incorporating OC of several years on interest
o How much will you be willing to trade in the present to forgo possible
Can also be extended to assets with multiple payments (as is common with
o Stream of payments
o Figure out what it’s worth today using this formula
Note: PV is negatively correlated with the interest rate
Consider a bond with a face value of $1000 and a coupon rate of 10% that expires
after 3 years. If the market interest rate is 8%, what is the present value of the bond?
Bonds – you know exactly how much you’ll be receiving and when (fixed
Face value – lump some payment that occurs when the bond expires – receive
$1000 at the end of 3 years
Coupon rate – annual rate – paid according to percentage of the face value
o At end of year 1, 2 and 3, you’ll receive a payment worth 10% of face
value How much would we expect this bond to sell for? What is the rate of return or yield at
Context: look at it as a much simpler bond
Consider a bond with a face value of $1000 and no coupon that expires after 3
years. If the market interest rate is 11%, what is the present value of the