Money, the Price Level and Inflation
What is Money?
• Money is any commodity or token that is generally acceptable as the means of
• A means of payment is a method of settling a debt.
• When payment has been made, there is no remaining obligation between the
parties to a transaction.
• Money performs three other functions:
o Medium of exchange
o Unit of account
o Store of value
• A medium of exchange is any object that is generally acceptable in exchange for
goods and services.
• Without money, it would be necessary to exchange goods and services directly
for other goods and services—an exchange called barter.
• A unit of account is an agreed measure for stating the prices of goods and
• In the absence of a standardized unit of account, keeping track of prices and
comparing prices would be difficult.
• A store of value is any commodity or token that can be held and exchanged later
for goods and services.
• The more stable the value of a commodity or token, the better it can act as a
store of value and the more useful it is as money.
• Money in Canada today consists of currency and deposits at banks and other
• The coins and Bank of Canada notes that we use today are known ascurrency.
• The two main measures of money are called:
• M1 consists of currency held outside the banks and chequable deposits of
individuals and businesses.
• M1 does not include currency held by banks, and it does not include currency
and bank deposits owned by the government of Canada.
• M2 consists of M1 plus all other deposits.
• Deposits are money but cheques are not money.
• A cheque transfers a deposit from one account to another. • Credit cards and debit cards are not money.
The Banking System
• A depository institution is a private firm that takes deposits from households
and firms and make loans to other households and firms.
• The deposits of three types of depository institutions make up the nation’s
o Chartered banks
o Credit unions and caisses populaires
o Trust and mortgage companies
• To provide security for its depositors, a bank divides its funds intoves,
which are currency in a bank’s vault plus its deposit at the Bank of Canada and
• A bank has four types of assets: overnight loans, liquid assets, investment
securities, and loans.
• Banks provide four services for which people are willing to pay: create liquidity,
minimize the cost of borrowing, minimize the cost of monitoring borrowers, and
• The Bank of Canada is Canada’s central bank, a public authority that
supervises other banks and financial institutions, financial markets, and the
payments system and conducts monetary policy.
• The Bank of Canada makes loans to banks and serves as the lender of last
resort, which means that it stands ready to make loans when the banking
system as a whole is short of reserves.
• The payments system is the system through which banks make payments to
each other to settle transactions.
• The Large Value Transfer System (LVTS) is an electronic payments system
that enables financial institutions and their customers to make large payments
instantly and with the sure knowledge that the payment has been made. The
Automated Clearing Settlement System (ACSS) is the system through
which all payments not processed by the LVTS are handled. How Banks Create Money
• We will use the word ‘bank’ to refer to any depository institution.
• Banks create money by making loans.
• We will start by looking at a one-bank economy.
• The fraction of a bank’s total deposits that are held in reserves is called the
• The desired reserve ratio is the ratio of reserves to deposits that banks wish
• A bank’s desired reserves are equal to its deposits multiplied by the desired
• Actual reserves minus desired reserves are excess reserves.
• When a bank has excess reserves it makes loans.
• We call the leakage of currency from the banking system the currency drain, and
we call the ratio of currency do deposits theurrency drain ratio.
• There are nine steps in the sequence of money creation:
1. Banks have excess reserves.
2. Banks lend excess reserves.
3. The quantity of money increases.
4. New money is used to make payments.
5. Some of the new money remains on deposit.
6. Some of the new money is a currency drain.
7. Desired reserves increase because deposits have increased.
8. Excess reserves decrease, but remain positive.
• The proc