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Chapter 27

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ECON 110
Ian James Cromb

Chapter 27: Money and Banking The Nature of Money What is Money?  Money is a medium of exchange – anything that is generally acceptable in return for a p/s Money as a Medium of Exchange  If there were no money, goods would have to be exchanged through barter o Barter is a system in which p/s are traded directly for other goods and services  The major difficulty with barter is that it requires a double coincidence of wants – If you have A and want B, you have to find someone that has B and wants A o The use of money solves this problem – people can sell their output for money and in a separate transaction use that money to buy things they want from others  To be efficient, money must be easily recognizable, readily acceptable, have high value relative to its weight, divisible, durable, and difficult/impossible to counterfeit Money as a Store of Value  Money is a convenient means of storing purchasing power – to be a good store of value, money must have a relatively stable value o When price level is stable, purchasing power of a given sum of money is stable o If it is highly variable, the usefulness of money as a store of value is undetermined Money as a Unit of Account  Might also be used purely for accounting purposes without having any physical existence  Canadian banks transfer dollars credited to deposits each time you make a purchase with a debit card – thus a bank deposit acts as both a unit of account & a medium of exchange The Origins of Money Metallic Money  The use of gold and silver proved to have many advantages o They were precious (limited supplies) so they were in constant demand and therefore had high and stable prices o They were easily recognizable and divisible, and did not easily wear out  Before coins, they carried the metal in bulk and then would cut off the necessary amount  When coins were made, Kings/Queens would have to regulate the money with the use of royal seals on each coin to denote the value of the coin o However people started clipping coins altering the real value of each coin o Started minting coins w. rough edge so you could tell if the coin had been clipped  Some rulers started debasing – collect coins from people, melting them with other cheap metal, make new coins, re-distributing them  same gold, more money, lead to inflation Gresham’s Law  The theory that “bad”, or debased, money drives “good” or, non-debased, money out of circulation  would rather keep the more valuable one and spend the others  One reason that modern coins’ metallic value is only a fraction of their face value Paper Money  The public began to deposit gold with the goldsmiths (because they had very secure safes) & goldsmiths would give depositors receipts promising to give it back on demand o Take it out, buy something, the receiver of the gold would then bring it back to the goldsmith (who would then give them a receipt)  Eventually people began to just trade the receipts instead of the gold (paper money)  Bank notes are paper money issued by commercial banks Fractionally Backed Paper Money  Banks and goldsmiths realized that they didn’t need to have the same amount of gold as they did claims to the gold  not everyone wanted their gold at the same time  Banks then started issuing out loans and would collect interest on those loans o Even today, banks have more outstanding claims than money in reserves o In this situation, the currency issued is fractionally backed by the reserves  If there wasn’t enough gold to back it up, ppl would have with worthless pieces of paper Fiat Money  As time went on, central banks too control of issuing currency (only ones allowed to)  Gold Standard: A currency standard whereby a country’s currency is convertible into gold at a fixed exchange rate – could still be in a situation of fractionally backed reserves  Fiat Money: Paper money or coinage that is neither backed by nor convertible into anything else but is decreed by the gov’t to be acceptable as legal tender o Today, all money is fiat money – it’s a medium of exchange, (if it’s purchasing power is stable) it is a good store of value, both = it’s a good unit of account  Legal Tender is anything that by law must be accepted when offered either for the purchase of goods and services, or to repay a debt Modern Money: Deposit Money  Private banks cannot issue currency, but they can create deposit money  Deposit money: Money held by the public in the form of deposits with commercial banks o The use of a debit card instantly (electronically) transfers funds from the bank account of the purchaser to the bank account of the seller  It is faster, simpler, and more secure than using bank notes or cheques The Canadian Banking System  The central bank is a gov’t owned and operated institution that acts as banker to the commercial banking system and often to the gov’t as well o It controls the banking system and is the sole money-issuing authority  Financial intermediaries are privately owned institutions that serve the general public o Commercial banks (in this text) accept deposits and create deposit money, some include chartered banks, trust companies, credit unions, and caisses popularities The Bank of Canada  Early central banks were private, profit-making institutions that provided service to ordinary banks  their importance caused them to develop close ties to gov’ts The Organization of the Bank of Canada  Publicly owned corporation, all profits are remitted to Canadian gov’t  The responsibility of the bank’s affairs rest with the BOD – governor, senior deputy governor, deputy minister of finance, 12 directors  The organization of the BOC is designed to keep the operation of monetary policy free from day-to-day political influence o Has considerable autonomy in the way it carries out its operations – the ultimate responsibility of the bank’s actions lies with the gov’t  not full autonomy Basic Functions of the Bank of Canada Banker to Commercial Banks  Accepts deposits from commercial banks and will transfer them to the account of other banks  provides a “chequing “accounts and a means of settling debt w. other banks o These deposits are also called reserves for the BoC  To maintain the flow of credit and help reduce interest rates, the BoC provided liquidity to commercial banks by extending short-term loans  Also loan money to private banks if they are in urgent need of cash (but also had sound investments to back up the loan)  don’t want these banks to become insolvent Banker to the Federal Government  Gov’ts also need account where they hold their funds & on which they can write cheques  When the gov’t needs more money than it collects in taxes, it issues gov’t securities (short-term treasury bills or long-term bonds)  B of C usually buys some o These are an asset for the B of C  they earn interest/profit – this profit is eventually remitted to the government Regulator of the Money Supply  Majority of central bank’s liabilities are either currency held by the public or the reserves in commercial banks – these reserves underlie the deposits of households and firms o By changing its liabilities, the B of C can change the money supply Regulator and Supporter of Financial Markets  Usually assume a major responsibility to support the country’s financial system and to prevent serious disruption by wide-scale panic and resulting bank failures  Large, unanticipated increases in interest rates tend to squeeze institutions as businesses banks are in the busines
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