Money, the price Level and Inflation
Money - is any commodity or token that is generally acceptable as a means of payment.
Money serves 4 functions
1. Means of payment - method of settling debt
2. Medium of exchange - objects that is generally accepted in exchange of goods and
services. Examples like barering, which require a double coincidence of wants and
medium of exchange overcomes this need.
3. Unit of account - is an agreed measure for stating the prices of goods and services.
This makes it easy to calculate the opportunity cost of a product
4. Store of Value - it can be held and exchanged 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 more
useful it is as money. Inflation lowers the value, so a low inflation is ideal.
Money in Canada Today consists of:
1. Currency - which are notes and coins held by individuals and businesses. But currency
held inside of banks are not counted as currency because it is not held by individuals
2. Deposits - is considered money because the owners of the deposits can use them to
make payments. Deposits owned by Government of Canada are not counted as money
because they are not held by individuals and businesses.
The two official measures of Money
1. M1 - currency held by indiv/businesses, Non/personal chequable deposits
2. M2 - consists of M1, plus Non/Personal chequable deposits and Fixed term Deposits
The liquidity of money determines the level M1 or M2, because deposits can be converted to
cash immediately into currency or other means of payment they are counted as money (M2).
Credit cards is not considered money because it is form of short term loan. As in credit card
verification requires income and other identification sources to start a credit card account. Also
there is promise of payment at the end of each month.
Depository institution - is a financial firm that takes deposits (M1,M2) from households and
3 Types of Depository Institutions in Canada
1. Chartered banks - is a private firm chartered under the Bank Act of 1991 to receive
deposits and make loans. The chartered banks are by far the largest institutions in the
2. Credit Union and Caisses Populaires a credit union is a cooperative organization that
operates under the Cooperative credit Association Act of 1991 and receive deposits from
and makes loans to its members. 3. Trust and Mortgage Loan Companies- a trust and mortgage loan companies is a
privately owned depository institution that operate under the Trust and Loan Companies
Act of 1991. These institutions receive deposits, make loans, and act as trustee for
pension funds and for estates.
What Depository Institution Do
They provide service such as cheque clearing, account management, credit cards and internet
banking etc withs service fee attached. But most of the income is earned by using fund they
receive from depositors to make loans and buy securities that earn higher interest rates thn paid
to depositors. A charter bank puts its depositor’s savings into four types of assets:
2. Liquid assets
Reserves - are notes and coins in its vault or its deposits at the Bank of Canada. These funds
are used to meet depositor’s currency withdrawals and to make payments to other banks. In
normals times, a bank keeps about 0.5% of deposits as reserves.
Liquid Assets - are Government of Canada Treasury bills and commercial bills. This is first line
of defense and can be sold very easily with no risk of loss. There is low risk, hence low interest
Securities- are Government of Canada bonds and other bonds such as mortgage-backed
securities. These assets can be converted to reserves but the prices fluctuate and is considered
more riskier than liquid assets. It has a higher interest rate to compensate for the added risk.
Loans- are any commitments of funds for an agreed-upon period of time. Banks can make
loans to other businesses (corporate bonds), mortgages and home line of credit (mortgages
backed securities), car loans and even credit card debts . This is riskiest form of assets for
banks because there is risk of nonpayment (default), liquidity risk since the loans are paid back
in set times and in times of uncertainty depositors might request to drawn down their savings
leading to a bank run.
Economic Benefits Provided by Depository Institutions
1. Create Liquidity - by borrowing short (savings/deposits) and lending long (loans)
2. Pool Risk - reduced the individual risk of default in loans. The risk is spread out
and the risk premium for banks are lowered.
3. Lower the cost of Borrowing - lowers search cost for borrowers and depositors.
The banks can vertically scale and reduce the cost of business.
4. Lowers the cost of Monitoring Borrowers- by monitoring borrowers, a lender can
encourage good decision that prevents defaults.
How Depository Institutions are Regulated The responsibility of financial regulation in Canada is shared by the Department of Finance, the
Bank of Canada, the Office of the Superintendent of Financial Institutions, The Canada Deposit
Insurance Corporation and provincial agencies. Their goals is to identify, evaluate and lessen
the consequences of financial risk.
Department of finance- bears the ultimate responsibility but delegates task to other agencies.
Bank of Canada - ensures the bank has adequate liquidity and provides general guidance and
advice to government.
The office of superintendent of Financial Institutions - supervise the banks and other depository
institutions and ensures that their balance sheets have a high enough capital ratio and assets
are sufficiently liquid to withstand stress.
Canada Deposit Insurance Corporation operate a system of deposit insurance that insures
deposits held at canadian banks up to $100,000 in case of bank failure.
Provincial government agencies regulate credit unions and caisse populaires.
Fractional-reserve banking - is a system in which banks keep a fraction of their depositors’
funds as cash reserves and lend the rest, was invented by goldsmiths in 16th century.
100 percent reserve banking - a system in which banks keep the full amount of their depositors’
fund as cash reserves.
Should banks keep 100% cash reserves to prevent them from failing and bringing
Pros - the Austrian School believes that the fractional reserve banking violates property rights
because the deposits are owned by the savers and not the banks. Hence they have no right to
lend the deposits to someone else.
Milton Friedman and Irving Fisher believed that that 100% reserve would enable central banks
to precisely control the quantity of money and eliminate the risk of bank running out of cash and
also better control the national economy by regulating the credit supply.
Cons - this 100% reserve requirement would reduce lending since bank profits would reduce.
The demand would receive loans from shadow banks that are unregulated and might make the
situation worse. The new Basel III requirement for higher capital would theoretically reduce the
likelihood for another banking crisis (higher capital ratios).
Financial Innovation - in the pursuit of larger profits, banks are constantly seeking ways to
improve their products through financial innovation. During the 1970s when fixed mortgages
were at 15%, banks introduced variable rates to lower the borrowing cost. During 2000s, when
the interests rate were low, banks started to securitize mortgages and lend to subprime
borrowers. This was done by reselling this MBS securities to other institutions and pension funds that wanted a higher interest rate delivering assets and the banks were able to mitigate
their risk of originating the loans from their balance sheet.
The Bank of Canada - is the central bank and public authority that supervises other banks and
financial institutions, financial markets and the payments systems and conduct monetary policy.
It accepts deposits. Makes loans and holds investments securities but there 3 other important
1. Bank to Banks and Governments - They have restrictive list of custome