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Chapter 27 Money and Banking Notes
27.1 The Nature of Money
What is Money?
x medium of exchange Æ anything that is generally accepted in return for goods and services sold
x barter Æ a system in which goods and services are traded directly for other goods and services
x the double coincidence of wants is unnecessary when a medium of exchange is used
The Origins of Money
x Gresham’s law Æ the theory that “bad”, or debased, money drives “good”, or undebased, money out of circulation
x law predicts that when 2 types of money are used side by side, one with greater intrinsic value will be driven out of circulation
x bank notes Æ paper money issued by commercial banks
x gold standard Æ a currency standard whereby a country’s currency is convertible into gold at a fixed rate of exchange
x fiat money Æ paper money or coinage that is neither backed by nor convertible into anything else but is decreed by the
government to be accepted as legal tender
x legal tender Æ anything that by law must be accepted for the purchase of goods and services or the repayment of a debt
x if fiat money is generally acceptable, it is a medium of exchange; it its purchasing power remains stable, it is a satisfactory store
of value; if both of these things are true, it serves as a satisfactory unit of account; today, almost all currency is fiat money
Modern Money: Deposit Money
x deposit money Æ money held by the public in the form of deposits with commercial banks
x bank deposits are money; today, just as in the past, banks create money by issuing more promises to pay (deposits) than they
have cash reserves available to pay out
27.2 The Canadian Banking System
x central bank Æ a bank that acts as banker to the commercial banking system and often to the government as well; usually a
government-owned institution that controls the banking system and is the sole money-issuing authority
The Bank of Canada
x the system of joint responsibility keeps the conduct of monetary policy free from day-to-day political influence while ensuring
that the government retains ultimate responsibility for monetary policy
x basic functions of the bank—banker to the commercial banks, banker to the federal government, regulator of the money supply,
and regulator and supporter of financial markets
Commercial Banks in Canada
x commercial bank Æ a privately owned, profit-seeking institution that provides a variety of financial services, such as accepting
deposits from customers and making loans and other investments
x clearing house Æ an institution where interbank indebtedness, arising from the transfer of cheques between banks, is computed
and offset and net amounts owing are calculated
Reserves
x the reserves needed to ensure that depositors can withdraw their deposits on demand will normally be quite small
x bank run Æ a situation in which many depositors rush to withdraw their money, probably leading to a banks financial collapse
x fractional-reserve system Æ a banking system in which commercial banks keep only a fraction of their deposits in cash or on
deposit with the central bank
x reserve ratio Æ fraction of its deposits that commercial bank holds as reserves in form of cash or deposits with central bank
x target reserve ratio Æ the fraction of its deposits that a commercial bank wants to hold as reserves
x excess reserves Æ reserves held by a commercial bank in excess of its target reserves
27.3 Money Creation by the Banking System
The Creation of Deposit Money
x if v is target reserve ratio, new deposit to banking system will increase total amount of deposits by 1/v times new deposit
x with no cash drain from the banking system, a banking system with a target reserve ratio of v can change its deposits by 1/v
times any change in reserves
Excess Reserves and Cash Drains
x deposit creation does not happen automatically; it depends on the decisions of bankers; if banks do not choose to lend their
excess reserves, there will not be an expansion of deposits
x the larger is the cash drain from banking system, the smaller will be total expansion of deposits created by a change in reserves
27.4 The Money Supply
x money supply Æ the total quantity of money in an economy at a point in time; also called the supply of money
Kinds of Deposits
x term deposit Æ an interest-earning bank deposit, subject to notice before withdrawal
x the long-standing distinction between money and other highly liquid assets used to be that, narrowly defined, money as a
medium of exchange that did not earn interest, whereas other liquid assets earned interest but were not media of exchange; today,
this distinction has almost completely broken down
Definitions of the Money Supply
x M1 Æ currency plus demand deposits
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x M2 Æ M1 plus savings deposits at the chartered banks
x M2+ Æ M2 plus deposits held at institutions that are not chartered banks
Near Money and Money Substitutes
x near money Æ liquid assets that are easily convertible into money without risk of significant loss of value and can be used as
short-term stores of value but are not themselves media of exchange
x money substitute Æ something that serves as a medium of exchange but is not a store of value
Summary
27.1 The Nature of Money
x Money is anything that serves as a medium of exchange, a store of value, and a unit of account.
x Money arose because of the inconvenience of barter, and it developed in stages: from precious metal to metal coinage, to paper
money convertible to precious metals, to taken coinage and paper money fractionally backed by precious metals, to fiat money,
and to deposit money.
27.2 The Canadian Banking System
x The banking system in Canada consists of tow main elements: the Bank of Canada (which is the central bank) and the
commercial banks.
x The Bank of Canada is a government-owned corporation that is responsible for the day-to-day conduct of monetary policy.
Though the Bank has considerable autonomy in its decisions, ultimate responsibility for monetary policy resides with the
government.
x Commercial banks are profit-seeking institutions that allow their customers to transfer deposits from one bank to another by
means of cheques or debit cards. They create money as a by-product of their commercial operations by making or liquidating
loans and various other investments.
27.3 Money Creation by the Banking System
x Because most customers are content to pay by cheque or debit card rather than with cash, banks need only small reserves to back
their deposit liabilities. It is the fractional reserve aspect of the banking system that enables commercial banks to create deposit
money.
x When the banking system receives a new cash deposit, it can create new deposits equal to some multiple of this amount. For a
target reserve ratio of v and a cash-deposit ratio of c, the total change in deposits following an injection of reserves is:
û Deposits = û Reserves / (c + v)
27.4 The Money Supply
x The money supplythe stock of money in an economy at a specific moment—can be defined in various ways. M1, the
narrowest definition, includes currency and chequable deposits. M2 includes M1 plus savings deposits and smaller term deposits.
M2+ includes M2 plus deposits at nonbank financial institutions and money-market mutual funds.
x Near money includes interest-earning assets that are convertible into money on a dollar-for-dollar basis but that are not currently
a medium of exchange. Money substitutes are things such as credit cards that serve as a medium of exchange but are not money.
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