27.1 The Nature of Money
Money: any generally accepted medium of exchange.
o Medium of exchange: anything that is generally acceptable in return
for goods and services sold.
o Money acts as a store of value and as a unit of account.
Barter: a system in which goods and services are traded directly for other
goods and services.
Double coincidence of wants: anyone who is specialized in producing one
commodity has to find someone who wants that commodity and who
specializes in producing the item that the first person needs.
The double coincidence of wants is unnecessary when a medium of exchange
o Be easily recognizable
o Be readily acceptable
o Have a high value relative to its weight
o Be divisible
o Be reasonably durable
o Be difficult (if not impossible) to counterfeit
When the price level is stable, the purchasing power of a given sum of money
is also stable; when the price level is highly variable, so is the purchasing
power of money, and the usefulness of money as a store of value is
o Between the 1970s and early 1990s, inflation in Canada was high
enough and sufficiently variable to diminish money’s usefulness as a
store of value.
Precious metals came to circulate as money and to be used in many
o They had high and stable prices
o They were easily recognizable
o They were easily divisible into extremely small units
o They did not easily wear out
The invention of coins eliminated the need to carry around bulk quantities of
metals and also the need to weigh amounts.
o A king/queen would affix his/her seal, which guaranteed the amount
of precious metal that the coin contained.
o The face value of the coin was nothing more than a statement that a
certain weight of metal was contained therein.
Clipping: the practice whereby people would clip off pieces of coins and keep
the clippings (undermined the acceptability of coins).
Milling: the process whereby coins were minted with a rough edge so that if
the edge of a coin was smooth, it was known that it had been clipped. Debasing: when rulers would remint coins by melting them down, adding in
inexpensive metals and giving back just what had been given and putting the
extras in the royal vault.
o This increased the amount of money in the economy (but not the
amount of gold).
o This caused inflation since when rulers paid their bills, the recipients
of the extra coins could be expected to spend them.
This caused a net increase in demand (bid up prices).
Gresham’s law (after Sir Thomas Gresham, an advisor to the Elizabethan
court): the theory that “bad,” or debased, money drives “good,” or undebased,
money out of circulation.
o It predicts that when two types of money are used side by side, the
one with the greater intrinsic value will be driven out of circulation.
This was seen when Queen Elizabeth I minted new coins that
contained their full face value in gold which quickly
disappeared out of circulation.
Would you rather use the debased or undebased coins
to make a purchase?
o This law is the reason why modern coins are merely tokens that
contain a metallic value that is only a small fraction of their face value.
The invention of paper money should be credited to the process by which
people would deposit their gold at goldsmiths who would in return give the
depositor a note promising to return the gold on demand.
o If the goldsmith was reliable and well known, people often simply
traded the notes when making a purchase.
o When paper money first came into being, it represented a promise to
pay so much gold on demand.
The paper money was backed by precious metal and was
convertible on demand into this metal.
Was issued by banks, and was called bank notes (each bank
had a different one).
Bank notes: paper money issued by commercial banks.
Banks quickly began to issue more paper money redeemable in gold than the
amount of gold that it held in its vaults.
o They had noticed that people were constantly trading, depositing and
o The currency issued in such a situation is said to be fractionally
backed by reserves.
o If banks issued too much paper money, they could easily run into
trouble if confidence was lost in the bank or if demand for gold rose
(would not be able to satisfy claims).
Soon it was only central banks who were able to issue currency in a country.
o Gold would be brought to the central bank, which would issue
currency in the form of “gold certificates”. This set an upper limit on the amount of currency that could
circulate in the economy.
o Gold standard: a currency standard whereby a country’s currency is
convertible into gold at a fixed rate of exchange.
o The central banks, however, still issued more currency than they had
In normal times, only a small fraction of the outstanding
currency was presented for payment at any one time.
The smaller the fraction held in reserves, the larger the supply
of paper currency that could be supported with a given stock of
Between World Wars, countries abandoned the gold standard for fiat money.
o Fiat money: 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.
Legal tender: anything that by law must be accepted when
offered either for the purchase of goods or services or to repay
o Gold backing for Canadian currency was eliminated in 1940.
If fiat money is generally acceptable, it is a medium of exchange. If 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.
o Almost all currency today is fiat money.
Deposit money: money held by the public in the form of deposits with
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
Central Bank: 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.
Financial intermediaries: privately owned institutions that serve the general
o Intermediaries because they stand between savers, whom they accept
deposits, and investors, to whom they make loans.
Many of the world’s early central banks were private, profit-making
institutions that provided services to ordinary banks (close ties developed
with the government causing them to eventually become central banks).
o The Bank of England is one of the world’s oldest and most famous
Began to operate in the 17 century, but was formally taken
over by the government in 1947.
The Bank of Canada commenced operations on March 11, 1935.
o It is a publicly owned corporation. o All its profits accruing from its operations are remitted to the
Government of Canada.
o The responsibilities for the Bank’s affairs rests with a board of
directors composed of:
There have been eight since its inception (7 year term).
The senior deputy governor
The deputy minister of finance
o It’s organization is designed to keep the operation of monetary policy
free from day-to-day political influence.
o The ultimate responsibility for the Bank’s actions rest with the
government, since it is the government that must answer to
Known as the “joint responsibility” system (dates back to
In this system, the governor of the Bank and the minister of
finance consult regularly.
In the case of a fundamental disagreement over
monetary policy, the minister of finance can issue an
explicit directive to the governor.
o The governor would carry out the minister’s
directive (or resign), and the responsibility for
monetary policy would rest with the
In the absence of such a directive, responsibility rests
with the governor of the Bank.
o 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.
o A central bank serves four main functions:
A banker for private banks
The central bank accepts deposits from commercial
banks and will, on order, transfer them to the account of
These deposits with the Bank are called reserves.
Lenders of last resort: whereby central banks lend
money to private banks that had sound investments but
were in urgent need of cash.
A bank for the government
When the government requires more money than it
collects in taxes, it needs to borrow, and it does so by
issuing government securities. o The Bank buys many of these and the interest
earned on these securities is largely what
accounts for the Bank’s profits every year.
The regulator of the nation’s money supply
Most measures of money supply include currency in
circulation plus deposits held at commercial banks.
o The majority of the Bank’s liabilities are either
currency held by the public or the reserves of the
Thus, by changing the levels of its assets and liabilities
(can be done in many different ways), as its liabilities
rise and fall, so does the money supply.
A regulator and supporter of financial markets
Central banks usually assume a major responsibility to
support the country’s financial system and to prevent
serious disruption by wide-scale panic and resulting
o I.e. The Bank’s action during the ’07-’08
recession in which it attempted