1

Understanding Economics

Chapter 13Money

Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

3rd editionby Mark Lovewell, Khoa Nguyen and Brennan Thompson

2Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Learning Objectives

In this chapter, you will:1. examine the functions of money, its

components, and the various definitions of money

2. learn about the demand for and supply of money and about equilibrium in the money market

3. see how money is created and consider the money multiplier

3Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

The Functions of Money There are three main functions that money performs

• a means of exchange (it overcomes the need for barter) Without money, market participants must trade

one product for another product, a transaction known as barter.

• a store of purchasing power Money’s major advantage is its liquidity, or the

ease with which it can be turn into a means of payment.

• a measure of value Money provides buyers and sellers with a unit of

account, or pricing standard that allows all products to be valued consistently.

4Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

The Canadian Financial System

The supply of money is closely associated with institutions known as deposit-takers.

Deposit-takers• accept funds provided by savers and lend these

funds to borrowers Deposit-takers also keep on hand some

amount, known as cash reserves• hold cash reserves to meet the needs of

depositors withdrawing funds

5Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

The Canadian Financial System

The four traditional pillars of the Canadian financial system were• chartered banks:• trust companies• insurance companies• investment dealers

Financial deregulation is allowing institutions in each pillar to perform a wider range of functions

6Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Chartered Banks and Near Banks

Chartered banks are deposit-takers allowed by federal charter to offer a wide range of financial services

Near banks are deposit-takers that are not chartered and have more specialized services• trust companies: administer various types of

accounts, including estates and trust funds and also compete with chartered banks by taking deposits and granting loans mainly to household.

• mortgage loan companies: specialize in granting mortgages and raise some of their funds through deposit-taking,

• credit unions and caisses populaires

7Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Chartered Banks and Near Banks in Canada Figure 13.1, Page 313

(total assets, $ billions, 31 July 2002)

Chartered Banks Near Banks

Trust and mortgageloan companies $ 10.2

Credit unions andcaisses populaires 134.1

Total $144.3

RBC $ 377.7Scotiabank 296.4TD 278.0CIBC 273.3BMO 252.9National 74.6Others 135.6

Total $1688.5

8Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Components of the Money Supply (a)

There are various possible components of the money supply• currency includes notes and coinage• demand deposits are funds to which depositors

have immediate access• notice deposits are funds for which deposit-takers

may require notice for withdrawals• term deposits are funds to which depositors have

no access for a fixed period• foreign currency deposits are funds held by

Canadian residents that are valued in foreign currency

9Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Money Defined (a)

There are four common definitions of money in Canada• M1 includes currency outside chartered banks

and publicly held demand deposits at chartered banks

• M2 consists of M1 plus notice deposits and personal term deposits at chartered banks

• M3 consists of M2 plus nonpersonal term deposits and foreign currency deposits at chartered banks

• M2+ consists of M2 plus corresponding deposits at near banks and some other liquid assets

10Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

The Canadian Money SupplyFigure 13.2, Page 315

0

100

200

300

400

500

600

700

800

900

M1 M2 M3 M2+

Money Definition

$ B

illio

ns (

Oct

ober

200

2)Near Bank Deposits andOther Liquid Assets

Other Chartered BankDeposits

Chartered Bank Noticeand Personal TermDeposits

Chartered Bank DemandDeposits

Currency OutsideChartered Banks

141

563

756806

57%

75%57%

26%29%

52%

18% 13% 13%

43% 7% 5% 5%

11Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Choosing a Definition (a)

Some economists believe that M1 is the most accurate definition of the money supply

Other economists prefer M2 or M2+ especially because of recent innovations in payments methods• credit cards make it more convenient for

purchasers to use deposits for payments purposes by borrowing funds for short periods

• debit cards add to the convenience of using deposits for payment purposes by allowing funds to be electronically moved from these deposits

12Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Money Demand (a)

There are two types of money demand• transactions demand is related to

money’s use as a means of exchange and varies directly with real output and the price level

• asset demand is related to money’s use as a store of purchasing power and is inversely related to the nominal interest rate

13Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Money Demand and Money Supply

Money demand• represents the amounts of money

demanded (for both transactions and asset demand purposes) at all possible interest rates

• is represented by a schedule or curve Money supply

• is a set amount determined by government decision-makers

• is represented by a schedule or curve

14Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

The Demand for MoneyFigure 13.3, Page 320

Money Demand Curve

0 10 20 30 40 50 60 70 80

1

2

3

4

5

Quantity of Money ($ billions)

Nom

inal In

tere

st R

ate

(%

)532

405060

506070

Money DemandSchedule

NominalInterest

Rate(%)

Quantityof Money

Dm0 Dm1

($ billions)

Dm0 Dm1

15Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

The Supply of MoneyFigure 13.4, Page 320

Money Supply Curve

0 10 20 30 40 50 60 70 80

1

2

3

4

5

Quantity of Money ($ billions)

Nom

inal In

tere

st R

ate

(%

)Money SupplySchedule

NominalInterest

Rate(%)

QuantityOf Money

Sm0 Sm1

($ billions)

532

505050

606060

Sm0 Sm1

16Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Equilibrium in the Money Market

Equilibrium in the money market occurs at the intersection of the money demand and money supply curves

The equilibrium interest rate is inversely related to the money supply

17Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Equilibrium in the Money MarketFigure 13.5, Page 321

Surplus

Shortage

Dm

Sm

Money Demand andSupply Curves

0 10 20 30 40 50 60 70 80

1

2

3

4

5

Quantity of Money ($ billions)

Nom

inal In

tere

st R

ate

(%

)

Money Demand andSupply Schedules

NominalInterest

Rate(%)

($ billions)(surplus (+) or shortage (-))

QuantitySupplied

QuantityDemanded-

532

(50 – 40) = +10(50 – 50) = 0(50 – 60) = - 10

18Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Money Creation (a)

Desired reserves are the minimum cash reserves that deposit-takers hold to satisfy anticipated withdrawal demands

The reserve ratio equals desired reserves divided by deposits

Excess reserves equal cash reserves minus desired reserves

As long as excess reserves exist new money will be created

19Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Opening a DepositFigure 13.6, Page 323

Cabot Bank

Assets Liabilities

Saver A’s Deposit $1000Cash Reserves +$1000

20Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Granting a LoanFigure 13.7, Page 324

Cabot Bank

Assets Liabilities

Saver A’s Deposit $1000Borrower X’s Deposit +$900

Cash Reserves $1000Loan to Borrower X +$900

21Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Withdrawing a DepositFigure 13.8, Page 324

Cabot Bank

Assets Liabilities

Saver A’s Deposit $1000Borrower X’s Deposit$0($900 - $900)

Cash Reserves $100($1000 - $900)Loan to Borrower X $900

22Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Accepting Deposit FundsFigure 13.9, Page 325

Fraser Bank

Assets Liabilities

Saver B’s Deposit +$900Cash Reserves +$900

23Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Granting a LoanFigure 13.10, Page 325

Fraser Bank

Assets Liabilities

Saver B’s Deposit +$900Borrower Y’s Deposit +$810

Cash Reserves +$900Loan to Borrower Y +$810

24Copyright © 2005 by McGraw-Hill Ryerson Limited. All rights reserved.

Money Creation (b)

The money multiplier

• is the value by which an amount of excess reserves is multiplied to give the maximum change in the money supply

• equals (1/the reserve ratio) The actual money supply change is less than

the maximum amount found using the above formula because of publicly held currency and non-monetary deposits