Money, Banking and the

Central Banking System

Chapter 14

SECOND CANADIAN EDITION

MACROECONOMICSPaul Krugman | Robin Wells

Iris Au | Jack Parkinson

© 2014 Worth Publishers

• The various roles money plays.

• The many forms of money.

• How the actions of banks and the Bank of Canada determine the money supply.

• How the Bank of Canada uses open-market operations to change the monetary base and money supply.

WHAT YOUWILL LEARN

IN THIS CHAPTER

Money and the Money Supply

• Money is any asset that can easily be used to purchase goods and services.

• The money supply is the total value of financial assets in the economy that are considered money.

• Measures of the money supply always include: Currency in circulation: cash held by the public. Bank deposits accessible by cheque or debit card (text calls

these: chequeable deposits or demand deposits).

• Some measures of money supply include other assets that can easily be converted into cash.

Measuring the Money Supply

• A monetary aggregate is an overall measure of the money supply.

e.g. M1, M1+, M2 etc. (higher the number the broader the range of assets included)

• M1+ consists, roughly speaking, of assets you can use to buy groceries: currency and chequeable deposits.

• M2, M2+, and M3 are broader definitions of money supply include assets such as savings and term deposits, and other assets that may, at some cost, be converted into M1. Are these additional assets liquid enough to be money?

Canadian Money Supply: December 2014

Currency in circulation $69 billionM1+ $769 billionM2+ $1,669 billion

• Most money is deposit money not currency.

• Most money doesn’t physically exist!

Monetary Aggregates, August 2012

Pitfalls

What’s Not in the Money Supply

• Are financial assets like stocks and bonds part of the money supply? No, not under any definition, because they’re not liquid enough.

• Normally, for example, you can switch funds between your savings and chequing accounts with a click of a mouse or a call to an automated phone service.

• Converting a stock or a bond into cash requires selling the stock or bond. That makes these assets much less liquid than bank deposits. So stocks and bonds aren’t considered money.

The Big Moneys

GLOBAL COMPARISON

What does money do? 3 Roles of Money

(1) Medium of exchange: an asset that individuals use to buy goods and services.

- This is the defining role of money.- Allows us to avoid the inefficiencies of a barter economy- Barter economies: trade goods for goods. Time consuming! Need a “double coincidence of wants”.

(2) Store of value: money is a means of storing purchasing power over time.

- allows for greater flexibility: can earn and consume at different times.

- money is one of many stores of value (all real and financial assets are stores of value)

(3) Unit of account: a measure used to set prices and make economic calculations, i.e. money units measure values.

- Having common measures of value makes economic decision-making easier.

Types of Money Through the Ages

• Commodity money is a good used as a medium of exchange that has intrinsic value in other uses.

e.g. precious metals (gold and silver coins)

• A commodity-backed money is a medium of exchange with no intrinsic value whose ultimate value is guaranteed by a promise that it can be converted into valuable goods.

e.g. early paper money could be changed into silver or gold.

• Fiat money is a medium of exchange whose value derives from its official status as a means of payment.

Modern currency (coins and bills) is fiat money.Confidence: fiat money has value because we believe others will

accept it as payment. No confidence, no value! (Zimbabwe 2008)

Fiat Money• Value from its official status as money and confidence.

- earlier money: overcame the confidence problem by being linked to something of intrinsic value)

- New forms of money e.g. Bitcoin must surmount the confidence problem.

• Fiat money is an efficient form of money. Plays the roles of money but doesn’t tie up otherwise useful

resources (can use gold and silver for other things).

• Are new electronic forms of money even more efficient?

What’s with All the Currency?

• $61 billion of currency in circulation (2012). That’s $1756 in cash for every man, woman, and child in Canada. How many people do you know who carry $1756 in their wallets? Not many. So where is all that cash? Part of the answer is that it isn’t in individuals’ wallets: it’s in cash registers.

FOR INQUIRING MINDS

What’s with All the Currency?

• Economists also believe that cash plays an important role in transactions that people want to keep hidden.

• Small businesses and the self-employed sometimes prefer to be paid in cash so they can avoid paying taxes by hiding income from the Canadian Revenue Agency.

• Drug dealers and other criminals obviously don’t want bank records of their dealings.

• Ratio of currency in circulation is sometimes used to estimate the size of the underground/illegal economy.

FOR INQUIRING MINDS

The History of the Canadian Dollar

• Canadian paper bills are pure fiat money: they have no intrinsic value, and they are not backed by anything that does.

• But money in Canada wasn’t always like that. In the 1600s and 1700s, the colonies used commodity money, partly consisting of gold and silver coins minted in Europe. (“Dollars” were originally a type of Spanish coin)

In 1817, the circulation of commodity-backed paper money began: unlike now this was issued by private banks!

(1817: Bank of Montreal)

ECONOMICS IN ACTION

The History of the Dollar

• In 1934, the government took on full responsibility for issuing paper bills with the creation of a central bank (the Bank of Canada), and private banknotes were gradually phased out.

• Gold backing for Canadian currency was eliminated in 1940, Today’s Bank of Canada notes simply say “This note is legal tender” (that means fiat money).

(More info? James Powell’s History of the Canadian Dollar is available via the Bank of Canada website)

ECONOMICS IN ACTION

The Monetary Role of Banks

• Private sector or chartered banks are a financial intermediary that uses liquid assets (bank deposits) to finance the illiquid investments of borrowers (bank loans).

Banks borrow from depositors (at low interest!) Banks lend to households or businesses (at higher interest!) Make profit from the ‘spread’ between deposit and loan rates.

• Deposits are the key raw material for the banking business model. (Source of funds to lend out)

• Deposits are also part of the money supply.

Monetary Role of Banks: Bank Reserves• Bank reserves are funds held by banks to meet their

depositors’ demands for cash withdrawals.

• Bank reserves take two forms: the currency banks hold in their vaults or in bank machines; deposits at the Bank of Canada.

• The second type of reserve is used for clearing interbank obligations.

e.g. if a BMO depositor makes a payment to a TD depositor then a transfer is made from BMO’s account at the Bank of Canada to TD’s account at the Bank of Canada.(So the accounts at the Bank of Canada underlie cheque and debit payment systems).

Monetary Role of Banks: Why hold reserves?• Banks hold reserves to avoid the costs of having too few

funds to meet depositor’s needs. Costs?- unhappy customers won’t deposit at your bank!- shortfalls at the Bank of Canada must be covered by

potentially expensive borrowing! (Bank Rate)

• There is also a cost to holding reserves.Funds held at reserve can’t be used as loans (so some loan

interest is foregone)

• Banks choose how many reserves to hold by comparing the benefits vs. costs of reserves: result is a desired reserve ratio — the fraction of deposits that banks want to hold as reserves.

Reserve Ratio (rr) for Canadian Banks: 2003-12

Notice the sharp rise in ‘rr’ in 2008: associated with the Financial crisis. Partly due to fear that depositors would be more likely to withdraw funds, partly due to unattractiveness of making loans due to high risk.

The Problem of Bank Runs• A bank run is a phenomenon in which many of a bank’s

depositors try to withdraw their funds because of fears of a bank failure. Bank collapses produced by runs are rooted in the bank

business model: deposits are liquid but loans often are not!

• Historically, bank runs have often proved contagious, with a run on one bank leading to a loss of faith in other banks, causing additional bank runs.

• One reason for the severity of the 1930s Depression were bank collapses produced by bank runs.

• 2008 Financial Crisis: like a bank run on bank-like financial

institutions?

Policy Responses to the Possibility of Bank Runs

• Deposit insurance — guarantees that a bank’s depositors will be paid even if the bank can’t come up with the funds, up to a maximum amount per account. The CDIC currently guarantees the first $100 000 of each account.

• Capital requirements — regulators require that the owners of banks hold substantially more assets than the value of bank deposits, this reduces the possibility of a run on the bank.

(assets could be sold to meet obligations to depositors)

• Reserve requirements — rules set by the central bank that determine the minimum reserve ratio banks.

- Intended to assure depositors that funds would be on hand.- Required reserves are less common now (Canada eliminated

them in the 1990s)

Banks and the Money Supply: Deposit Expansion• Say quantity of reserve assets increases by $1000

e.g. Silas the miser deposits $1000 of cash into a First Bank.

• First Bank has an extra $1000 of reserves (currency) and an extra $1000 of deposits.

• First Bank will want: rr x $1000 extra reserves to back up its new deposit.

(rr = desired reserve ratio = 0.10)

• This leaves First Bank with (1-rr)x $1000 excess reserves that it will lend out.

e.g. if rr=0.1 it lends out $900 =(1-0.1)x$1000.

Deposit Expansion (continued)• Say (as in text) Maya is the customer who received the loan.

• Maya uses her (1-rr)x$1000 = $900 loan to buy something from Anne.

• Anne deposits her $900 in into Second Bank. Second Bank now has created a $900 deposit for Anne. Second Bank has $900 in extra reserves. Second Bank only wants rr x$900= $90 reserves. Second Bank lends out its (1-rr)x$900=$810 excess reserves. The recipient of the loan uses it to buy something for $810 leaving

the seller (Ben) with $810 in cash that he deposits in Third Bank. Third Bank creates an $810 deposit, keeps $81 in reserves and lends out the $729 =(1-rr)x$810 in excess reserves. Process continues ….

Deposit Expansion (continued)• Result?Initially $1000 in money (currency in circulation)

• At each stage of the process additional deposit money was created:First Bank $1000 deposit to Silas $1000Second Bank $900 deposit to Anne $1000x(1-rr)Third Bank $810 deposit to Ben $1000x(1-rr)2

Fourth Bank $729 deposit to ?? $1000x(1-rr)3

. .

. .

Nth Bank (depends on N) $1000x(1-rr)N-1

Total Effect: $10,000 $1000/rr

Determining the Money SupplyEffect on the money supply of turning cash into a deposit at First Street Bank

Reserves, Bank Deposits, and the Money Multiplier

• Excess reserves are bank reserves over and above the bank’s desired reserves.

• Increase in bank deposits from $1,000 in excess reserves =$1,000 + ($1,000 × (1 − rr)) + ($1,000 × (1 − rr)2) +($1,000 × (1 − rr)3) + . . .

• This can be simplified to: $1,000/rr- this is called the “deposit multiplier”

(this uses our earlier, Ch. 11 result for geometric series)

• Lesson? A central bank can change the amount of deposit money in the economy by changing the

quantity of reserve assets in the economy.

The Monetary Base• The monetary base is the sum of currency in circulation and

bank reserves.

• The money multiplier is the ratio of the size of the money supply to the size of the monetary base.

• Deposit expansion process explains why the money supply exceeds the monetary base.

• Money multiplier is not the same as the deposit multiplier because, unlike our example, people hold both currency and deposits.

ECONOMICS IN ACTION

Multiplying Money Down

• Between 1929 and 1933, as bank failures shook the public’s confidence in the banking system, the public’s holdings of currency increased sharply, as many Americans decided that money under the bed was safer than money in the bank, after all.

• The value of chequeable bank deposits fell sharply, through the multiplier process we have just analyzed, when individuals pulled their cash out of banks.

ECONOMICS IN ACTION

Multiplying Money Down

• Loans also fell because banks that survived the waves of bank runs increased their excess reserves, just in case another wave began.

• The value of M1 fell sharply, because the total reduction in chequeable or near-chequeable bank deposits was much larger than the increase in currency in circulation.

Central Banks

A central bank is an institution that oversees and regulates the banking system and controls the monetary base.

Functions of a central bank (Bank of Canada or BOC):• Banker for private banks – the BOC acts as a “lender of

last resort” for a private bank with sound investments that needs cash and cannot find a lender.

• Banker for the federal government – manages government bank accounts, and may sometimes buy securities that the government issues.

• Issues currency – ensures the supply of banknotes meets public demand and prevents counterfeiting.

• Conducts monetary policy – controls the quantity of money, interest rates and/or the exchange rate.

The Bank of Canada (BOC) accepts deposits from, and makes loans to, both the federal government and domestic private banks. Deposits of private banks at BOC are bank reserves.

The BOC makes loans to both the government and the commercial banks by buying government bonds, which explains why its greatest asset is Government of Canada bonds. Banknotes in circulation are its greatest liability

(see next slide)

Functions of the Bank of Canada

Functions of the Bank of Canada

The BOC is a crown corporation owned by the government and any profit it makes is remitted to the government.

Operations are overseen by the Board of Directors that consists of the governor, the senior deputy governor, the deputy minister of finance (who has no vote), and 12 outside directors drawn from across the country.

The governor is the BOC’s chief executive officer appointed for a seven-year term by the Board of Directors.

Canada’s monetary policy is implemented by the Governing Council (the governor and five deputy governors).

Structure of the Bank of Canada

Reserve Requirements and the Bank Rate

Like many advanced economies, banks in Canada are not required to hold a given fraction of their deposits as reserves.

The overnight market is a financial market in which banks that are short of reserves can borrow funds from banks with excess reserves. The overnight rate is the interest rate determined in the overnight funds markets.

The target for the overnight rate is the BOC’s official key policy interest rate. The bank rate is the interest rate that the BOC charges on loans to banks (it is also known as the discount rate in some countries).

Bank of Canada’s Operating Band

Open-Market Operations

An open-market operation is the purchase or sale of assets by a central bank. For the BOC, these assets are predominantly Government of Canada bonds, but they may also be foreign exchange.

The Bank of Canada’s Assets and Liabilities:

Open Market Operations: Buying Securities• Say Bank of Canada purchases $100 million of T-Bills from

the Bank of Montreal (BMO).

BMO has $100 million fewer T-Bills but now has a $100 million claim on the Bank of Canada, i.e. $100 million more in BMOs account at the BOC. These extra funds are bank reserves!

BOC has $100 million more T-bills but has increased its liabilities (BMOs deposits at BOC) by $100 million. This is the increase monetary base in the table.

The extra reserves (larger monetary base) will set off the deposit expansion process. Money supply will rise!

Open-Market Operations by the Bank of Canada

Open Market Operations: Selling Securities• Say Bank of Canada sells $100 million of T-Bills to the Bank

of Montreal (BMO).

BOC has $100 million fewer T-Bills but now has a $100 million claim on BMO, i.e. BOC can reduce BMOs account at the BOC by $100 million. These represents a fall in bank reserves!

BMO has $100 million more T-bills but has decreased its bank account at the BOC by $100 million.

The fall in reserves (smaller monetary base) will set off the deposit contraction process. Money supply will fall!

Open-Market Operations by the Bank of Canada

Deposit Switching Operations by the Bank of Canada

Deposit switching is the shifting of government deposits between the Bank of Canada and the private banks. It is a major tool used by the Bank of Canada in its day-to-day operations.

Such switches also change the amounts of bank reserves.

e.g. If BOC shifts $10 million of Federal government money from the governments account at the BOC to the government’s account at Bank of Nova Scotia then Bank of Nova Scotia is credited with an extra $10 million in its account at the BOC: these are reserves!

Deposit Switching Operations by the Bank of Canada

Interest Rate Targets versus Money Supply Targets

Open market operations or deposit switches both change the quantity of reserve assets and eventually the money supply.

In fact since the later 1980s the Bank of Canada has used these tools not to achieve a target level of money supply but to achieve a target interest rate. (see next chapter!)

Why not target the money supply? Harder to control than the level of interest rates. It is not clear what the money supply is. Monetary

aggregates M1, M2, and M2+ differ not only in their annual growth rates, but may also move in different directions.

Interest Rate Targets versus Money Supply Targets

Interest Rate Targets versus Money Supply Targets

The Evolution of the Canadian Banking System

The 21st century Canadian banking system emerged in response to troubling historical and financial developments, such as global war and depression.

The falling money supply and shrinking trade balance of the early 1930s acted to significantly worsen and prolong the economic slump (now known as the Great Depression) after the Wall Street stock market crash of 1929.

In 1933, a royal commission recommended the creation of a central bank. Despite strong opposition from Canadian banks, as they feared their profits might fall once the central bank became the sole issuer of domestic banknotes, the Bank of Canada was established in 1935.

The U.S. Financial Crisis of 2008

• Advances in technology and financial innovation along with U.S. regulators’ reluctance to take aggressive action created weaknesses that played a central role in the financial crisis of 2008.

• Subprime lending during the U.S. housing bubble of the mid-2000s spread through the financial system via securitization.

i.e. mortgage loans to risky borrowers were pooled and securities were created from the pooled loans.

• When the bubble burst, massive losses by banks and nonbank financial institutions led to widespread collapse in the financial system.

• To prevent another Great Depression, the US central bank (the Federal Reserve) and the U.S. Treasury expanded lending to bank and nonbank institutions, provided capital through the purchase of bank shares, and purchased private debt.

• Because much of the crisis originated in nontraditional bank institutions, the crisis of 2008 indicated that a wider safety net and broader regulation are needed in the financial sector.

The U.S. Financial Crisis of 2008

The U.S. Financial Crisis of 2008TED spread is the difference between what banks must pay to borrow short-term and the risk-free government rate, i.e. it indicates riskiness of banks.

ECONOMICS IN ACTION

Why Are Canada’s Banks More Stable?

• In 2012, for the fifth year in a row, the World Economic Forum ranked Canada’s banking system as the most sound in the world as bank failures have been quite rare in Canada, even during market crashes, depressions, wars, and other financial turmoil.

• The prudent lending decisions avoid problems that have plagued banks elsewhere.

• The Canadian banking system has been more concentrated than those of some other jurisdictions allowing banks to be well capitalized and diversified.

ECONOMICS IN ACTION

Why Are Canada’s Banks More Stable?

• The government imposes and enforces strict regulations in the banking sector through mortgage default insurance requirements, shorter amortization periods, the inability to deduct the interest paid on owner-occupied mortgages from taxes to prevent housing bubble, and warnings to Canadians on excessive borrowing.

1. Money is any asset that can easily be used to purchase goods and services. Currency in circulation and chequeable bank deposits are both considered part of the money supply.

Money plays three roles: it is a medium of exchange used for transactions, a store of value that holds purchasing power over time, and a unit of account in which prices are stated.

Summary

2. Over time, commodity money, which consists of goods possessing value aside from their role as money, such as gold and silver coins, was replaced by commodity-backed money, such as paper currency backed by gold. Today, the dollar is pure fiat money, whose value derives solely from its official role.

Summary

3. The Bank of Canada calculates a number of measures of the money supply.

M1 is the narrowest monetary aggregate, containing only currency in circulation and demand deposits, such as chequing accounts, held at chartered banks.

M2 and M3 include a wider range of assets called near-moneys, mainly other forms of chartered bank deposits, that can easily be converted into chequing bank deposits.

Summary

4. Banks allow depositors immediate access to their funds, but they also lend out most of the funds deposited in their care.

To meet demands for cash, they maintain desired (or voluntary) reserve ratios composed of both currency held in their vaults and deposits at the Bank of Canada.

Excess reserves refer to any reserves above the desired level of reserves.

The reserve ratio is the ratio of bank reserves to bank deposits.

A T-account summarizes a bank’s financial position.

Summary

5. Banks have sometimes been subject to bank runs, most notably in the early 1930s in the U.S. and briefly just before World War I in Canada. To avert this danger, depositors are now protected by deposit insurance. Although Canadian banks are no longer required to meet minimum reserve requirements, bank owners still face capital requirements that reduce the incentive to make overly risky loans with depositors’ funds.

Summary

6. When currency is deposited in a bank, it starts a multiplier process in which banks lend out excess reserves, leading to an increase in the money supply—so banks create money.

If the entire money supply consisted of chequable bank deposits, the money supply would be equal to the value of reserves divided by the reserve ratio.

In reality, much of the monetary base consists of currency in circulation, and the money multiplier is the ratio of the money supply to the monetary base.

Summary

7. The monetary base is controlled by the Bank of Canada (BOC), the central bank of Canada. The BOC regulates banks and helps to set overnight interest rates.

To meet those desired reserve requirements, banks borrow and lend reserves in the overnight funds market usually at an interest rate very close to the BOC’s target for the overnight rate.

When banks are unable to borrow funds in the overnight market, they have the option to borrow from the Bank of Canada at the bank rate. Such a loan is referred to as a lender of last resort loan.

Summary

8. The Bank of Canada’s principal tools of monetary policy are open-market operations and deposit switching. To increase the monetary base, the BOC can buy Canadian treasury bills from commercial banks or switch government deposits from itself to banks. To reduce the monetary base, the BOC can sell Canadian treasury bills to banks or switch government deposits from banks to itself.

9. To counteract a poor monetary policy that had worsened the effects of the Great Depression, the Bank of Canada was created. The BOC’s duties were to be the sole issuer of legal tender of Canadian banknotes, centralize holding of reserves, regulate and inspect banks’ books, and make the money supply sufficiently responsive to varying economic conditions.

Summary

10. The Great Depression sparked widespread bank runs in the United States, which greatly worsened and prolonged it even further.

In response, the American government created federal deposit insurance to reduce the risk of bank runs. Public acceptance of deposit insurance finally stopped the American bank runs of the Great Depression.

Canada did not experience significant bank runs during the Depression and, as a result, deposit insurance was not set up in Canada until 1967.

Summary

11. During the mid-1990s, the U.S. hedge fund LTCM used huge amounts of leverage to speculate in global financial markets, incurred massive losses, and collapsed.

LTCM was so large that, in selling assets to cover its losses, it caused balance sheet effects for firms around the world, leading to the prospect of a vicious cycle of deleveraging. As a result, credit markets around the world froze.

The New York Fed coordinated a private bailout of LTCM and revived world credit markets.

Summary

12. Subprime lending during the U.S. housing bubble of the mid-2000s spread through the financial system via securitization.

When the bubble burst, massive losses by banks and nonbank financial institutions led to widespread collapse in the financial system in the U.S. and elsewhere.

To prevent another Great Depression, the U.S. Federal Reserve and the U.S. Treasury expanded lending to bank and non-bank institutions, provided capital through the purchase of bank shares, and purchased private debt.

Summary

Because much of the crisis originated in nontraditional bank institutions, the crisis of 2008 indicated that a wider safety net and broader regulation are needed in the financial sector.

The 2010 Dodd-Frank bill, the biggest American financial reform since the 1930s, is an attempt to prevent another crisis.

Summary

13. During the crisis of 2008 and subsequent recession, the Bank of Canada acted much like the Fed, the American central bank. It lowered its target rate for the overnight market, increased lending to the Canadian financial institutions, and lengthened the list of securities it would accept as collateral from financial institutions.

Summary

• Money• Currency in circulation• Chequeable (or demand) deposits• Money supply• Medium of exchange• Store of value• Unit of account• Commodity money• Commodity-backed money• Fiat money• Monetary aggregate• Near-moneys• Bank reserves• T-account• Reserve ratio• Bank run• Deposit insurance• Capital requirements

• Reserve requirements• Desired (or voluntary) reserve ratio• Excess reserves• Monetary base• Money multiplier• Central bank• Overnight funds market• Overnight rate• Target for the overnight rate• Bank rate• Discount rate• Open-market operation• Deposit switching• Commercial bank• Leverage• Balance sheet effect• Vicious cycle of deleveraging• Sub-prime lending

Key Terms

• Securitization• Investment bank

Key Terms