CHAPTER 12

Money, Banking, and Money

Creation

1

Slides prepared by Bruno Fullone, George Brown College

© 2010 McGraw-Hill Ryerson Limited

PART 4: MONEY, BANKING,

AND MONETARY POLICY

Chapter 12 2

• Learning Objective 12.1: The definition and functions of money

• Learning Objective 12.2: What constitutes the supply of money

• Learning Objective 12.3: What backs Canada’s money supply

• Learning Objective 12.4: About the structure of the Canadian financial system

• Learning Objective 12.5: How a chartered bank can create (or destroy) money through loans to the public

• Learning Objective 12.6: About the multiple deposit expansion of the entire chartered banking system

• Learning Objective 12.7: What the monetary multiplier is and how to calculate it

In This Chapter You Will Learn:

LO12.1 3

“Money is what money does”

• Medium of exchange

• Measure of value

• Store of value

12.1 The Definition and Functions

of Money

LO12.2 4

Money Definition M1 • Currency: Coins + Paper Money

– token money – Bank of Canada notes

• Demand Deposits – about 3/4 of M1

• Institutions That Offer Demand Deposits – chartered banks are the primary depository institutions

• Two Qualifications: currency held by the Bank of Canada and chartered banks

is excluded from M1 and other measures of the money supply

also excluded from the money supply are any deposits of the federal government or the Bank of Canada that are held by chartered banks

12.2 The Components of the Money Supply

LO12.2 5

Money Definition M2

• M1 + near monies

– Near monies are highly liquid financial assets that do not directly function as a medium of exchange but can be readily converted into currency

The Components of the Money

Supply

LO12.2 6

Currency (coins & paper money)

plus Demand deposits

equals M1 plus Personal savings deposits,

plus Non-personal notice

deposits

equals M2

Table 12-1

(billions of dollars) December, 2005

M1

529

M2

939

The Components of the Money Supply

LO12.2 7

Money Definition M2+

• M2+ is M2 plus

– deposits at trust & mortgage loan companies

– deposits at caisses populaires & credit unions & other non-bank deposit-taking institutions

– money market mutual funds

Money Definition M2++

• M2++ is M2 plus Canadian saving bonds and non-money market mutual funds

The Components of the Money

Supply

LO12.2 8

Currency (coins & paper money)

plus Demand deposits

equals M1

plus Personal savings deposits,

plus Nonpersonal notice deposits

equals M2

plus Deposits: Other intermediaries

equals M2+ plus Canadian saving bonds plus non-money market mutual funs equals M2++

M1 M2+

1277

M2

(billions of dollars) December, 2005

939

529

M2++

1811 Table 12-1

The Components of the Money Supply

LO12.3 9

• Money as Debt

• Value of Money – Acceptability

– Legal Tender

– Relative Scarcity

• Money and Prices – Purchasing Power of the Dollar

– Inflation and Acceptability

– Stabilizing the Purchasing power of money

What Backs the Money Supply?

LO12.4 10

• The Evolution of the Canadian Banking System

• Canadian Chartered Banks

• Making Loans

• Other Financial Intermediaries

• Cheque Clearing

12.4 The Canadian Financial System

LO12.4 11

12.1 Global Perspective

LO12.5 12

• The creation of money is done with the help of Canada’s chartered banks

• The Fractional Reserve System

12.5 Chartered Banks and the

Creation of Money

LO12.5 13

• Goldsmiths accepted gold deposits and issued paper receipts

• Paper receipts were used as a medium of exchange

• 100% reserve system

ð eventually led to fractional reserve system

Illustrating the Idea: the Goldsmiths

LO12.5 14

• Fractional Reserve System

– Money creation & reserves

– Bank panics & regulation

Significant Characteristics of

Fractional Reserve Banking

LO12.5 15

ASSETS LIABILITIES AND

NET WORTH Vancouver Bank

TRANSACTION 1

Creating a bank

$250,000 Cash

for

Capital Stock

Formation of a Chartered Bank

LO12.5 16

ASSETS LIABILITIES AND

NET WORTH

Cash $250,000 Capital Stock $250,000

Vancouver Bank

Formation of a Chartered Bank

LO12.5 17

ASSETS LIABILITIES AND

NET WORTH Vancouver Bank

TRANSACTION 2

Acquiring

property and

equipment

$240,000

buildings and

equipment

Acquiring Property and Equipment

Cash $250,000 Capital Stock $250,000

LO12.5 18

ASSETS LIABILITIES AND

NET WORTH

Cash $ 10,000

Property 240,000

Capital Stock $250,000

Vancouver Bank

Acquiring Property and Equipment

LO12.5 19

ASSETS LIABILITIES AND

NET WORTH

Cash $ 10,000

Property 240,000

Capital Stock $250,000

Vancouver Bank

TRANSACTION 3

Accepting

Deposits

Demand

$100,000

Deposits

Accepting Deposits

LO12.5 20

ASSETS LIABILITIES AND

NET WORTH

Cash $110,000

Property 240,000

Demand

Deposits $100,000

Capital Stock 250,000

Vancouver Bank

Accepting Deposits

LO12.5 21

ASSETS LIABILITIES AND

NET WORTH

Cash $110,000

Property 240,000

Demand

Deposits $100,000

Capital Stock 250,000

Note: demand

deposits

are LIABILITIES

to the bank

Vancouver Bank

Accepting Deposits

LO12.5 22

ASSETS LIABILITIES AND

NET WORTH

Reserves $ 110,000

Property 240,000

Demand

Deposits $100,000

Capital Stock 250,000

Vancouver Bank

Note:

cash is part of the

bank’s reserves

- Desired Reserves

Reserves

LO12.5 23

ASSETS LIABILITIES AND

NET WORTH

Reserves $110,000

Property 240,000

Demand

Deposits $100,000

Capital Stock 250,000

Vancouver Bank

Reserves

Demand Deposits are subject to Desired Reserve

Ratio

sliabilitie deposit-demands bank' chartered

reserves desired bank' chartered

ratioreserve

Desired

LO12.5 24

ASSETS LIABILITIES AND

NET WORTH

Demand

Deposits $100,000

Capital Stock 250,000

Reserves $110,000

Property 240,000

Two Important Points...

1. Excess Reserves (E)

= Actual Reserves - Desired Reserves

• Assume 20% Desired Reserve Requirement

• FIND THE EXCESS RESERVES

desired reserves

= 20% X $100,000

=$20,000

actual reserves

Vancouver Bank

Excess Reserve

LO12.5 25

ASSETS LIABILITIES AND

NET WORTH

Demand

Deposits $100,000

Capital Stock 250,000

Reserves $110,000

Property 240,000

Two Important Points...

1. Excess Reserves (E)

= Actual Reserves - Desired Reserves

• Assume 10% Desired Reserve Requirement

• E = $110,000 - 20,000 = $90,000

Vancouver Bank

Excess Reserve

LO12.5 26

ASSETS LIABILITIES AND

NET WORTH

Demand

Deposits $100,000

Capital Stock 250,000

Reserves $110,000

Property 240,000

Two Important Points...

1. Excess Reserves (E)

= Actual Reserves - Desired Reserves

• Assume 10% Desired Reserve Requirement

• E = $110,000 - 10,000 = $100,000

2. Bank of Canada can influence the lending ability

of banks through reserves

Vancouver Bank

Excess Reserve

LO12.5 27

ASSETS LIABILITIES AND

NET WORTH

Reserves $110,000

Property 240,000

Demand

Deposits $100,000

Capital Stock 250,000

TRANSACTION 4

Clearing a

cheque drawn

against the

bank

= $50,000

Vancouver Bank

Clearing a Cheque

LO12.5 28

ASSETS LIABILITIES AND

NET WORTH

Reserves $ 60,000

Property 240,000

Demand

Deposits $50,000

Capital Stock 250,000

TRANSACTION 4

This bank

loses reserves

and

deposits to the

Bank of

Manitoba

Vancouver Bank

After Cheque Clearing

LO12.5 29

• The maximum amount of new money which can be created by a single bank is equal to its excess reserves

– The bank creates money when it creates new loans

– Money is destroyed when loans are repaid

– Banks create money when they buy government bonds from the public

Money Creation: Single Bank

LO12.5 30

ASSETS LIABILITIES AND

NET WORTH

Reserves $ 60,000

Property 240,000

Demand

Deposits $ 50,000

Capital Stock 250,000

Bank has excess

reserves of how

much?

of HOW MUCH?

Use a 20% reserve

ratio

Vancouver Bank

Granting a New Loan

LO12.5 31

ASSETS LIABILITIES AND

NET WORTH

TRANSACTION 5

Reserves $ 60,000

Property 240,000

Demand

Deposits $ 50,000

Capital Stock 250,000

Bank makes a

loan to Grisley

Company equal to

the excess reserves

$50,000

Vancouver Bank

Granting a New Loan

LO12.5 32

ASSETS LIABILITIES AND

NET WORTH

Reserves $ 60,000

Loans 50,000

Property 240,000

Demand

Deposits $100,000

Capital Stock 250,000

Vancouver Bank

A new loan & a new

deposit of $50,000 are

created

When a Loan is Negotiated

LO12.5 33

ASSETS LIABILITIES AND

NET WORTH

Reserves $ 60,000

Loans 50,000

Property 240,000

Demand

Deposits $100,000

Capital Stock 250,000

Vancouver Bank

Grisley Co. writes a

cheque worth $50,000

payable to Quickbuck

Co. which banks at the

Manitoba Bank

Before a Cheque is Drawn on the Loan

LO12.5 34

ASSETS LIABILITIES AND

NET WORTH

Reserves $ 10,000

Loans 50,000

Property 240,000

Demand

Deposits $50,000

Capital Stock 250,000

Vancouver Bank

Note that after clearing,

the Vancouver Bank has

no more excess

reserves!

After a Cheque is Drawn on the Loan

LO12.5 35

ASSETS LIABILITIES AND

NET WORTH

Reserves $ 10,000

Loans 50,000

Property 240,000

Demand

Deposits $50,000

Capital Stock 250,000

New Loan After Cheque Clearing

Vancouver Bank

A bank MUST have

excess reserves to

create

loans

35

LO12.5 36

ASSETS LIABILITIES AND

NET WORTH

TRANSACTION 6

Reserves $ 60,000

Property 240,000

Demand

Deposits $ 50,000

Capital Stock 250,000

Bank buys

securities from the

public for an

amount equal to

the excess reserves

Vancouver Bank

Buying Government Securities

LO12.5 37

ASSETS LIABILITIES AND

NET WORTH

Reserves $ 60,000

Securities 50,000

Property 240,000

Demand

Deposits $100,000

Capital Stock 250,000

Vancouver Bank

Once again, the money

supply has increased by

$50,000

Buying Government Securities

LO12.5 38

• Bond purchases from the public by the chartered banks increases the money supply

• Bond sales to the public decreases the money supply

Government Securities

LO12.5 39

• Bankers have two conflicting goals:

– Profit

– Liquidity

• Overnight loans rate paid on overnight loans to cover temporary shortages of reserves

Profits, Liquidity, and the

Overnight Lending Rate

LO12.6 40

• A single bank can lend one dollar for each dollar of excess reserves

• The banking system can lend (create money) by a multiple of its excess reserves

12.6 The Banking System: Multiple-

Deposit Expansion

LO12.6 41

Bank

Acquired reserves

and deposits

Desired

reserves

Excess

reserves

Amount bank

can lend. New

money created

A

$100.00

$ 20.00

Multiple-Deposit Expansion Process

1.A Junkyard owner deposit $100

2.Bank adds the $100 in its

reserves

3.20% is the desired reserve ratio

LO12.6 42

Bank

Acquired reserves

and deposits

Desired

reserves

Excess

reserves

Amount bank

can lend. New

money created

A

$100.00

$ 20.00

$80.00

Money is created

once the loan is

made

$80.00

Multiple-Deposit Expansion Process

LO12.6 43

Bank

Acquired reserves

and deposits

Desired

reserves

Excess

reserves

Amount bank

can lend. New

money created

A

$100.00

$ 20.00

$80.00

$80.00

Multiple-Deposit Expansion Process

Loan recipient now spends the money. He/she buys something; Seller deposits proceeds in his/her bank.

LO12.6 44

Bank

Acquired reserves

and deposits

Desired

reserves

Excess

reserves

Amount bank

can lend. New

money created

A

B

$100.00

80.00

$ 20.00

$80.00

$80.00

Multiple-Deposit Expansion Process

New deposit means excess reserves in seller’s bank; process repeats…

LO12.6 45

Bank

Acquired reserves

and deposits

Desired

reserves

Excess

reserves

Amount bank

can lend. New

money created

A

B

C

$100.00

80.00

64.00

$ 20.00

16.00

12.80

$80.00

64.00

51.20

$80.00

64.00

51.20

Multiple-Deposit Expansion Process

LO12.6 46

Bank

Acquired reserves

and deposits

Desired

reserves

Excess

reserves

Amount bank

can lend. New

money created

A

B

C

D

E

F

G

H

I

J

K

L

M

N

Other banks

$100.00

80.00

64.00

51.20

40.96

32.77

26.22

20.98

16.78

13.42

10.74

8.59

6.87

5.50

21.97

$ 20.00

16.00

12.80

10.24

8.19

6.55

5.24

4.20

3.36

2.68

2.15

1.72

1.37

1.10

4.40

$80.00

64.00

51.20

40.96

32.77

26.22

20.98

16.78

13.42

10.74

8.59

6.87

5.50

4.40

17.57

$80.00

64.00

51.20

40.96

32.77

26.22

20.98

16.78

13.42

10.74

8.59

6.87

5.50

4.40

17.57 Total amount of money created by the bank system = $400.00

Multiple-Deposit Expansion Process

Monetary destruction works the same way in reverse

LO12.7 47

Maximum

demand-deposit

creation = Excess

reserves x Monetary

multiplier

Monetary multiplier = 1/desired reserve ratio

R

1

= = .20

1 = 5

12.7 The Money Multiplier

LO12.7 48

Table 12-3 Expansion of the Money Supply by

the Chartered Banking System

• Before deposit insurance

• Bank failure led to mass withdrawals

• Forced loan reduction

• 25-33% decline in money supply

• 1933 national bank holiday to evaluate all banks

• Contributed to the Great Depression

• Regulation protects the system today

Slide prepared by Bruno Fullone, George Brown College 49

The Last Word: The U.S. Bank

Panics of 1930 to 1933

Chapter 12 50

12.1 The Definition and Functions of Money

12.2 The Components of the Money Supply

12.3 What Backs the Money Supply?

12.4 The Canadian Financial System

12.5 Chartered Banks and the Creation of Money

12.6 The Banking System: Multiple-Deposit Expansion

12.7 The Monetary Multiplier

Chapter 12 Summary