1 of 40

Economics 12

[The Money Market]

Part 1 – Money and Banking

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

2 of 40

Money

Humanity’s greatest invention and its greatest curse.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

3 of 40

Money

Is it possible to be extremely wealthy but literally have no money?

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

4 of 40

Money Increases Wealth

A society possessing no money would be very simple and materially very poor. This is because exchange would be difficult and time consuming. Imagine a person possessing a pound of honey but wanting a package of medium-sized, flat-head screws. How long might it take to find someone with the right screws who just happened to want some honey? In short, what we are saying here is that almost everybody would be forced to produce most of the necessities of survival for themselves. Few could earn a livelihood by specializing in producing just one product and then trading it for other products. This lack of specialization, along with the high cost of exchange, would ensure an existence in which a minimal quantity of goods and services was exchanged. Thus, the use of money increases a nation's wealth.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

5 of 40

Functions of Money

What is money good for? To spend, of course!

Prime function of money – acts as a medium of exchange

Something that is accepted as payment for goods and services.
Without money, barter is required.

The function of money that allows people to hold and accumulate wealth is called store of wealth.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

It has been suggested that money imparts value only in parting.

The first, and prime, function of money is that it acts as a medium of exchange. Without money, people would be forced to barter goods and services directly. However, barter requires what is called the double coincidence of wants. This simply means that if I am to trade with you, you must have what I want, and I must have what you want. If this is not the case, then we must try to find a third, fourth, or fifth party to act as intermediary. This would mean that to obtain a bare minimum of goods and services through barter, a person would spend far more time and effort in exchanging than in producing. Thus, economists describe the barter system as having high transactions costs.

The use of money reduces the wasted effort associated with barter as long as people will readily accept money as a medium of exchange. Money, as we will see, can be almost anything, but its most important characteristic is that it should be widely acceptable. In addition, if we are going to carry it around with us, it should be reasonably portable.

Money, however, is not just used for exchange. Some of us like to keep it. In other words, money can be used as a store of wealth. This is its second function. As we mentioned, wealth can be stored in other forms-from stocks and bonds to real estate, or from savings accounts to art collections-but these other forms are not as convenient as money and often involve more risk. Compared with all other forms of wealth, money is the most liquid, that is, it can be used directly as a means of payment. If it is to act as a store of wealth, money should obviously possess other desirable characteristics. Besides portability, it should also be reasonably durable and of such a nature that people are willing to hold it.

Finally, money is used as a unit of account (or measure of value). Think of the problems in trying to value a commodity in a moneyless community. Assume, for instance, that a suit of clothes is worth 10 litres of beer, that a litre of beer is worth 2 loaves of bread, and that you need

6 of 40

Functions of Money

Money also used as a unit of account or measure of value.

Assume, for instance, that a suit of clothes is worth 10 litres of beer, that a litre of beer is worth 2 loaves of bread, and that you need 100 loaves of bread to buy a table-how many suits of clothes does it take to buy a table?

Given the clothes-table example above, how many suits of clothes would it cost to buy a table if a litre of beer is worth only one loaf of bread?

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

Finally, money is used as a unit of account (or measure of value). Think of the problems in trying to value a commodity in a moneyless community. Assume, for instance, that a suit of clothes is worth 10 litres of beer, that a litre of beer is worth 2 loaves of bread, and that you need 100 loaves of bread to buy a table – how many suits of clothes does it take to buy a table? The answer is 5 suits, but the answer does not come quickly. By providing a single uniform measure of values, money simplifies comparisons of prices, wages, and incomes.

1 suit = 10 litres

1 litre = 2 loaves

Therefore,

1 suit = 20 loaves

100 loaves = 1 table

Therefore,

5 suits = 100 loaves = 1 table

2^nd example

1 suit = 10 litres = 10 loaves

Therefore

10 suits = 100 litres = 100 loaves = 1 table

7 of 40

Characteristics of Money

Money needs to be all of the following:

acceptable
durable
portable
divisible
standardized, easily recognized but not easily copied
controlled by central authority

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

While anything can be, and most things have been, used as money, some things are definitely better than others. For instance, let us imagine a (particularly silly) society that hit upon the idea of using stones as a form of money. Well, certainly stones are durable, portable, divisible (big stones and little stones), and easily recognized by the general public, which are characteristics that all money needs. The problem is that without very much trouble at all, everybody would spend time collecting piles of stones and therefore think they had become fabulously rich almost overnight. The result would, of course, be rampant inflation. This would happen because although the amount of money has increased, the amount of goods and services available has not. As a result, the prices of all products would rise significantly as demand far exceeds supply. To avoid this outcome, the supply of money in an economy needs to be sufficient to facilitate trade and economic growth but also be controlled by a central authority so as not to become too large relative to the real wealth of the country. We might add that it should also be of a standardized form (each unit of currency should be like all others) but of a form that cannot be easily copied. In short, money needs to be all of the following:

- acceptable

- durable

- portable

- divisible

- standardized, easily recognized but not easily copied

- controlled by central authority

8 of 40

Different Kinds of Money

Commodity money is a type of money that can also function, and is useful, as a commodity
Fiat money is anything that is declared as money by government order.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

When such things as beads, whales' teeth, salt, or shells are used as money, they have intrinsic value in themselves as well as having value as money. This type of money is called commodity money. Even today, in situations like jails and prisoner-of-war camps, where people have no access to the outside community, such things as cigarettes or playing cards act as forms of commodity money.

One particularly important commodity that has been used as money over the ages is gold (and, less often, other precious metals). Gold certainly fits the bill in terms of portability, durability, and scarcity. However, there is one serious drawback: precious metals do not come in standardized units; the metal needs to be weighed out each time a transaction is made. To overcome this problem, since the dawn of civilization, metals have been produced in the standardized form of coins of specific sizes and weights. The trouble with coins made of gold is that they are open to abuse. Gold is a particularly soft metal so that in earlier times, it was possible for some people to make money out of money. They did this by such practices as sweating the currency (shaking the coins up in a bag so as to produce a residue of gold dust in the bottom) or by clipping the currency (shaving a thin sliver from the outside of unmilled coins). Perhaps the worst offenders were the sovereigns whose portraits on the coins were supposedly a mark of trust and integrity. An important event, such as a coronation or royal wedding, was an occasion for the sovereign to call in the old coins and replace them with newly minted coins. However, in the process of melting down the old coins, a base metal, such as lead, was often added to the vat of gold. Over time, the currency became more and more debased which resulted in inflation so that the new coins became worth only their weight in lead.

In addition, gold has another serious defect as a form of money: it is very heavy. Because of this and because of the dangers of carrying about large sums of money, people in Europe in the Middle Ages started to deposit their money in the goldsmith's (i.e., jeweler's) vault. In return for making a deposit (for which they were required to pay a fee), they received a certificate from the goldsmith acknowledging the deposit. In time, these certificates were considered as reliable as gold and could be easily transferred from one person to another as a form of payment. In other words, paper money was introduced.

9 of 40

Different Kinds of Money

Commodity money
Gold and other precious metals
Coins
Paper money
Chequebook money (deposits)

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

With the formation of commercial banks in the early eighteenth century, many of the functions of the goldsmiths were taken over by these banks – including that of issuing paper money. Since 1935, in Canada, the only bank with the power to issue currency – sometimes called fiat money in that it is declared legal tender by law – is the Bank of Canada. Canada's central bank no longer acts as a commercial bank, as it once did, but now acts solely as an agent of government.

As the commercial banks became more prominent, so, too, did bank notes become more acceptable. But just as people, in earlier times, were wary of carrying large sums of gold and coins, they also preferred to deposit their bank notes in the banks. Thus, the nineteenth century saw the development of the last form of modern money: chequebook money. In return for depositing notes and coins with the bank, the customer could now receive a chequebook from the bank. A cheque is nothing more than a standardized form of instruction by a customer to the bank, telling it to transfer a sum of money from the customer's account to the person specified on the cheque.

10 of 40

Fractional Reserve Banking

A fractional reserve system is a banking system in which banks keep only a small fraction of their total deposits on reserve in the form of cash.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

The average bank certainly has enough cash. However, banks do not act simply as big safety deposit boxes, guarding your money until you require it. This means that if all of the bank's customers were to descend en masse demanding their money, any bank in the modern banking world would find itself acutely embarrassed. It simply would not have that amount of cash on hand. So, what happened to the cash that you and all the other customers deposited in the past? The answer is that the bank lent it out. Banks only keep a small fraction of the amounts of cash that have been deposited, and thus they may be vulnerable to a run on the bank, that is more money being withdrawn than deposited. So, how did such a state of affairs come to be?

Now let us go back to the goldsmiths. Goldsmiths discovered, very early on in the game, that most of the time the gold and coins sitting in the vaults did just that: they sat there. Most unproductively! Certainly, customers came in from time to time to withdraw some of their cash, but that same cash usually got redeposited with the goldsmith rather soon. Certainly, money was turning over. But the goldsmiths realized that on any given day of the week, about as much gold was deposited as was withdrawn.

So, what would be the harm in the goldsmiths lending out the gold that was not needed?

Unless all of the customers arrived on the doorstep at the same time-a very remote possibilitythere would be no harm done. So, lend it they did. In fact, the goldsmiths also learned that when they started offering loans, most people did not particularly want to receive gold but preferred to receive one of the goldsmiths' certificates of deposit. The goldsmiths could simply make loans by giving customers a piece of paper. Thus was born the basis of modern banking: the fractional reserve system. In a similar manner, with the rise of commercial banking, bankers discovered that they, too, only needed to keep a small fraction of their customers' deposits in the form of cash reserves. Today, banks in Canada keep only a very small percentage of their customers' deposits in the form of cash. As long as people do not hoard it, any cash that anyone bank issues to its customers generally finds its way back to another bank, that is, back into the banking system. So, the average bank is safe as long as its depositors do not all demand their cash on the same day. The fact that modern banks operate on a fractional reserve basis has important implications for the monetary system and for monetary policy, as we shall see later.

11 of 40

A Definition

Money is anything that is widely accepted as a medium of exchange and therefore can be used to buy goods or settle debts.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

12 of 40

M1 Definition

Simplest, most basic definition
Includes currency in circulation (coins and paper bank notes) plus demand deposits in the chequing accounts of all commercial banks.

The word demand in demand deposits refers to the fact that depositors can demand their deposits in cash at any time.

The money supply (in $ billions) in Canada in November 2007 was:

M1 = currency plus demand deposits

189 = 49 + 140

(26% ) (74%)

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

Since the Bank of Canada needs to control the supply of money to the economy, it needs to be able to clearly define and measure the amount. What may come as a surprise to many is the fact that there really is not one single accepted measure of the money supply.

Some have suggested, however, that this definition is too narrow. They argue that if chequing accounts are included as part of the money supply, then why not also include savings accounts and other types of notice deposits? Notice deposits, as the name suggests, require the depositor to give notice to the bank before making a withdrawal. Surely these accounts, in practice, are no different from chequing accounts, since banks seldom enforce the requirement of giving notice before withdrawal. So, we have a wider definition of money, called M2.

13 of 40

M2 Definition

includes all of M1 plus all notice deposits (savings accounts on deposit for an undefined length of time) and what are called personal term deposits, which are on deposit for a specific term, such as six months.

The money supply (in $ billions) in Canada in November 2007 was:

M2 = M1 plus notice deposits and personal term deposits

769 = 189 + 580

(25% ) (75%)

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

14 of 40

M3 Definition

includes M2 but adds to it term deposits of businesses (known as certificates of deposits), which are easily convertible into chequable deposits.

The money supply (in $ billions) in Canada in November 2007 was:

M3 = M2 plus certificates of deposits

1191 = 769 + 422

(65% ) (35%)

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

15 of 40

The 3 Measures of Money

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

16 of 40

What is Not Money?

Only the portion of currency issued by the Bank of Canada that is in circulation is included as money.

The currency in the vaults or tills of banks is not included in any definition of money.

A new bank deposit of currency changes the composition of the money supply but does not change its total.
Also excluded:

Gold
Financial securities such as stocks and bonds
Accounts at near-banks (nonbank financial institutions)

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

The reason for this is that when you or I deposit currency in a bank, the balance of our bank account increases, and since the amount of deposits in our accounts is part of the money supply, it would be double-counting to count both the increase in our accounts and the increase in the bank's tills. In other words, when people deposit currency in a bank, the amount of currency in circulation goes down, and the amount in deposit accounts goes up. This means that:

A new bank deposit of currency changes the composition of the money supply but does not change its total.

Another exclusion from the money supply is gold. Similarly, such financial securities as stocks and bonds are also excluded. So, too, is peoples' available credit on their credit cards. That is, credit cards, as well as the more recent debit cards, are merely a means of accessing money but are not money in themselves. You might argue that in many instances, credit cards are more acceptable than personal cheques, and that is true. However, credit cards merely represent a loan that you have negotiated with a finance company. More importantly, you cannot payoff a debt with a credit card. Certainly, you can obtain cash with a credit card, but that is the clue: you can use a credit card to get money; it is not itself money. Similarly, cheques are not money but merely give you access to the money in your chequing account. The final exclusion from the modern definition of money is chequing accounts at near-banks. These near-banks include credit unions, trust companies, and mortgage and loan associations. In other words, all of our three alternative definitions of money-Ml, M2, M3-refer to accounts only at commercial banks. Canada's central bank, the Bank of Canada, exercises a degree of control over the commercial banks but has a lesser degree of power over near-banks (also termed nonbank financial intermediaries). The central bank prefers to count as money only that which it can control directly; hence the exclusion of accounts at near-banks. Nonetheless, the Bank of Canada does also measure what it calls M2+, which includes demand and notice deposits at near-banks.

The term chartered banks includes the six major commercial banks in Canada (all of which received a charter under the Bank Act) and a few dozen much smaller banks.

17 of 40

Canada’s Big Banks

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

18 of 40

Practice

If David deposits $240 cash into his chequing account at a commercial bank, has the money supply changed?
If, later on, David transfers this $240 from his chequing account to a saving account in the same bank, has M1 changed? Has M2?
Given the following data (all in billions of Canadian$):

Coins 13
Certificates of deposit 137
Demand deposits 72
Notice and personal term deposits 215
Notes 27

What are the values of M1, M2, and M3?

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

19 of 40

Stop Here for Day 1

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

20 of 40

Modern Banks and the Creation of Money

Banks are in the business to make money.
Major source of profit comes from using any excess deposits productivity be lending them out.
Profit comes from the spread – the difference between the interest rate a bank charges to borrowers and the interest rate it pays to depositors.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

21 of 40

Modern Banks and the Creation of Money

Not much difference in spread between different banks.
Total profits come from total volume rather than differences in spreads.
Banks do not carry excess inventory (money).

No return on idle money balances
Reserves kept to a minimum

Target reserve ratio is the proportion of demand deposits that a bank wants to hold in the form of cash.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

There is not much difference in the spread among Canada's major banks. The total profits of a bank come more from the total volume of its transactions rather than from a difference in the spread. Like any other business, banks do not like to carry excess inventories. In the case of banks, their inventory is money. They do not earn a return on idle money balances. Therefore, they will always try to ensure that the amount of reserves they retain is kept to a minimum, consistent with security. Until recently, the Bank Act laid down exactly how much commercial banks had to keep in reserves. Such a required reserve ratio is no longer applicable, but banks still hold reserves. What we will call the target reserve ratio is the proportion of demand deposits that a bank wants to hold in the form of cash in its vaults or with the Bank of Canada. These target reserves provide some degree of security for the bank's customers. However, the main security for depositors comes from insurance. All banks are required by law to take out insurance on customers' deposits. The deposits are insured with the Canada Deposit Insurance Corporation up to a maximum of $100000 per depositor per bank.

22 of 40

Modern Banks and the Creation of Money

Canadian banking system is remarkably secure.
Branch banking system

Dominated by a few large banks each with many branches operating across the country
Size and geographical diversity spreads risk and minimizes possibility of bank failure

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

The Canadian banking system is remarkably secure. (There were only three bank failures in all of the twentieth century, although two occurred within the last twenty-five years.) What economists call a branch banking system accounts for this stability. This is a system dominated by a few large banks, each of which has many branches operating across the entire country. For example, Canada's six big banks each have several hundred branches coast to coast. The sheer size and geographical diversity of this type of structure spreads the risk and therefore minimizes the possibility of bank failure.

Contrast this with a unit banking system, which, though currently in transition, is still the basic system in the United States. This system is made up of thousands of relatively small banks that either have only one branch or multiple branches that are confined to a single state. Such a system is less secure. For example, the First National Bank of Dalton (Nebraska) is small compared with the average branch of anyone of Canada's big six banks. Furthermore, most of the loans by First National would be to local wheat farmers for equipment, seed, and so on. If a bad hailstorm wipes out the local wheat crop and most of the farmers go bankrupt, then the bank could face the same fate.

23 of 40

Modern Banks and the Creation of Money

Pro

Security

Con

Only six big banks so competition within the system is weak

Inconveniences like long lineups, hours of operation
Size of spread is wider
Loan policies unfavourable to small business

Canadian banking system is very secure and stable, but also very conservative.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

Does this mean that the Canadian banking system is superior? From a security sense, yes. But the source of this security is a system dominated by only six big banks, and this means that competition within the system is weak. There are several consequences of this lack of competition. First, the merely irritable: long lineups for routine transactions, short operating hours (closed on Saturdays and Sundays), and the inability of customers to deal face-to-face with the decision makers. More significantly, the size of the spread in the Canadian banking system is, historically, wider than that in the American system. Finally, there is the issue of the banks' loan policies. From time to time throughout history, one can find references to a recurring complaint by small businesses in Canada: large banks do not recognize the unique circumstances of a small business, and they do not make loans to unproven companies or ideas. Although one can understand the position of the large banks on this issue, it is also obvious that the whole economy does, from time to time, fail to benefit from the potential success of a new business or product because of the lack of loans needed to get started. In summary, the Canadian branch banking system is very secure and stable, but it is also very conservative.

Some of this may be changing. Foreign banks have recently been allowed to operate in Canada, although there are constraints on size. This should, at least to some extent, increase competition in this industry.

24 of 40

Assets, Liabilities and Balance Sheets

Assets represent what a company owns or what others owe it.
Liabilities represent what a company owes to others.
The difference between the two is the net worth of the company (equity).

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

We now know that money includes demand deposits as well as currency. The only institution that can actually create currency is the Bank of Canada. The public can decide what fraction of this currency is held outside the banks and what fraction it deposits with banks and other financial institutions. However, it is the banks, given the amount of currency they hold, that decide how much they wish to hold as reserves and how much they want to lend.

To understand how just a small amount of reserves can support a multiple amount of loans and deposits, we need first to understand a few very basic accounting terms.

Actually, all we need to understand are the basic features of a balance sheet. (The profit and loss statement is of no concern here.) A balance sheet presents the financial condition of an institution at a particular moment in time. On one side, we list all the assets, and on the other side, the liabilities. The assets represent what a company owns or what others owe it. Liabilities represent what a company owes to others. The difference between the two is the net worth of the company, otherwise known as equity. Equity is the book value of the company to its shareholders. (The company's market value may be more or less than its book value.) The following is a simplified balance sheet of the Saymor Bank Limited – see above slide.

The assets are all listed in terms of liquidity (closeness to cash), with the most liquid at the top. Reserves are the currency held in part by the bank as cash on hand (vault cash) and, in accordance with the Bank Act, in part on deposit with the Bank of Canada. Loans to customers represent one of the income-earning assets of the bank and are their most important and most lucrative assets. Securities are shares (gilt-edged, that is, very secure – "as good as gold") or bonds (usually government bonds and treasury bills). Fixed assets include the buildings, equipment, and furniture of the bank. The major liability, and the only one shown here, is demand deposits, which represents the total amount of depositors' accounts owed by the bank to its customers. The equity figure shows that the book value of this bank is $20 000 (in $ million, of course).

25 of 40

Assets, Liabilities and Balance Sheets

Transaction 1: Fred, a customer of the bank, deposits $200 cash in the bank. The reserves of the bank would therefore increase by $200. The other entry? Fred's bank balance will increase by $200. (An asset for Fred, of course, but a liability for the bank, since it now owes Fred $200 more.) So, demand deposits increase by $200. In sum, both assets and liabilities have increased.

Transaction 2: Penny withdraws $500 cash from her account. This is straightforward, since it is just the reverse of transaction 1. The bank's reserves are reduced by $500, and the demand deposits go down by $500. So, both assets and liabilities are reduced accordingly.

Transaction 3: The bank buys some securities for $200 cash. In this case, reserves decrease by $200, and securities increase by $200. Therefore, one asset decreases, and another increases; the net effect on total assets is zero.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

26 of 40

Assets, Liabilities and Balance Sheets

Each time that a bank issues a loan, it creates money.

Transaction 4: Suppose that the bank grants you a loan. What exactly does this imply? Generally speaking, it does not mean that the bank gives you cash. Instead, in exchange for your written acceptance of the terms and conditions for repayment of the loan, the bank will give you immediate credit in your chequing account for the amount of the loan. Now, whether you actually draw out cash or, instead, write a cheque for the whole or part of the amount is up to you. But what the bank has given you is "direct and immediate access to goods and services" and the ability to settle a debt. It has, in other words, by a single bookkeeping entry, created money for you. The two accounts affected, therefore, are: an increase in loans (an asset) and an increase in demand deposits (a liability). Cash reserves are unaffected.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

27 of 40

Assets, Liabilities and Balance Sheets

Now, having been granted the loan you might do one of three things:

Transaction 4a: You decide that you are going to withdraw some or all of it in cash. In which case, the bank's reserves decrease by the amount of the withdrawal and the demand deposits are decreased by the same amount.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

28 of 40

Assets, Liabilities and Balance Sheets

Now, having been granted the loan you might do one of three things:

Transaction 4b: You decide to write a cheque to buy an airline ticket. Suppose that the airline company also does its banking at the same bank. In that case, your demand deposit balance is reduced by the amount of the cheque, and that of the airline company is increased by the same amount. Here, the total amount of demand deposits remains unchanged. In addition, note that the bank's reserves were unaffected.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

29 of 40

Assets, Liabilities and Balance Sheets

Now, having been granted the loan you might do one of three things:

Transaction 4c: You write a cheque to buy a new sofa from the Sogood Sofa company. Sogood Sofa deposits your cheque at its bank, which is a different bank from yours. At the end of the day, its bank will come to yours for payment of the cheque. The cheque is then cleared against your bank, whose reserves will drop as a result. Therefore, your bank's reserves and demand deposits will be reduced, while the other bank's reserves and demand deposits will increase.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

30 of 40

Practice

Give the necessary bank bookkeeping entries for each set of circumstances below.

The bank makes a $2000 loan to Fadia.
Fadia writes a $2000 cheque to Middle East Travel, which has its accounts at a different bank.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

31 of 40

The Money Multiplier

An example to start

Target reserves set at 10 percent

Target Reserves = Target Reserve Ratio x Demand Deposits

Target Reserves = 10% x $100 000 = $10 000

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

32 of 40

The Money Multiplier

Tom finds $1000 to deposit in bank.

Target Reserves = 10% x $101 000 = $10 100
Excess Reserves = Actual Reserves – Target Reserves

$11 000 – 10 100 = $900 (over-reserved)

Bank keeps only 10% of deposit for cash reserves, therefore has 90% to lend out

90% of $1000 deposit = $900

Reserves $11 000 Demand Deposits $101 000

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

Now, assume that Tom, rummaging about under his bed one morning, comes across $1000 in currency. Not knowing what to do with it, he decides to deposit it in the bank. The bank credits the $1000 to his account. Its reserves now equal $11 000, and its demand deposits are $101 000. The bank now finds that it has excess reserves, since it wants to hold only 10% X $101 000, or $10 100. It is overreserved to the tune of $900, that is:

Excess reserves = Actual reserves - target reserves

900 = 11000 - 10100(10% X 101000)

Or look at it another way: of the $1000 that Tom deposited, the bank aims to keep only 10 percent in the form of cash reserves and therefore has $900 more than it considers necessary to hold. As we mentioned before, banks do not like to have such idle cash; they want to earn some return on it. They will be very happy to lend it out.

33 of 40

The Money Multiplier

Wing Lee requires a $900 loan
Buys a car from New Star Car Company who deposits cheque into another bank, J.M.K.
After J.M.K. clears cheque against Saymor

J.M.K. keeps only 10% of deposit for cash reserves, therefore has 90% to lend out

Excess Reserves = 90% of $900 = $810

Reserves + $900 Demand Deposits + $900

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

Now, let us assume Wing Kee happens to come into the bank the next day in need of a $900 loan. The loan is happily granted, and he walks out having $900 more in his chequing account. Within a few hours Wing Kee purchases a used Volkswagen from the New Star Car Company. A New Star employee deposits his cheque in another bank called the J.M.K. Bank. Recall our assumption that the J.M.K. bank, prior to the deposit by New Star, had no reserves in excess of its targeted amount. After J.M.K. Bank clears Wing Kee's cheque against the Saymor Bank, the following accounts at J.M.K. Bank will be affected:

Reserves + $900 Demand deposits + $900

We assume that the J.M.K., like all other banks, also wants to keep 10 percent of the increased demand deposits, that is, 10% X $900, or $90. It therefore has $810 in excess reserves. It, too, is anxious to lend these reserves out.

34 of 40

The Money Multiplier

Sue needs $810 to pay off some debt
Negotiates loan from J.M.K. to pay Sarbjit by cheque
Sarbjit deposits cheque into M.P.C.
After M.P.C. clears cheque against J.M.K.

J.M.K. keeps only 10% of deposit for cash reserves, therefore has 90% to lend out

Excess Reserves = 90% of $810 = $729

Reserves + $810 Demand Deposits + $810

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

Now, let us assume that Sue is in need of $810 to payoff a debt to her friend Sarbjit and manages to negotiate an $810 loan from J.M.K., in the form of an increased credit balance to her chequing account. She immediately pays Sarbjit by cheque. Sarbjit deposits the cheque at his bank, which we will call the M.P.C. Bank. After this deposit, and Sue's cheque clearing, the balance sheet of the M.P.C. Bank changes as follows:

Reserves + $810 Demand deposits + $810

The M.P.C. Bank now finds itself with excess reserves (over its targeted amount). It wants to keep back only 10 percent of the $810, or $81, as cash reserves. Therefore, it has $810 minus $81, or $729, in excess reserves. Let us assume that this amount is lent out. Regardless of whom it is lent to and regardless of how the loan is spent (assuming that recipients of the cheque deposit it back into a bank), sooner or later one of the banks in the banking system will find itself again with excess reserves and be ready and able to lend.

35 of 40

The Money Multiplier

Although the cash moves from bank to bank, the banking system seems unable to get rid of this additional cash.
A bank lends it out, but each time it returns to some other bank.
Each time it returns, the receiving bank retains 10 percent of that new deposit in additional reserves.

Reserves Loans Deposits

+1000 +1000 (Tom)

+900 (to Wing Kee) +900 (New Star)

+810(to Sue) +810 (Sarbjit)

+729 +729

… …

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

Although the cash moves from bank to bank, the banking system seems unable to get rid of this additional cash. A bank lends it out, but each time it returns to some other bank. However, each time it returns, the receiving bank retains 10 percent of that new deposit in additional reserves. Let us follow the trail resulting from Tom's initial deposit of $1000:

Reserves Loans Deposits

+1000 +1000 (Tom)

+900 (to Wing Kee) +900 (New Star)

+810(to Sue) +810 (Sarbjit)

+729 +729

… …

You can see that both the loans and deposits columns above follow a geometric pattern. What we are interested in finding out is the total of the deposits column. Why would we be interested in this figure? Because it is money. Think back to the definition of money (Ml): currency in circulation plus demand deposits. The banks' cash reserves are not part of the money supply, but the total amount in peoples' chequing accounts certainly is.

So, what will be the total of all demand deposits that result from Tom's initial deposit of $1000? The answer is 1000 + 900 + 810 + 729 + ... It is reasonably easy to solve if you remember the formula for summing a geometric progression.

36 of 40

Entire Banking System

Target Reserves = 10% of Demand Deposits therefore

Demand Deposits = 10 x Target Reserves

Tom deposits $1000 so Reserves become $101 000
Demand Deposits can rise to 10 x $101 000 or $1 010 000

Reserves $100 000 Demand Deposits $1 000 000

Loans $900 000

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

But let us tackle the problem from a different perspective by looking at part of the balance sheet of the entire banking system. Assume it looked like the following prior to Tom's deposit:

�Reserves $100 000 Demand Deposits $1 000 000

Loans $900 000

�Staying with our assumption that banks want to keep a 10-percent reserve ratio, the banking system illustrated above is neither over- nor underreserved. If the target reserves must equal 10 percent of deposits, it means that demand deposits will equal 10 times the amount of reserves. Now, Tom deposits $1000 in one of the banks so that reserves equal $101 000. Demand deposits can potentially rise to a maximum of 10 X $101 000, or $1 010 000. As a result of the lending process we described, the new combined balance sheet would look like this:

�Reserves $101 000 Demand Deposits $1 010 000

Loans $909 000

In other words, if the target reserve ratio is 10 percent, a new deposit of $X will lead to an increase in total deposits throughout the whole banking system of 10 times $X.

37 of 40

The Money Multiplier

The money multiplier is the increase in total deposits that would occur in the whole banking system as a result of a new deposit in a single bank.

Money Multiplier =

Or Money Multiplier =

Δ reserves

Δ deposits

target reserve ratio

1

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

As you probably recognize, what we have here is another multiplier; this time, the money multiplier, which is determined in the following way:

Money Multiplier = change in deposits / change in reserves

It is calculated by the formula:

Money Multiplier = 1 / target reserve ratio

In our example, the target reserve ratio is 10 percent, or 0.1, and so the money multiplier is 1/0.1, or 10. If the target reserve ratio was 5 percent, or 0.05, it would mean that banks want to keep a smaller amount of reserves and therefore would have more to lend out. In this case, the money multiplier would be 1/0.05, or 20.

The principle of the money multiplier is based on the fact that banks only keep a small fraction of deposits in the form of cash reserves. Excess reserves allow banks to increase loans and therefore increase deposits by a multiple of the excess reserves. The money multiplier shows what will happen in the whole banking system over a period of time.

Be careful not to confuse the effect of the money multiplier working through the whole banking system with the circumstances facing a single bank. Simply because a single bank happens to find itself with excess reserves does not mean that it could increase loans by a multiple of those excess reserves. For instance, look at the following circumstances for the Saymor Bank:

Reserves $100 Demand deposits $1000

�The target reserve ratio is 10 percent. Someone now deposits cash of $50. Excess reserves would then equal $45 (90 percent of $50), and this is all Saymor wants to lend. It could not lend out $450, since the bank would be in a very embarrassing situation if the borrower immediately asked for cash. In short:

A single bank has to tread carefully and limit its loans to the amount of its excess reserves.

38 of 40

Can Banks Ever Be Short of Reserves

At the end of the day, bank might find that it has less reserves than it targeted.

Borrow from the Bank of Canada

The bank rate is the rate of interest that the Bank of Canada charges a commercial bank for a loan.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

39 of 40

Money Multiplier in Reverse

If a single bank finds itself under-reserved, it will have to increase its reserves in some more permanent way.
Doing so will be at the expense of some other bank's reserves.
The total loans in the whole banking system will decrease and, as a result, deposits also reduce by an amount determined by the money multiplier.
Banks can neither create nor destroy currency.

What they can do is create or destroy loans and demand deposits, and this is what they do whenever they are over- or underreserved.

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

Are there other consequences if a single bank – Saymor, for instance – finds itself under-reserved? Well, after receiving a loan from the Bank of Canada, Saymor will have to increase its reserves in some more permanent way. While it is not difficult for a single bank to increase its reserves, doing so will be at the expense of some other bank's reserves. Let us explain this by assuming that Saymor calls in an outstanding loan that was made earlier to the New Star Car Company. New Star will be forced to quickly sell off some of its inventory. The car buyers involved in this selloff will be reducing their deposits in other banks as they pay for their purchases. This will result in other banks finding themselves underreserved and thus forced to call in some of their loans. Soon, we will find the total loans in the whole banking system decreasing and, as a result, deposits also being reduced by an amount determined by the money multiplier. As an example, look at the following combined balance sheet of a banking system:

Reserves $ 95 Demand Deposits $ 1000

Loans $ 905

�If the target reserve ratio is 10 percent, the banking system is underreserved in the amount of $5. How can the whole banking system produce another $5 worth of reserves? The answer is: it cannot. What will happen, in fact, is that the banking system, over a period of time, will be forced to call in outstanding loans. In this case, the money multiplier is 10, and so the banks in total will have to call in 10 X $5, or $50, to get their reserves back in line with the deposits. After this contraction, the balance sheet will look like this:

Reserves $ 95 Demand Deposits $ 1000

Loans $ 855 ��We emphasize that banks can neither create nor destroy currency. What they can do is create or destroy loans and demand deposits, and this is what they do whenever they are over- or underreserved. It is in this sense that we say that banks can create and destroy money (demand deposits). However, as we will see in the next chapter, it is the Bank of Canada that ultimately controls the money supply by determining the amount of currency held by the commercial banks.

40 of 40

A Smaller Money Multiplier

Factors that May Reduce the Size of the Multiplier

An increase in the banks' target reserves
An increase in amount of cash that people hold (currency drain)
An insufficient number of creditworthy applicants for loans
A reduced demand for loans by people in times of recession

Chapter 7 Money and Banking – Principles of Macroeconomics 6^th Edition – Sayre and Morris

There are certain instances, when the size of the money multiplier will be diminished. As we have already seen, if a bank were to increase its target reserves, it would be lending out less, and the money multiplier would be reduced. However, in a modern banking system, banks are likely to keep their targets as low as is safely possible, since they earn no return on idle cash. Second, it is possible that people may decide to keep a larger portion of their assets in the form of cash. This increase in cash holdings will mean fewer deposits into the banking system and would reduce the size of the multiplier. (This is referred to as currency drain.) Thirdly, simply because a bank has excess reserves does not mean that it will make more loans. It is possible that the banks may find, in their judgment, that there are not enough creditworthy applicants for loans and that their excess reserves would persist. Finally, it should be noted that in a recession, banks often find it difficult to make loans because many people simply do not want to get deeper into debt when times are tough. Here, again, the banks' excess reserves would persist and reduce the size of the multiplier. In summary, the four factors that may reduce the size of the multiplier are as follows:

an increase in the banks' target reserves
an increase in amount of cash that people hold
an insufficient number of creditworthy applicants for loans
a reduced demand for loans by people in times of recession