Money, Banking and the Financial Sector



Money, Banking and the Financial Sector

Introduction

* Real goods and services are exchanged in the real sector of the economy.

* For every real transaction, there is a financial transaction that mirrors it.

Introduction

* The financial sector is central to almost all macroeconomic debates because behind every real transaction, there is a financial transaction that mirrors it.

* All trade in the goods market involves both the real sector and the financial sector.

Why Is the Financial Sector So Important to Macro?

* The financial sector is important to macroeconomics because of its role in channeling savings back into the circular flow.

* Savings are returned to the circular flow in the form of consumer loans, business loans, and loans to government.

* Savings are channeled into the financial sector when individuals buy financial assets such as stocks or bonds and back into the spending stream as investment.

* For every financial asset there is a corresponding financial liability.

The Role of Interest Rates in the Financial Sector

* While price is the mechanism that balances supply and demand in the real sector, interest rates do the same in the financial sector.

* The interest rate is the price paid for use of a financial asset.

* When financial assets such as bond make fixed interest payments, the price of the financial asset is determined by the market interest rate.

* When interest rates rise, the value of the flow of payments from fixed-interest-rate bonds goes down because more can be earned on new bonds that pay the new, higher interest.

* As the market interest rates go up, price of the bond goes down.

Banks

* A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms.

The Canadian Central Bank: Bank of Canada

* Bank of Canada – The Canadian central bank whose liabilities (bank notes) serve as cash in Canada.

The Definition and Functions of Money

* Money is a highly liquid financial asset.

* To be liquid means to be easily changeable into another asset or good.

* Social customs and standard practices are central to the liquidity of money.

* Money is generally accepted in exchange for other goods.

Functions of Money

* Money is a medium of exchange.

* Money is a unit of account.

* Money is a store of wealth.

Money As a Medium of Exchange

* Without money, we would have to barter—a direct exchange of goods and services.

* Money facilitates exchange by reducing the cost of trading.

* Money does not have to have any inherent value to function as a medium of exchange.

* The Bank of Canada’s job is to not issue too much or too little money.

Money As a Unit of Account

* Money prices are actually relative prices.

* A single unit of account saves our limited memories and helps us make reasonable decisions based on relative costs.

* Money is a useful unit of account only as long as its value relative to other prices does not change too quickly.

Money as a Store of Wealth

* Money is a financial asset.

* It is simply a government bond that pays no interest.

* As long as money is serving as a medium of exchange, it automatically also serves as a store of wealth.

* Money’s usefulness as a store of wealth also depends upon how well it maintains its value.

* Our ability to spend money for goods makes it worthwhile to hold money even though it does not pay interest.

Alternative Measures of Money

* Since it is difficult to define money unambiguously, economists have defined different measures of money.

* They are called M1, M2 and M3, M1+, M2+ and M2++.

Alternative Measures of Money: M1

* M1 consists of currency in circulation and chequing account balances at chartered banks.

* Chequing account deposits are included in all definitions of money.

Alternative Measures of Money: M2

* M2 is made up of M1 plus personal savings deposits, and non personal notice deposits (that can be withdrawn only after prior notice) held at chartered banks.

* Time deposits are also called certificates of deposit (CDs), or term deposits.

* The money in savings accounts is counted as money because it is readily available.

* All M2 components are highly liquid and play an important role in providing reserves and lending capacity for chartered banks.

Alternative Measures of Money: M2

* The M2 definition is important because economic research has shown that the M2 definition often most closely correlates with the price level and economic activity.

Beyond M2: “The Pluses”

* Numerous financial assets also have some attributes of money. That is why they are included in some measures of money.

* There are measures for M3, M1+, M2+ and beyond.

* The broadest measure is M2++.

* It includes almost all assets that can be turned into cash on short notice.

* Broader concepts of asset liquidity have gained greater appeal than the measures of money, because money measures have been rapidly changing.

* M1, M2 and M3 measures only include deposits held at chartered banks.

* Measures containing a “+” also include deposits at other financial institutions (near banks).

Distinguishing Between Money and Credit

* Credit card balances cannot be money since they are assets of a bank.

* In a sense, they are the opposite of money.

* Credit cards are prearranged loans.

Banks and the Creation of Money

* Banks are both borrowers and lenders.

* Banks take in deposits and use the money they borrow to make loans to others.

* Banks make a profit by charging a higher interest on the money they lend out than they pay for the money they borrow.

* Banks can be analyzed from the perspective of asset management and liability management.

* Asset management is how a bank handles its loans and other assets.

How Banks Create Money

* Banks create money because a bank’s liabilities are defined as money.

* When a bank incurs liabilities it creates money.

* When a bank places the proceeds of a loan it makes to you in your chequing account, it is creating money.

The First Step in the Creation of Money

* The Bank of Canada creates money by simply printing currency and exchanging it for bonds.

* Currency is a financial asset to the bearer and a liability to the Bank of Canada.

The Second Step in the Creation of Money

* The bearer deposits the currency in a chequing account at the bank.

* The bank holds your money and keeps track of it until you write a cheque.

Banking and Goldsmiths

* In the past, gold was used as payment for goods and services.

* But gold is heavy and the likelihood of being robbed was great.

From Gold to Gold Receipts

* It was safer to leave gold with a goldsmith who gave you a receipt.

* The receipt could be exchanged for gold whenever you needed gold.

* People soon began using the receipts as money since they knew the receipts were backed 100 percent by gold.

* Little gold was redeemed, so the goldsmith began making loans by issuing more receipts than he had gold.

* He charged interest on the newly created gold receipts.

The Third Step in the Creation of Money

* When the goldsmith began making loans by issuing more receipts than he had in gold, he created money.

* The gold receipts were backed partly by gold and partly by people’s trust that the goldsmith would pay off in gold on demand.

* The goldsmith soon realized that he could make more money in interest than he could earn in goldsmithing.

Banking Is Profitable

* As the goldsmiths became wealthy, others started competing in offering to hold gold for free, or even offering to pay for the privilege of holding the public’s gold.

* That is why most banks today are willing to hold the public’s money at no charge – they can lend it out and in the process, make profits.

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