ECON 101 - Chapter 10

1. Medium of exchange: an item buyers give to sellers when they want to purchase g&s

2. Unit of account: the yardstick people use to post prices and record debts

3. Store of value: an item people can use to transfer purchasing power from the present to the future

* Liquidity is the ease with which an asset can be converted into the medium of exchange. Although money is the most liquid asset, other assets offer a greater return as a store of value.

Without money, trade would require barter, the exchange of one good or service for another.

1. Every transaction would require a double coincidence of wants – the unlikely occurrence that two people each have a good the other wants.

2. Most people would have to spend time searching for others to trade with – a huge waste of resources.

This searching is unnecessary with money, the set of assets that people regularly use to buy g&s from other people.

1. Commodity money: takes the form of a commodity with intrinsic value

Examples:  gold coins, cigarettes in POW (prisoner of war) camps or in the film “The Shawshank Redemption

2. Fiat money:  money without intrinsic value, used as money because of govt decree

Example:  the Canadian dollar

Currency is legal tender in Canada, which means the federal government requires that it be accepted in payment of debts and requires that cash or cheques denominated in dollars be used in payment of taxes.

* Households and firms have confidence that if they accept paper dollars in exchange for goods and services, the dollars will not lose much value during the time they hold them.

1. The quantity of money available in the economy

2. money stock

3a. Currency: the paper bills and coins in the hands of the public

b. Demand deposits: balances in bank accounts that depositors can access on demand by writing a check

• 1. M1+: currency, demand deposits, traveler’s checks, and other checkable deposits.
•  
• 2. M2: everything in M1 plus savings deposits, small time deposits, money market mutual funds, and a few minor categories (e.g. Canada Savings Bonds)

** The distinction between M1+ and M2 will usually not matter when we talk about “the money supply” in this course.

Central bank: an institution that oversees the banking system and regulates the money supply

Monetary policy: the setting of the money supply by policymakers in the central bank

The Bank of Canada: the central bank of Canada

Buying things with credit cards is, in effect, taking out loans from the banks that issued them, so they are not included in definitions of the money supply.

Only when you pay your credit card bill at the end of the month—often with a cheque or an electronic transfer from your chequing account—is the transaction complete.

In contrast, with a debit card, the funds to make the purchase are taken directly from your chequing account.

• 1. The difference between the value of this bank’s total assets and its total liabilities is equal to its shareholders’ equity.
• As a consequence, the left side of the balance sheet always equals the right side.

• 2. Reserves, loans and deposits
• 

1a. Banks keep a fraction of deposits as reserves, and use the rest to make loans.

b. Banks may hold more than this minimum amount if they choose.

2. Excess reserves

• 3. The reserve ratio, R
• =  fraction of deposits that banks hold as reserves
• =  total reserves as a percentage of total deposits

Note. Some countries have reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits. (US=10%, Brazil=20%, UK & Canada=0%)

• 1. a simplified accounting statement that shows a bank’s assets & liabilities.
• 
• In this example, notice that  R = $10/$100 = 10%.

• 2. Assets: Reserves and loans
•     Liabilities: deposits

1. CASE 1:  no banking system

• Public holds the $100 as currency.
• Money supply = $100.  

2. CASE 2:  100% reserve banking system

Public deposits the $100 at First National Bank (FNB). 

FNB holds 100% of deposit as reserves (no loan) 

Money supply    = currency + deposits = $0 + $100 = $100

• In a 100% reserve banking system, banks do not affect size of money supply.  
• 

3. CASE 3:  Fractional reserve banking system

Suppose R = 10%.   FNB loans all but 10% of the deposit:

• Money supply = $190 (!!!) depositors have $100 in deposits, borrowers have $90 in currency. ** banks create money.
• 

In a fractional reserve system, when banks make loans, they create money

Example:

• STEP 1
• The borrower gets
• * $90 in currency (an asset counted in the money supply)
• * $90 in new debt (corresponding liability)

• STEP 2
• Creation of money doesn’t stop with FNB. Suppose borrower deposits the $90 at Second National Bank (SNB).

• Initially, SNB’s T-account looks like this
• 

If R = 10% for SNB, it will loan all but 10% of the deposit.

STEP 3

The borrower deposits the $81 at Third National Bank (TNB).

• Initially, TNB’s T-account looks like this:
• 

• If R = 10% for TNB, it will loan all but 10% of the deposit.
• STEP 4

The process continues, and money is created with each new loan.  

• Original deposit = $100
• FNB lending = $90 (0.9 x 100)
• SNB lending = $81 (0.9 x 90)
• TNB lending = $72.90 (0.9 x 81)

Total money supply = $1000

** In this example, $100 of reserves generates $1000 of money.

The money multiplier is the amount of money the banking system generates with each dollar of reserves

The money multiplier equals 1/R.

• R = 10%
• money multiplier = 1/R = 10
• $100 of reserves creates $1000 of money

1. The reserves fall by $1 million and the money supply decreases by $10 million, since the money multiplier is 10. 

2. The banks may choose to hold excess reserves when they are uncertain about future economic conditions. The money multiplier is still 10.  - The money supply decreases by $10 million, the same as before.

-This example shows that the Bank of Canada has only partial control over the money supply. In times of recession, when banks are reluctant to lend, monetary policy may become ineffective.

1. Velocity of money  The average number of times each dollar in the money supply is used to purchase goods and services included in GDP.

ex. V = 2.7 means that during a given time period, say 2012, each dollar was spent an average of 2.7 times on goods or services included in GDP.

2. M x V  = P x Y

The quantity equation states that the money supply (M) multiplied by the velocity of money (V) equals the price level (P) multiplied by real output (Y).

• Price level (P) can be GDP deflator
• Real output (Y) can be real GDP
• Money supply (M) can be M1+

3. Rewriting the original equation by dividing both sides by M, we have the equation for velocity:

V = P x Y ÷ M

1. A theory about the connection between money and prices that assumes that the velocity of money is constant.

2. An equation where variables are multiplied together is equal to an equation where the growth rates of these variables are added together.

So, we can transform the quantity equation from M x V = P x Y , to

Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (or inflation rate) + Growth rate of real output

The growth rate of the price level is the inflation rate, so we can rewrite the quantity equation to help understand the factors that determine inflation:

3. Inflation rate = Growth rate of the money supply + Growth rate of velocity − Growth rate of real output

4. Inflation rate = Growth rate of the money supply − Growth rate of real output

1. a. If the money supply grows at a faster rate than real GDP, there will be inflation.

b. If the money supply grows at a slower rate than real GDP, there will be deflation. (Recall that deflation is a decline in the price level.)

c. If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation nor deflation.

2. Because there can be significant fluctuations in velocity from year to year, the predictions of the quantity theory of money do not hold every year, so Irving Fisher was wrong in asserting that the velocity of money is constant.

Still, the quantity theory may provide useful insight into the long-run relationship between the money supply and inflation:

In the long run, inflation results from the money supply growing at a faster rate than real GDP.

1. 50% a month or a 130 fold increase in the price level over the course of a year.

2. Central banks increasing the money supply at a rate far in excess of the growth rate of real GDP.

3a. A high rate of inflation causes money to lose its value so rapidly that households and firms avoid holding it.

b. If inflation becomes severe enough that people stop using paper currency, it will no longer serve the important functions of money.

c. Economies suffering from high inflation usually also suffer from very slow growth, if not severe recession.

War reparations by the US, France, Great Britain and Italy provoked Germany to raise funds by selling bonds to the central bank which increased the money supply.

The mark—the German currency—became worthless after its total number in circulation rose from 115 million to 1.3 billion to 497 billion billion in two years time, resulting in a hyperinflation just as predicted by the quantity theory.

The German government took steps to end the hyperinflation, including introducing a new mark worth 1 trillion old marks, and a decade later the Nazis seized power.