Money, Banking, and Interest Rates

1. 25 Money, Banking, and Interest Rates CHAPTER

2. Objectives • After studying this chapter, you will able to • Define money and describe its functions • Describe the banking system and explain the economic functions of banks, the Bank of Canada, and the payments system • Explain how banks create money • Explain what determines the demand for money • Explain what determines the supply of money and the interest rate

3. Money Makes the World Go Around • Money has taken many forms; what is money now? • What do banks do, and can they create money? • What determines the amount of money that people stuff into their wallets and keep in the bank? • What determines interest rates and what makes them rise and fall?

4. What Is Money? • Money is any commodity or token that is generally acceptable as a means of payment. • A means of payment is a method of settling a debt. • Money has three other functions: • Medium of exchange • Unit of account • Store of value

5. What Is Money? • Medium of Exchange • A medium of exchange is an object that is generally accepted in exchange for goods and services. • In the absence of money, people would need to exchange goods and services directly, which is called barter. • Barter requires a double coincidence of wants, which is rare, so barter is costly. • Unit of Account • A unit of account is an agreed measure for stating the prices of goods and services.

6. What Is Money? • Store of Value • As a store of value, money can be held for a time and later exchanged for goods and services. • Money in Canada Today • Money in Canada consists of • Currency • Deposits at banks and other financial institutions • Currency is the general term for bills and coins.

7. What Is Money? • Official Measures of Money • The two main official measures of money in Canada are M1 and M2+. • M1 consists of currency outside banks and demand deposits at chartered banks that are owned by individuals and businesses. • M2+ consists of M1 plus personal savings deposits at chartered banks, non-personal notice deposits at chartered banks, deposits at trust and mortgage loan companies, deposits at credit unions and caisses populaires, and deposits at other financial institutions.

8. What Is Money? • Figure 25.1 illustrates the composition of these two measures in June 2005 and shows the relative magnitudes of the components of money.

9. What Is Money? • The items in M1 clearly meet the definition of money; the items in M2+ do not do so quite so clearly but still are quite liquid. • Liquidity is the property of being instantly convertible into a means of payment with little loss of value. • Chequeable deposits are money, but cheques are not– cheques are instructions to banks to transfer money. • Credit cards are not money. Credit cards enable the holder to obtain a loan quickly, but the loan must be repaid with money.

10. The Banking System • The banking system consists of private and public institutions that create money and manage the nation’s monetary and payments system. • The institutions in the banking system divide into: • Depository institutions • The Bank of Canada • The payments system

11. The Banking System • Depository Institutions • A depository institution is a firm that accepts deposits from households and firms and uses the deposits to make loans to other households and firms. • The deposits of three types of depository institution make up Canada’s money: • Chartered banks • Credit unions and caisses populaires • Trust and mortgage loan companies

12. The Banking System • Chartered Banks • A chartered bank is a private firm that is licensed to receive deposits and make loans. • A chartered bank’s balance sheet summarizes its business and lists the bank’s assets, liabilities, and net worth. • The objective of a chartered bank is to maximize the net worth of its stockholders.

13. The Banking System • Credit Unions and Caisses Populaires • A credit union is a co-operative organization that operates under the Co-operative Credit Association Act of 1992 and that receives deposits from and makes loans to its members. • A caisse populaire is a credit union that operates in Quebec. • In 2001, these institutions had deposits of $115 billion.

14. The Banking System • Trust and Mortgage Loan Companies • A trust and mortgage loan company is a privately owned depository institution that operates under the Trust and Loan Companies Act of 1992. • These institutions receive deposits, make loans, and act as trustees for pension funds and estates. • In 2001, these institutions had deposits of $8 billion included in M2+.

15. The Banking System • Profit and Prudence: A Balancing Act • To goal of any bank is to maximize the wealth of its owners. To achieve this objective, interest rate at which it lends exceeds the interest rate paid on deposits. • But the banks must balance profit and prudence; loans generate profit, but depositors must be able to obtain their funds when they want them.

16. The Banking System • Reserves and Loans • To achieve security for its depositors, a bank divides its funds into two parts: reserves and loans. • Reserves are the cash in a bank’s vault and deposits at the Bank of Canada. • Bank lending takes the form of • Overnight loans • Liquid assets • Investment securities • Loans

17. The Banking System • The Economic Functions of Banks • Depository institutions make a profit from the spread between the interest rate they pay on their deposits and the interest rate they charge on their loans. • This spread exists because depository institutions • 1. Create liquidity • Minimize the cost of obtaining funds • Minimize the cost of monitoring borrowers • Pool risk

18. The Banking System • Bank of Canada • The Bank of Canada is Canada’s central bank. • A central bank is the public authority that supervises financial institutions and markets and conducts monetary policy. • The Bank of Canada is • Banker to the banks and government • Lender of last resort • Sole issuer of bank notes

19. How Banks Create Money • Banker to Banks and Government • The Bank of Canada accepts deposits from depository institutions that make up the payments system and the government of Canada. • Lender of Last Resort • The Bank of Canada is the lender of last resort, which means that it stands ready to make loans when the banking system as a whole is short of reserves. • If some banks have surplus reserves and others are short of reserves, the overnight loans market moves funds from one bank to another.

20. How Banks Create Money • Sole Issuer of Bank Notes • The Bank of Canada is the only bank that is permitted to issue bank notes. The Bank of Canada has a monopoly on this activity. • The Bank of Canada’s Balance Sheet • The Bank of Canada’s assets are government securities and last-resort loans to banks. • Its liabilities are Bank of Canada notes and deposits of banks and the government.

21. The Banking System • The Payments System • The payments system is the system through which banks make payments to each other to settle transactions by their customers. • The payments system is owned by the Canadian Payments Association (CPA) and it operates two national payments systems: • Large Value Transfer System • Automated Clearing Settlement System

22. How Banks Create Money • Large Value Transfer System • The Large Value Transfer System (LVTS) is an electronic payments that enables financial institutions and their customers to make large payments instantly and with sure knowledge that the payment has been made. • Automated Clearing Settlements System • The Automated Clearing Settlements System (ACSS) is the system through which all payments not processed by the LVTS are handled. These payments include debit card and ABM transactions.

23. How Banks Create Money • Creating Deposits by Making Loans • Banks create deposits when they make loans and the new deposits created are new money. • The quantity of deposits that banks can create is limited by three factors: • The monetary base • Desired reserves • Desired currency holding

24. How Banks Create Money • Monetary Base • The liabilities of the Bank of Canada (plus coins issued by the Canadian Mint) form the monetary base. • The monetary base is the sum of Bank of Canada notes outside the Bank of Canada, banks’ deposits at the Bank of Canada, and coins held by households, firms, and banks.

25. How Banks Create Money • Reserves • The fraction of a bank’s total deposits held as reserves is the reserve ratio. • The desired reserve ratio is the ratio of reserves to deposits that banks are want to hold. Reserves are the not required, so bank are free to determine the prudent level of reserves. • Excess reserves equal actual reserves minus desired reserves.

26. How Banks Create Money • Desired Currency Holding • We hold money in the form of currency and bank deposits and people hold some fraction of their money as currency. • So when the total quantity of money increases, so does the quantity of currency that people want to hold. • Because desired currency holding increases when deposits increase, currency leaves the banks when loans are made and deposits increase. • This leakage of currency is called the currency drain ratio and is the ratio of currency to deposits.

27. How Banks Create Money • The Money Creation Process • The nine steps in the money creation process are • Banks have excess reserves. • Banks lend excess reserves. • Bank deposits increase. • The quantity of money increases. • New money is used to make payments. • Some of the new money remains on deposit. • Some of the new money is a currency drain. • Desired reserves increase because deposits have increased. • Excess reserves decrease, but remain positive. 26-28

28. How Banks Create Money • Figure 25.2 illustrates how the banking system creates money by making loans.

29. How Banks Create Money • To see how the process of money creation works, suppose that the desired reserve ratio is 10 percent and the currency drain ratio is 50 percent. • The process starts when all banks have zero excess reserves except one bank and it has excess reserves of $100,000. • Figure 25.3 in the next slide illustrates the process and keeps track of the numbers. 26-30

30. How Banks Create Money • The process repeats until the banks have created enough deposits to eliminate the excess reserves. • $100,000 of excess reserves creates $250,000 of money.

31. How Banks Create Money • The Money Multiplier • The money multiplier is the ratio of the change in the quantity of money to the change in the monetary base. • In our example, when the monetary base increased by $100,000, the quantity of money increased by $250,000, so the money multiplier is 2.5.

32. How Banks Create Money • The size of the money multiplier depends on the currency drain ratio (a) and the desired reserve ration (b), so the formula: • Money = (1 + a)/(a + b) x Monetary base • In our example, a is 0.5 and b is 0.1, so • Money = (1 + 0.5)/(0.1 + 0.5) x Monetary base • Money = (1.5)/(0.6) x Monetary base • Money = 2.5 x Monetary base

33. The Demand for Money • How much money do people want to hold? • The Influences on Money Holding • The quantity of money that people plan to hold depends on four main factors: • The price level • The interest rate • Real GDP • Financial innovation

34. The Demand for Money • The Price Level • A rise in the price level increases the nominal quantity of money but doesn’t change the real quantity of money that people plan to hold. • Nominal money is the amount of money measured in dollars. • The quantity of nominal money demanded is proportional to the price level—a 10 percent rise in the price level increases the quantity of nominal money demanded by 10 percent.

35. The Demand for Money • The Interest Rate • The interest rate is the opportunity cost of holding wealth in the form of money rather than an interest-bearing asset. • A rise in the interest rate decreases the quantity of money that people plan to hold. • Real GDP • An increase in real GDP increases the volume of expenditure, which increases the quantity of real money that people plan to hold.

36. The Demand for Money • Financial Innovation • Financial innovation that lowers the cost of switching between money and interest-bearing assets decreases the quantity of money that people plan to hold. • The Demand for Money Curve • The demand for money curve is the relationship between the quantity of real money demanded (M/P) and the interest rate when all other influences on the amount of money that people wish to hold remain the same.

37. The Demand for Money • Figure 25.4 illustrates the demand for money curve. • A rise in the interest rate brings a decrease in the quantity of money demanded. • A fall in the interest rate brings an increase in the quantity of money demanded.

38. The Demand for Money • Shifts in the Demand for Money Curve • The demand for money changes and the demand for money curve shifts if real GDP changes or if financial innovation occurs.

39. The Demand for Money • Figure 25.5 illustrates a change in the demand for money. • A decrease in real GDP or a financial innovation decreases the demand for money and shifts the demand curve leftward. • An increase in real GDP increases the demand for money and shifts the demand curve rightward.

40. The Demand for Money • The Demand for Money in Canada • Figure 25.6(a) shows a scatter diagram of the interest rate against real M1 from 1968 through 2004. • The graph interprets the data in terms of movements along and shifts in the demand for money curve.

41. The Demand for Money • Figure 25.6(b) shows a scatter diagram of the interest rate against real M2+ from 1968 through 2004 • The graph interprets the data in terms of movements along and shifts in the demand for money curve.

42. Interest Rate Determination • An interest rate is the amount received by a lender and paid by a borrower expressed a s percentage of the amount of the loan. • The price of a bond (a financial asset) and the interest rate on it are inversely related. • If the price of a bond falls, the interest rate rises. • If the price of a bond rises, the interest rate falls. • We can study the forces that determine the interest rate in the market for money.

43. Interest Rate Determination • Money Market Equilibrium • The supply of and the demand for money determine the interest rate. • The actions of the Bank of Canada and the banking system determine the supply of money. • The Bank of Canada is the sole supplier of monetary base and it can choose the terms on which currency and reserves for the banks are supplied.

44. Interest Rate Determination • The Bank of Canada can choose to • Target the quantity of money • Target the interest rate • Quantity of Money Target • If the Bank of Canada targets the quantity of money, then the quantity of money supplied is fixed and the money supply curve is the vertical. • Figure 25.7 illustrates.

45. Interest Rate Determination • With a fixed quantity of money, the interest rate adjusts to make the quantity of money demanded equal to the quantity supplied.

46. Interest Rate Determination • If the interest rate is above the equilibrium, the quantity of money that people are willing to hold is less than the quantity supplied. • They try to get rid of their “excess” money they are holding by buying bonds. • This action raises the price of a bond, which lowers the interest rate.

47. Interest Rate Determination • If the interest rate is below the equilibrium, the quantity of money that people want to hold exceeds the quantity supplied. • They try to get more money by selling bonds. • This action lowers the price of a bond, which raises the interest rate.

48. Interest Rate Determination Interest Rate Target • If the Bank of Canada targets the interest rate, then the quantity of money supplied by the banking system must equal the quantity of money demanded at the chosen interest rate. • To achieve this quantity of money supplied, the Bank of Canada adjusts the monetary base. • Figure 25.7 illustrates.

49. Interest Rate Determination • With a 5% interest rate target, the quantity of money demanded is $600 billion and Bank of Canada set the monetary base so that the quantity of money supplied by the banking system is $600 billion.

50. Interest Rate Determination • If the Bank of Canada wants to lower the interest rate to 4%, the Bank of Canada must increase the monetary base such that the quantity of money supplied by the banking system increases to $650 billion equal to the quantity of money demanded.