Unit 3: Macroeconomics

Unit 3: Macroeconomics Chapter 9: An Introduction to Macroeconomics Chapter 10: The Business Cycle and Fiscal Policy Chapter 11: Money and Banking

Chap 11: Money and Banking • Overview • The history of money • The evolution of currency • The origins of banking • What is money? • Functions • Characteristics • Measuring Canada’s money supply • Canada’s financial system • How banks “create” and “destroy” money

The History of Money • We use money to pay for goods and services, which we purchase from individuals or businesses • Money was not invented in one place or time • As societies progressed from producing a few goods to producing many, money became a necessity

The History of Money • Thousands of years ago, hunter-gatherers spent most of their time trying to find food, shelter, and clothing in order to survive • Few goods were produced • Any exchanges of goods between people were carried out through barter

The History of Money • In barter, the value of the good was determine in relation to another good, usually in terms of weight • Ex: 2 goats = 1 cow • This system worked well, but it faced the double coincidence of wants problem • If you want to exchange wheat for goats, you need to find someone who both has goats and wants wheat • This problem led to the invention of money

The History of Money • Cattle were the first type of money • Came to be the measure of value for all other goods • Eventually became the medium of exchange, a type of money that was used to buy a good from a seller • People no longer had to offer what another wanted and want what the other offered

The History of Money • Hunter-gatherers eventually discovered agriculture, and were able to produce a surplus of food • Allowed some people to shift their energies for working the land to taking on other occupations • Became artisans, merchants, soldiers, government officials, priests, etc. • These specialists needed a way to obtain food, shelter, and clothing • Didn’t have access to cattle • Led to the development of money as we know it today

The Evolution of Currency Commodities • Money is anything that is generally acceptable in purchasing goods or settling debts • For most of us that means coins or notes • Cattle, oxen, wheat, shells, salt, amber, and whiskey have all served as money in various societies • These items are called commodity money • They had value in themselves

The Evolution of Currency • Cattle were most commonly used in early agricultural societies, but they weren’t practical for small transactions • They weren’t divisible while they were alive! • As various societies discovered metals, cattle were replaced by smaller commodities • Ex: metal picks, hoes, fishhooks

The Evolution of Currency • About 5000 years ago, gold, silver, and copper were introduced as commodity money • First used in the form of ornaments or jewellery given value by weight • Made into ingots, usually oblong pieces of metal • By 3000 BCE, Babylonia was using silver as money • Measured it by units of weight (known as shekals and talents) that had originated for grain measurement

The Evolution of Currency • Today the shekal is the principal unit of money in Israel • The British pound dates from the time when precious metals were circulated by weight • The pound was originally an amount of silver that weighed a pound • In 1816, Britain switched to the gold standard, which we’ll discuss later this chapter

The Evolution of Currency Coinage • The use of gold and silver as money, which merchants measured using grain on their scales, began to supersede their use as commodities • The ancient Lydians (lived in what is now Turkey) are credited with minting the first coins in the 7th century BCE • The Greeks copied the idea and produced their own coinage, spreading it throughout their Mediterranean empire

The Evolution of Currency • Alexander the Great started the custom of imprinting the head of the ruler on coinage • Served as a guarantee of purity and weight of the metal • This didn’t stop people, or even the ruler, from cheating though • Slivers of gold and silver were often collected using one of two processes • Clipping: Shaving small slivers from the edges of coins • Sweating: Collecting small slivers and dust by shaking the coins in a bag • Rulers often debased the coins they issued by reducing the gold or silver content of coins but keeping their value the same • Provided extra revenue for themselves

The Evolution of Currency Paper • The Chinese were the first people to develop paper money (in the 7th century CE) • From the 7th-11th centuries CE, paper receipts were issued by Christian moastic orders for coinage deposited for safekeeping in monasteries and churches

The Evolution of Currency • By the 13th century, Italian merchants in Venice, Genoa, and Florence had begun operating as merchant-bankers • Paper receipts were used to transfer ownership of coinage from one person to another • It was not until the 17th century that goldsmiths in England introduced paper receipts as a form of money that could be used to purchase goods

The Evolution of Currency • Travelling merchants found it safer to deposit their large numbers of coins or precious metals with a local goldsmith and accept a receipt for the amount deposited • These receipts could be transferred to another person as payment for a good or service • The holder could redeem the receipt for the metals stored safely in the goldsmith's vault • The receipts were “as good as gold” • By the 17th century, the idea that paper could represent monetary value was accepted in England • It was a short step from paper receipts to paper currency

The Origins of Banking and Money Creation • Goldsmiths eventually figured out that the holders of receipts seldom returned for payment of the full amount of gold/silver • The receipts themselves were safer and easier to use as a form of money • Small amounts of metals or coins may be withdrawn, but the store of valuable metals in the vaults continued to pile up • A wonderful opportunity to make money now presented itself

The Origins of Banking and Money Creation • Goldsmiths could offer loans from the coinage or metals in the vault and charge the borrower interest • The borrower would have to pledge some property or valuable assets that would be surrendered if the loan could not be repaid • The loan would be granted in the form of a notation in the goldsmith’s account books

The Origins of Banking and Money Creation • Goldsmiths felt secure in the knowledge that borrowers tended to leave most of the coinage untouched in the vaults • Relied on their paper certificates that represented the coinage instead • Soon there was more paper in circulation than there was coinage and metal • With the creation of paper currency, along with the notations in their account books, goldsmiths had, in reality, created money

The Origins of Banking and Money Creation • In their lending and deposit-accepting roles, goldsmiths had also created baking • Based on the discovery that only a fraction of the total amount of money deposited for safekeeping needed to be kept on reserve • The rest could be lent in the form of paper • Fractional reserve banking was born, ushering in a change in the nature of money • We’ll learn more about this system later in the chapter

The Origins of Banking and Money Creation Central banks • Obviously if all the holders of paper receipts had all wanted to cash in at the same time, there would not have been enough coins/metals to pay them • Indeed, this has happened in every country at one time or another • When a financial crisis occurred (ex: a war or a poor harvest) a “run on the banks” took place as note holders demanded payment in “hard money” • The banks, unable to pay all the note holders, were forced to close their doors and declare bankruptcy • During the 19th and 20th centuries, many banks collapsed in Europe, Canada, and the US, taking with them the savings of their depositors • Ex: Between 1897-1900 there were 51 banks in Canada. By 1900, 17 had failed

The Origins of Banking and Money Creation • The collapse of banks and problems associated with coinage and paper money led to demands for the federal governments to establish central banks and regulate the issue of coins and paper money • The Bank of England, founded in 1694, was one of the first central banks to be established with the support of its federal government

The Origins of Banking and Money Creation • Canada’s central bank, the Bank of Canada, was established in 1934 • By the 20th century, most nations had central banks to: • Regulate private banks • Provide security for depositors • Issue paper currency

The Origins of Banking and Money Creation • Like the goldsmiths’ receipts, most national currencies were convertible into gold, until the 1930s • Nations that promised to pay gold for their notes were said to be on the gold standard • Central banks counted on the fact that all national currency wouldn’t be presented for payment in gold at the same time • Like the goldsmiths, they could issue more currency than the amount of gold held in reserve (within limits)

The Origins of Banking and Money Creation • But with the Great Depression of the 1930s, most nations “unhooked” their currencies from gold, abandoning the gold standard • Governments feared their citizens might suddenly demand gold for their currency – gold the government did not have • Currencies became known as fiat money • Money that is accepted, not because it can be exchanged for gold, but because government declare that it is legal tender and must be accepted for all payments

The Origins of Banking and Money Creation Bank deposit money • Although currency is the most visible type of money that we use, it is not the most important • Currency comprises only 7-8% of the total money supply • The rest of the supply is called bank deposit money • Created by the banks when they grant loans • We’ll discuss this later in the chapter

Assignment #1 • Please complete the case study provided

What is Money? • We have defined money as anything that is generally acceptable as payment for goods and services • As money evolves, it becomes more abstract • Started as a valuable commodity in itself, to coins and paper backed by gold and silver, to fiat money representing value, to notations in bank accounts, to electronic money

The Functions of Money • It’s said that “money is what money does” • People will accept anything as money as long as it performs the three functions for which it is designed • A medium of exchange • A measure of value • A store of value

A Medium of Exchange • Barter requires a double coincidence of wants • You have to find someone who wants what you have and has what you want • It would require a lot of time and effort to find someone who meets this criteria • Using money as a medium of exchange saves time • You can sell the goods you have to any willing buyer, then use the money to buy the goods that you need

A Medium of Exchange • The time and effort wasted on barter force people to try to become as self-sufficient as possible • They can’t be sure of obtaining all the goods that they need through trade • Money, however, gives people the freedom to specialize in the goods and services they produce • They can obtain the other goods they need through purchase • When people specialize they become more skilled and productive, contributing to an increase in their community’s wealth

A Measure of Value • As a measure of value, or standard unit of account, money allows us to compare the value of various goods in our economy • In the barter system, the value of any good would be expressed tin terms of many other goods • Ex: A loaf of bread = so many eggs, so much milk, etc. • In a money system, there is a unit of currency that serves as a standard against which we can measure the value of a good or service and compare its value with that of another good or service • Ex: If the cost of a vacation trip is equal to the cost of a car, money makes the comparison easy because the items are the same price

A Store of Value • Money also serves as a store of value, or an instrument for storing purchasing power for the future • With barter, some good must be accepted in exchange for another • With money, a good can be sold today, and the money received for that good can be stored until it is needed • While other items known as assets (jewellery, rare paintings, antiques, real estate, stocks, and bonds) can store value as well, money is the asset that allows us to pay most easily for a good or service

A Store of Value • The term liquidity refers to the relative ease with which an asset can be used to make a payment • Money is the most liquid of assets • Other assets are less liquid because they are not so easily exchanged for goods since they must first be sold in order to obtain money

The Characteristics of Money • In order for money to serve as a medium of exchange, it must be generally acceptable • There are several other characteristics that enhance money’s acceptability: • Since it is used on a daily basis, it should be portable and easy to use • Must be durable because it is passed from hand to hand countless times, stored in wallets and purses, and used in vending machines • Must be easily divided into units to facilitate small and large purchases

The Characteristics of Money • Coins and bills should be readily recognizable by shape and color in order to avoid transaction mistakes • Counterfeiting is a universal problem in money systems • Designers of currency try to create designs and use materials that are difficult to duplicate • Most important, a money system composed of currency and deposits must retain its value over time • Each unit of money loses value when prices rise (inflation) because more of each unit is required to purchase a good or service • The Bank of Canada is vigilant about inflation and quick to warn the public and politicians of its impending appearance

Assignment #2 • Please complete the case study provided

Measuring Canada’s Money Supply • The total money supply of a modern economy is the total amount of cash in circulation outside the banks plus bank deposits • Money serves as a medium of exchange, and to measure and store value • Currency serves all these functions as well, but what about all the various types of bank deposits? • If they don’t perform the medium of exchange function, should they be included in the money supply?

Measuring Canada’s Money Supply • People now hold different types of bank deposits, along with other financial assets • Makes it difficult to determine an exact definition of what should be included in the money supply • The term near money is used to define these other types of deposits or assets that act as a store of value and can be converted into a medium of exchange, but are not themselves a medium of exchange • In order to understand the problem of measuring the money supply, we need to define the main types of deposits and financial assets

Components of the Money Supply • Demand deposits • Can be held by individuals, businesses, and governments • Allow holders to transfer money immediately, or “on demand”, by cheque or debit card • There are 3 different types of demand deposits

Components of the Money Supply • Chequing accounts • Pay little or no interest and usually charge service fees • Used primarily as a medium of exchange • Current accounts • Set up for businesses but operate in the same way as chequing accounts • Also used as a medium of exchange • Savings accounts • Allow holders to save money for the future and earn interest • Not generally used for making immediate payments (though some have chequing privileges) • Banks reserve the right to require notice of withdrawal on these deposits but, in practice, allow people to withdraw at any time

Components of the Money Supply • Term deposits • Accounts in which the customer agrees to deposit a fixed amount of money for a fixed period of time (ranging from 1 month to several years) • Customer receives a higher rate of interest, which is surrendered if the deposit is cashed

Components of the Money Supply • Notice accounts • Require the depositor to give notice to the bank before withdrawal • These accounts pay some interest and are used primarily by businesses (in which case they are called non-personal accounts) • Money market mutual funds • Mutual funds specializing in short-term (less than a year) securities issued by governments (ex: treasury bills) and corporations (ex: bonds)

Definitions of the Money Supply • The Bank of Canada has broken down the money supply into several categories ranging from a narrow definition to a very broad one • M1 • The narrowest definition of the money supply • It is money that is used primarily as a medium of exchange to make payments • Includes all currency in circulation outside the banks, as well as demand deposits held in chequing and current accounts • Currency that is out of circulation or held in bank vaults or ATMs is excluded because when this currency is deposited, it becomes a bank deposit (and would be counted twice as a result)

Definitions of the Money Supply • M2 • A larger measure of the money supply • Includes all M1 plus personal savings accounts, including: • Chequing-savings accounts • Term deposits • Non-personal notice deposits • This is a broader definition as it includes term and non-personal notice deposits, which are not generally used for making immediate payments (they are examples of near money)

Definitions of the Money Supply • M2++ • Includes all M2 as well as deposits at non-bank deposit-taking institutions • Ex: credit unions, trust companies, caissepopulaires • Also includes money market mutual funds and individual annuities at life insurance companies • These assets are used primarily as a store of value, but can be turned into cash in one or two business days

Definitions of the Money Supply • M3 • Comprises M2++ as well as large term deposits held by businesses and foreign currencies held by Canadians • Although both types of deposits are used primarily as a store of value, they can be converted into cash

Definitions of the Money Supply • The Bank of Canada must have an accurate measure of the money supply actually being used for transactions in the economy • Based on this measurement, it adjusts policies (such as the level of interest rates) to support our economy’s growth • The problem for economists revolves around the question of what account or asset can be used for immediate payment by most people

Definitions of the Money Supply • Should the money supply include only M1, the narrowest definition? • M1 includes currency about which there is no argument because it is legal tender that must be accepted for payment • Also includes chequing accounts, which people use for payment as readily as they do currency (increasingly so with the advent of debit cards)

Definitions of the Money Supply • However there is a strong argument for including M2 • Most people now use ATMs, as well as telephone and internet banking • These systems allow easy transfer of funds between the various accounts • Do the systems that facilitate immediate payment encourage people to ignore the divisions between different accounts and assets? • If so, a broader definition of the money supply (M2, or even M3) is most accurate

Unit 3: Macroeconomics