Money, Banking and the Financial Sector

1. Money, Banking and the Financial Sector

2. 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.

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

4. Introduction • All trade in the goods market involves both the real sector and the financial sector.

5. 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.

6. Why Is the Financial Sector So Important to Macro? • Savings are returned to the circular flow in the form of consumer loans, business loans, and loans to government.

7. Why Is the Financial Sector So Important to Macro? • 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.

8. Why Is the Financial Sector So Important to Macro? • Financial assets such as stocks and bonds, are obligations or financial liabilities of the issuer.

9. Outflow from spending stream Inflow from spending stream Pension funds CDs Savings deposits Chequing deposits Stocks Bonds Government Securities Life insurance Large business loans Small business loans Venture capital loans Construction loans Investment loans Gov’t Gov’t Saving Loans House- holds House- holds Financial sector Corpor- ations Corpor- ations The Financial Sector as a Conduit for Savings, Fig. 13-1, p 307

10. 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.

11. The Role of Interest Rates in the Financial Sector • The interest rate is the price paid for use of a financial asset. • Bonds are promises to pay a certain amount plus interest in the future.

12. The Role of Interest Rates in the Financial Sector • When financial assets such as bond make fixed interest payments, the price of the financial asset is determined by the market interest rate.

13. The Role of Interest Rates in the Financial Sector • 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.

14. The Role of Interest Rates in the Financial Sector • As the market interest rates go up, price of the bond goes down. • As the market interest rates go down, the price of the bond goes up.

15. 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.

16. The Definition and Functions of Money • Money is generally accepted in exchange for other goods. • Money is used as a reference in valuing other goods. • Money can be stored as wealth.

17. The Canadian Central Bank: Bank of Canada • Bank of Canada – The Canadian central bank whose liabilities (bank notes) serve as cash in Canada.

18. Bank of Canada • A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms. • Individuals’ deposits in savings and chequing accounts serve the same function as does currency and are also considered money.

19. Functions of Money • Money is a medium of exchange. • Money is a unit of account. • Money is a store of wealth.

20. 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.

21. Money As a Medium of Exchange • Money does not have to have any inherent value to function as a medium of exchange. • All that is necessary is that everyone believes that other people will exchange it for their goods.

22. Money As a Medium of Exchange • The Bank of Canada’s job is to not issue too much or too little money. • If there is too much money, compared to the goods and services at existing prices, the goods and services will sell out, or the prices will rise.

23. Money As a Medium of Exchange • If there is too little money, compared to the goods and services at existing prices, there will be a shortage of money and people will have to resort to barter, or prices will fall.

24. 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.

25. Money As a Unit of Account • Money is a useful unit of account only as long as its value relative to other prices does not change too quickly. • In a hyperinflation, all prices rise so much that our frame of reference is lost and money loses its usefulness as a unit of account.

26. Money as a Store of Wealth • Money is a financial asset. • It is simply a government bond that pays no interest.

27. Money as a Store of Wealth • As long as money is serving as a medium of exchange, it automatically also serves as a store of wealth.

28. Money as a Store of Wealth • Money’s usefulness as a store of wealth also depends upon how well it maintains its value. • Hyperinflations destroy money’s usefulness as a store of value.

29. Money as a Store of Wealth • Our ability to spend money for goods makes it worthwhile to hold money even though it does not pay interest.

30. 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++.

31. 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.

32. 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.

33. Alternative Measures of Money: M2 • The money in savings accounts is counted as money because it is readily available.

34. Alternative Measures of Money: M2 • All M2 components are highly liquid and play an important role in providing reserves and lending capacity for chartered banks.

35. 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.

36. 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.

37. Beyond M2: “The Pluses” • 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.

38. Beyond M2: “The Pluses” • M1, M2 and M3 measures only include deposits held at chartered banks. • Measures containing a “+” also include deposits at other financial institutions (near banks).

39. 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.

40. Distinguishing Between Money and Credit • Credit cards are prearranged loans. • Credit cards affect the amount of money people hold. • Generally, credit card holders carry less cash.

41. 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.

42. Banks and the Creation of Money • Banks can be analyzed from the perspective of asset management and liability management.

43. Banks and the Creation of Money • Asset management is how a bank handles its loans and other assets. • Liability management how a bank attracts deposits and how it pays for them.

44. 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.

45. 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.

46. 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.

47. 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.

48. 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.

49. From Gold to Gold Receipts • People soon began using the receipts as money since they knew the receipts were backed 100 percent by gold. • At this point, there were two forms of money – gold and gold receipts.

50. The Third Step in the Creation of Money • 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.