Ragan: Macroeconomics

Seventeenth Canadian Edition

Chapter 11
Money and Banking

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Chapter Outline/Learning Objectives

Section Learning Objectives

Blank After studying this chapter, you will be able to
11.1 The Nature of Money 1. describe the various functions of money,
and how money has evolved over time.
11.2 The Canadian Banking 2. see that modern banking systems include
System both privately owned commercial banks
and government-owned central banks.
11.3 Money Creation by the 3. explain how commercial banks create
Banking System money by taking deposits and making
loans.
11.4 The Money Supply 4. describe the various measures of the
money supply.

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11.1 The Nature of Money
• Functions of Money
– Medium of exchange
– Store of Value
– Unit of account

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Money Need Not Be Physical
• Money need not have a physical presence to serve
as a medium of exchange, a store of value, and a unit
of account.
• Most Canadians hold much more money in their bank
accounts, and they can easily make a transaction
with a debit card.
• In the overall economy, there is much more money in
the form of bank deposits than there is in the form of
physical money.

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The Origins of Money
• Metallic Money
• Milling/Debasing the
currency
• Gresham’s Law

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Paper Money
• The role of goldsmiths
• Banknotes –
convertible on demand
• Fractionally backed
paper money
• Fiat money
• Gold standard

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Modern Money: Deposit Money
• Money held by the public in the form of deposits with
commercial banks is deposit money.
• Bank deposits are considered money.
• Today, just as in the past, banks create money by
issuing more promises to pay (deposits) than they
have cash reserves available to pay out.
• Another modern form of money is “cryptocurrencies”
such as Bitcoin, Ethereum, and Ripple.

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11.2 The Canadian Banking System
• Two types of institutions make up a modern banking
system:
1. Central bank (Bank of Canada)
2. Financial intermediaries
• “Commercial banks” refer to financial intermediaries
that are deposit accepting and loan granting.

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The Bank of Canada (1 of 3)
• The Bank of Canada commenced operations on
March 11,1935.
• The organization of the Bank of Canada is designed
to keep the operation of monetary policy free from
day-to-day political influence.
• The Bank of Canada has considerable autonomy, but
the ultimate responsibility for the Bank’s actions rests
with the government.
• This system is known as “joint responsibility.”

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The Bank of Canada (2 of 3)
• The basic functions of the Bank of Canada:
– Banker to the commercial banks
– Banker to the federal government
– Regulator of the money supply

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The Bank of Canada (3 of 3)
• Table 11-1 shows the Bank of Canada’s balance sheet
from December 2019, just before the pandemic began.
Table 11-1 Assets and Liabilities of the Bank of
Canada, December 2019 (millions of dollars)

The balance sheet of the Bank of Canada shows that it serves as banker to the commercial
banks and to the government of Canada, and as issuer of our currency; it also suggests
the Bank’s role as regulator of the money supply. The principal liabilities of the Bank are the basis of the
money supply. Bank of Canada notes are currency, and the deposits of the commercial banks give them the
reserves they need to create deposit money. The Bank’s holdings of Government of Canada securities arise
from its operations designed to regulate the money supply.
(Source: Adapted from Bank of Canada, Annual Report 2019. www.bankofcanada.ca.)

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The Bank’s Balance Sheet During the
COVID-19 Pandemic
• Beginning early in 2020, the Government of Canada
issued a massive amount of new securities to provide
financial relief to unemployed workers and businesses
whose revenue had collapsed.
• The Bank of Canada played an important role by
purchasing a large amount of these newly issued
securities, thereby expanding the amount of money in the
banking system.
• With the arrival of vaccines in early 2021 and the swift
recovery of the economy that followed, it is expected that
the Bank of Canada’s balance sheet to return to a more
normal situation by 2022 or soon thereafter.
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Commercial Banks in Canada
• Commercial bank ‒ a privately owned, profit-seeking
institution that provides a variety of financial services,
such as accepting deposits from customers and
providing loans, mortgages, and other financial
products.
– Essential intermediaries in the credit market.
– Undertake interbank activities.
– Multibank systems make use of a clearing house.
– Commercial banks also act as profit seekers.

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Commercial Bank Reserves
• Fractional-reserve system
• Reserve ratio
• Target reserve ratio
• Excess reserves.
• At the core of any commercial banking system lies
both confidence and risk.
• Applying Economic Concepts 11-2 ‒ examines
some of the key Canadian banking regulations
designed to maintain confidence and manage risks.

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11.3 Money Creation by the Banking
System
• Some Simplifying Assumptions
– To focus on the essential aspects of how commercial
banks create money, suppose that banks can invest in
only one kind of asset—loans—and they have only one
kind of deposit.
– We assume that all banks have the same target
reserve ratio, which does not change, and that there is
no cash drain from the banking system.

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The Creation of Deposit Money (1 of 6)
• The bank initially has a reserve ratio of 20 percent.
Table 11-3: The Initial Balance Sheet of TD
Assets ($) Blank Liabilities ($) Blank
Reserves (cash and deposits with 200 Deposits 1 000
the central bank)
Loans 900 Capital 100
Blank 1 100 Blank 1 100

TD has reserves equal to 20 percent of its deposit liabilities. The

commercial bank earns profits by finding profitable investments for
much of the money deposited with it. In this balance sheet, loans are its
income-earning assets.

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The Creation of Deposit Money (2 of 6)
• A new deposit of $100 raises the bank’s reserve ratio to
27%.
Table 11-4: TD’s Balance Sheet Immediately After a New Deposit of $100

Assets ($) Blank Liabilities ($) Blank

Reserves 300 Deposits 1 100
Loans 900 Capital 100
Blank 1 200 Blank 1 200

The new deposit raises liabilities and assets by the same amount.
Because both reserves and deposits rise by $100, the bank’s actual reserve
ratio, formerly 0.20, increases to 0.27. The bank now has excess reserves of
$80.

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The Creation of Deposit Money (3 of 6)
• The bank now has $80 of excess reserves which it can
lend.
Table 11-5: TD’s Balance Sheet After Making a New Loan of $80

Assets ($) Blank Liabilities ($) Blank

Reserves 220 Deposits 1 100
Loans 980 Capital 100
Blank 1 200 Blank 1 200

TD converts its excess cash reserves into new loans. The bank keeps $20 as a
reserve against the initial new deposit of $100. It lends the remaining $80 to a
customer, who writes a cheque to someone who deals with another bank. Comparing
Table 11-3 and 11-5 shows that the bank has increased its deposit liabilities by the $100
initially deposited and has increased its assets by $20 of cash reserves and $80 of new
loans. It has also restored its target reserve ratio of 0.20.

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The Creation of Deposit Money (4 of 6)
• The second-round bank receives $80 in new deposits and
expands its loans by $64.
Table 11-6: Changes in the Balance Sheets of Second-Round Banks

Assets ($) Blank Liabilities ($) Blank

Reserves +16 Deposits +80
Loans +64 Blank
Blank +80 Blank +80

Second-round banks receive cash deposits and expand loans. The

second-round banks gain new deposits of $80 as a result of the loan granted
by TD. These banks keep 20 percent of the cash that they acquire as their
reserve against the new deposit, and they can make new loans using the
other 80 percent.

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Table 11-7 The Sequence of Loans and
Deposits After a Single New Deposit of $100
Addition
New to
Bank Deposits New Loans Reserves
TD 100.00 80.00 20.00
2nd-round bank 80.00 64.00 16.00
3rd-round bank 64.00 51.20 12.80
4th-round bank 51.20 40.96 10.24
5th-round bank 40.96 32.77 8.19
6th-round bank 32.77 26.22 6.55
7th-round bank 26.22 20.98 5.24
8th-round bank 20.98 16.78 4.20
9th-round bank 16.78 13.42 3.36
10th-round bank 13.42 10.74 2.68
Total (10 rounds) 446.33 357.07 89.26

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The Creation of Deposit Money (5 of 6)
• If ν is the target reserve ratio, a new deposit to the
banking system will increase the total amount of
deposits by 1/ν times the new deposit.
• In our example, ν = 0.2 and the new deposit
is $100. So total deposits eventually increase by $100
× 1/0.2 = $500.
• With no cash drain from the banking system, a
banking system with a target reserve ratio of ν can
change its deposits by 1/v times any change in
reserves.
ΔDeposits = ΔReserves/ν
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The Creation of Deposit Money (6 of 6)
• The total change in the combined balance sheets of the
entire banking system is shown in Table 11-8
Table 11-8: Change in the Combined Balance Sheets of All the Banks
in the System Following the Multiple Expansion of Deposits

Assets ($) Blank Liabilities ($) Blank

Reserves +100 Deposits +500
Loans +400 Blank
Blank +500 Blank +500
The reserve ratio is returned to 0.20. The entire initial deposit of $100
ends up as additional reserves of the banking system. Therefore, deposits
rise by (1/0.2) times the initial deposit – that is, by $500.

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Excess Reserves and Cash Drains
• Deposit creation depends on the decisions of bankers.
• If commercial banks must choose to lend their excess
reserves, otherwise, no deposit expansion.
• If people decide to hold an amount of cash equal to a
fixed fraction of their bank deposits, any multiple
expansion of bank deposits will be accompanied by a
cash drain.
• If c is the ratio of cash to deposits that people want to
maintain, the final change in deposits will be given by:
ΔDeposits = (New Cash Deposit)/(c + ν)

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11.4 The Money Supply
• The money supply is the total quantity of money that
is in the economy at any time.
• Economists use several alternative definitions for the
money supply.
• Each definition includes the amount of currency in
circulation plus some types of deposit liabilities of the
financial institutions.
Money supply = Currency + Bank deposits

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Kinds of Deposits
• Demand deposits
• Savings deposits
• Term deposit
• Money market mutual funds
• Money market deposit accounts

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Definitions of the Money Supply
• Two commonly used measures of money in Canada
today are M2 and M2+.
• M2 is currency plus demand and notice deposits at
the chartered banks.
• M2+ is M2 plus similar deposits at other financial
institutions.

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Near Money and Money Substitutes
• Near money is liquid assets that are easily
convertible into money without risk of significant loss
of value.
• Near money can be used as short-term stores of
value but are not themselves media of exchange.
• Term deposits are an example of near money.
• A money substitute is something that serves as a
medium of exchange but is not a store of value.
• An example of a money substitute is a credit card.

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The Role of the Bank of Canada
• We have seen how the commercial banking system,
when presented with a new deposit, can create a
multiple expansion of bank deposits.
• This shows how the reserves of the banking system
are systematically related to the money supply.
• In Chapter 13, we will see the details of how the Bank
of Canada conducts its monetary policy and how its
actions influence the total amount of reserves in the
banking system.

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