Principles of Macroeconomics 3
Chapter 11- Money and Banking
What is the Nature of Money?
- For money to be considered an asset, it must fulfill three functions:
1. It must serve as a medium of exchange, something that could be accepted for goods and services. An
alternative would be barter, which requires a double coincidence of wants.
2. It must be able to be used as a store of value, used to transport purchasing power. An advantage of
holding money is that it is liquid, making it portable and ready to use. The disadvantage is that its
value falls over time due to inflation.
3. It is a unit of account, meaning that money is a standard way of quoting prices.
Coinage and Goldsmiths
- The invention of coinage eliminated the need to weigh the metal at each transaction, but coins often
could not be taken at their face value because people would clip them.
- Gresham’s Law is the theory that bad money derives good money out of circulation.
- Goldsmiths would give their depositors receipts, promising to return the gold on demand so buyers
began to transfer the goldsmith's receipts when making a purchase, and the transferring of paper
receipts, rather than gold was the invention of paper money, which was backed by precious metal and
convertible on demand into this metal.
- Goldsmiths and banks discovered that it was not necessary to keep 1 ounce of gold in the vaults for
every claim to 1 ounce circulating as paper money, we say that such a currency is fractionally backed
by the reserves.
- Currency issued by private banks became rare and central banks took control of issuing currency.
- Money today is fiat money because it is decreed by the government to be legal tender.
- Money held by the public as deposits with commercial banks are deposit money, and banks create
money by issuing more promises to pay deposits than they have cash reserves available to pay out
What is the Canadian Banking System?
- The central bank acts as a banker to the commercial banking system, and often to the government as
well, and is usually the sole money-issuing authority.
- Financial intermediaries are privately owned institutions that serve the general public. They are the
intermediaries amid savers, from whom they take deposits, and borrowers, to whom they make loans.
- The organization of the Bank of Canada is designed to keep the operation of monetary policy, free
from day-to-day political influence. (1935)
- The Bank of Canada’s basic functions is to act as a banker to commercial banks to act as banker to the
federal government to regulate the money supply, and to support financial markets.
- A commercial bank is a privately owned profit-seeking institution that provides a variety of financial
services, such as accepting deposits from customers and making loans and other investments.
What are Bank Reserves?
- Bank reserves are the deposits a commercial bank has made with the Bank of Canada plus its cash on
hand, vault cash.
- 100% reserve banking is a situation in which banks’ reserves equal 100% of their deposits.
- The way that banks earn a profit is by making loans at higher interest rates than what they pay the
depositors for using their money.
- The modern banking system is therefore a fractional-reserve banking system, a banking system in
which bank reserves are less than deposits.
