25
MONEY, BANKING,
AND INTEREST
RATES
© Pearson Education Canada, 2003
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 makes interest rates rise and fall?
How do interest rates affect spending?
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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.
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Objectives
CHAPTER
After studying this chapter, you will able to
ƒ Define money and describe its functions
ƒ Explain the economic functions of banks and other
depository institutions
ƒ Describe some financial innovations that have changed
the way we use money today
ƒ Explain how banks create money
ƒ Explain what determines the demand for money
ƒ Explain how interest rates are determined
ƒ Explain how interest rates
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Education expenditure plans
Canada, 2003
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:
ƒ Medium of exchange
ƒ Unit of account
ƒ Store of value
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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
ƒ Currency
ƒ Deposits at banks and other financial institutions
Currency is the general term for bills and coins.
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What is Money? What is Money?

The two main official measures of money in Canada are

M1 and M2+. Figure 25.1
illustrates the
M1 consists of currency outside banks and demand composition of
deposits at chartered banks that are owned by individuals these two measures
and businesses. in December 2001
and shows the
M2+ consists of M1 plus personal savings deposits at relative magnitudes
chartered banks, nonpersonal notice deposits at of the components
chartered banks, deposits at trust and mortgage loan of money.
companies, deposits at credit unions and caisses
populaires, and deposits at other financial institutions.

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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.
Checkable deposits are money, but checks are not–
checks 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.

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Depository Institutions Depository Institutions

A depository institution is a firm that accepts deposits Chartered Banks

from households and firms and uses the deposits to make
A chartered bank is a private firm that is licensed to
loans to other households and firms.
receive deposits and make loans.
The deposits of three types of depository institution make
A chartered bank’s balance sheet summarizes its
up Canada’s money:
business and lists the bank’s assets, liabilities, and net
ƒ Chartered banks worth.
ƒ Credit unions and caisses populaires The objective of a chartered bank is to maximize the net
worth of its stockholders.
ƒ Trust and mortgage loan companies

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Depository Institutions
To achieve its objective, a bank makes risky loans at an
interest rate higher than that 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.
So banks divide their 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 liquid assets, investment
securities, and loans.
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Depository Institutions
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+.
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How Banks Create Money
Reserves: Actual and Required
The fraction of a bank’s total deposits held as reserves is
the reserve ratio.
The required reserve ratio is the fraction that banks are
required, by regulation, to keep as reserves. Required
reserves are the total amount of reserves that banks are
required to keep.
Excess reserves equal actual reserves minus required
reserves.
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Depository Institutions
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.
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Depository Institutions
The Economic Functions of Depository Institutions
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
ƒ Create liquidity
ƒ Minimize the cost of obtaining funds
ƒ Minimize the cost of monitoring borrowers
ƒ Pool risk
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How Banks Create Money
Creating Deposits by Making Loans in a One-Bank
Economy
When a bank receives a deposit of currency, its reserves
increase by the amount deposited, but its required
reserves increase by only a fraction (determined by the
required reserve ratio) of the amount deposited.
The bank has excess reserves, which it loans. These
loans can only end up as deposits in our one and only
bank, where they boost deposits without changing total
reserves, which creates money.
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3
How Banks Create Money

Figure 25.2
illustrates how one
bank creates
money by making
loans.

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How Banks Create Money How Banks Create Money

Creating Deposits by Making Loans with Many Banks

The Deposit Multiplier
The deposit multiplier is the amount by which an
increase in bank reserves is multiplied to calculate the
increase in bank deposits.
The deposit multiplier = 1/Required reserve ratio.
With many banks, one bank lending out its excess
reserves cannot expect its deposits to increase by the full
amount loaned; some of the loaned reserves end up in
other banks.
But then the other banks have excess reserves, which
they loan.
Ultimately, the effect in the banking system is the same as
if there was only one bank, so long as all loans are
deposited in banks.

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How Banks Create Money

Figure 25.3
illustrates money
creation with many
banks.

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The Demand for Money The Demand for Money

The price level

The Influences on Money Holding
A rise in the price level increases the nominal quantity of
The quantity of money that people plan to hold depends money but doesn’t change the real quantity of money that
on four main factors people plan to hold.
ƒ The price level Nominal money is the amount of money measured in
ƒ The interest rate dollars.

ƒ Real GDP The quantity of nominal money demanded is proportional

to the price level — a 10 percent rise in the price level
ƒ Financial innovation increases the quantity of nominal money demanded by 10
percent.

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The Demand for Money 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. Financial innovation

A rise in the interest rate decreases the quantity of money Financial innovation that lowers the cost of switching
that people plan to hold. between money and interest-bearing assets 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.

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The Demand for Money The Demand for Money

Figure 25.4 illustrates the

demand for money curve.
The Demand for Money Curve A rise in the interest rate
The demand for money curve is the relationship between brings a decrease in the
the quantity of real money demanded (M/P) and the quantity of money
interest rate when all other influences on the amount of demanded
money that people wish to hold remain the same. A fall in the interest rate
brings an increase in the
quantity of money
demanded

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5
 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.

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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.
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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 1971 through
2001 and interprets the
data in terms of
movements along and
shifts in the demand for
money curve.
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6
The Demand for Money

The Demand for Money in

Canada
Figure 25.6(b) shows a
scatter diagram of the
interest rate against real
M2+ from 1971 through
2001 and interprets the
data in terms of
movements along and
shifts in the demand for
money curve.
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Interest Rate Determination Interest Rate Determination

An interest rate is the percentage yield on a financial

security such as a bond or a stock.
The price of a bond and the interest rate are inversely
related.
If the price of a bond falls, the interest rate on the bond
rises.
If the price of a bond rises, the interest rate on the bond
falls.
We can study the forces that determine the interest rate in
the market for money.
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Money Market Equilibrium
The Fed determines the quantity of money supplied and
on any given day, that quantity is fixed.
The supply of money curve is vertical at the given quantity
of money supplied.
Money market equilibrium determines the interest rate.
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Interest Rate Determination

Figure 25.7 illustrates the

equilibrium interest rate.

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7
Interest Rate Determination
If the interest rate is
above the equilibrium
interest rate, 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 by buying
financial assets.
This action raises the
price of these assets and
lowers the interest rate.
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Interest Rate Determination

If the interest rate is below
the equilibrium interest
rate, the quantity of
money that people want to
hold exceeds the quantity
supplied.
They try to get more
money by selling financial
assets.
This action lowers the
price of these assets and
raises the interest rate.
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Interest Rate Determination

Influencing the Interest

Rate
Figure 25.8 shows how the
Bank of Canada influences
the interest rate.
If the Bank of Canada
increases the quantity of
money, the money supply
curve shifts rightward, and
the interest rate falls.
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8
Interest Rate Determination
If the Bank of Canada
decreases the quantity of
money, the money supply
curve shifts leftward, and
the interest rate rises.
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Interest Rate Determination
Influencing the Exchange Rate
The exchange rate is the price at which the Canadian
dollar exchanges for another currency.
The exchange rate is determined by demand and supply
in the global foreign exchange market.
A rise in the Canadian interest rate increases the demand
for the Canadian dollar and the exchange rate rise.
A fall in the Canadian interest rate decreases the demand
for the Canadian dollar and the exchange rate fall.
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The Interest Rate and Expenditure Plans
Interest Rate and Opportunity Cost
The nominal interest rate is the opportunity cost of holding
money and so influences the quantity of money
demanded.
The real interest rate is the opportunity cost of spending.
Two components of aggregate expenditure influenced by
the real interest rate are
ƒ Consumption expenditure
ƒ Investment
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© Pearson Education Canada, 2003
The Interest Rate and Expenditure Plans
Nominal Interest and Real Interest
The nominal interest rate is the percentage return on an
asset such as a bond expressed in terms of money.
The real interest rate is the percentage return on an
asset such as a bond expressed in terms of what money
will buy.
The two interest rates are linked by the inflation rate in the
following approximate way:
Real interest rate = Nominal interest rate – Inflation rate
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The Interest Rate and Expenditure Plans
Consumption Expenditure
Other things remaining the same, the lower the real
interest rate, the greater is the amount of consumption
expenditure and the smaller is the amount of saving.
The interest rate effect on consumption expenditure
influences autonomous consumption expenditure.
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The Interest Rate and Expenditure Plans The Interest Rate and Expenditure Plans

Investment Net Exports and the Interest Rate

Other things remaining the same, the lower the real Net exports change when the real interest rate changes
interest rate, the greater is the amount of investment. because:

The funds used to finance investment might be borrowed
or the firm’s own (retained earnings).
Either way, the real interest rate is the opportunity cost of
those funds.
Firms invest only if the expected rate of return on a project
exceeds the real interest rate.
ƒ The exchange rate influences net exports—other things
remaining the same, the higher the exchange rate, the
smaller are net exports, and
ƒ The interest rate influences the exchange rate—other
things remaining the same, the higher the interest rate, the
higher is the exchange rate.

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The Interest Rate and Expenditure Plans The Interest Rate and Expenditure Plans

Interest-Sensitive Expenditure Curve

The interest-sensitive expenditure curve (the IE curve)
shows the relationship between aggregate planned
expenditure and the real interest rate when all other
influences on expenditure plans remain the same.
Figure 25.9 on the next slide illustrates the IE curve.

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25
MONEY, BANKING,
AND INTEREST CHAPTER

RATES

THE
END
© Pearson Education Canada, 2003

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