Money, Banking and the Financial Sector 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. Introduction The financial sector is central to almost all macroeconomic debates because behind every real transaction, there is a financial transaction that mirrors it. All trade in the goods market involves both the real sector and the financial sector. 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. Savings are returned to the circular flow in the form of consumer loans, business loans, and loans to government. 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. 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. The interest rate is the price paid for use of a financial asset. When financial assets such as bond make fixed interest payments, the price of the financial asset is determined by the market interest rate. 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. As the market interest rates go up, price of the bond goes down. Banks A bank is a financial institution whose primary function is holding money for, and lending money to, individuals and firms. The Canadian Central Bank: Bank of Canada Bank of Canada – The Canadian central bank whose liabilities (bank notes) serve as cash in Canada. 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. Money is generally accepted in exchange for other goods. Functions of Money Money is a medium of exchange. Money is a unit of account. Money is a store of wealth. 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. Money does not have to have any inherent value to function as a medium of exchange. The Bank of Canada’s job is to not issue too much or too little money. 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. Money is a useful unit of account only as long as its value relative to other prices does not change too quickly. Money as a Store of Wealth Money is a financial asset. It is simply a government bond that pays no interest. As long as money is serving as a medium of exchange, it automatically also serves as a store of wealth. Money’s usefulness as a store of wealth also depends upon how well it maintains its value. Our ability to spend money for goods makes it worthwhile to hold money even though it does not pay interest. 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++. 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. 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. The money in savings accounts is counted as money because it is readily available. All M2 components are highly liquid and play an important role in providing reserves and lending capacity for chartered banks. 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. 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. 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. M1, M2 and M3 measures only include deposits held at chartered banks. Measures containing a “+” also include deposits at other financial institutions (near banks). 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. Credit cards are prearranged loans. 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. Banks can be analyzed from the perspective of asset management and liability management. Asset management is how a bank handles its loans and other assets. 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. 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. 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. 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. 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. People soon began using the receipts as money since they knew the receipts were backed 100 percent by gold. 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. The Third Step in the Creation of Money When the goldsmith began making loans by issuing more receipts than he had in gold, he created money. The gold receipts were backed partly by gold and partly by people’s trust that the goldsmith would pay off in gold on demand. The goldsmith soon realized that he could make more money in interest than he could earn in goldsmithing. Banking Is Profitable As the goldsmiths became wealthy, others started competing in offering to hold gold for free, or even offering to pay for the privilege of holding the public’s gold. That is why most banks today are willing to hold the public’s money at no charge – they can lend it out and in the process, make profits.