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									Money, Banking and the Financial Sector
      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.
      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
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.
      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
      Money facilitates exchange by reducing the cost of trading.
      Money does not have to have any inherent value to function as a medium of
      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
      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
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
       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.

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