What is money? How is it created?

When
does it matter to the economy?

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 four functions:

1.Means of payment
Paying people what you owe them
2.Medium of exchange
Avoid Barter. Sell for money, then use the
money to buy another good.
3. Unit of account
List prices as in a catalogue or list debts as
in an account book.
4. Store of value
Hold money now in order to buy goods
later.
Money in Canada Today
Money in Canada consists of
Currency (bills and coins)
Deposits at banks and other financial
institutions, such as chequing accounts.

M1 is narrowly defined money.

It is currency in circulation in your pockets or

in cash registers and money in chequing
accounts (demand deposits) at chartered banks.

M2 + is more broadly defined money.

It includes:
1.M1
2.plus personal savings deposits at chartered
banks,
3.plus nonpersonal (business) notice deposits
(savings accounts) at chartered banks,
deposits at trust and mortgage loan
companies,
4.deposits at credit unions and caisses
populaires, and deposits at other financial
institutions.
 Cheques, debit cards and credit cards are not
money.

Cheques and debit cards are methods of

instructing your bank to take money out of your
account and put it into some one elses account.

Credit cards are a means of instantaneously

qualifying for a loan and instructing a financial
institution to transfer the sum of the loan to the
person you are buying from. So if you pay $25
for a CD, you are simultaneously negotiating a
loan from Visa, and telling Visa to give the
money you borrowed to the music store. You
are obliged to transfer money to Visa later.

Cheques, debit cards and credit cards greatly

increase the efficiency of our banking system,
and they influence how much cash we keep in
our pocket or chequing account, but they are not
money.
The definition of money is somewhat arbitrary.

One principle is that narrowly defined money

earns no interest as in deposit accounts or cash
in your pocket.

Some broadly defined money earns interest, as

in savings accounts, but it earns much less than
government bonds.

In general, the more liquid money is, that is

the more easily it is spent, the less interest it
will earn and the more like money it is.
Cash, most chequing accounts: zero interest.
Savings accounts: low interest.
Before debit cards, you had to transfer
funds from a savings account to a
chequing account or to cash to spend
it.
G.I.C.s, Canada Savings Bonds, R.E.S.Ps
must be cashed in to be spent, sometimes
at a penalty in interest rates. They are not
money.
Chartered Banks
A chartered bank is a private firm that is
licensed to receive deposits and make loans.
A chartered banks balance sheet summarizes its
business and lists the banks assets, liabilities,
and net worth.
The objective of a chartered bank is to
maximize the net worth of its stockholders.
To achieve its objective, a bank makes loans at
an interest rate higher than that paid on deposits.
The riskier the loan, the higher the interest rate
you must pay the bank.
But the banks must balance profit and prudence;
loans generate profit, but depositors must be
able to obtain their funds when they want them.
Banks lend out depositors money, but they
must pay pack the money on demand.
They could always pay all the money back, no
matter what, if they kept all deposits in the vault.
But then they couldnt make loans, and wouldnt
make a profit. They would have to charge a
storage fee to cover the costs of bookkeeping
and protecting the vault.
Banks keep a portion of deposits as
RESERVES funds available to pay the
depositors what they owe them.
Banks now can decide the proportion of deposits
they wish to hold as cash.
Reserves are:
1. Vault Cash or currency
2. Deposits at the Bank of Canada (The
Bankers Bank, controlled by the Govt.)
These deposits can be cashed on
demand for more currency
Bank Assets that pay interest and contribute
to profit.
1. Banks also hold highly liquid and safe
assets, such as government treasury bills.
These are short term bonds of the
government. They pay interest and are not
money. The smallest are for $10,000. They
are payable in 30, 60 or 90 days, so they can
fairly quickly be turned into cash.
2. Other financial securities, such as 20 year
government or corporate bonds. These can
be sold at any time, but because it is so long
until the issuer must repay them, the price at
which they sell may vary. If the corporation
that issued them goes bankrupt, they will
become worthless.
3. Loans to firms and to individuals. The
riskier the loan, the higher the interest. If
you are starting a business, you will likely
have to pay a high loan, because the risk of
your being unable to repay the loan is high.
But Nova Scotia Power Corporation can pay
a low rate (usually prime), because it is not
likely to go bankrupt.
The sum of the banks assets equal the value of
the banks liabilities the money it owes its
depositors, that is
Vault cash + Deposits with the bank of
Canada + treasury bills + other liquid assets +
loans to firms and individual = deposits of the
public in the banks.

If everyone demanded that their bank deposits

be redeemed in currency today, banks would be
unable to repay them.
The reserves of vault cash are much less than the
value of the deposits.
The banks can ask the Bank of Canada to cash their
deposits and send them currency (the truck with the
cash would have to drive here). But the banks
deposits are much less than what the banks owe their
depositors.
The banks can sell their treasury bills and other
bonds, although all banks would be selling these
assets at the same time. Their prices would fall
sharply, and be much lower than their purchase
price.
The banks cant demand immediate payment of your
student loan.
If everyone demanded that any bank repay all its
depositors immediately, every bank would fail (be
unable to repay depositors).
Individual banks have failed. Some deposits are
insured by the government. Eventually depositors
were repaid this money. Other deposits were not
insured, and the depositors lost their money.

If all banks fail, there would be a massive financial

crisis. Many banks failed in the United States and in
Europe (not Canada) during the early 1930s and
contributed substantially to the severity of the
depression.

Financial stability is extremely important to a well

functioning economy