Chapter 24

Money, the Price Level and Inflation

What is Money?
Money is any commodity or token that is generally acceptable as the means of payment.
A means of payment is a method of settling a debt.
When payment has been made, there is no remaining obligation between the parties to a
transaction.
Money performs three other functions:
o Medium of exchange
o Unit of account
o Store of value
A medium of exchange is any object that is generally acceptable in exchange for goods and
services.
Without money, it would be necessary to exchange goods and services directly for other goods
and services an exchange called barter.
A unit of account is an agreed measure for stating the prices of goods and services.
In the absence of a standardized unit of account, keeping track of prices and comparing prices
would be difficult.
A store of value is any commodity or token that can be held and exchanged later for goods and
services.
The more stable the value of a commodity or token, the better it can act as a store of value and
the more useful it is as money.
Money in Canada today consists of currency and deposits at banks and other financial
institutions.
The coins and Bank of Canada notes that we use today are known as currency.
The two main measures of money are called:
o M1
o M2
M1 consists of currency held outside the banks and chequable deposits of individuals and
businesses.
M1 does not include currency held by banks, and it does not include currency and bank
deposits owned by the government of Canada.
M2 consists of M1 plus all other deposits.
Deposits are money but cheques are not money.
A cheque transfers a deposit from one account to another.
Credit cards and debit cards are not money.

The Banking System
A depository institution is a private firm that takes deposits from households and firms and
makes loans to other households and firms.
The deposits of three types of depository institutions make up the nations money:
o Chartered banks
o Credit unions and caisses populaires
o Trust and mortgage companies
To provide security for its depositors, a bank holds reserves, which are currency in a banks vault
plus its deposit at the Bank of Canada.
A bank has four types of assets: overnight loans, liquid assets, securities, and loans.
Banks provide four services for which people are willing to pay: create liquidity, minimize the
cost of borrowing, minimize the cost of monitoring borrowers, and pool risk.
The Bank of Canada is Canadas central bank, a public authority that supervises other banks and
financial institutions, financial markets, and the payments system and conducts monetary
policy.
The Bank of Canada makes loans to banks and serves as the lender of last resort, which means
that it stands ready to make loans when the banking system as a whole is short of reserves.
How Banks Create Money
We will use the work bank to refer to any depository institution.
Banks create money by making loans.
We will start by looking at a one-bank economy.
The fraction of a banks total deposits that are held in reserves is called the reserve ratio.
The desired reserve ratio is the ratio of reserves to deposits that banks wish to hold.
A banks desired reserves are equal to deposits multiplied by the desired reserve ratio.
Actual reserves minus desired reserves are excess reserves.
When a bank has excess reserves it makes loans.
We call the leakage of currency from the banking system the currency drain, and we call the
ratio of currency to deposits the currency drain ratio.
There are nine steps in the sequence of money creation:
1. Banks have excess reserves.
2. Banks lend excess reserves.
3. The quantity of money increases.
4. New money is used to make payments.
5. Some of the new money remains on deposit.
6. Some of the new money is a currency drain.
7. Desired reserves increase because deposits have increased.
8. Excess reserves decrease, but remain positive.
The process repeats until the banks have created enough deposits to eliminate their excess
reserves.
The monetary base is the sum of Bank of Canada notes outside the Bank of Canada, banks
deposits at the Bank of Canada, and coins held by households, firms, and banks.
The money multiplier is the ratio of the change in the quantity of money to the change in
monetary base. So for example, if reserves increase by $100,000 and the quantity of money
increases by $300,000 then the money multiplier is 3.
Read pp. 586-587 in your textbook to work through the formula for the money multiplier.
The Market for Money
The quantity of money that people choose to hold depends on four main factors:
o The price level
o The nominal interest rate
o Real GDP
o Financial innovation
The quantity of money measured in dollars is nominal money.
The quantity of nominal money that people plan to hold is proportional to the price level.
The quantity of money measured in constant dollars is called real money.
Real money is equal to nominal money divided by the price level.
The quantity of real money held is independent of the price level.
The quantity of real money that people plan to hold depends on the interest rate.
The reason is that the interest rate is the opportunity cost of holding money.
The higher the interest rate, the greater the opportunity cost of holding money and the smaller
is the quantity of money that people plan to hold.
The quantity of real money that people plan to hold depends on real GDP.
The reason is that money is held to enable people to undertake transactions, and the larger the
amount transacted, the greater is the amount of money that people hold.
The quantity of real money that people plan to hold depends on financial innovation.
Five financial innovations have changed the quantity of real money that people hold:
o Daily interest chequable deposits
o Automatic transfers between chequable deposits and savings deposits
o Automatic teller machines
o Debit cards and credit cards
o Internet banking and bill paying
The demand for money curve is the relationship between the quantity of real money demanded
and the interest rate when all other influences on the amount of money that people wish to
hold remain the same.



The figure shows the demand for money curve.
A change in the interest rate brings a movement along the demand curve.

The figure below shows a change in the demand for money.
A change in real GDP brings a shift of the demand curve.
Financial innovation also shifts the demand for money curve.

Money Market Equilibrium
The interest rate is the amount received by a lender and paid by a borrower expressed as a
percentage of the amount of the loan.
The interest rate on a bond varies inversely with the price of the bond.
Example: The Government of Canada issues a bond that pays $5 a year in perpetuity.
o If the price of the bond is $100, the interest rate is 5%.
o If the price of the bond is $50, the interest rate is 10%.
o If the price of the bond is $200, the interest rate is 2.5%.
When the interest rate is high, people try to economize on holding money and put more of their
wealth into bonds.
When the interest rate is low, people hold more money and put less of their wealth into bonds.
The quantity of money demanded varies inversely with the interest rate.
The quantity of real money supplied depends on the price level and the quantity of nominal
money that the Bank of Canada enables the banks to create.
For a given price level, the Bank of Canada can determine the quantity of nominal money.
So, the quantity of real money is determined by the actions of the Bank of Canada.
The interest rate is determined such that the quantity of money demanded equals the quantity
supplied.
The figure shows money market equilibrium.

Here, the equilibrium interest rate is 5 percent a year.
At interest rates above 5 percent a year, the quantity of money demanded is less than the
quantity supplied.
People try to get rid of money by buying bonds.
Bond prices rise and the interest rate falls.
At interest rates below 5 percent a year, the quantity of money demanded exceeds the quantity
supplied.
People try to get more money by selling bonds.
Bond prices fall and the interest rate rises.
Only when the interest rate is 5 percent a year are people not trying to change their holding of
money, so the interest rate is constant.
The Quantity Theory of Money
The quantity theory of money is the proposition that in the long run, an increase in the quantity
of money brings an equal percentage increase in the price level.
The velocity of circulation is the average number of times a dollar of money is used annually to
buy the goods and services that make up GDP.
GDP equals the price level (P) multiplied by real GDP (Y).
Call the quantity of money M.
Then V = PY/M
Rearranging this equation, gives the equation of exchange: MV = PY.
We can also express the equation of exchange in growth rates: Money growth rate + Rate of
velocity change = Inflation rate + Real GDP growth rate
Solving this equation for the inflation rate gives: Inflation rate = Money growth rate + Rate of
velocity change - Real GDP growth rate
In the long run, the rate of velocity change is approximately zero, so: Inflation rate = Money
growth rate - Real GDP growth rate