Money and Inflation: Macroeconomics Winter 2025

• Lecture notes on money and inflation for Introduction to Macroeconomics - Winter 2025
• Learning objectives include understanding the functions of money, describing developments in payment systems, discussing facts about money and inflation, studying the relationship between money growth and inflation, and examining inflation costs

Defining Money

• Money has different meanings for different people
• Economists define money differently than the general public
• Economists consider money a financial asset with unique characteristics
• Money represents a claim that holders have on a counterparty
• Money is a type of IOU promising repayment
• Money differs from other IOUs because it is trusted and used for goods and services purchases
• Bonds are also IOUs, but can't be used for transactions and may be risky
• Money issued by a central bank is unique as everyone trusts it
• Central bank-issued money overcomes trust issues of other currencies, including cryptocurrencies
• Individuals trust money issued by the central bank/government because it will be accepted as payment and hold its real value
• Money backed by a central bank/government is known as Fiat money

Money as an IOU

• Central bank/government -> Currency -> Holders of cash
• Central bank -> Central bank reserves -> Commercial banks
• Narrow (base) money = currency + reserves
• Commercial banks -> Bank deposits -> Deposit holders
• Broad money = narrow money + bank deposits
• Base money includes currency and reserves held by chartered banks (Bank of Canada)
• Banknotes account for over 95% of currency in circulation in Canada
• Currency is a small proportion of money held by individuals in the economy
• Base money is known as narrow, central bank, or outside money and measured as M0
• Currency in circulation and reserves are determined by transaction services demand and bank holdings relative to interest rates

Central Bank Reserves

• Chartered banks have accounts at the Bank of Canada and hold reserves
• Bank of Canada reserves are electronic records of central bank debts to each bank
• Reserves aren't required, meaning banks aren't legally obligated to maintain liquidity
• Canada abandoned required reserves for chartered banks in 1992
• Bank of Canada reserves are used by chartered banks to make payments when settling accounts

Bank Deposits

• Most money circulating in the economy is broad money via bank deposits of households and firms
• Broad money consists of M1 and M2
  • M1 = M0 + demand deposits
  • M2 = M1 + personal savings deposits + term deposits + money market mutual funds
• Financial innovations forced the Bank of Canada to broaden the definition of M1 and M2 including measures such as M1+, M1++, M2+, and M2++

Money Supply in Canada

• Base money on December 2024 totaled $244 billion
• Broad money on December 2024 totaled $2.63 trillion

Commercial Banks Creating Money

• Commercial banks create deposits through new loans, effectively making new money
• Banks credit the customer's bank account with the loan amount, instead of handing out cash
• Banks create an equal amount of deposits when making a loan due to double-entry accounting
• Banks create money anytime they make a loan since broad money includes deposits
• Banks create money out of nothing under certain conditions
• Money creation relies more on lending than the money multiplier

Bank Deposits and Money Creation

• Liabilities and capital are Deposits
• Assets are Loans to households and firms
• When banks make a loan, Assets and Deposits increase, leading to an increase in the Money supply

Limits on Money Creation

• Banks can't create infinite money
• Capital requirements and regulations constrain money creation
• Demand for loans from customers also limits money creation
• Monetary policy limits money creation
• The Bank of Canada influences the Overnight rate and Bank rate
• The Bank of Canada influences the cost of borrowing by raising the Overnight rate

Bank Capital

• Regulators protect depositors by forcing banks to hold a minimum amount of capital
• Capital requirements ensure banks absorb losses during financial stress without becoming insolvent
• Minimum capital requirements are to protect depositors and reduce bank failures
• In Canada, the Office of the Superintendent of Financial Institutions (OSFI) sets minimum capital requirements for financial institutions
• The total capital requirement ratio in Canada is 8% with a 2.5% minimum capital conservation buffer, totaling 10.5%
• Financial institutions in Canada must hold a minimum of 10.5 cents in capital for every dollar of risk-weighted assets
• The solvency of the banking system and depositors' money is endangered If the minimum capital requirement is too low
• Minimum capital requirement impedes the ability of banks to make loans if it is too high
• OSFI increases the minimum capital requirement if banks are becoming vulnerable to economic shocks or potential losses
• Banks in Canada hold more capital than required by OSFI, which reduces the ability of banks to expand their balance sheets by creating money

Example of Bank Capital

• RBC has $100 in equity and $1,200 of loans
• $300 of loans are completely safe (probability of default = 0)
• $900 are risky (probability of default >0)
• The weighted assets of RBC that are deemed risky is $900
• The capital ratio is 11.11%
• RBC satisfies the minimum capital ratio requirements of 10.5% imposed by OSFI

Limits on the Creation of Money Example

• A new demand for a risky loan of $500 is received by RBC
• Granting the new loan will increase RBC's total risk-weighted assets to $1400
• If capital is unchanged, the capital ratio would be 7.14%
• RBC would not be able to grant the loan because it would not satisfy its capital minimum requirements
• The limit on creating new money comes from RBC not satisfying the minimum capital requirements

Characteristics of Money

• Money is an IOU
• Modern money is mostly bank deposits
• All economies use paper or fiat money
• Fiat has the following characteristics:
  • Durable: Should not be spontaneously combustible
  • Easily transportable: Should not be like money on Yap island, Rai stones
  • Divisible: Small denominations should exist to facilitate transactions
  • Units of standard value: Money over time must look the same and should be easily recognized
  • Worthless as a commodity: Notes and coins should not have a value that is higher than their actual denomination
  • Uncounterfeited: Money should be safe and not physically or electronically reproducible

Functions of Money

• Money serves three main functions:
  • Medium of exchange
  • Medium of account
  • Store of value
• The medium of exchange and unit of account functions are the most important
• All three functions are linked to each other

Medium of Exchange

• Money is accepted as a means of payment for other goods and services
• Other assets and commodities are not used to buy goods and services
• A barter economy is where goods and services are exchanged for goods and services
• A monetary economy is where money is used to purchase goods or services
• The double coincidence of wants must prevail for barter to operate
• Large economies with barter systems can be very inefficient as individuals are forced to spend a large amount of their time searching for suitable partners for trade
• Search costs under barter are very high, and the probability of success is low
• A monetary economy uses a medium of exchange called money to conduct transactions
• An individual searches for the good/service and then exchanges money for it
• The double coincidence of wants is eliminated in a monetary market
• Search costs are lower in a monetary economy and the probability of exchange is much higher

Medium of Account

• Money serves as a medium (or unit) of account
• Prices are quoted in Canadian dollars in Canada
• The unit of account is perhaps the most distinct and vital function of money
• Relative price (real price) is defined as the ratio at which exchanges can take place for each pair of goods
• Relative price of good X in terms of good Y is the number of units of Y that needs to be exchanged for a unit of good X
• The relative price of good X in terms of money is the amount of money one has to give up to obtain X
• If juice costs $5, $5 must be given up to buy it
• If one is giving up more money to acquire juice, the relative price of the juice has increased
• The purchasing power or real value of money must be falling in that scenario
• There is an inverse relationship between the real value of money and the price of goods and services
• The the medium of exchange is used as the only medium of account in most economies
• Prices are quoted in Canadian dollars in Canada
• In some economies, prices are quoted in local currencies besides the U.S. dollar
• Dollarization is when people no longer trust or accept the local currency due to hyperinflation
• Money serves as an essential unit of account to compare a barter economy and a monetary economy
• The relative price of each good has to be computed in terms of all other goods & services in a barter economy
• An economy with a large number of goods and services can be complicated and costly
• All goods and services are priced in terms of the monetary unit in a monetary economy
• Money reduces the complexity of transactions and the time involved in calculating relative prices

Store of Value

• The third function of money is that it is a store of value
• Money allows the transfer of purchasing power from the present to the future
• People acquire and save money to save part of their current income for use at a future date
• Money isn’t the only store of value; bonds, stocks, commodities, paintings, antiques, etc serve as a store of value
• Money's function as a store of value is not as distinct

Money as Store of Value

• Many other assets are better than money as stores of value
• Money pays no interest and earns no return
• Bondholders earn a nominal interest rate i, and the opportunity cost of holding money is equal to i
• Real value of money is inversely related to the price level, and is not a good store a value when prices are increasing
• There are better assets to protect investors from the effects of rising prices

Monetary Standards

• Economies have adopted money as a medium of exchange, due to the inefficiency of the barter system
• Specific standards, rules, and regulations govern money’s circulation
• Governments and central banks can print money
• Two types of standards have emerged in recent modern history including commodity and monetary standards
• A third standard appeared in the last ten years being the crypto standard

Gold Standard

• Fiat currency was used but collateralized by a commodity limited in supply under the commodity standard
• The IOU in this case was units of gold as units of currency that could be exchanged
• Gold was used to back every unit of currency in circulation in an economy under the Gold standard
• The gold standard was widely used in the 19th century, and most countries abandoned it after WWI
• Many countries abandoned the gold standard during the Great Depression of the 1930s
• The gold standard limits the ability to print money without check which can lead to hyperinflation
• A government can only increase the money supply if it has enough gold to back it up
• The gold standard does not offer much flexibility and gold can prevent governments from printing excessive amounts of money and stoking inflation
• The gold standard is ill-equipped to deal with situations when the central bank needs to increase the amount of liquidity in an economy
• High interest rates prevented economies from moving away from the depression since the cost of borrowing to consume and invest was too high
• Abandonment of the gold standard is credited as reason why countries like the U.S. and Canada recovered from the Great Depression

Fiat Standard

• The end of the gold standard led to the Fiat money system
• The medium of exchange is not backed by any valuable or physical asset such as silver or gold under a fiat standard
• Money is backed by a promise to keep the purchasing power stable over time
• Fiat standard allows central banks to use the money supply and interest rates to control the price level

Electronic Money

• Electronic money is used more to settle transactions instead of cash
• Examples of e-money are PayPal, ApplePay, Google Wallet, Venmo, Square, WeChat, AliPay, Paytm, credit and debit cards
• Electronic money is an innovation in payment systems and is a digital form of fiat currencies controlled by central banks or governments
• Transactions involve intermediaries
• For example, PayPal and the bank act as intermediaries between the buyer and the seller

Cash Alternative

• Use of cash as payment is disappearing in some countries
• More consumers in Sweden and China are using electronic payments instead of cash
• Chinese platforms have the biggest e-payment market in the world 
• Alipay in 2023 had over 1.3 billion users and handled over half of China's $50 Trillion payment market
• The global user base of Apple Pay is around 500 million

Mobile Payments

• Cash use in most economies will fall dramatically in the next 5-10 years
• The use of cash will even disappear in the next 5-10 years
• China, India, Scandinavian and some African countries are at the forefront of mobile payments
• Canada and the US are lagging in terms of adopting mobile payments
• Only about 50% of smartphone owners in Canada, use their phones to pay for goods and services
• Approximately 80% of smartphone owners in China, India and Sweden use their phones to pay for goods and services

Death of Cash?

• Many people are predicting the complete demise of cash
• Cash is still used for most transactions
• In Canada, in 2022, cash represented 10% of the total volume, with credit cards at 33% and debit cards at 31%
• Proponents of electronic money argue that cash's disappearance has advantages:
  • Reduction in crime
  • Fall in transaction costs
  • Less tax evasion
• Cash may never disappear for these reasons:
  • Reliable and easy to use
  • Widely accepted
  • Provides complete anonymity
  • Secure (no cyber fraud)
  • Is not subject to breakdowns in technology

Digital Currency

• Cryptocurrencies or digital currencies have emerged as a third monetary standard
• There are over 20,000 cryptocurrencies in existence
• Bitcoin and Ether are the most famous and traded cryptocurrencies
• Cryptos are primarily stores of value but are not a medium of exchange or unit of account

Electronic Money vs Crypto

• Electronic money is regulated and centralized, with Value equaling fiat currency in circulation
• KYC rules apply to Electronic money, and there is a trusted centralized custodian of records
• Cryptocurrency is less regulated and more Decentralized, with Value that is not directly related to fiat currency
• Cryptocurrency is Largely anonymous (KYC will come) and transactions are recorded on a distributed and public digital ledger (blockchain)

Digital Currency Standards

• Two types of Digital currency include Cryptocurrencies and Central Bank Digital Currency (CBDC)
• Cryptocurrencies - privately issued, completely decentralized and not backed by governments
  • Decentralized, issued by a private entity (Bitcoin, Ether, etc..)
  • Tens of thousands in circulation, and most of them are not very well regulated (KYC and AML)
  • Value is not directly related to fiat currency, except for stable coins such as Tether and others
  • Potential to significantly disrupt economies, payment platforms and systems and banking sector (Tether)
• Central Bank Digital Currency (CBDC) a digital form of fiat money - backed by the government
  • Issued by the government or central bank - centralized
  • CBDC will be a direct liability of the central bank just like paper cash unlike money in circulation
  • Potential to disrupt the banking system - interest-bearing accounts with the BoC

Crypto vs. CDBC

• Cryptocurrencies/CDBCs will one day replace fiat currency and alter payment/banking systems and undermine how central banks conduct monetary policy
• Cryptocurrencies would be the primary medium of exchange, unit of account, and store of value with peer-to-peer transactions
• The surge of some private cryptocurrencies and new ones is pushing central banks to innovate and think about issuing a CBDC
• In 2023, over 80% of central banks were investigating, conducting experiments, or issuing CBDCs

Why Central Banks want CDBC

• Desire to manage the Decline in the use of cash
  • In Canada, between 2017 and 2022, the annual value of cash transactions declined by 41%
• Support for the Digitization of the economy
  • Competition from private digital currencies
  • Need for faster and cheaper cross border payments
  • Growing importance of E-commerce
  • Covid-19 has accelerated this trend
• Concern of a Threat to monetary sovereignty and ability to conduct monetary policy

Threats

• The introduction of decentralized cryptocurrencies causes central banks to lose monopoly control as well as the ability to conduct monetary policy
• Cryptocurrencies may reduce the demand for central bank money or displace government currencies entirely
• If Canadian dollars are no longer the unit of account but rather Bitcoin, the BoC's monetary policy may become irrelevant
• Central banks need to create digital currencies to maintain monetary sovereignty

Cryptocurrencies as a Government Threat

• Cryptocurrencies do not currently represent a threat to government-issued currency due to a number of issues:
  • No credible candidate that can function as a medium of exchange and unit of account in Canada
  • Price volatility
  • High transaction costs
  • Cyber-security and thefts
  • Convenience and market penetration
  • Technological barriers (scalability, interoperability)

Advantages

• Advantages of using a CBDC or digital Canadian Dollar include improving financial access and inclusion, providing a faster and cheaper financial infrastructure and the ability to provide more liquidity

Issues with CBDC

• CBDC has a number of issues that include those with low financial literacy, privacy and cyber security concerns and the potential for serious competition

The Future

• In the Future there is a question of Whether it will be decentralized or centralized money
• Also, there is a question of whether intermediaries are going to disappear with a question of can the banking and payment system, fundamentally change

Money and Inflation

• The focus includes the short and long-run relationship between money, output and prices, how money is correlated with output and inflation, and if money can influence output

Short Run

• Most economists agree there is a positive correlation in the long run
• Economists disagree about the size of short run correlation in the long run
• Most economists agree that money causes inflation in the long-run, but they do disagree on whether money causes output and inflation in the short-run
• Most economists agree that the correlation is zero in the long-run and that money is neutral

Empirical Measures

• The money supply is the amount of money in an economy that is available for settlements and payments
• Measuring that amount would require only notes and coins
• Coins issued by the Bank of Canada represent only a tiny portion of all the money circulating in the economy
• Most of what we call money is in the form of bank deposits
• Central banks formally measure the money supply using different monetary aggregates and monitors is carefully

Monetary Quantities

• MO: Currency in circulation plus central bank reserves
• M1: Currency in circulation plus current, demand and personal chequing accounts (net of private sector float)
• M2:a broader measure, includes M1 plus personal savings accounts and other chequing accounts, term deposits, and non-personal deposits notice deposits
• Central banks used to monitor measures of money very carefully
• Financial innovation also changed relationship between money and inflation
• Central banking monetary regime has now failed as inflation rose in the 1970s
• The relationship has now weakened because of new technology

Measures

• Measurement became difficult because of financial innovations
• Innovation changed relationships between money, output and inflation
• Relationships debated on strength and causality and they relate

Economic Relationships

• Quantitive Theory of Money (QTM) - The Money Supply is directly proportional to price level
• Most believe money causes output and inflation in the short run and that prices and supply money have related factors

QTM

• Economists agree with relationships in long run despite short run variation
• Studies have shown that the growth rate and observation of almost the same relationship is equal in all environments
• Supports QTM

QTM Equation

• Irving Fisher popularized the QTM in 1911
• Has the equation
  • MV = PY
    • M denotes the amount of money circulating in the economy (money supply)
    • V the transactions velocity of money
    • P the general price level
    • Y real GDP
    • P Y is the value of all transactions undertaken with money (nominal GDP)

QTM Assumptions

• Y and V are exogenous
• Economy is at full employment
• The velocity, the rate at which money changes hands is independent of all varibales.

Authorities

• Monetary authority changes size of money
• The Price on other hand endogenous

Equation

• the price level is determine by the level over the money supply times the Velocity over real gdp

Change Equation

• Growth of money supply equates to equivalent change in price level assuming constant velocity and output
• A change in the money supply proportionally affects the price levels in the long run
• The QTM implies that supply does not effect variables since those are determined
• Changes only happen only to affect variable in long run

Summary

• The model has implications
  • The Central bank has the main point to control prices
  • The money has a clear goal that relies on the relationship of Y factors, capital, labor and preference to determine output
  • Bank is focused on this process

Evidence

• In practice there is a large body of data to support QTM with evidence from Mccandless that says the rates across different locations support QTM

Examples

• Nov. 2008, the annual rate of inflation rate reached 90 sextillion
• Germany experienced this and many governments have experienced it in printing too much money because revenue obtained from printing money is known as seignorage or to finance projects

Fisher Equation

• How does that compare to loans is one part of consideration
• That has consideration to other effects so has this equation
• Many will also measure this to inflation
• This equation has been found to in long run with a good measure and is known as “Fisher effect”
• Showed a good indication of the U.S with years of data

Ex Ante vs. Ex Post

• The difference can be determined by considering factors with economic models

Cost of Inflation

• Includes Economic agents and both expected and unexpected with differing calculations

Conclusions

• Inflation includes tax brackets, misallocation of resources, and the redistribution of wealth

Deflation

• Includes reverse of inflation and wages
• Those factors reduce confidence and negatively impact the outcome
• Conclusion has definition and studies