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Intro Macro Module 1: Introduction to Economics
This module covers:
What is economics, why it matters.
Supply and Demand
What is economics?
The study of how society manages its scarce resources. This requires choices, both at the individual
level and the societal level.
Why study economics?
Economic analysis can help us analyze the choices we face as a society, and provide a framework
for evaluating government policy decisions.
How do we manage our scarce resources?
For the most part, we use the market system, which is really just the combined actions of millions
of individuals and firms.
What actions? How much to work, what to buy, what to produce, how much labour to hire etc.
Note that the market system does not require any kind of central planning, or anyone telling people
what to do, or what to buy. People simply make choices, and resources are allocated according to
these choices.
In Canada, we have a mixed economy, in which we have decided to allocate some resources at the
societal level, like infrastructure spending, education spending, and health spending. But these
choices are not made separately from the market system, they still exist within it. How much we
spend on education, for example, depends on wages and the cost of supplies determined in the
market.
Societal decisions mostly come in the form of government policy, such as what to tax, how much
to tax it, and how to spend those tax revenues. Tax policy is often used to achieve societal
objectives, like reducing pollution, reducing inequality, or encouraging innovation. This can
involve the use of taxes and subsidies to affect the behaviour of buyers in a market.
What do individual and societal choices depend on?
Needs and wants, but also prices. (See Video 1 for more discussion of prices)
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Supply and Demand
Demand
Demand curve: graph relating the price of a good and the quantity demanded
In general, when prices rise, quantity demanded falls. There are some exceptions, explored in
more detail in micro courses.
Changes in various factors can cause the demand curve to shift:
eg. income, prices of complements and substitutes, tastes and preferences, population etc.
Supply
Supply curve: graph relating the price of a good and the quantity supplied
In general, when prices rise, quantity supplied also rises.
Factors that cause the supply curve to shift:
eg. input prices, technology, number of sellers
What’s usually missing from a microeconomic discussion of supply and demand:
Time. (See Video 1 for more discussion of Supply and Demand)
Video 1 Questions
You should be able to answer the following questions after watching Video 1.
1. Prices: What is a price? Does it represent the value of something? Why are prices
important? What role do they perform in a market economy?
2. Why must we take time into account when analyzing supply and demand? What disruptions
can a timing difference between a shift in demand and a shift in supply cause in the market
for a good or service?
3. Explain the circular flow model of the economy.
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Intro Macro Module 2: Standard of living, production, and growth
This module covers:
Measuring standard of living: Gross Domestic Product (GDP)
Production and Growth
How do we measure how the economy is doing? How do we measure economic progress?
Economists use Gross Domestic Product (GDP) to keep track of everything produced in the
economy in a given period of time, by adding up the total value of products and services bought
and sold (please see your textbook for the formal definition). It is also used as a measure of
society's well-being/standard of living. Canada’s GDP in 2019 was approximately $1.7 trillion,
making it the 10th largest economy in the world. On a per capita basis, Canada’s 2019 GDP was
$46,213 per person (17th in the world). For comparison, the GDP of the United States in 2019 was
over $21 trillion, or $65,112 per person. Does this mean that people in the United States have a
higher standard of living than people in Canada?
How does the amount of production translate into standard of living?
The idea is that societies that have more stuff will have a higher standard of living. So if we can
produce more stuff, our standard of living will be higher. We can also think of it from the income
perspective: the more we can produce, the higher our income (as a society), since we can sell all
of the extra production that we don’t need, and use the income to purchase what we do need (or
want). A higher income means we can obtain a higher standard of living.
BUT: There are some problems with equating GDP with standard of living. (See section 6.5 of the
textbook, which will be discussed in Video 2 in more detail).
Comparing the components of GDP in Canada and the US:
Canada
Consumption
58%
Investment
21%
Government Spending
20%
Exports
33%
Imports
-32%
Sources: Statistics Canada, Bureau of Economic Analysis
United States
70%
18%
17%
13%
-18%
[Note: as the textbook mentions, we care about Real GDP rather than nominal GDP, since Real
GDP is adjusted for changes in prices. More on this when we discuss the CPI and inflation in
Module 4.]
Economists typically focus on the change in GDP from one year to the next. For most of the past
100 years, GDP has increased at a fairly steady rate, with some periods of faster growth, other
periods of slower growth, and some periods of decline. A significant fall in GDP is a recession,
and a recession that lasts for a long time is called a depression. Does a recession/depression mean
standard of living has fallen? Generally speaking, if we are producing less as a country then our
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incomes are lower, which means our standard of living will fall. But recessions tend to impact
different sectors of the economy differently, so that some people will see a fall in their living
standards (for example, if they lose their jobs), while others may see no change. We will discuss
this more in Module 3. Something to note about the current recession is that it has impacted the
entire economy at the same time, which means a very broad decline in standard of living, not just
in Canada but all over the world.
What if we borrow money and spend it? How does this affect GDP?
Spending can be increased using both public debt (government borrowing) and private debt
(borrowing by households and businesses). If we spend more, GDP increases, so it follows that
standard of living will increase. But will this last? It depends on what we spend the money on.
Productive debt: debt that finances new plant and equipment (or other capital accumulation) is
productive debt. It adds to existing capital that, in turn, earns future debt service (i.e. will earn
enough income to cover interest payments). Think of this as debt that is used to invest in the future,
that is, we produce something now, like a new machine, that will produce even more in the future.
So GDP increases in the present, and will also increase in the future.
Unproductive debt: debt that is not self-financing. This occurs when we borrow and spend it on
consumption. GDP increases today, but eventually the debt will have to be repaid, with interest,
which means we will have less money available in the future.
When using unproductive debt, the government is, in effect, borrowing from future taxpayers.
GDP will be increased today, but decreased in the future. So current generations will have a higher
standard of living, but this reduces the standard of living of future generations.
When households and businesses use unproductive debt, the result is the same, you are simply
trading a higher standard of living today for a lower standard of living in the future, which is the
opposite of how human progress has been achieved since the dawn of civilization.
There is evidence that debt has become much less productive over time.
Some numbers:
Year
1994
2019
Global GDP
$28 trillion
$87 trillion
Global Debt
$40 trillion
$250 trillion
Over the 25 years from 1994 to 2019, global GDP grew at approximately 4.6% per year. Over
the same time period, global debt grew at 7.6%. This is unsustainable (to be discussed in more
detail in our special topics series).
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Economic Growth
A country's standard of living depends on its ability to produce goods and services.
Why? They can be sold, and the income can be used to acquire other goods and services.
Almost all of the economic growth in human history has happened in the last 200 years (to be
discussed in more detail in our first special topic).
Property Rights and Economic Growth
Property rights are a key component in a well-functioning economic system. Would you go to the
trouble of producing something if you knew it would be stolen as soon as you finished it? Property
rights that are not enforced discourage investment. Throughout the history of civilization, nations
with well-defined and enforced property rights have developed faster than nations that had neither.
Just look at which countries today are developed versus those that are developing to see where
property rights have been enforced consistently over the last two hundred years. The only
exceptions to this are several oil-rich countries, but while these countries are wealthy, they have
massive inequality, far more than exists in any other developed countries. Property rights apply to
far more than just physical property. Importantly, they also apply to intellectual property. The
development of the patent system went hand-in-hand with the tremendous innovation of the
industrial revolution.
What is the main driver of increases in standard of living?
Productivity: the quantity of goods and services produced from each hour of a worker's time.
What determines productivity?
Capital: machines, technology, education and training (human capital), basically anything that
enhances a person's ability to produce.
Policies to improve productivity will be discussed in Video 2.
The interaction of productivity, technology, and economic convergence, will be discussed in more
detail in our first special topic.
Economic Growth, Population Growth, and Demographics
Rapid population growth stretches the resources of many developing countries. Birth rates tend to
fall, however, as countries become richer. This leads to a demographic transition, whereby
population growth falls despite longer life expectancy, which can lead to a higher ratio of elderly
to the working age population. This puts a strain on the welfare system, as pensions and healthcare
become more costly, but the tax base becomes smaller as the working age population shrinks,
putting a greater burden on workers. This is an ongoing issue that Canada will have to deal with
over the next decade and beyond. More details in Video 2.
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Video 2 Questions
You should be able to answer the following questions after watching Video 2.
1. Why is GDP a flawed measure of standard of living?
2. Why is it important to look at both the level of GDP and the growth rate of GDP?
3. How does the age structure of a country’s population affect economic growth?
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Intro Macro Module 3: Unemployment
Unemployment is the biggest economic policy issue that a country faces. But we need to look
beyond the unemployment rate in order to get a full picture of unemployment in the economy. This
is due to the way the unemployment rate is defined, as it excludes people who are categorized as
being ‘out of the labour force’, and also does not give any indication of people who are
underemployed. This is why it is important to also look at estimates of the labour force
participation rate, as well as any estimates of underemployment.
Measuring Unemployment
Every month, Statistics Canada conducts a survey of 50,000 households, called the Labour Force
Survey.
Every person 15 and older is put in one of 3 categories:
- employed
- unemployed
- not in the labour force
A person is unemployed if that person is on temporary layoff or is looking for a job.
Video 3 will go into more detail on Canada’s unemployment rate and how it is measured.
Public Policy and Unemployment
Government policies can affect the amount of frictional unemployment in the economy.
How?
1. Through employment agencies, which provide information about job vacancies
2. Training programs for unemployed workers
3. Employment Insurance
Employment insurance (EI) is a government program that partially protects workers’ incomes
when they become unemployed. To qualify, a worker must have worked for some minimum
amount of time over the past year. Workers then receive a fraction of their previous wages for a
specified number of weeks. The minimum work period and number of weeks during which a
worker will receive benefits depends on local labour market conditions.
Benefits of EI:
Reduces income uncertainty and allows for a longer job search, which often results in a better job
than would have been found otherwise.
Problems with EI:
EI can increase unemployment:
Unemployed workers may expend less effort in searching for a new job, and are more likely to
turn down unattractive job offers. Note that this only applies when the economy is doing well,
since during a recession, workers will be less picky about accepting jobs.
More details on public policy and unemployment in Video 3.
Employment and the state of the economy
One way to define a recession is not purely by whether GDP is contracting, but if there is a large
increase in the number of unemployed workers. Businesses often have to make hiring decisions
based on their plans for the future: if they think the economy is doing well, then they may choose
to expand, and will hire more workers. If they think economic prospects are poor, then they will
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choose either to stop hiring, or to let go of workers. Obviously economic conditions will have a
big effect on unemployment. Long-term unemployment, which typically occurs as a result of bad
recessions, can have a particularly devastating impact on workers. Not only is income lost during
the recession, but so is the opportunity to gain valuable skills and job experience, which will impact
income for many years to come.
But unemployment can also have a big effect on the economy. The onset of a recession can lead
to a self-reinforcing cycle: say consumers cut back on spending for some reason (like, I don’t
know, a global pandemic…). This causes businesses to cut back production due to a decline in
revenues, and if conditions persist, businesses will start laying off workers. Unemployed workers
lose income and cut back on spending, which leads to a further decline in revenues for businesses,
and further job cuts, and lower spending, and so on. The purpose of programs like EI is to maintain
incomes while people are out of work, to keep standards of living from falling, but also to stop this
self-reinforcing cycle before it begins. If consumer incomes can be maintained, then they can keep
spending and other businesses and workers do not lose income. This works in a normal recession,
when only part of the economy is not doing well. The current recession has hit the entire economy,
so the cushioning impact of EI will be less effective. More discussion on this in Video 3, and in
the Special Topics of this course.
Video 3 Questions
You should be able to answer the following questions after watching Video 3.
1. What does it mean when we say that unemployment is a lagging indicator?
2. Why is it necessary to look at other statistics, like the labour force participation rate, in
addition to the unemployment rate?
3. What might the impact of the Canadian Emergency Response Benefit (CERB) be over
the next few months?
4. Although there were a huge number of initial layoffs at the beginning of the economic
shutdowns in March, we should actually be more concerned about layoffs that are
happening now. Why is that the case?
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Intro Macro Module 4: Inflation
Why should we care about inflation?
Inflation is an increase in the cost of living. If our cost of living goes up but our income does not, then our
standard of living has fallen, as we cannot purchase the same amount of goods and services as before. To
counter this, many contracts (salaries, pensions) include cost of living adjustments, which are automatic
increases tied to the rate of inflation. Another problem caused by inflation is that inflation always erodes
the return you receive from saving money, since the benefit of any interest you earn is reduced by the fall
in purchasing power. On the other hand, if you are a borrower and not a saver, then inflation benefits
you. Inflation makes debt easier to repay, since the debt is repaid in dollars that are lower in value. This
can have an effect on the financial decisions that people make (which I will discuss in Video 4).
Real and Nominal Interest Rates
Say I deposit $1000 in a bank account earning 2% interest per year. After one year I get $20 interest.
Am I $20 richer than last year? If prices have risen, my dollars buy less than they did one year ago.
Say inflation was 3%. So what used to cost $1000 now costs $1030. Overall, my purchasing power has
actually fallen by $10.
Interest rate bank pays: nominal interest rate
Interest rate corrected for inflation: real interest rate
Real interest rate = Nominal interest rate – inflation rate [approximately]
In our example, real interest rate = 2% - 3% = -1%
Is inflation a problem in Canada?
The biggest economic concern facing central banks of developed economies, Canada included, for the last
4 decades has been the threat of high inflation. This threat was largely neutralized starting in the early
1990s, when central banks (and the Bank of Canada) began a policy of 'inflation targeting' with the goal
of keeping inflation between 1%-3%. This policy was largely helped along by the trend of globalization, in
particular the emergence of China as a low-cost producer of consumer goods, which has kept prices low
for the last 20 years. Inflation in Canada today fluctuates mainly as a result of changes in the price of oil.
Why not aim for 0% inflation?
Why do we deliberately set a policy of reducing our purchasing power by 2% per year? The main reason
is that policymakers want to avoid deflation at all costs. Deflation is associated with the most severe
recessions in modern times (like the Great Depression), and while deflation can increase purchasing
power, this will not lead to an increase in the standard of living. If businesses and individuals expect
deflation, they may change their behaviour as a result. Businesses may cut back on production or they
may layoff workers in order to cut costs. Individuals may choose to delay major purchases (like houses
and cars) since they expect prices to be lower in the future. This feeds back into lower business production
and less income for workers. Falling prices as a result of technological change is a huge boost to standard
of living, but remember that inflation is measuring prices across the whole economy. Falling prices across
the whole economy are an indication of major problems, as businesses must be cutting prices to sell
excess inventory, which is a clear sign of recession. This will be discussed in more detail in Video 4.
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Video 4 Questions
You should be able to answer the following questions after watching Video 4.
1. Why do we need to avoid deflation when debt levels are high?
2. Does low inflation, as measured by the CPI, mean that inflation is low across the whole
economy?
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Intro Macro Module 5: Money and the Financial System
What is money? Why do you accept money as payment? Isn't it just a piece of paper?
Your textbook’s description of money, its history, and how money is created in the modern
economy is not accurate. But it is still important to read chapter 14 so you get an idea of how
most economists (and thus most economic policymakers in both government and central banks)
think money works. This leads to misguided policies, as we will see when we discuss the financial
crisis.
The Barter System
Note that the barter system described in your textbook is not exactly how it worked, and it
oversimplifies how early economies functioned, since payment systems could actually be quite
complex, even in the absence of what we would define as money. Yes, people exchanged goods
and services directly, but they did not necessarily exchange them simultaneously. Instead, many
societies created early forms of debt, which was simply an obligation to repay at some point in
the future. So if you gave me something today, I would be obligated to repay you with some good
or service in the future. In societies that were small enough that the buyer and seller were known
to each other, this obligation was often very strong, and could even extend beyond the life of the
buyer, so that their family would be responsible for repayment in the event of the buyer’s death.
Many early societies also developed their forms of payment to the extent that these debt
obligations could be traded. So if I bought something from you with a promise to repay you in the
future, I could divest this obligation not just by repaying you, but instead by repaying someone
else (likely with a different good or service), who would then be responsible for paying you,
creating a chain of obligations. What this means is that there was no need for what the textbook
refers to as a double coincidence of wants, which would have severely restricted the amount of
trade that could occur within an economy. Instead, all that was required was trust in other
members of society.
As economies developed, they started keeping track of these debt obligations with a ledger
system, which is simply a record of transactions. This meant the chain of obligations could be as
long as you wanted, and buyers and sellers did not have to know each other for there to be trust,
since the ledger would provide a record of the transaction. Obligations could be also be settled
by netting debt contracts, that is, if the person who was originally owed an obligation incurred an
obligation with someone else, this could cancel out the initial obligation. Essentially, the ledger
system is exactly how money and the modern financial system functions today.
What is money?
One way to define money is by the functions it performs. For money to be widely used in
transactions, it must fulfill the following three functions:
1. It is a unit of account: goods, services and financial assets are measured in terms of
money.
2. It is a means of payment (or medium of exchange): buyers give money to sellers when
they want some good or service in return. Following Borio (2018), “the means of payment
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is a generally accepted instrument that settles (extinguishes) obligations.”
3. It is a store of value: money is expected to retain its value over a long period of time. We
can use money to transfer purchasing power from one period to another. Note: our
currency is an imperfect store of value since its value is eroded by inflation. Also, any asset
functions as a store of value. So this is not a distinguishing feature of money, but any
means of payment must also be a store of value, otherwise nobody would accept it as
payment. This has happened to money repeatedly throughout history, as we shall see.
Commodity Money and Fiat Money
Commodity money: money that takes the form of a commodity that has value due to some
alternative use. Eg. Gold, cigarettes
An economy is operating under a gold standard if paper money can be converted into gold on
demand. It is very rigid, since the amount of money in any economy is restricted by the amount
of gold a country has. This lack of flexibility is the main reason it would be difficult to return to a
gold standard.
Fiat money: Money with no alternative use that is used as money because of government decree.
The entire world is currently using a fiat money system after abandoning the gold standard (which
we will discuss in Module 6). As Borio (2018) puts it: “At an even deeper level, money is debt in
the form of an implicit contract between the individual and society. The individual provides
something of value in return for a token he/she trusts to be able to use in the future to obtain
something else of value. He/she has a credit vis-à-vis everyone and no one in particular (society
owes a debt to him/her).”
Fiat money is just a special form of IOU (that is, a debt obligation), or, in the language of
economics, a financial asset (there are many other financial assets, eg. Stocks, bonds, mortgages
etc.). A financial asset is simply a claim on someone else in the economy: a person, company, or
government. One person's financial asset is also another person's debt (a financial liability). Thus,
all financial assets in an economy equal all financial liabilities.
Commodity money is a non-financial asset, and does not have a corresponding amount of debt.
Why do we use fiat money?
It is mainly based on trust. Because everyone trusts that money will continue to be accepted in
exchange for something tomorrow, it is accepted as a form of payment today. It is also based on
the fact that the government requires you to pay taxes with its own currency. So everyone in the
economy must acquire this currency in order to pay their taxes.
How is money created?
The textbook does not describe this correctly. The textbook (and every economics textbook I
have ever seen) describes a process whereby you deposit money in the bank, it lends a fraction
of that to someone else, who then deposits it at another bank, and the loan is newly created
money. That loans create money is the only accurate part of this description. Instead, please refer
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to the notes below, and the Bank of England reading listed in the course outline (and at the end
of this module). Also note that since deposits do not lead to loans, the concept of the money
multiplier is not useful.
To understand how money is created, we need to look at the different categories of money.
Categories of money
Currency is made up of notes in circulation, mostly held by households and firms, also held by
banks to meet withdrawals. It is the part of the money supply issued by the Bank of Canada
(Canada’s central bank, discussed in Module 6), representing less than 5% of the Canadian money
supply.
Bank deposits make up the bulk of money in Canada. These deposits are what the bank owes
you, while a loan is what you owe the bank. We often use deposits as a means of payment without
ever converting them into currency.
Unlike currency, which is created by the Bank of Canada, bank deposits are mostly created by the
banks themselves. When a bank makes a loan to a household or firm, it simply credits that
amount to the customer's account, and new money is created (this happens within the same
bank, not through a new deposit at another bank, as described in the textbook).
Why can banks create money? Because we use the deposits themselves as a means of payment.
When you buy a coffee with your debit card, what the bank owes you decreases by the amount
of the payment, and what the bank owes the coffee shop increases by the amount of the
payment. But no currency has changed hands.
When you take out a loan to buy a car, the bank increases the car dealership's deposits (what the
bank owes the car dealership) and you now owe the bank the price of the car. Again, no currency
has changed hands, but the dealership can now spend that money, which didn't exist before you
took out the loan.
Note: when you deposit currency into a bank, the total amount of deposits increases, and
currency in circulation decreases. If you make a withdrawal, the total amount of deposits
decreases, and currency in circulation increases. The amount of money in the economy is
unchanged in either case.
However, if you make a loan repayment, currency in circulation decreases, but there is no
corresponding increase in deposits. Thus, the amount of money in the economy decreases.
Repaying a loan is the equivalent of destroying money. See Video 5 for more discussion of the
money creation process and its implications.
Central bank reserves are the amounts owed by the central bank to each commercial bank. They
play a similar role for commercial banks as that of bank deposits for households and firms. Banks
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make payments to each other every day (say when you make an e-transfer to someone at another
bank), and these payments are processed by adjusting reserve balances at the Bank of Canada.
The amount of these reserves does not affect the amount of money creation in the economy.
Banks will choose to hold more or less reserves depending on the interest rate and the amount
of withdrawals from depositors (in some countries with a slightly different central bank setup, the
amount of bank reserves is independent of the interest rate). Instead, you should think of bank
reserves as a separate form of money, which is not at all connected to the money that you use.
Bank reserves are used only within the banking system itself as a means of payment (no individual
or business can be paid with bank reserves, only banks with an account with the Bank of Canada).
A bank is really just a ledger system for keeping track of all the debt obligations of itself (deposits)
and borrowers (loans) and all the transactions completed using these obligations (does this
remind you of anything? Go back and read the barter system section at the beginning of this
module. All that’s changed from early economies to the modern economy is the complexity of
this record-keeping). A central bank performs the ledger function for keeping track of obligations
between banks. The Bank of International Settlements (BIS) performs the ledger function for
keeping track of obligations between central banks, to settle international transactions. See Video
5 for a discussion of where cryptocurrency fits in.
Can banks create an unlimited amount of money?
The short answer is no. There are regulations in place to limit lending, and banks also decide how
much to lend based on available profitable opportunities. This depends on interest rates, the
perceived risk of the borrower, and how many households and firms wish to borrow money. It
does not depend on the existing amount of bank deposits, since every loan creates a new bank
deposit (this is the most important thing your textbook gets wrong). Note that while banks cannot
create unlimited money, there is also no way to force them to create more money.
Video 5 Questions
1. Why are banks able to create money?
2. What does it mean for the economy that banks are responsible for creating money?
3. Is bitcoin money?
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References:
Bank of England, Quarterly Bulletin, Vol. 54 No. 1, 2014.
Available here:
Reading 1 (introduction to money)
https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-in-themodern-economy-anintroduction.pdf?la=en&hash=E43CDFDBB5A23D672F4D09B13DF135E6715EEDAC
Reading 2 (money creation)
https://www.bankofengland.co.uk/-/media/boe/files/quarterly-bulletin/2014/money-creation-in-themodern-economy.pdf?la=en&hash=9A8788FD44A62D8BB927123544205CE476E01654
Borio, Claudio. “On Money, Debt, Trust and Central Banking.” Keynote speech, Cato Institute, 36th
Annual Monetary Conference, November 2018. Bank of International Settlements.
Available here:
https://www.bis.org/publ/work763.pdf
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Intro Macro Module 6: Money and The Financial System
The financial system is made up of the institutions in the economy that help to people save for
the future and help others borrow to invest in new and growing businesses. Savers earn interest
in exchange for giving up their money for a period of time, while borrowers pay interest in
exchange for using money for a period of time.
What brings the two together?
The typical answer is that this is what banks are for, but that’s not exactly true. Banks do provide
interest for savings, and they do provide loans to borrowers, but we know from Module 5 that
they are not simply acting as financial intermediaries, by taking deposits and using them to fund
loans. Instead, banks fulfill two very important functions:
First, as we saw in Module 5, banks facilitate virtually all of the payments that we make in a
modern economy, since we use bank deposits as money.
Second, banks allow both savers and borrowers to move their own money through time (rather
than to each other). If I have no need to borrow and have extra income to save, I can put the
money in a savings account and earn interest. In the future, I will have more money, so in effect I
am exchanging some amount of money today to receive a larger amount of money in the future.
If instead I need to borrow money, say, to make a large purchase like a house, I can get a mortgage
from the bank (a loan to buy property), and then I will be responsible for repaying the bank the
amount of the loan plus interest. Mortgages are repaid in equal installments over the life of the
loan (typically 25 or 30 years), so I am receiving money today, and in exchange I am paying regular
payments in the future. Large loans like mortgages require collateral, which is an asset that you
own that you will have to give to the bank if you fail to make your mortgage payments. For a
mortgage, the house you buy with the mortgage is the collateral, so if you fail to pay your
mortgage the bank will own your house (this will be important to remember when we discuss the
financial crisis). The collateral essentially replaces your own creditworthiness.
In both cases, saving and borrowing, I am simply moving money through time, exchanging some
of my income today for more in the future, or exchanging some of my income tomorrow for more
today.
Financial Markets
The main way savers directly provide money to borrowers is through financial markets. There
are two main financial markets, the bond market and the stock market.
The Bond Market
A bond is a debt contract, in which a company or a government borrows money from investors.
The contract specifies the date on which the loan will be repaid, called the date of maturity, and
also identifies the rate of interest. The amount that is borrowed is called the principal. Bonds can
have terms to maturity that can vary from a few months to 30 years or longer, while the interest
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rate depends both on the term to maturity and the risk of the borrower. The risk of the borrower
depends on an estimate of its probability of paying all the interest and principal of the bond.
Bonds also typically require collateral in the form of property or other fixed assets of a company,
which lowers the risk of not being paid. If the borrower fails to make an interest payment, the
bond is in default, and the borrower will have to renegotiate the loan or declare bankruptcy. If
bankruptcy occurs, then, in the case of a company, the bondholders own the company, and can
sell the assets posted as collateral to get some of their money back. If a government defaults, too
bad.
A bond only transfers money directly from savers to borrowers when the bond is first issued. After
that, the bond can be traded in the bond market, which means that whoever initially bought the
bond from the company can now sell the bond to someone else. The majority of trading that
happens in the bond market is between savers buying bonds from each other, and this does not
provide any money to the bond issuer.
The Stock Market
A share of stock (or stock) is a claim to partial ownership in a firm. Stocks entitle shareholders to
some of the firm’s profits, while bondholders only get interest on their bonds. As in the bond
market, the firm only receives money when the shares are first issued, and the majority of trading
that happens in the stock market is people buying stock from each other, which does not provide
money to the firm. Why buy stocks? Firms can distribute profits to shareholders through regular
payments, called dividends, or by repurchasing shares from the public. These amounts can often
be higher than the interest rate paid by savings accounts or bonds. You can also profit when the
price of the stock goes up, and you sell it for more than you paid for it (the same can be said of
bonds). If a company goes bankrupt, however, bondholders get paid first, before shareholders
receive anything, and in most bankruptcies, shareholders receive nothing (and stocks have no
collateral in the form of a firm’s assets). Stocks offer both higher risk, and potentially higher
return.
The Bank of Canada
The Bank of Canada is the central bank of Canada. A central bank is an institution intended to
regulate the amount of money in the economy. The Bank of Canada’s mandate is to achieve low
and stable inflation, and to maintain financial stability. The central bank of the United States is
called the Federal Reserve, often referred to as simply the Fed. Your textbook covers the Fed in
detail.
Functions of the Bank of Canada:
1. Issues currency
2. Acts as a banker for commercial banks, holding bank reserves, which are commercial bank
deposits with the Bank of Canada.
3. Acts as a banker for the Government of Canada.
4. Influences the money supply, which is the amount of money available in the economy.
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This last function is called monetary policy, and changes to the money supply can profoundly
affect the Canadian economy. Monetary policy will be covered in Module 7, in the context of the
Great Financial Crisis.
The Global Financial System
One of the most important aspects of our financial system that you need to understand is that it
is a truly global system, and that Canada’s financial system is highly integrated with the rest of
the world. Video 6 will provide some background detail on the modern history of money in the
global economy, and the nature of the global financial system.
Video 6 Questions
1. What was the problem with the Bretton Woods agreement?
2. Why is the US dollar still used as the main global currency?
3. What is a Eurodollar? Where do Eurodollars come from?
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Intro Macro: Guiding questions for Special Topics videos
The special topics videos cover material that you will be tested on for the midterm and final exam. You
are not required to memorize specific numbers or facts, but to have an understanding of the economic
concepts and to be able to explain the causes behind specific economic changes or crises. I have provided
the following questions to help you. This document will be updated with new questions for each week as
we progress through the course.
Week 1: 200 years of Economic Growth
1. Why is life expectancy a good measure of standard of living? How is GDP related to life
expectancy?
2. What explains the difference in our standard of living today compared to 200 years ago? Explain
in detail, with reference to agricultural production, education, and health.
Week 2: Hyperinflation
1. What causes hyperinflation?
2. Why is hyperinflation so bad for the economy?
3. Why is hyperinflation unlikely to happen in Canada?
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