ECON 101 · Macroeconomics

Money &
Banking

The institutional foundations of every modern economy — how money is created, how banks multiply it, and how the central bank keeps it under control.

Prof. Muhebullah Karimzada · UNBC Economics

The Functions of Money

Money is defined by what it does,
not what it is made of.

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Three Functions

Medium of exchange — accepted in payment, eliminating the need for barter. Store of value — transfers purchasing power through time. Unit of account — prices expressed in a common unit for easy comparison.

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M1 and M2

M1 (narrow money): currency in circulation + chequable deposits — the most liquid measure. M2 (broad money): M1 + savings deposits + other near-money assets. The Bank of Canada monitors both.

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Fiat Money

Modern money has no intrinsic value — it is valuable because the government declares it legal tender and people trust it will be accepted. The alternative — commodity money like gold — is impractical for modern economies.

Banks Create Money

When you deposit $1,000, the bank keeps a fraction as a reserve and lends the rest. That loan becomes someone else's deposit — and the process repeats. One deposit multiplies into far more money.

Reserve Banks are required to hold a reserve ratio — a fraction of deposits — as liquid funds. The rest can be lent out. With r = 10%, a $1,000 deposit supports $100 in reserves and $900 in new loans.

Cascade Each loan is spent and re-deposited, allowing another bank to lend 90% again. The cascade continues until the initial $1,000 has supported $10,000 in total deposits across the system.

Risk Fractional reserve banking is efficient — but it means no bank holds enough cash to meet all depositors at once. A bank run, where everyone withdraws simultaneously, can collapse even a solvent institution.

The Money Multiplier

The money multiplier = 1 ÷ reserve ratio. A lower reserve requirement allows banks to lend more from each deposit — creating more money from the same initial base.

Formula MM = 1 / r, where r is the reserve ratio. With r = 10%: MM = 10. With r = 20%: MM = 5. With r = 5%: MM = 20. A tiny change in the reserve ratio has an enormous effect on money creation.

Reality In practice, the actual multiplier is smaller than the theoretical maximum. Cash leakage (people holding bills rather than depositing) and excess reserves held by cautious banks both reduce the true multiplier.

Crisis In recessions, banks hold excess reserves and tighten lending standards — the multiplier contracts, amplifying the downturn. This is why the Bank of Canada's emergency liquidity operations matter: they prevent the multiplier from collapsing.

The Bank of Canada

Canada's central bank is not a commercial bank — it does not lend to households or businesses. It operates at the apex of the banking system, controlling the conditions under which all other banks lend.

Monetary Policy

🎯 Managing Inflation & Growth

The Bank sets the overnight rate — the interest rate at which banks lend to each other overnight. Raising the rate cools borrowing and inflation; lowering it stimulates spending and growth.

Target: 2% inflation (1–3% control range), in place since 1991.

Financial Stability

🏛️ Lender of Last Resort

If a solvent bank faces a liquidity crisis — more withdrawals than it can immediately meet — the Bank of Canada can provide emergency loans, preventing a bank run from cascading into a system-wide collapse.

Also issues Canadian bank notes and oversees payment system safety.

Key distinction: The Bank of Canada controls the monetary base (currency + bank reserves). Commercial banks then multiply this base through lending. Together, the central bank and commercial banks jointly determine the total money supply.

Interest Rates & Equilibrium

The Money Market

The interaction of money supply and money demand determines the equilibrium interest rate — the price of holding money rather than interest-bearing assets.

MS The money supply is set by the Bank of Canada — represented as a vertical line. The Bank can fix it at any quantity regardless of the interest rate.

MD The money demand curve slopes downward: at higher interest rates, the opportunity cost of holding cash rises, so households and firms prefer bonds and deposits over money.

↑ MS When the Bank increases the money supply, the MS line shifts right — the equilibrium interest rate falls. Lower rates stimulate investment and spending, boosting aggregate demand.

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Money is more than coins and notes — it is a social institution built on trust. Banks multiply that trust into the credit that funds investment and growth. The central bank's most valuable asset is not its balance sheet — it is its credibility.

— Prof. Muhebullah Karimzada · ECON 101 · UNBC

Money · Fractional Reserve · Money Multiplier · Bank of Canada · Money Market

Money &Banking

Money is defined by what it does,not what it is made of.