NEXT Money and Banking

NEXT Chapter 10: Money and Banking KEY CONCEPT Money provides a low-cost method of trading one good or service for another. It makes the system of voluntary exchange efficient. WHY THE CONCEPT MATTERS Money is important to everyone in our society. What were the last three economic transactions you completed using money? Imagine what it would have been like to make those purchases without paper bills and coins.

NEXT Functions of Money KEY CONCEPTS Money –anything people will accept as a medium of exchange for goods and services –over time, cattle, grain, metals, shells, other objects used as money Whatever it is that people choose to use as money, it should perform three important functions. Money: Its Functions and Properties

NEXT Functions of Money Function 1: Medium of Exchange A medium of exchange is the means through which goods and services can be exchanged. Without money, economic transactions must be made through barter – exchanging goods and services for other goods and services. Barter is cumbersome and inefficient because two people who want to barter must at the same time want what the other has to offer. Money allows for the precise and flexible pricing of goods and services, making any economic transaction convenient.

NEXT Functions of Money Function 2: Standard of Value Money serves as a standard of value Determines the economic worth in the exchange process. Allow people to measure the relative costs of goods and services. The dollar is the basic monetary unit in the United States Serves as the standard by which the economic worth of all goods and services can be expressed or measured

NEXT Functions of Money Function 3: Store of Value Money acts as a store of value, something that holds value over time. People don’t have to spend all their money at once or in one place, can save for later use. Money will be accepted wherever and whenever it is presented to purchase goods and services. Inflation – a sustained rise in the general level of prices – causes money not to function well as a store of value.

NEXT Properties of Money KEY CONCEPTS Item used as money must possess certain properties Physical properties are characteristics of item itself Economic properties are linked to role money plays in the market

NEXT Properties of Money Property 1: Physical Durability –sturdy enough to last through many transactions –Something that falls apart or spoils easily would not be good to use as money Portability —small, light, easy to carry Divisibility –divisible so change can be made –allows for flexible pricing Uniformity –distinctive features and markings make it recognizable

NEXT Properties of Money Property 2: Economic Stability of value –purchasing power should be relatively stable –Amount of goods and services that you buy with a certain amount of money should not change quickly. –Rapid change would show it is not a good store of value Scarcity –must be scarce to have any value –When supply of money is more than the demand, money loses value, or purchasing power Acceptability –users must agree that it is valid medium of exchange –People will accept it because others will accept it as payment

NEXT Types of Money KEY CONCEPTS Money derives value from one of three sources Commodity money—value based on the material from which it is made Representative money—paper money backed by something tangible Fiat money—declared by government to have value, accepted by citizens

NEXT Types of Money Type 1: Commodity Money Items have value in themselves apart from their value as money –includes gold, precious stones, salt, olive oil; scarce or useful Coins most common; precious metal in them worth their face value If item becomes too valuable, people hoard, don’t circulate Commodity money is rarely used today.

NEXT Types of Money Type 2: Representative Money Paper money that can be exchanged for something else of value. Used in Middle Ages by merchants, goldsmiths, and moneylenders Inconvenient and not safe to transport large quantities of precious metals Government regulated how much metal needed to be stored to back up the paper money Problems –Value changes with the supply and price of gold and silver –Can cause inflation or deflation in general price levels

NEXT Types of Money Fiat Money Has value only because the government has issued a fiat, or order, saying the money has value. Coins contain only a token amount of precious metal that is far less than its worth Paper money has no intrinsic value People cannot exchange paper money for gold and silver Can be used because the government says it can be used as money; people accept that it will fulfill all the functions of money Dollar bill –“This note is legal tender for all debts, public, and private” Government controls the supply, keeping it scarce

NEXT Money in the United States KEY CONCEPTS Narrowest sense, money is item used immediately for transactions Currency—paper money and coins Demand deposits—checking accounts; funds become currency on demand Near money—savings accounts, time deposits; funds become cash easily

NEXT Money in the United States Money in the Narrowest Sense Transactions money –Can be used immediately –Half of transactions money is currency –Paper money and coins –Used by individuals and businesses Demand deposits –Noninterest-bearing checking accounts that can be convereted into currency by writing checks –Traveler’s checks can be used around the world. –Negotiable order of withdrawal (NOW) – interest-bearing savings accounts

NEXT Money in the United States Are Savings Accounts Money? Near money cannot be used directly to make transactions Savings account: funds can be moved to checking account, withdrawn Time deposits: –funds deposited for specific period to receive higher interest –include certificates of deposit (CDs), money market accounts

NEXT Money in the United States How Much Money? Economists use M1, M2 instruments for measuring money M1 –Narrowest measure of the money supply –Currency –Demand deposits –Other checkable deposits –Liquid assets –Are or can easily become currency M2 –Broader measure of the money supply –Consists of M1 plus various kinds of near money –Savings accounts –CD’s of less than $100,000 –Money market mutual funds

NEXT Reviewing Key Concepts Explain the difference between the terms in each of these pairs: standard of value and store of value commodity money and representative money demand deposits and near money

NEXT The Origins of Banking KEY CONCEPTS Late Middle Ages, Italian merchants stored people’s money; made loans American colonial merchants followed same practice Private banks insecure: if merchant’s business failed, deposits lost After revolution, state banks chartered by state governments –many banks issued own currency, not backed by gold or silver held The Development of U.S. Banking

NEXT Alexander Hamilton: Shaping a Banking System The First Bank of the United States In 1789, became first Secretary of the Treasury; proposed national bank Against strong opposition, First Bank of the United States chartered in 1791 –issued national currency –controlled money supply by refusing state bank money not backed –loaned money to federal government, state banks, businesses

NEXT 19th-Century Developments KEY CONCEPTS 1811, Congress refused to renew charter of First Bank of the U.S. –government had difficulty financing War of 1812 –state banks again issued currency not linked to gold, silver reserves –increased money supply led to inflation during the war

NEXT 19th-Century Developments The Second Bank of the United States 1816, Congress chartered Second Bank of the United States –more resources than First Bank; made money supply more stable Opponents thought bank too powerful, too close to wealthy –1832, President Andrew Jackson vetoed renewal of charter

NEXT 19th-Century Developments Wildcat Banking Second Bank’s charter lapsed in 1836; no federal oversight of banking All banks state banks; issued own paper currency called bank notes States passed free banking laws; resulted in wildcat banks –susceptible to bank runs leading to panics, economic instability

NEXT 19th-Century Developments The Struggle for Stability In 1863, National Banking Act created national banks chartered by U.S. government –created national currency backed by U.S. Treasury bonds –required minimum amount of capital for national banks, to back currency –taxed state bank notes issued after 1865, taking them out of circulation 1900, United States adopted gold standard—made dollar equal a set amount of gold

NEXT 20th-Century Developments KEY CONCEPTS National banks, gold standard initially brought stability to banking Economy still experienced inflation, recession, financial panics United States needed central decision-making body to manage money supply

NEXT 20th-Century Developments A New Central Bank 1913, Federal Reserve System created; consists of 12 regional banks, one decision-making board –provides financial services to federal government –makes loans to banks that serve the public –issues Federal Reserve notes as national currency –regulates money supply

NEXT 20th-Century Developments The Great Depression and the New Deal 1929, many banks failed due to bank runs Banking Act of 1933 part of President Franklin Roosevelt’s New Deal –regulated interest rates banks paid; prohibited sale of stocks by banks –Federal Deposit Insurance Corporation (FDIC) insured people’s savings

NEXT 20th-Century Developments Deregulation and the S&L Crisis 1980, 1982 laws lifted federal limits on savings interest rates Savings and loans associations now operating like commercial banks –made riskier loans Many S&Ls failed; Congress funded industry restructuring

NEXT Financial Institutions in the United States KEY CONCEPTS Bank: commercial banks, savings and loan associations, credit unions State, federal governments charter financial institutions, regulate –amount of money owners must invest in a bank –size of reserves a bank must hold –ways loans may be made

NEXT Financial Institutions in the United States Type 1: Commercial Banks Privately owned commercial banks are oldest type of banks –initially created to provide business loans –today, checking and savings accounts, loans, investments, credit cards All national, about 16 percent of state commercial banks belong to the Fed

NEXT Financial Institutions in the United States Type 2: Savings Institutions S&Ls first chartered by states in 1830s –took savings deposits; provided home mortgage loans –today, provide many of same services as commercial banks Since 1933, federal government also charters S&Ls –many federally chartered S&Ls call selves savings banks

NEXT Financial Institutions in the United States Type 3: Credit Unions In 1909, first credit union chartered; 1934, federal system created –offer savings and checking accounts; specialize in auto, mortgage loans –deposits insured by National Credit Union Association (NCUA) Credit unions have membership requirements –cooperatives: nonprofit organizations owned by, operated for members

NEXT Reviewing Key Concepts Use each of the terms in a sentence that illustrates the meaning of the term: state bank national bank gold standard

NEXT What Services Do Banks Provide? KEY CONCEPTS Banks are like stores where money is bought (borrowed), sold (lent) Customers can store money, earn money, borrow money Banks earn money by charging interest or fees Innovations in Modern Banking

NEXT What Services Do Banks Provide? Service 1: Customers Can Store Money Banks store currency in vaults; insured against theft, other loss Customers also store –money in bank accounts; insured against bank failure –papers and valuables in safe deposit boxes

NEXT What Services Do Banks Provide? Service 2: Customers Can Earn Money Savings accounts, some checking accounts pay interest Money market accounts, CDs pay higher interest rate

NEXT What Services Do Banks Provide? Service 3: Customers Can Borrow Money Banks lend money through fractional reserve banking –percent of deposit banks must keep is set by Fed Banks make loans to customers it approves –loans have set time period and interest rate; property is collateral Credit card purchases are loans; interest charged after one month

NEXT Banking Deregulation KEY CONCEPTS Before 1980s, government regulated interest rates paid and charged –required banks to operate in one state; some states limited branches In 1980s, 1990s, deregulation ended restrictions, changed banking

NEXT Banking Deregulation Bank Mergers Deregulation led to mergers; no more restrictions on interstate banking Advantages: more competition meant low interest rates, more services –also more branches; economies of scale, especially for technology Disadvantages: fewer banks to choose from –fear larger banks uninterested in small customers, local communities

NEXT Banking Deregulation Banking Services Financial Services Act of 1999 lifted last restriction on banks Banks, insurance companies, investment companies compete –sell stocks, bonds, insurance, traditional banking services Customers continue to use different companies for different services

NEXT Technology and Banking KEY CONCEPTS Technology has led to electronic banking Automated teller machines (ATMs)—use special cards –customers make transactions without bank officers Debit cards—used to withdraw cash or make purchases Stored-value cards—represent money holder has on deposit with issuer

NEXT Technology and Banking Automated Teller Machines ATMs—data terminals linked to a bank’s computer network –customer needs personal identification number (PIN) –check balances, make deposits, withdrawals, transfers, loan payments All ATM networks connected; some banks charge fees Save banks money: cheaper than human tellers; more “bank” locations

NEXT Technology and Banking Debit Cards Debit cards are linked to a bank account Can be used at ATM machines to make transactions Can be used to make purchases at retail outlets; also called check cards –price of purchase is immediately deducted from the account –unlike credit cards, can only spend as much as have in account

NEXT Technology and Banking Stored-Value Cards Also called prepaid cards—pay for card, use it to pay for products –include transit fare cards, gift cards, telephone cards –convenient: no need to have exact change Need to compare to cost of checking account or check-cashing service Not always covered by FDIC insurance that protects customer deposits

NEXT Technology and Banking Electronic Banking Electronic banking transactions performed through the Internet –direct deposit, transaction review, transfers, bill paying Information security and identity theft are problems for banks –must reveal privacy policies; let customers decide what data is shared –developing more sophisticated information security systems

NEXT Reviewing Key Concepts How are these three terms related? How are they different? automated teller machine debit card stored-value card

NEXT Student Loans Background The high cost of a college education forces 10 million students and 800,000 parents to take out loans to pay for at least part of college. Federally guaranteed loans are the main source of funding for college, not banks, S&Ls, or credit unions. What’s the Issue? What is the current situation with student loans? What are the future ramifications of the increasing cost of paying for college?

NEXT Student Loans {continued} Thinking Economically 1.Compare the financial news presented in documents A and C. What bearing do you think the information in document A might have on what you learned from document C? 2.Document B humorously points to the prominence of student loans in U.S. higher education. Specifically, what parts of documents A and C support this view? 3.In document A, what does the federal government seem to be saying about who should pay for a college education? With this in mind, what does Figure 10.7 mean for students and parents?