Money and the Financial System Chapter 14 Money and the Financial System © 2009 South-Western/ Cengage Learning

The Evolution of Money No exchange Specialization Barter No money Exchange: Barter Barter Double coincidence of wants Agree on exchange rate

The Evolution of Money The earliest money Functions of money Good – easily traded later High degree of acceptability Functions of money Medium of exchange Commodity money Unit of account Store of value Retains purchasing power over time

The Evolution of Money Properties of the ideal money Durable Portable Divisible Uniform quality Low opportunity cost Relatively stable in value

Exhibit 1 Six properties of ideal money Quality Rationale Good examples Bad examples 1. Durable 2. Portable 3. Divisible 4. Uniform quality 5. Low opportunity cost 6. Stable value Money should not wear out quickly Money should be easy to carry, even relatively large sums Market exchange is easier if denominations support a range of possible prices If money is not of uniform quality, people will hoard the best and spend the rest, reducing its quality The fewer resources tied up in creating money, the more available for other uses People are more willing to accept and hold money if they believe it will keep its value over time Coins; sea shells Diamonds; paper money Honey; paper money and coins Salt bricks; paper money; coins Iron coins; paper money Anything whose supply can be controlled by issuing authorities, such as paper money Strawberries; seafood Lead bars; potatoes Cattle; diamonds Diamonds Gold; diamonds Farm crops

Coins Coinage Problems Token money Amount and quality of the metal By count Problems Getting clipped Counterfeiting Token money Face value > cost of coinage Seigniorage – profit from coinage

The hassle of small change Pennies Cost: 1.5 cents per coin Nickels Cost: 5.5 cents per coin Rising metal prices Lower cost alloy Abolish the penny Penny = 5 cents; withdraw nickels

The hassle of small change Production of pennies Increased 6.8 billion pennies in 2003 To 8.2 billion pennies in 2006 Demand for pennies Hoarding Sales tax Zinc producers – lobby

Money and Banking Banks = Goldsmith Safekeeping Earn interest Checks Extend loans Create medium of exchange, money Public confidence Fractional reserve banking system

Representative Money and Fiat Money Bank notes IOUs Paper money As good as gold Representative money Fiat money From the power of the state Legal tender

The Value of Money Purchasing power of money Rate of exchange for goods and services Higher price level in economy Smaller purchasing power Purchasing power of $ in a year 100 ÷ Price index in same year Evolution over time Steady decline since 1960

Exhibit 2 Purchasing power of $1 measured in 1982-1984 constant dollars An increase in the price level over time reduces what $1.00 buys. The price level has risen every year since 1960, so the purchasing power of $1.00 (measured in 1982-1984 constant dollars) has fallen from $3.38 in 1960 to $0.48 in 2007

When Money Performs Poorly Hyperinflation in Brazil Prices grow by the hour Not reliable store of value Exchange for stable currency Barter

When Monetary Systems Break Down Too much money in circulation Increase demand for hard currency Hoarding the hard currency Not enough money in circulation Hoarding currency Vouchers; Barter Bank panics Strict price control Barter 14

Financial Institutions in the US Depository institutions Commercial banks Loans to businesses Thrift institutions Savings banks Credit unions Loans to households

The Fed Before 1863: State banks National Banking Act of 1863 Chartered by states National Banking Act of 1863 National banks Issue notes Regulated Dual banking system 19th century Panic ‘runs’

The Fed 1913 Federal Reserve System National banks State banks Central bank Monetary authority 12 Federal Reserve districts National banks Had to join the Fed State banks Voluntary membership to the Fed

Exhibit 3 The twelve Federal Reserve Districts The map shows by color the area covered by each of the 12 Federal Reserve districts. Black dots note the locations of the Federal Reserve Bank in each district. Identified with a star is the Board of Governors headquarters in Washington, D.C.

The Fed Powers of the Fed Banker’s bank Issue bank notes Buy and sell government securities Extend loans to member banks Clear checks in the banking system Reserve requirement for member banks Banker’s bank

The Fed Board of Governors 7 members Set and implement monetary policy Appointed by the President Confirmed by the Senate 14-year nonrenewable term Insulated from political pressure 1 chair: 4 years Set and implement monetary policy Oversees the 12 reserve banks

The Fed Federal Open Market Committee FOMC Open-market operations The Fed buys, sells government securities 7 board governors 5 presidents of reserve banks Advise the board

Exhibit 4 Organization chart of the Federal Reserve System Members of the Board of Governors: appointed by the president, confirmed by the Senate. Seven board members also belong to the 12-member Federal Open Market Committee, which advises the board. The Board of Governors controls the Reserve Banks in each of the 12 districts, which in turn control the US banking system.

The Fed Regulating the money supply Deposit insurance Open-market operations Discount rate Reserve requirements Deposit insurance Federal Deposit Insurance Corporation, FDIC $100,000 per depositor per bank 90% banks

The Fed Goals High level of employment in economy Economic growth Price stability Interest rate stability Financial market stability Exchange rate stability

Banks Before 1930s: Own corporate stock; bonds After 1930s Banking = heavily regulated Loans, government securities Ceiling on interest rates for deposits 1970s: Inflation Increase interest rates Withdrawals Money market mutual fund Limited check-writing

Banking Deregulation Money market deposit accounts Deposit insurance $8 billion in 1978 $200 billion in 1982 Deposit insurance Unregulated interest rates Wider variety of assets Moral hazard problem

Savings Banks on the Ropes Wild gambles Insolvency Collapse of a growing number of banks 1989 largest financial bailout 3,418 in 1984 1,290 in 2007 Credit unions Declined 34%

Exhibit 5 Failures of US savings banks peaked in 1989

Commercial Banks Were Failing Too Demise of commercial banks Risky decisions Unsound loans Failures, mergers, acquisitions 14,496 in 1984 7,410 in 2007

Exhibit 6 Failures of US commercial banks peaked in 1988

US Banking Structure Today Large number of US banks Past restrictions on bank branches Branching restrictions Inefficiencies Bank failures (Great Depression) Bank holding company Owns several banks Offers other services Bank mergers Expand geographically

Exhibit 7 Number of commercial banks declined over the last two decades, but the number of branches continue to grow

Top Banks in America and the World US banks Domestic deposits Mergers and acquisitions National banks Worldwide assets 2 US banks Citibank 100 countries Bank of America

Exhibit 8 (a) Largest US banks based on total domestic deposits

Exhibit 8 (b) World’s largest banks based on total assets