Money and the Financial System Chapter 28 Money and the Financial System © 2006 Thomson/South-Western

Evolution of Money Barter is the direct trading of one good for another good Problems with barter Requires a double coincidence of wants: traders have products that other traders want The traders must agree on the exchange rate between the two goods

Medium of Exchange Anything that is generally accepted by all parties in payment for goods and services Money is anything generally accepted in exchange for goods/services – making it a medium of exchange Commodity money: anything that serves both as money and as a commodity; money that has intrinsic value, such as gold and silver

Unit of Account A common unit for measuring the value of each good and service Eliminates the necessity of having to determine how much of each good exchanged for every other good

Store of Value Money serves as a store of value when it retains purchasing power over time: the better it preserves purchasing power, the better money serves as a store of value Recall the distinction between stock and flow Stock is an amount measured at a particular point in time Flow is an amount per unit of time Money is a stock, and income is a flow

Desirable Qualities of Money Durable Portable or easily carried Divisible Acceptable Gresham’s Law:People tend to trade away inferior money and hoard the best. Uniform Quality: Over time, the quality of money in circulation becomes less acceptable, so money should be of uniform quality. Low opportunity cost Relatively stable value

Exhibit 1: Six Desirable Qualities of Money

Coins Quality and quantity of commodity was questionable Precious metals could be debased with cheaper metals: the quantity and quality of the metal had to be determined with each exchange This quality-control problem was addressed by coining the metal where coinage determined both the amount and quality of the metal However, because of the possibility of clipping or shaving some of the metal from the coin, coins had to be bordered with a well-defined rim and were milled around the edges

Coins Seigniorage: The difference between the face value of money and the cost of supplying it; the “profit” from issuing money Token money: Money whose face value exceeds its cost of production

Money and Banking Goldsmiths offered the community “safekeeping” for money and other valuables In return, they gave depositors their money back on request However, since deposits by some people tended to offset withdrawals by others, the amount of idle cash, or gold, in the vault remained relatively constant over time

Money and Banking For this reason, the goldsmiths found they could earn interest by making loans from this pool of idle cash However, visiting the goldsmith every time money was needed created a problem As a result, goldsmiths devised written instruments that could be used in payment: the first checks

Money and Banking The goldsmith soon discovered how to make loans against which the borrower could write checks, written orders instructing the goldsmith (now, a bank) to pay someone from an amount deposited: they were able to create money This money, based only on an entry in the goldsmith’s ledger, was accepted because of the public’s confidence that these claims would be honored

Fractional Reserve Banking The total claims against the goldsmith consisted of Claims by those who had deposited their money, plus Claims by people to whom the goldsmith had extended loans Because these claims exceeded the value of gold on reserve, this was the beginning of a fractional reserve banking system

Fractional Reserve Banking System in which the goldsmith’s reserves amounted to just a fraction of total deposits The reserve ratio measures reserves as a share of total claims against the goldsmith, or total deposits For example, if the goldsmith had gold reserves valued at $5,000 but deposits totaling $10,000, the reserve ratio would be 50%

Paper Money Another way a bank could create money was by issuing bank notes, pieces of paper promising the bearer specific amounts of gold or silver when the notes were presented to the issuing bank for redemption Banks in London introduced checks Principal difference between checks and bank notes Checks could be redeemed only if endorsed by the payee Notes could be redeemed by anyone who presented them Representative money Bank notes that exchange for a specific commodity Paper money was often as good as gold since the bearer could redeem it for gold

Fiat Money Fiat money derives its status as money from the power of the state: is money because the government says so Not redeemable for anything other than more fiat money, nor is it backed by anything of intrinsic value Fiat money is declared legal tender by the government: person has made a valid and legal offer of payment when payment is made with this money

Value of Money Why does money have value? The commodity feature of money bolstered confidence because of its acceptability Initially paper money was acceptable because it was redeemable in gold, silver of some other item of value However, what makes paper money acceptable today is that individuals accept these pieces of paper because they have reason to believe others will do so as well: it can be used for exchange

Exhibit 2: Purchasing Power of $1 Exhibit 2: Purchasing Power of $1.00 Measured in 1982-1984 Constant Dollars

Purchasing Power of Money The purchasing power of money is the rate at which it exchanges for goods and services The higher the price level, the less can be purchased with each dollar  each dollar is worth less Specifically, the purchasing power of a dollar over time varies inversely with the price level

Financial Institutions in U.S. Financial institutions accumulate funds from savers and lend these funds to borrowers Serve as intermediaries between savers and borrowers – accept funds from savers and lend them to borrowers Intermediaries earn a profit by paying a lower interest rate to savers than they charge borrowers

Depository Institutions Two types of depository institutions: Commercial banks Historically made loans primarily to commercial ventures Hold two-thirds of all deposits of depository institutions Mainstay of checking accounts or demand deposits Thrift institutions

Thrift Institutions Include savings and loan associations, mutual savings banks, and credit unions Only recently have been given the authority to offer demand deposits (so named because a depositor can write a check demanding those deposits) Credit unions are by far the largest group and can extend loans only to their members

Federal Reserve System Federal Reserve System was created in 1913 as the central bank and monetary authority of the United States Consists of 12 central banks in 12 Federal Reserve Districts around the country

Exhibit 3: 12 Federal Reserve Districts

Federal Reserve System The Federal Reserve Act moved the country toward a system that was partly centralized and partly decentralized All national banks became members of the Federal Reserve System and were subject to new regulations issued by the Fed For state banks, membership was voluntary and most state banks have not joined

Powers of Federal Reserve General statement was to exercise general supervision over the Federal Reserve System to ensure sufficient money and credit in the banking system The power to issue bank notes was taken away from national banks and turned over to the Federal Reserve Banks

Powers of Federal Reserve The Fed’s other powers: to buy and sell government securities, to extend loans to member banks, to clear checks to require that member banks hold reserve equal to at least some specified fraction of their deposits.

Federal Reserve Banks Can be thought of as a bankers’ bank Hold deposits of member banks Extend loans to member banks Interest rate charged for these loans is called the discount rate Hold member bank reserves on deposit Reserves are funds that Satisfy the cash demands of their customers Satisfy the reserve requirements of the Fed; Consist of cash held by banks plus deposits at the Fed

Reforms to Federal Reserve System Banking Acts passed in 1933 and 1935 shored up the banking system and centralized the power of the Federal Reserve System Most important features Board of Governors Federal Open Market Committee Regulating the Money Supply Deposit Insurance Restricting Bank Investment Practices

Board of Governors Responsible for setting and implementing the nation’s monetary policy Consists of 7 members appointed by the president and confirmed by the Senate Each member serves one 14-year non-renewable term with one member appointed every two years and one member is appointed as the chair for a 4-year renewable term

Federal Open Market Committee FOMC: The 12-member group that makes decisions about open-market operations—purchases and sales of U.S. government securities by the Fed that affect the money supply and interest rates Open market operations Purchases and sales of U.S. government securities by the Fed Most important tool of monetary policy, to influence monetary supply Consists of the 7 board governors plus 5 presidents of the Reserve Banks

Exhibit 4: Organization Chart for the FED

Regulating the Money Supply FED has three major tools for regulating the money supply Conducting open market operations – buying and selling U.S. government securities on the open market Setting the discount rate – the interest rate charged by Reserve Banks for loans to member banks Setting legal reserve requirements for member banks

Deposit Insurance Not a specific part of the Fed Federal Deposit Insurance Corporation, FDIC, was established to insure the first $100,000 of each deposit account About 97% of commercial banks and 90% of savings and loan associations are FDIC insured Members of the Fed must purchase FDIC insurance

Bank Investment Practices As part of the Banking Act of 1933, commercial banks could no longer own corporate stocks and bonds The general feeling was that these holdings contributed to instability of the banking system Act limited bank assets primarily to loans and government securities/bonds Bond is an IOU issued by federal, state, or local governments

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

Money Market Mutual Fund These funds have limited check-writing privileges Shares in these funds are claims on a portfolio, or collection, of short-term interest-earning assets Provide competition for bank deposits, especially demand deposits, which paid no interest

Bank Deregulation Thrifts: combination of deposit insurance, unregulated interest rates, and wider latitude in the kinds of assets they could purchase gave them a green light to compete for large deposits in national markets to acquire assets as they pleased Some thrifts on the verge of failing were encouraged to take bigger risks because depositors were protected by deposit insurance

Bank Deregulation This combination created a moral hazard in which bankers took unwarranted risks because depositors were insured Zombie banks – banks that were already virtually bankrupt – were able to attract additional deposits from healthy banks by offering higher interest rates

Thrift Bailout Most of these gambles, particularly loans to real estate developers, failed and thrifts lost considerable amounts of money with the result that they failed at record rates The insolvency and collapse of a growing number of thrifts prompted Congress to approve the largest financial bailout – $250 billion – in history with taxpayers paying nearly two-thirds of the total

Exhibit 5: Failures of U.S. Savings Banks Peaked in 1989

Bank Failures Risky decisions by commercial banks coupled with a slump in real estate hastened the demise of many commercial banks in Texas, Oklahoma, and the Northeast In Texas and Oklahoma, loans to oil drillers and farmers proved unsound In the Northeast, falling real estate values caused borrowers to default

Exhibit 6: Failures of U.S. Commercial Banks Peaked in 1988

Structure of U.S. Banking United States has more banks than other countries and bank assets are distributed more evenly across banks This reflects past restrictions on branches, which are additional offices that carry out banking operations The combination of intrastate and interstate restrictions on branching spawned the many commercial banks that exist today, most small

Structure of U.S. Banking Two developments have allowed banks to get around branching restrictions Bank holding companies Mergers Bank holding company:a corporation that may own several different banks Many states let holding companies cross state lines Holding companies can provide other services that banks are not authorized to offer

Exhibit 7: Number of Commercial Banks Declined over the Last Two Decades, But the Number of Branches Continues to Grow

Structure of U.S. Banking Bank mergers allows banks to expand their geographical reach Allows banks to Gain more customers The higher volume of transactions should reduce operating costs per customer May also be a way of avoiding the concentration of bad loans that sometimes occur in one geographical area

Exhibit 8: America’s Ten Largest Banks, based on Assets (as of early 2004)

Exhibit 8: World’s Ten Largest Banks, based on Assets (as of early 2004)