1 Money and the Financial System CHAPTER 13 © 2003 South-Western/Thomson Learning

2 Evolution of Money Without exchange, there was little need for money and most of the exchanges involved barter Refers to the direct trading of one good for another good Problems with barter Requires a double coincidence of wants  the traders each have products that the other wants The trades must agree on the exchange rate between the two goods

3 Medium of Exchange Anything that is generally accepted in payment in exchange for goods and services sold In early times, money was commodity money like gold and silver

4 Unit of Account A standard upon which prices are based Common denominator or yardstick for measuring the value of all other goods and services

5 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

6 Problems with Commodity Money Commodity money refers to the use of some item – gold, silver, wampum – as money Problems If the commodity money is perishable it must be properly stored or its quality can deteriorate  money must be durable If the commodity used as money is bulky, exchanges for major purchases can become unwieldy  money should be portable

7 Problems with Commodity Money Some commodity money is not easily divisible into smaller units  money should be divisible If commodity money is valued equally in exchange, regardless of its quality, people will tend to keep the best and trade away the rest  money should be of uniform quality.

8 Problems with Commodity Money Fifth, commodity money usually ties up otherwise valuable resources  which gives it a relatively high opportunity cost  money should have a low opportunity cost A final problem with commodity money is that its supply and demand determine the prices of all other goods and if either of these fluctuate unpredictably, so will the economy’s price level  the value of money should not fluctuate erratically

9 Goldsmiths Individuals who 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

10 Goldsmiths 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

11 Goldsmiths The goldsmith soon discovered how to make loans against which the borrower could write checks  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

12 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

13 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

14 Paper Money Another way a bank could create money was by issuing bank notes Bank notes were pieces of paper promising the bearer specific amounts of gold or silver when the notes were presented to the issuing bank for redemption

15 Paper Money The amount of paper money issued by a bank depended on that bank’s estimate of the proportion of notes that would be redeemed The greater the redemption rate, the fewer notes could be issued based on a given amount of reserves

16 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

17 Purchasing Power of Money The purchasing power of money is the rate at which it exchanges for goods and services The purchasing power of a dollar over time varies inversely with the price level

18 Financial Institutions in U.S. Financial institutions accumulate funds from savers and lend these funds to borrowers, thereby serving as intermediaries between savers and borrowers hence the name financial intermediaries These intermediaries earn a profit by paying a lower interest rate to savers than they charge borrowers

19 Federal Reserve System Federal Reserve System was created in 1914 as the central bank and monetary authority of the United States in response to a series of bank failures. Consists of 12 central banks in 12 Federal Reserve Districts around the country

20 11 Exhibit 2: 12 Federal Reserve Districts 1Boston 2New York 3Philadelphia 4Cleveland 5Richmond 6Atlanta 7Chicago 8St. Louis 9Minneapolis 10Kansas City 11Dallas 12San Francisco

21 Mission of Federal Reserve Board 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

22 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 cash that banks have on hand or on deposit

23 Banking During the Great Depression Federal Reserve System was created to eliminate some of the problems of bank panics However, the FED failed to act as a lender of last resort, e.g., they did not lend banks the money they needed to satisfy deposit withdrawals in cases of runs on otherwise sound banks

24 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

25 Board of Governors Responsible for setting and implementing the nation’s monetary policy Regulation of the economy’s money supply and interest rates to promote macroeconomic objectives 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

26 Federal Open Market Committee FOMC Open market operations Purchases and sales of U.S. government securities by the FED Most important tool of monetary policy Consists of the 7 board governors plus 5 presidents of the Reserve Banks

27 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

28 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

29 Objectives of the FED High level of employment in the economy Economic growth Price stability Stability in interest rates Stability in financial markets Stability in foreign exchange markets