1 Money and the Financial System CHAPTER 28 © 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 Functions of Money Variety of items have functioned as money throughout history Money fulfills three important functions A medium of exchange A unit of account A store of value

4 Medium of Exchange Anything that is generally accepted in payment in exchange for goods and services sold Thus, so long as a number of individuals believe something can be used to purchase whatever is desired, it can serve as money In early times, money was commodity money like gold and silver

5 Unit of Account A standard upon which prices are based Common denominator or yardstick for measuring the value of all other goods and services Eliminates the necessity of having to determine how much of each good exchanged for every other good

6 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

7 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

8 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 Gresham’s Law: bad money drives out good money People tend to trade away inferior money and hoard the best As a result, the supply of money shrinks and the quantity in circulation becomes less acceptable Therefore, money should be of uniform quality

9 Problems with Commodity Money Fifth, commodity money usually ties up otherwise valuable resources  it has a relatively high opportunity cost, compared with, say paper money  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

10 Coins When silver and gold were used as commodity money, both their quality and quantity were open to question These precious metals could be debased with cheaper metals (for example, adding a less valuable metal to the coin when it was minted)  the quantity and quality of the metal had to be determined with each exchange

11 Coins 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

12 Coins The power to coin was originally considered an act of sovereignty Seigniorage refers to the revenue earned from coinage by the seignior Token money is money whose face value exceeds its cost of production Alternatively, its value as money exceeds its value as a commodity For example, the quarter costs only about 3 cents to make and is worth more as money than as a metal

13 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

14 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

15 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

16 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

17 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%

18 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 Banks in London introduced checks

19 Bank Notes and 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 Paper money was often as good as gold since the bearer could redeem it for gold

20 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 Once paper money became widely accepted, governments began issuing fiat money

21 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

22 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 in exchange

23 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 each dollar is worth Specifically, the purchasing power of a dollar over time varies inversely with the price level

24 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

25 Depository Institutions Depository institutions can be classified into two types Commercial banks Thrift 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 Demand deposits are so named because a depositor can write a check demanding those deposits

26 Thrift Institutions Include savings and loan associations, mutual savings banks, and credit unions Only recently have been given the authority to offer demand deposits Credit unions are by far the largest group and can extend loans only to their members

27 Dual Banking System Originally commercial banks in the United States were chartered by the states  state banks The National Banking Act of 1863 and its later amendments created a system of federally chartered banks  national banks

28 Federal Reserve System Federal Reserve System was created in 1914 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 2 shows the Federal Reserve Districts

29 11 Exhibit 2: 12 Federal Reserve Districts 1Boston 2New York 3Philadelphia 4Cleveland 5Richmond 6Atlanta 7Chicago 8St. Louis 9Minneapolis 10Kansas City 11Dallas 12San Francisco

30 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 thus subject to new regulations issued by the FED For state banks, membership was voluntary and most state banks have not joined

31 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 Federal Reserve was also given other powers

32 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 –Promote bank safety –Facilitate interbank transfers of funds –Satisfy the cash demands of their customers –Comply with Federal Reserve regulations

33 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 Specifically, the management of the FED did not seem to understand that the banking system’s instability was contributing to the deterioration of the economy

34 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

35 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

36 Board of Governors Board membership is relatively stable since a new president can be sure of appointing or reappointing only two members in a presidential term Board structure was designed to insulate monetary authorities from short-term political pressure by elected officials

37 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 Exhibit 3 shows the organizational structure of the FED

38 Exhibit 3: Organization Chart for the FED

39 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

40 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

41 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

42 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

43 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

44 Bank Deregulation The combination of deposit insurance, unregulated interest rates, and wider latitude in the kinds of assets that thrifts could purchase gave them a green light to compete for large deposits in national markets and 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

45 Bank Deregulation This combination created a moral hazard in which bankers take unwarranted risks because depositors were insured  most paid little attention to their bank’s health Zombie banks – banks that were already virtually bankrupt – were able to attract additional deposits from healthy banks by offering higher interest rates

46 Thrift Bailout Most of these gambles, particularly loans to real estate developers, failed and thrifts lost a ton 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

47 Bank Failures As in the case of the thrifts, 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 while in the Northeast falling real estate values caused borrowers to default

48 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

49 Structure of U.S. Banking Two developments have allowed banks to get around branching restrictions Bank holding companies Mergers Bank holding company is 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

50 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