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

2. 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

3. 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

4. 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

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
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

6. 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

7. Exhibit 1: Six Desirable Qualities of Money

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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%

15. 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

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
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

17. 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

18. Exhibit 2: Purchasing Power of $1
Exhibit 2: Purchasing Power of $1.00 Measured in Constant Dollars

19. 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

20. 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

21. 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

22. 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

23. 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

24. Exhibit 3: 12 Federal Reserve Districts

25. 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

26. 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

27. 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.

28. 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

29. 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

30. 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

31. 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

32. Exhibit 4: Organization Chart for the FED

33. 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

34. 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

35. 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

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

37. 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

38. 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

39. 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

40. 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

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

42. 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

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

44. 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

45. 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

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

47. 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

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

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