Transcript Document

Money and the
Financial System
CHAPTER
28
© 2003 South-Western/Thomson Learning
1
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
2
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
3
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
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
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
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
• 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
8
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
9
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
10
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
11
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
12
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
13
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
14
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
15
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
16
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%
17
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
18
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
19
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
20
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
21
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
22
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
23
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
24
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
25
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
26
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
27
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
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Exhibit 2: 12 Federal Reserve Districts
1
2
3
Boston
New York
Philadelphia
4
5
6
7
8
9
Cleveland
Richmond
Atlanta
Chicago
St. Louis
Minneapolis
10 Kansas City
11 Dallas
12 San Francisco
1
9
2
3
7
12
4
10
8
1111
5
6
29
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
30
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
31
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
32
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
33
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
34
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 nonrenewable term with one member
appointed every two years and one
member is appointed as the chair for a
4-year renewable term
35
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
36
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
37
Exhibit 3: Organization Chart for the FED
38
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
39
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
40
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
41
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
42
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
43
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
44
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
45
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
46
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
47
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
48
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
49
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
50