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Money and the Financial System

CHAPTER

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© 2003 South-Western/Thomson Learning

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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 barterRequires a double coincidence of wants the traders each have products that the other wantsThe trades must agree on the exchange rate between the two goods

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Functions of Money

Variety of items have functioned as money throughout history

Money fulfills three important functions

A medium of exchangeA unit of accountA store of value

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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

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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

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Store of ValueMoney 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 timeFlow is an amount per unit of timeMoney is a stock and income is a flow

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Problems with Commodity Money

Commodity money refers to the use of some item – gold, silver, wampum – as money

ProblemsIf the commodity money is perishable it must be properly stored or its quality can deteriorate money must be durableIf the commodity used as money is bulky, exchanges for major purchases can become unwieldy money should be portable

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Problems with Commodity Money

Some commodity money is not easily divisible into smaller units money should be divisibleIf 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

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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

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CoinsWhen 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

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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

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CoinsThe 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 commodityFor example, the quarter costs only about 3 cents to make and is worth more as money than as a metal

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GoldsmithsIndividuals 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

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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

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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

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Fractional Reserve Banking

The total claims against the goldsmith consisted of

Claims by those who had deposited their money, plusClaims 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

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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%

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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

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Bank Notes and Checks

Principal difference between checks and bank notes

Checks could be redeemed only if endorsed by the payeeNotes could be redeemed by anyone who presented them

Paper money was often as good as gold since the bearer could redeem it for gold

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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

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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

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Value of Money

Why does money have value?The commodity feature of money bolstered confidence because of its acceptabilityInitially paper money was acceptable because it was redeemable in gold, silver of some other item of valueHowever, 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

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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

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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

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Depository Institutions

Depository institutions can be classified into two types

Commercial banksThrift institutionsCommercial 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

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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

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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

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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 Boston

2 New York

3 Philadelphia

4 Cleveland

5 Richmond

6 Atlanta

7 Chicago

8 St. Louis

9 Minneapolis

10 Kansas City

11 Dallas

12 San Francisco

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11

10

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6

7

8 5

4

2

3

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Federal Reserve SystemThe 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

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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

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Federal Reserve Banks

Can be thought of as a bankers’ bank

Hold deposits of member banksExtend 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

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Banking During the Great Depression

Federal Reserve System was created to eliminate some of the problems of bank panicsHowever, 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 banksSpecifically, the management of the FED did not seem to understand that the banking system’s instability was contributing to the deterioration of the economy

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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 featuresBoard of GovernorsFederal Open Market CommitteeRegulating the Money SupplyDeposit InsuranceRestricting Bank Investment Practices

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Board of GovernorsResponsible 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

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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

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Federal Open Market Committee

FOMC

Open market operationsPurchases and sales of U.S. government securities by the FEDMost 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

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Exhibit 3: Organization Chart for the FED

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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 marketSetting the discount rate – the interest rate charged by Reserve Banks for loans to member banksSetting legal reserve requirements for member banks

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Deposit InsuranceNot 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

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Bank Investment PracticesAs 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

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Objectives of the FED

High level of employment in the economyEconomic growthPrice stabilityStability in interest ratesStability in financial marketsStability in foreign exchange markets

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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

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Bank DeregulationThe 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

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Bank DeregulationThis 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

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Thrift BailoutMost 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

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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

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Structure of U.S. BankingUnited 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

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Structure of U.S. Banking

Two developments have allowed banks to get around branching restrictions

Bank holding companiesMergers

Bank holding company is a corporation that may own several different banks

Many states let holding companies cross state linesHolding companies can provide other services that banks are not authorized to offer

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Structure of U.S. Banking

Bank mergers allows banks to expand their geographical reach

Allows banks to Gain more customersThe higher volume of transactions should reduce operating costs per customerMay also be a way of avoiding the concentration of bad loans that sometimes occur in one geographical area