Money and Banking

Section 1 - Money

Three Uses of Money

Economists define money as anything that serves as a medium of exchange, a unit of account, and a store of value.

Medium of exchange is anything that is used to determine value during the exchange of goods and services. Without a medium of exchange people would have to barter or exchange one set of goods or services for another. The problems with bartering though is it becomes too difficult to establish the relative value of items to be bartered.

Three Uses of Money

Money also serves as a unit of account. That is, money provides a means for comparing the values of goods and services.

For example, a unit of account lets you compare prices of one item at various stores to know if you are getting a good deal or not.

Three Uses of Money

Money also serves as a store of value. This means that money keeps its value if you decide to hold on to – or store – it instead of spending it.

Your $100 bill will still be worth a $100 a few weeks or months from now. However, an exception is inflation which may devalue your currency, should it occur.

The Six Characteristics of Money

Currency is defined as the coins and paper bills that are used as money.

Money has to contain durability. Currency frequently exchanges hands and needs to be durable over time.

Money needs to have portability. People must be able to transfer money easily from one person to another when they use money for purchases. Paper money and coins are very portable because they are small and light.

Money has to contain divisibility. To be useful, money must be divided easily into smaller denominations, or units of value

The Six Characteristics of Money

Money needs to have uniformity. People need to be able to count and measure money accurately.

Money needs to be in limited supply. Limited supply ensures money retains its value.

Money has to have acceptability. Everyone in the economy must be able to take the objects that serve as money and exchange them for goods and services.

Sources of Money’s Value

What makes money valuable? The answer is one of the following answers: It can be commodity money, representative money, or fiat money.

Commodity money consists of objects that have value in and of themselves and that are also used as money. For example, various societies have used salt, cattle, and precious stones as commodity money.

Representative money makes use of objects that have value solely because the holder can exchange them for something else of value. Early representative money took the form of paper receipts for gold and silver. Specie is coins made out of gold or silver.

Sources of Money’s Value

United States money today is fiat money. A fiat is an order or decree. Fiat money, also called “legal tender,” has value because a government has decreed that it is an acceptable means to pay debts. Citizens have confidence that the money will be accepted. It remains in limited supply, and therefore valuable, because the Federal Reserve controls its supply.

Section 2 – The History of American Banking

American Banking Before the Civil War

During the first part of our nation’s history, local banks were informal businesses that merchants managed in addition to their regular trade. For example, a merchant who sold cloth, grain, or other goods might allow consumers to deposit money. The merchant would then charge a small fee to keep the money safe. These informal banks were not completely safe, however. If a merchant went out of business or invested deposits in risky schemes, customers could lose all of their savings.

Two Views of Banking

After the Revolutionary War, the leaders of the new nation agreed on the need to establish a safe, stable banking system.

However, there were two opposing views on how the nation should have its banking system. These opposing views were between Alexander Hamilton and Thomas Jefferson. As a Federalist, Hamilton believed that a centralized banking system was key to promoting industry and trade. As an Antifederalist, however, Jefferson wanted the states to establish and regulate banks in its area.

The First Bank of the United States

At first, the Federalists were successful in creating a strong central bank. In 1791, Congress set up the Bank of the United States, granting it a 20-year charter to operate. The US Treasury used the Bank to hold the money that the government collected in taxes and to issue representative money in the form of bank notes, which were backed by gold and silver. The Bank also supervised state chartered banks, making sure they held sufficient gold and silver in exchange for bank notes should the demand arise.

The Bank succeeded in bringing stability to American banking. However, opponents of the Bank charged that ordinary people who needed to borrow money to maintain or expand their farms and small businesses were being refused loans. The Antifederalists pointed out that the Constitution does not explicitly give Congress the power to create a national bank. Therefore, they argued, the bank was unconstitutional.

Chaos of State Banks

When Alexander Hamilton died in a famous duel with Vice President Aaron Burr in 1804, the Bank lost its main backer. The Bank functioned only until 1811, when its charter ran out.

Once the banks charter expired, state banks (banks chartered by state governments) began issuing bank notes that they could not back with specie – gold or silver coins. The states also chartered many banks without considering whether these banks would be stable or creditworthy.

Without any kind of regulation, financial confusion resulted. Prices rose rapidly. Neither merchants nor customers had confidence in the value of the paper money in circulation. Different banks issued different currencies, and bankers always faced the temptation to print more money than they had gold and silver to back it up.

The Second Bank of the United States

To eliminate the state bank chaos, Congress chartered the Second Bank of the United States in 1816. Like the first bank, the Second Bank was limited to a 20-year old charter. The Second Bank slowly managed to rebuild the public’s confidence in a national banking system. Nicholas Biddle was the president of the Second Bank in 1823 and responsible for restoring stability. He put some state banks who could not function too well out of business by making them pay for representative currency in gold or silver that the banks did not have.

Many Americans though were still weary of the federal government’s banking powers. They believed the bank was a tool for the wealthy to further increase their wealth. Even though the Supreme Court ruled the Bank constitutional, President Jackson agreed with the bank’s opponents. In 1832, Jackson vetoed its renewal.

The Free Banking Era

The fall of the Second Bank of the United States once again allowed state-chartered banks to flourish. For this reason, the period between 1837 and 1863 is known as the Free Banking, or “Wildcat,” Era.

Between 1830 and 1837 the number of state-chartered banks nearly tripled. However, with the large amount of banks in existence, there would be many problems.

Free Banking Problems

Bank runs and panics – State-chartered banks often did not keep enough gold and silver to back the paper money that they issued. This sometimes would lead to bank runs – widespread panics in which great numbers of people try to redeem their paper money at the same time. Many banks failed as a result, and public confidence plummeted.

Wildcat banks – Some banks were located on the frontier. They were called wildcat banks because people joked that only wildcats lived in such remote places. Wildcat banks were inadequately financed and had a high rate of failure.

Fraud – A few banks engaged in out-and-out fraud. They issued bank notes, collected gold and silver money from people who bought the notes, and then disappeared. Customers who were left holding the notes lost their money.

Many different currencies – Chartered banks – as well as cities, private banks, railroads, stores, churches, and individuals – were allowed to issue currency. Notes of the same denomination often had different values, so that a dollar issued by the “City of New York” was not necessarily worth the same as a dollar issued by the “City of Atlanta.” The profusion of currencies made it easier to create counterfeits, or worthless imitations of real notes.

Stability in the Later 1800s

By 1860, an estimated 8,000 different banks were circulating currency. To add to the confusion, the federal government played no role in providing paper currency or regulating reserves of gold or silver. The Civil War would make existing problems worth.

During the Civil War both North and South needed to raise money for the war effort. In 1861, the United States printed its first paper currency since the Continental. The name of the currency was “demand notes” but most people called them greenbacks because they were printed with green ink.

In the South, the Confederacy issued currency backed by cotton, hoping that a Confederate victory would ensure the currency’s value. As the war weakened, however, Confederate notes became worthless.

Unifying American Banks

With war raging, the federal government enacted reforms aimed at restoring confidence in paper currency. These reforms resulted in the National Banking Acts of 1863 and 1864. Together, these Acts gave the federal government the power to charter banks, the power to require that banks hold adequate gold and silver reserves to cover their bank notes, and the power to issue a single national currency.

The new national currency led to the elimination of the many different state currencies in use and helped stabilize the country’s money supply.

The Gold Standard

Despite the reforms made during the Civil War, money and banking problems still plagued the country. In the 1870s, the nation adopted the gold standard – a monetary system in which paper money and coins had the value of certain amounts of gold.

The gold standard set a definite value for the dollar, so that one ounce of gold equaled about $20. Since the value was set, people knew that they could redeem the full value of their paper money at any time.

Now, the government could issue currency only if it had enough gold in the treasury to back the notes. Because of the limited supply of gold, the government was prevented from printing an unlimited number of notes. The gold standard thus fulfilled an essential requirement of a banking system; a stable currency that inspires the confidence of the public.

Banking in the Early 1900s

The gold standard helped the banks but did not create a central-decision making authority. Such an authority could help banks provide funds for growth and manage the money supply based on what the economy needed.

Continuing problems in the nation’s banking system resulted in the Panic of 1907. Lacking adequate reserves, many banks had to stop exchanging gold for paper money. Several long established New York banks failed, and many people lost their jobs because businesses could not borrow money to invest in future projects.

The Federal Reserve System

The Federal Reserve Act of 1913 established the Federal Reserve System. The Federal Reserve System, or Fed, served as the nation’s first true central bank, or bank that can lend to other banks in time of need.

The banking system was reorganized in many ways: Federal Reserve Banks – As many as 12 Federal Reserve Banks were created throughout the country.

These banks serve as the central banks of their district. Member banks – banks that belong to the Fed – store some of their cash reserves at the Federal Reserve Bank in their district.

Federal Reserve Board – All of the Federal Reserve Banks are supervised by a Federal Reserve Board appointed by the President of the United States.

Short-Term Loans – Each of the regional Federal Reserve Banks allowed member banks to borrow money to meet short-term demands. This helped prevent bank failures.

Federal Reserve Notes – The system also created the national currency we use today. This allowed the Federal Reserve to increase or decrease the amount of money in circulation according to business needs.

Banking and the Great Depression

The Fed helped restore public confidence in the banks. It was unable, however, to prevent the terrifying Great Depression – the severe economic decline that began in 1929 and lasted for more than a decade.

During the 1920s, banks loaned large sums of money to many high-risk businesses. Many of these businesses were unable to pay back their loans. Because of hard times on the nation‘s farms, many farmers also failed to repay bank loans. Then in 1929, the stock market crash led to widespread bank runs as depositors in all parts of the country rushed to withdraw their money. The combination of unpaid loans and bank runs resulted in the failure of thousands of banks across the country.

Banking Reforms

After becoming President in 1933, Franklin D. Roosevelt acted to restore public confidence in the nation’s banking system. Only days after his inauguration, Roosevelt closed the nation’s banks. This “bank holiday” was a desperate last resort to restore trust in the nation’s financial system. Within a matter of days, sound banks began to reopen.

In 1933, Congress passed the act that established the Federal Deposit Loan Corporation (FDIC). The FDIC insures customer deposits if a bank fails. By 2008, each depositor’s basic accounts in one bank were insured up to $250,000.

Federal legislation severely restricted individual’s ability to redeem dollars for gold. Eventually, currency became fiat money backed only by the government’s decree that established its value. In this way, the Federal Reserve could maintain a money supply at adequate levels to support a growing economy.

Two Crisis in Banking

As a result of many bank failures of the Great Depression, banks were closely regulated from 1933 through the 1960s. The government restricted the interest rates banks could pay depositors and the rates that banks could charge consumers for loans. By the 1970s, bankers were eager for relief from federal legislation.

The Savings and Loan Crisis

In the late 1970s and 1980s, Congress passed laws to deregulate, or remove some restrictions on, several industries. Unfortunately, this deregulation contributed to a crisis in a class of banks known as Savings and Loans (S&Ls).

After deregulation, S&Ls were unprepared for competition. During the 1970s, S&Ls had made long-term loans at low rates of interest. By the 1980s, interest rates skyrocketed. This meant S&Ls had to pay large amounts of interest to their depositors. The S&L industry made many risky loans in the early 1980s. Losses on loans forced many banks out of business.

In 1989, Congress passed legislation that essentially abolished the independence of the savings and loans industry. This legislation expanded the insurance responsibilities of the FDIC.

Financial “Meltdown” and Bailout

In late 2006, problems in the U.S. banking industry began to threaten the housing market, The episode quickly spiraled into a full-fledged crisis, the most serious threat to the U.S. economy since the Great Depression.

Beginning in the 1990s, US banks decided to issue “subprime” loans to people seeking to purchase homes. The term “subprime” refers to loans that are made to borrowers with an unfavorable credit history. The higher interest rate banks charge because of a greater risk makes these loans more profitable.

Banks began to market these loans aggressively among people who did not qualify for standard loans. By 2005, subprime loans made up more than a quarter of all U.S. mortgages. Bankers also devised ways of packaging these mortgages in ways they could be sold off to investors. The value of these bundled mortgages depended on the ability of individual homeowners to repay their loans.

Financial “Meltdown” and Bailout

The situation reached a crisis point when many homeowners had trouble repaying these loans. This led to a sharp increase of foreclosures, the seizure of property from borrowers who are unable to repay their loans. This hurt the lenders, as well as the investors who had bought the mortgage bundles. A number of the nation’s largest financial institutions that had invested heavily in subprime mortgages were forced into bankruptcy. The ripple effect was great, as hundred of thousands of U.S. workers lost their jobs. Businesses and individuals found it difficult to get credit.

By late 2008, the U.S. economy was on the edge of financial catastrophe. It was officially a recession. Treasury Secretary Henry M. Paulson, President George Bush, and U.S. lawmakers organized a $700 billion bailout of the banks, automakers, and Wall Street financial firms. The money was used to help them avoid bankruptcy and restart the flow of credit to businesses and individuals.

In 2009 President Obama signed into law a $787 billion stimulus package – the largest in U.S. history. Approximately one-third of the package was devoted to tax cuts; the rest went to spending increases. These included infrastructure projects and support for state healthcare obligations.

Section 3 – Banking Today

Measuring the Money Supply

The U.S. money supply is all of the money available in the U.S. economy. The money supply can be split up into several categories. The main categories are M1 and M2.

M1 represents money that people can gain access to easily and immediately to pay for goods and services. In other words, M1 consists of assets that have liquidity, or the ability to be used as, or directly converted into, cash. About 55 percent of M1 is made of currency held by the public. Another large component of M1 is deposits in checking accounts. Funds in checking accounts are also called demand deposits, because checks can be paid “on demand,” that is, at any time. Traveler’s checks also make up a part of M1.

M2 consists of all assets in M1 plus several additional assets. These additional M2 funds cannot be converted to cash directly, but can be converted to cash fairly easily. M2 assets are also called near money. M2 includes savings deposits and money market mutual funds.

Functions of Financial Institutions

Banks and other financial institutions are essential to managing the money supply. They also perform many functions and offer a wide range of services to consumers.

Storing Money – Banks provide a safe, convenient place for people to store money. Banks keep cash in fireproof vaults and are insured against the loss of money in the event of a robbery.

Saving Money – Banks offer a variety of ways to save money. Four of the most common ways are savings accounts, checking accounts, money market accounts, and certificates of deposit (CDs).

Loans – Banks provide loans to people. A banking system that keeps only a fraction of its funds on hand and lends out the remainder is called fractional reserve banking. The more money a bank lends out, and the higher the interest rate it charges borrowers, the more profit the bank is able to make. Banks can help businesses get created and grow through the use of loans. If a borrower defaults or fails to pay back their loans, the bank may lose a large amount of money.

Functions of Financial Institutions

Mortgages – A mortgage is a specific type of loans that is used to buy real estate.

Credit Cards – Banks issue credit cards which entitle their owners to buy goods and services based on the owner’s promise to pay.

Simple and Compound Interest – Interest is the price paid for the use of borrowed money. The amount borrowed is the principal. Simple interest is interest paid only on principal. Banks also give interest on savings accounts, checking accounts, and certificates of deposit (CDs).

Types of Financial Institutions

Several kinds of financial institutions operate in the U.S. These include commercial banks, savings and loans associations, mutual savings banks, and credit unions. During the 1990s, these financial institutions became more similar than dissimilar, although differences still remain.

Commercial Banks – Commercial banks offer checking accounts, accept deposits, and make loans to businesses and individuals. Some commercial banks are chartered by the states and regulated by the FDIC. One-third of commercial banks are national banks and are part of the Federal Reserve System. Commercial banks provide the most services and play the largest role in the economy of any type of bank.

Types of Financial Institutions

Savings and Loan Associations – Savings and Loan associations have taken on many of the same roles as commercial banks. However, they are often referred to as “thrifts” because they originally enabled “thrifty” working class people.

Mutual Savings Banks – Mutual Savings Banks can sell stock to raise additional capital. The banks also typically contain checking accounts that pay interest.

Credit Unions – Credit Unions are cooperative lending associations usually established by and for particular groups, usually employees of a specific firm or government agency. Some are open to an entire community. Credit Unions are commonly fairly small and specialize in consumer loans, usually on interest rates favorable to members. Some credit unions also provide checking account services.

Finance Companies – Finance companies make installment loans to consumers. These loans spread the cost of major purchases such as computers, cars, and large appliances over a few number of months. Because people who borrow from finance companies more frequently fail to repay their loans, finance companies generally charge higher interest rates than banks do.

Electronic Banking

Banks began using computers in the early 1970s to keep track of transactions. As computers have become more common in the United States, their role in banking has also increased dramatically.

Automated Teller Machines (ATMs) – ATMs are computers that customers can use to deposit money, withdraw cash, and obtain account information at their convenience. ATMs are typically open 24 hours a day and save banks money they would have to spend on labor costs.

Debit Cards – A debit card is a card that sends signals through a machine and subtracts money from your checking account. Debit cards have passwords or PINS the owner types in.

Home Banking – Many banks, credit unions, and other financial institutions allow people to check account balances, transfer money to different accounts, automatically deposit their paychecks, and pay their bills via computer. You can also transfer money to accounts via the internet.

Electronic Banking

Automated Clearing House – Automated Clearing Houses (ACHs) located at Federal Reserve Banks and their branches, allow consumers to pay bills without writing checks. People can use ACHs to pay regular bills.

Stored-Value Cards – Stored value cards, or smart cards, are similar to debit cards. These cards have a value put on them using prepay. College students, for example, use these cards to pay for cafeteria food, computer time, or photocopying. Phone cards and gift cards are other examples of stored-value cards.