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Money and the Financial System

Chapter 28

© 2006 Thomson/South-Western

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Evolution of Money

Barter is the direct trading of one good for another good

Problems with barterRequires a double coincidence of wants:

traders have products that other traders want

The traders must agree on the exchange rate between the two goods

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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

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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

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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 flowStock 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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Desirable Qualities of MoneyDurablePortable or easily carriedDivisibleAcceptableGresham’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 costRelatively stable value

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Exhibit 1: Six Desirable Qualities of Money

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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

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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

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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

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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

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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

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Fractional Reserve Banking

The total claims against the goldsmith consisted ofClaims 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 depositsFor 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, 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 payeeNotes could be redeemed by anyone who presented them

Representative moneyBank notes that exchange for a specific commodityPaper money was often as good as gold since the bearer

could redeem it for gold

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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 soNot 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 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

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Exhibit 2: Purchasing Power of $1.00 Measured in 1982-1984 Constant Dollars

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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 dollar is worth less

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

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

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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

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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 (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

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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

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Exhibit 3: 12 Federal Reserve Districts

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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

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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

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The Fed’s other powers: to buy and sell government securities,to extend loans to member banks, to clear

checksto require that member banks hold reserve

equal to at least some specified fraction of their deposits.

Powers of Federal Reserve

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Federal Reserve Banks

Can be thought of as a bankers’ bankHold deposits of member banksExtend loans to member banks

Interest rate charged for these loans is called the discount rate

Hold member bank reserves on depositReserves 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

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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 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

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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 operationsPurchases and sales of U.S. government securities

by the FedMost important tool of monetary policy, to influence

monetary supply

Consists of the 7 board governors plus 5 presidents of the Reserve Banks

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Exhibit 4: Organization Chart for the FED

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Regulating the Money Supply

FED has three major tools for regulating the money supplyConducting 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

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Deposit Insurance

Not a specific part of the FedFederal 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 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/bondsBond 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 stabilityInterest rate stabilityFinancial market stabilityExchange rate stability

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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 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 marketsto 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 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

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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

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

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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

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

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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

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Structure of U.S. Banking

Two developments have allowed banks to get around branching restrictionsBank holding companiesMergers

Bank holding company:a corporation that may own several different banksMany states let holding companies cross state linesHolding companies can provide other services that

banks are not authorized to offer

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Exhibit 7: Number of Commercial Banks Declined over the Last Two Decades, But the

Number of Branches Continues to Grow

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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

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

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