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1
Money and the Financial System
Chapter 28
© 2006 Thomson/South-Western
2
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
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
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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
7
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
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 $1.00 Measured in 1982-1984 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
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
28
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
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 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
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 economyEconomic growthPrice stabilityInterest rate stabilityFinancial market stabilityExchange 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 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
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)