1

Money and the Financial System

CHAPTER

13

© 2003 South-Western/Thomson Learning

2

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

3

Medium of Exchange

Anything that is generally accepted in payment in exchange for goods and services sold

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

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

6

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

7

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 money should be of uniform quality.

8

Problems with Commodity Money

Fifth, commodity money usually ties up otherwise valuable resources which gives it a relatively high opportunity cost 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

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

10

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

11

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

12

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

13

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

14

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

15

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

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

17

Purchasing Power of Money

The purchasing power of money is the rate at which it exchanges for goods and services

The purchasing power of a dollar over time varies inversely with the price level

18

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

19

Federal Reserve System

Federal Reserve System was created in 1914 as the central bank and monetary authority of the United States in response to a series of bank failures.

Consists of 12 central banks in 12 Federal Reserve Districts around the country

20

11

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

12

11

10

19

6

7

8 5

4

2

3

21

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

22

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

23

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 banks

24

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

25

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

26

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

27

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

28

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

29

Objectives of the FED

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