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Money and Banking
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Chapter 10: Money and Banking
KEY CONCEPT• Money provides a low-cost method of trading one good or service for
another. It makes the system of voluntary exchange efficient.
WHY THE CONCEPT MATTERS• Money is important to everyone in our society. What were the last
three economic transactions you completed using money? Imagine what it would have been like to make those purchases without paper bills and coins.
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Functions of MoneyKEY CONCEPTS
• Money—anything people will accept as a medium of exchange– over time, cattle, grain, metals, shells, other objects used as
money
Money: Its Functions and Properties
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Functions of Money
Function 1: Medium of Exchange • Medium of exchange—means through which products can be
exchanged • Barter—exchanging goods or services for other goods or services
– inefficient: both people must want what the other one has to exchange
• Money convenient: allows for precise and flexible pricing of products
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Functions of Money
Function 2: Standard of Value • Money serves as a standard of value:
– measure of economic worth of goods, services in the exchange process
• In United States, the dollar is the standard of value of all products
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Functions of Money
Function 3: Store of Value• Money acts as a store of value:
– holds its value over time– can set aside for later use because will be accepted in future
• Does not function well as store of value when there is significant inflation
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Properties of Money
KEY CONCEPTS• Item used as money must possess certain properties
– physical properties are characteristics of item itself– economic properties are linked to role money plays in the market
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Properties of Money
Property 1: Physical• Durability—sturdy enough to last through many transactions• Portability—small, light, easy to carry• Divisibility—divisible so change can be made
– allows for flexible pricing• Uniformity—distinctive features and markings make it recognizable
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Properties of Money
Property 2: Economic• Stability of value—purchasing power should be relatively stable• Scarcity—must be scarce to have any value• Acceptability—users must agree that it is valid medium of exchange
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Types of Money
KEY CONCEPTS• Money derives value from one of three sources • Commodity money—value based on the material from which it is
made• Representative money—paper money backed by something tangible
• Fiat money—declared by government to have value, accepted by
citizens
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Types of Money
Type 1: Commodity Money• Items have value in themselves apart from their value as money
– includes gold, precious stones, salt, olive oil; scarce or useful• Coins most common; precious metal in them worth their face value• If item becomes too valuable, people hoard, don’t circulate
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Types of Money
Type 2: Representative Money• Can be exchanged for something else of value• Beginnings in Middle Ages: people issued promises to pay in metal
– often unsafe or inconvenient to transport gold and silver• Later, governments regulated amount stored of metal needed to back
paper • Value changes with metal supply, price; causes inflation, deflation
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Types of Money
Fiat Money• Value based on government fiat, or order, saying the money has
value• Coins have token amount of precious metal; paper money has no
intrinsic value• Government maintains value by controlling supply—keeping it scarce
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Money in the United States
KEY CONCEPTS• Narrowest sense, money is item used immediately for transactions• Currency—paper money and coins • Demand deposits—checking accounts; funds become currency on
demand• Near money—savings accounts, time deposits; funds become cash
easily
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Money in the United States
Money in the Narrowest Sense• Money in narrowest sense sometimes called transactions money• Currency is about half of transactions money used• Demand deposits are mostly noninterest-bearing checking accounts
– traveler’s checks are small part– negotiable order of withdrawal (NOW), other checkable deposits
are rest
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Money in the United States
Are Savings Accounts Money?• Near money cannot be used directly to make transactions• Savings account: funds can be moved to checking account,
withdrawn• Time deposits:
– funds deposited for specific period to receive higher interest– include certificates of deposit (CDs), money market accounts
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Money in the United States
How Much Money?• Most often cited instruments for measuring money are M1, M2• M1—currency, demand deposits, other checkable deposits
– called liquid assets• M2—M1, savings accounts, small time deposits, money market
accounts
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Reviewing Key Concepts
Explain the difference between the terms in each of these pairs:
• standard of value and store of value• commodity money and representative money• demand deposits and near money
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The Origins of BankingKEY CONCEPTS
• Late Middle Ages, Italian merchants stored people’s money; made loans
• American colonial merchants followed same practice • Private banks insecure: if merchant’s business failed, deposits lost• After revolution, state banks chartered by state governments
– many banks issued own currency, not backed by gold or silver held
The Development of U.S. Banking
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Alexander Hamilton: Shaping a Banking SystemThe First Bank of the United States
• In 1789, became first Secretary of the Treasury; proposed national bank
• Against strong opposition, First Bank of the United States chartered in 1791– issued national currency– controlled money supply by refusing state bank money not backed – loaned money to federal government, state banks, businesses
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19th-Century Developments
KEY CONCEPTS • 1811, Congress refused to renew charter of First Bank of the U.S.
– government had difficulty financing War of 1812– state banks again issued currency not linked to gold, silver
reserves– increased money supply led to inflation during the war
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19th-Century Developments
The Second Bank of the United States• 1816, Congress chartered Second Bank of the United States
– more resources than First Bank; made money supply more stable• Opponents thought bank too powerful, too close to wealthy
– 1832, President Andrew Jackson vetoed renewal of charter
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19th-Century Developments
Wildcat Banking• Second Bank’s charter lapsed in 1836; no federal oversight of
banking• All banks state banks; issued own paper currency called bank notes• States passed free banking laws; resulted in wildcat banks
– susceptible to bank runs leading to panics, economic instability
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19th-Century Developments
The Struggle for Stability• In 1863, National Banking Act created national banks chartered by
U.S. government– created national currency backed by U.S. Treasury bonds– required minimum amount of capital for national banks, to back
currency– taxed state bank notes issued after 1865, taking them out of
circulation• 1900, United States adopted gold standard—made dollar equal a set
amount of gold
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20th-Century Developments
KEY CONCEPTS• National banks, gold standard initially brought stability to banking• Economy still experienced inflation, recession, financial panics• United States needed central decision-making body to manage
money supply
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20th-Century Developments
A New Central Bank• 1913, Federal Reserve System created; consists of 12 regional
banks, one decision-making board– provides financial services to federal government– makes loans to banks that serve the public– issues Federal Reserve notes as national currency– regulates money supply
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20th-Century Developments
The Great Depression and the New Deal• 1929, many banks failed due to bank runs• Banking Act of 1933 part of President Franklin Roosevelt’s New Deal
– regulated interest rates banks paid; prohibited sale of stocks by banks
– Federal Deposit Insurance Corporation (FDIC) insured people’s savings
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20th-Century Developments
Deregulation and the S&L Crisis• 1980, 1982 laws lifted federal limits on savings interest rates• Savings and loans associations now operating like commercial banks
– made riskier loans• Many S&Ls failed; Congress funded industry restructuring
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Financial Institutions in the United States
KEY CONCEPTS• Bank: commercial banks, savings and loan associations, credit
unions• State, federal governments charter financial institutions, regulate
– amount of money owners must invest in a bank– size of reserves a bank must hold– ways loans may be made
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Financial Institutions in the United States
Type 1: Commercial Banks• Privately owned commercial banks are oldest type of banks
– initially created to provide business loans– today, checking and savings accounts, loans, investments, credit
cards• All national, about 16 percent of state commercial banks belong to
the Fed
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Financial Institutions in the United States
Type 2: Savings Institutions• S&Ls first chartered by states in 1830s
– took savings deposits; provided home mortgage loans– today, provide many of same services as commercial banks
• Since 1933, federal government also charters S&Ls– many federally chartered S&Ls call selves savings banks
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Financial Institutions in the United States
Type 3: Credit Unions• In 1909, first credit union chartered; 1934, federal system created
– offer savings and checking accounts; specialize in auto, mortgage loans
– deposits insured by National Credit Union Association (NCUA)• Credit unions have membership requirements
– cooperatives: nonprofit organizations owned by, operated for members
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Reviewing Key Concepts
Use each of the terms in a sentence that illustrates the meaning of the term:
• state bank• national bank• gold standard
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What Services Do Banks Provide?KEY CONCEPTS
• Banks are like stores where money is bought (borrowed), sold (lent)• Customers can store money, earn money, borrow money• Banks earn money by charging interest or fees
Innovations in Modern Banking
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What Services Do Banks Provide?
Service 1: Customers Can Store Money • Banks store currency in vaults; insured against theft, other loss• Customers also store
– money in bank accounts; insured against bank failure– papers and valuables in safe deposit boxes
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What Services Do Banks Provide?
Service 2: Customers Can Earn Money • Savings accounts, some checking accounts pay interest• Money market accounts, CDs pay higher interest rate
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What Services Do Banks Provide?
Service 3: Customers Can Borrow Money• Banks lend money through fractional reserve banking
– percent of deposit banks must keep is set by Fed• Banks make loans to customers it approves
– loans have set time period and interest rate; property is collateral• Credit card purchases are loans; interest charged after one month
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Banking Deregulation
KEY CONCEPTS• Before 1980s, government regulated interest rates paid and charged
– required banks to operate in one state; some states limited branches
• In 1980s, 1990s, deregulation ended restrictions, changed banking
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Banking Deregulation
Bank Mergers• Deregulation led to mergers; no more restrictions on interstate
banking• Advantages: more competition meant low interest rates, more
services– also more branches; economies of scale, especially for technology
• Disadvantages: fewer banks to choose from– fear larger banks uninterested in small customers, local
communities
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Banking Deregulation
Banking Services• Financial Services Act of 1999 lifted last restriction on banks• Banks, insurance companies, investment companies compete
– sell stocks, bonds, insurance, traditional banking services• Customers continue to use different companies for different services
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Technology and Banking
KEY CONCEPTS• Technology has led to electronic banking• Automated teller machines (ATMs)—use special cards
– customers make transactions without bank officers• Debit cards—used to withdraw cash or make purchases • Stored-value cards—represent money holder has on deposit with
issuer
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Technology and Banking
Automated Teller Machines• ATMs—data terminals linked to a bank’s computer network
– customer needs personal identification number (PIN)– check balances, make deposits, withdrawals, transfers, loan
payments • All ATM networks connected; some banks charge fees• Save banks money: cheaper than human tellers; more “bank”
locations
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Technology and Banking
Debit Cards• Debit cards are linked to a bank account• Can be used at ATM machines to make transactions• Can be used to make purchases at retail outlets; also called check
cards– price of purchase is immediately deducted from the account– unlike credit cards, can only spend as much as have in account
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Technology and Banking
Stored-Value Cards• Also called prepaid cards—pay for card, use it to pay for products
– include transit fare cards, gift cards, telephone cards– convenient: no need to have exact change
• Need to compare to cost of checking account or check-cashing service
• Not always covered by FDIC insurance that protects customer deposits
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Technology and Banking
Electronic Banking• Electronic banking transactions performed through the Internet
– direct deposit, transaction review, transfers, bill paying• Information security and identity theft are problems for banks
– must reveal privacy policies; let customers decide what data is shared
– developing more sophisticated information security systems
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Reviewing Key Concepts
How are these three terms related? How are they different?
• automated teller machine• debit card• stored-value card
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Student Loans
Background• The high cost of a college education forces 10 million students and
800,000 parents to take out loans to pay for at least part of college.• Federally guaranteed loans are the main source of funding for
college, not banks, S&Ls, or credit unions.
What’s the Issue?• What is the current situation with student loans? What are the future
ramifications of the increasing cost of paying for college?
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Student Loans {continued}
Thinking Economically1. Compare the financial news presented in documents A and C. What
bearing do you think the information in document A might have on what you learned from document C?
2. Document B humorously points to the prominence of student loans in U.S. higher education. Specifically, what parts of documents A and C support this view?
3. In document A, what does the federal government seem to be saying about who should pay for a college education? With this in mind, what does Figure 10.7 mean for students and parents?