MONEY & MONEY & BANKINGBANKING

• COINS = disks of precious metal - usually gold or silver (specie)

• Since ‘65, U.S. doesn’t have any coins…now they are merely tokenstokens.

CURRENCYCURRENCY = Paper Money + Coins

• Look at the edges of pennies and nickels and note that these coins have no grooves – the grooves are known as REEDINGREEDING

• Look at the reeded coins -- dimes, quarters and half dollars – and note there is copper sandwiched between a nickel-zinc metal -- k/a CLAD COINS

• Before 1965, coins were not clad, they were made of 900 (90% pure) silver.

MONETARY LAWS OF MONETARY LAWS OF ECONOMICS:ECONOMICS:Age old problem of government -- they spend money, they tax to raise additional $, but overtaxing leads to revolution so….

COUNTERFEITINGCOUNTERFEITING becomes the new solution: * Gov’t began clippingclipping coins (clipped off edges-used the shavings to make more coins) * People noticed & began to use reedingreeding to tell the difference * Reeding made clipping obvious so gov’t then came up with debasingdebasing of coins (melted down, base metal added so could make more coins)

GRESHAM’S LAWGRESHAM’S LAW eventually develops …. Bad money drives good money out of circulation

FUNCTIONS OF MONEYFUNCTIONS OF MONEY

• A MEDIUM OF EXCHANGE– simply means that a seller will accept it in

exchange for a good or service•gold, silver, salt…

– without money, people would have to barterbarter

• A UNIT OF ACCOUNT– used to compare the value of goods &

services in relation to one another– serves as a measure of value

• A STORE OF VALUE– holds its value longer than most goods

CHARACTERISTICS OF CHARACTERISTICS OF MONEYMONEY

• In the past, people have used many things as currency including cattle, salt, precious stones, fur, and dried fish.

• Why would these things NOT serve as good currency in today’s world?

• The six characteristics of money are:1. Durability2. Portability3. Divisibility4. Uniformity5. Limited supply6. Acceptability

CHARACTERISTICS OF CHARACTERISTICS OF MONEYMONEY

CHARACTERISTICS OF CHARACTERISTICS OF MONEYMONEY

• DurabilityDurability– Must be able to use it over and over again– Why is paper $ considered durable?

• PortabilityPortability– An obvious advantage of paper money &

coins

• DivisibilityDivisibility– Must be easily divisible into smaller units

• UniformityUniformity– People must be able to count and measure

money accurately

• Limited SupplyLimited Supply– Must be limited in supply by nature or

government– Value needs to be stable / should remain

constant– Amount of $ in circulation and value of that $

have an inverse relationship (e.g., too much $ in circulation, value goes down

• AcceptabilityAcceptability– Must be acceptable to people as having valueMust be acceptable to people as having value– All in society must be able to take the things All in society must be able to take the things

that serve as money and exchange them for that serve as money and exchange them for goods and servicesgoods and services

• There are several sources of money’s value depending on whether it is:– Commodity Money– Representative Money– Fiat Money

What Makes Money Valuable?What Makes Money Valuable?

• Commodity MoneyCommodity Money– objects that have value in and of

themselves, like cattle, and that are also used as money

– Why is it impractical for use?– What characteristics of money is it

lacking?

What Makes Money Valuable?What Makes Money Valuable?

• Representative MoneyRepresentative Money– 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.

What Makes Money Valuable?What Makes Money Valuable?

• People left their gold in goldsmith’s safes and would carry paper ownership receipts to show how much gold they owned.

• During the American Revolution, problems arose with Continentals - they were not backed by gold or silver and were therefore useless.

FIAT FIAT MONEYMONEY

• Fiat Money has value just because a government has decreed that it is an acceptable means to pay debts.

• Today’s U.S. Dollar is a federal reserve note– Not a silver certificate (which was

backed up by silver)• It is fiat money - the only thing that

gives the dollar value is the legal tender statement– Inconvertible Fiat Money Standard –

can’t be converted into gold or silver

History of Legal TenderHistory of Legal Tender• Kublai Khan’s gov’t –

“amount” of gold just written on paper….refusal to accept = severe punishment

• French 200 years ago, phony $ with legal tender statement … refusal = guillotine

• U.S. in Revolutionary gov’t – refusal to accept its “Continental Dollars” = treason and thrown in jail

• Now in U.S., refusal to accept Federal Reserve Notes in payment = cancellation of the debt.

History of Banking in the U.S.

• Originally, merchants served as bankers in America

• After the American Revolution, the new nation’s leaders decided that they needed to establish a safe, stable banking system.

• This need led to a tireless disagreement on how to organize the national banking system.

Opposing Views of the B.U.S.

• FederalistsFederalists– Favored a centralized banking system– Proposed a national bank in 1789– Alexander Hamilton, Sec. of .Treasury

• AntifederalistsAntifederalists– Favored a decentralized banking

system in which states established and regulated banks within their borders

– Thomas Jefferson favored this plan

First Bank of the United States

• Federalists won - in 1791 Congress established the Bank of the United States (B.U.S.)– Had power to create national currency, manage federal

gov’ts funds & monitor other banks in country

• Antifederalists, led by Jefferson, argued that the Bank was unconstitutional and that it benefitted only the wealthy.

• BUT, when Jefferson later became P, he continued the Bank & it functioned until 1811, when its charter (authority to operate) ran out.

• State banks then took over for the B.U.S.• Major chaos and confusion for the next 5 years.

The Second B.U.S.

• To eliminate the chaos, Congress chartered the Second B.U.S. in 1816. Declared constitutional by SCOTUS in 1819.

• Economic stability was restored but many, such as President Andrew Jackson, were still wary of the Bank’s powers.

• In 1832 Congress tried to renew the Bank’s charter

• President Andrew Jackson vetoed the renewal and killed the bank.

• Claimed it was a monopoly, unconstitutional, favored only the rich, etc.

From Free Banking to Stability

• State-charted banks flourished once again from 1837 to 1863 – the “Wildcat Era”

• Huge numbers of banks caused a variety of problems:– Bank runs and panics– Wildcat banks (inadequately financed / high rate

of failure)– Fraud– Many different currencies (different values)

•National Banking Acts passed in 1863 and 1864 to remedy the problems

From Free Banking to Stability

• National Banking Acts of 1863 and 1864 gave the federal government the power to:– Charter banks– Require that banks hold an adequate

amount of gold and silver reserves– Issue a national currency

• In the 1870s the nation adopted the gold gold standardstandard

• set a definite value for the dollar• Currency had the value of certain amounts of

gold, e.g., one dollar =one ounce of gold

Banking in the Early 1900s• Still had problems in spite of having a

national currency and being on a standard – the gold standard.

• There still was no central decision-making authority in banking.

– Panic of 1907

• In 1913, the Federal Reserve Act established the Federal Reserve System, which reorganized the federal banking system

What is the Federal Reserve?• The central banking system of the U.S. – it is a corporation

• The Fed is both public and private

• Owned by privately-owned banks, not the government

• BUT, controlled to a small degree by the government (members of its Board of Governors are picked by the President & confirmed by Congress)

• Generally though, it acts independently • Duties:

– to conduct the nation's monetary policy

– supervise and regulate banking institutions

– maintain the stability of the financial system

– provide financial services to depository institutions and the U.S. government

Banking and the Great Depression

• The Fed, however, was unable to prevent the Great Depression.

• President Franklin Roosevelt acted to restore the banking system in the 1930s – Banking Holiday

• Established the FDICFDIC, which insured customer deposits if a bank failed (amount insured is now $250,000)

• FDR also changed the American currency to fiat money fiat money – no more gold standard

• the Fed could adequately control the money supply

The Savings and Loan Crisis• In the late 1970s and 1980s, Congress passed laws to

deregulate several industries.• This deregulation led to a crisis for the Savings and

Loan industry, which was unprepared for the intense competition it faced after deregulation.

• High interest rates and risky loans added to the crisis.• In 1989, Congress passed legislation that

abolished the independence of the Savings and Loan industry.

The Sub-Prime Mortgage Crisis

• Mortgage companies and banks began to loan people money who could not afford to pay these loans back – “subprime” “subprime” loans. WHY?

• When interest rates rose, many people couldn’t afford to pay their mortgages, which led to foreclosures.

• The ripple effect of the mortgage crisis hit banks and creditors hard

• Contributed to U.S. economy in a recession by 2008/2009.

• Bush bailout in 2008 ($700 billion)

• Obama stimulus in 2009 – recovery has been slow …

BANKING TODAY• What banking services do

financial institutions provide?– Checking & Savings Accounts– Issue credit cards– Make loans to businesses– Personal loans to individuals– Provide mortgages to prospective

home buyers– Manage ATM machines

Measuring the Money Supply

• 2 categories of money supply:

• M1 represents money that people can gain access to easily. It has great liquidity. This includes:– Currency– Deposits in checking accounts (demand

deposits)– Traveler’s checks

M1

M2• M2 consists of all the assets in

M1 plus several additional assets – like deposits in savings accounts. These funds cannot be used as cash directly, but can be converted to cash fairly easily.– What is the

difference between M1 and M2?

Functions of Financial Institutions

• Storing money– They provide a safe place to store $

• Saving money– They offer people ways to save money

through:• Checking accounts• Savings accounts• Money market accounts, which allow people

to save and write a limited number of checks

– Riskier than savings accounts because they are NOT insured by the federal gov’t

• CDs, which offer a guaranteed rate of interest but cannot be removed until after a specified period of time.

Loans• Banks loan $ and charge interest• Typical consumer loans:

– Buy homes (mortgages)– Pay for college– Start and grow

businesses• Fractional reserve banking: bank

keeps a fraction of its funds on hand and lends out the rest.

• See pages 266-267 for example of how banks “grow” money to loan out

Mortgages and Credit Cards

• A mortgage is a specific type of loan that is used to buy real estate.– Traditional mortgage = 30 years– Mortgage interest is deductible on

income tax return

• Credit cards entitle their owners to buy goods and services based on a promise to pay.– High interest rates!– Do NOT just make the minimum payments!

Simple and Compound Interest

• Banks pay simple interest only on the principal of a deposit.

• Compound interest is interest paid on both principal and accumulated interest.– According to the

table, after five years, what is the total interest that the deposit-holder will have earned?

How Banks Make a Profit

Types of Financial Institutions

• Commercial Banks– Offer checking accounts, accept deposits,

and make loans• Savings and Loan Associations

– Allow people to save up and borrow enough for their own homes

• Savings Banks– Owned by depositors who make smaller

deposits than a commercial bank would handle

• Credit Unions– Cooperative lending associations

established for particular groups• Finance Companies

– Make installment loans to consumers

Electronic Banking

• ATMs allow customers to deposit money, withdraw cash, and obtain information.

• Debit cards can be used at an ATM or in a store to purchase goods.– a PIN required for security reasons.

• Home banking—More and more people use the Internet to check balances, transfer money, automatically deposit paychecks, and pay bills.

• How does a debit card work?– How is it different from a credit card?

ACHs and Stored-Value Cards

• Automated Clearing Houses (ACHs) allow consumers to pay bills without writing checks.

• Stored-value cards carry money on them and can be used by college students on campus or by people using a phone card with stored minutes, metro cards, etc.