Money and the Financial System

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Macro
ECON
McEachern 2008-2009
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CHAPTER
Money and the Financial System
Designed by Amy McGuire, B-books, Ltd.
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The Evolution of Money

• No exchange
• No money
• Specialization
• Exchange Barter
• Barter
• Double coincidence of wants
• Agree on exchange rate

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The Evolution of Money

• The earliest money
• Good easily traded later
• High degree of acceptability
• Functions of money
• Medium of exchange
• Commodity money
• Unit of account
• Store of value
• Retains purchasing power over time

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The Evolution of Money

• Properties of the ideal money
• Durable
• Portable
• Divisible
• Uniform quality
• Low opportunity cost
• Relatively stable in value

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Exhibit 1
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Six Properties of Ideal Money
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Coins

• Coinage
• Amount and quality of the metal
• By count
• Problems
• Getting clipped
• Counterfeiting
• Token money
• Face value gt cost of coinage
• Seigniorage profit from coinage

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The Hassle of Small Change
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• Pennies
• Cost 1.5 cents per coin
• Nickels
• Cost 5.5 cents per coin
• Rising metal prices
• Lower cost alloy
• Abolish the penny
• Penny 5 cents withdraw nickels

Case Study
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The Hassle of Small Change
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• Production of pennies
• Increased
• 6.8 billion pennies in 2003
• To 8.2 billion pennies in 2006
• Demand for pennies
• Hoarding
• Sales tax
• Zinc producers - lobby

Case Study
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Money and Banking

• Banks Goldsmith
• Safekeeping
• Earn interest
• Checks
• Extend loans
• Create medium of exchange, money
• Public confidence
• Fractional reserve banking system

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Representative Money and Fiat Money

• Bank notes
• IOUs
• Paper money
• As good as gold
• Representative money
• Fiat money
• From the power of the state
• Legal tender

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The Value of Money

• Purchasing power of money
• Rate of exchange for goods and services
• Higher price level in economy
• Smaller purchasing power
• Purchasing power of in a year
• 100 Price index in same year
• Evolution over time
• Steady decline since 1960

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Exhibit 2
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Purchasing Power of 1 Measured in 19821984
Constant Dollars
An increase in the price level over time reduces
what 1.00 buys. The price level has risen every
year since 1960, so the purchasing power of 1.00
(measured in 1982-1984 constant dollars) has
fallen from 3.38 in 1960 to 0.48 in 2007
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When Money Performs Poorly

• Hyperinflation in Brazil
• Prices grow by the hour
• Not reliable store of value
• Exchange for stable currency
• Barter

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When Monetary Systems Break Down
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• Too much money in circulation
• Increase demand for hard currency
• Hoarding the hard currency
• Not enough money in circulation
• Hoarding currency
• Vouchers Barter
• Bank panics
• Strict price control
• Barter

Case Study
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Financial Institutions in the U.S.

• Depository institutions
• Commercial banks
• Loans to businesses
• Thrift institutions
• Savings banks
• Credit unions
• Loans to households

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The Fed

• Before 1863 State banks
• Chartered by states
• National Banking Act of 1863
• National banks
• Issue notes
• Regulated
• Dual banking system
• 19th century
• Panic runs

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The Fed

• 1913 Federal Reserve System
• Central bank
• Monetary authority
• 12 Federal Reserve districts
• National banks
• Had to join the Fed
• State banks
• Voluntary membership to the Fed

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Exhibit 3
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The Twelve Federal Reserve Districts
The map shows by color the area covered by each
of the 12 Federal Reserve districts. Black dots
note the locations of the Federal Reserve Bank in
each district. Identified with a star is the
Board of Governors headquarters in Washington,
D.C.
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The Fed

• Powers of the Fed
• Issue bank notes
• Buy and sell government securities
• Extend loans to member banks
• Clear checks in the banking system
• Reserve requirement for member banks
• Bankers bank

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The Fed

• Board of Governors
• 7 members
• Appointed by the President
• Confirmed by the Senate
• 14-year nonrenewable term
• Insulated from political pressure
• 1 chair 4 years
• Set and implement monetary policy
• Oversees the 12 reserve banks

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The Fed

• Federal Open Market Committee FOMC
• Open-market operations
• The Fed buys, sells government securities
• 7 board governors
• 5 presidents of reserve banks
• Advise the board

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Exhibit 4
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Organization Chart of the Federal Reserve System
Members of the Board of Governors appointed by
the president, confirmed by the Senate. Seven
board members also belong to the 12-member
Federal Open Market Committee, which advises the
board. The Board of Governors controls the
Reserve Banks in each of the 12 districts, which
in turn control the US banking system.
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The Fed

• Regulating the money supply
• Open-market operations
• Discount rate
• Reserve requirements
• Deposit insurance
• Federal Deposit Insurance Corporation, FDIC
• 100,000 per depositor per bank
• 90 banks

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The Fed

• Goals
• High level of employment in economy
• Economic growth
• Price stability
• Interest rate stability
• Financial market stability
• Exchange rate stability

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Banks

• Before 1930s Own corporate stock bonds
• After 1930s
• Banking heavily regulated
• Loans, government securities
• Ceiling on interest rates for deposits
• 1970s Inflation
• Increase interest rates
• Withdrawals
• Money market mutual fund
• Limited check writing

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Bank Deregulation

• Money market deposit accounts
• 8 billion in 1978
• 200 billion in 1982
• Deposit insurance
• Unregulated interest rates
• Wider variety of assets
• Moral hazard problem

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Savings Banks on the Ropes

• Savings banks
• Wild gambles
• Insolvency
• Collapse of a growing number of banks
• 1989 largest financial bailout
• 3,418 in 1984
• 1,290 in 2007
• Credit unions
• Declined 34

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Exhibit 5
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Failures of U.S. Savings Banks Peaked in 1989
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Commercial Banks Were Failing Too

• Demise of commercial banks
• Risky decisions
• Unsound loans
• Failures, mergers, acquisitions
• 14,496 in 1984
• 7,410 in 2007

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Exhibit 6
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Failures of U.S. Commercial Banks Peaked in 1988
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U.S. Banking Structure Today

• Large number of U.S. banks
• Past restrictions on bank branches
• Branching restrictions
• Inefficiencies
• Bank failures (Great Depression)
• Bank holding company
• Owns several banks
• Offers other services
• Bank mergers
• Expand geographically

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Exhibit 7
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Number of Commercial Banks Declined over the
Last Two Decades, but the Number of Branches
Continues to Grow
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Top Banks in America and the World

• U.S. banks
• Domestic deposits
• Mergers and acquisitions
• National banks
• Worldwide assets
• 2 U.S. banks
• Citibank
• 100 countries
• Bank of America

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Exhibit 8(a)
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Top 10 Banks in America and the World
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Exhibit 8(b)
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Top 10 Banks in America and the World