1 money and the financial system chapter 13 © 2003 south-western/thomson learning
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Money and the Financial System
CHAPTER
13
© 2003 South-Western/Thomson Learning
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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
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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
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Unit of Account
A standard upon which prices are based
Common denominator or yardstick for measuring the value of all other goods and services
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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
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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
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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.
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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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
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Objectives of the FED
High level of employment in the economyEconomic growthPrice stabilityStability in interest ratesStability in financial marketsStability in foreign exchange markets