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CHAPTER 14
MONEY AND THE FINANCIAL SYSTEM
In this chapter, you will find:
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Answers to the End-of-Book Questions and Problems for Chapter 14
Supplemental Cases, Exercises, and Problems
INTRODUCTION
This chapter begins with an explanation of barter and then traces the evolution of money from commodity
money to fiat money. Money is shown to serve most importantly as a medium of exchange but also as a
standard of value and a store of wealth. Problems of too much or too little money are discussed. The historical
evolution of the U.S. financial system is reviewed from the National Banking Act of 1863 through the banking
deregulation and thrift industry reorganization of the 1990s. The formation and functions of the Federal
Reserve System dominate the last half of the chapter. Although this chapter is not especially analytical, many
new terms are introduced.
LEARNING OUTCOMES
1
Discuss the evolution of money
Barter was the first form of exchange. As specialization grew, it became more difficult to discover the double coincidence of wants that barter required, bringing about the adoption of money. Anything that acquires a high degree of
acceptability throughout an economy becomes money. The first moneys were commodities, such as gold, then pieces
of paper that could be redeemed for such commodities. As paper money became widely accepted, governments introduced fiat money—money by law or by government fiat. People accept fiat money because, through experience,
they believe that other people will do so as well.
The value of money depends on what it buys. If money fails to serve as a medium of exchange, traders find other
means of exchange. If a monetary system breaks down, more time must be devoted to exchange, leaving less time for
production, so efficiency suffers. No machine increases an economy’s productivity as much as a properly functioning
money.
2
Identify types of financial institutions in the United States
Financial institutions, or intermediaries, earn a profit by paying a lower interest rate to savers than they charge borrowers. Of these, depository institutions, which obtain funds primarily through customer deposits, can be classified
broadly into commercial banks, which primarily extend loans for commercial ventures, and thrift institutions. Thrifts
can be classified into savings banks, which specialize in home mortgage loans, and credit unions, which primarily
finance loans for members’ consumer purchases.
The Federal Reserve System, or the Fed, was established in 1913 to regulate the banking system and issue the
nation’s currency. After a third of the nation’s banks failed during the Great Depression, the Fed’s powers were increased and centralized. The primary powers of the Fed became (a) to conduct open-market operations (buying and
selling U.S. government securities), (b) to set the discount rate (the interest rate the Fed charges borrowing banks),
and (c) to establish reserve requirements (the share of deposits banks must hold in reserve).
In response to the Great Depression, the banking industry became much more closely regulated. Reforms in the
1980s gave banks more flexibility to compete for deposits with other kinds of financial intermediaries. Some banks
used this flexibility to make risky loans, but these gambles often failed, causing bank failures. In 1989, Congress
approved a measure to close failing banks, pay off insured depositors, and impose tighter regulations. By the mid1990s, U.S. banks were thriving once again.
A decades-long increase in home prices, the growth of subprime mortgages, and the spread of mortgage-backed
securities created the financial crisis of September 2008. Credit dried up. The government first tried to stabilize markets by investing in financial institutions. Later, the Dodd-Frank Act of 2010, the most sweeping reform of financial
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 14
Money and the Financial System
190
markets since the Great Depression, authorized regulators to write and interpret hundreds of new financial rules.
Banks are back to being more tightly regulated about the kinds of assets they can own and trade. Mergers and holding companies are creating larger banks that span the nation. But U.S. banks are still not that large by world standards.
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDE 2 FOR THE FOLLOWING SECTION
The Evolution of Money
 Barter: Goods are traded directly for other goods.
Barter and the Double Coincidence of Wants
 Barter depends on a double coincidence of wants: two traders want to exchange their products directly.
USE POWERPOINT SLIDES 3-8 FOR THE FOLLOWING SECTION
The Earliest Money and Its Functions: Any commodity that acquires a high degree of acceptability
throughout an economy becomes money. Its three functions are:
 Medium of Exchange: Anything generally accepted in payment for goods and services.
 Unit of Account: A standard on which prices are based.
 Store of Value: Retains purchasing power over time.
Properties of the Ideal Money: The best money is durable, portable, divisible, and of uniform quality; has a
low opportunity cost; and is relatively stable in value.
USE POWERPOINT SLIDES 9-11 FOR THE FOLLOWING SECTION
CaseStudy: Mackerel Economics in Federal Prisons
USE POWERPOINT SLIDES 12-13 FOR THE FOLLOWING SECTION
Coins:
 The quantity and quality control problem addressed by coining precious metals.
 Seigniorage: Difference between the face value of money and the cost of supplying it
 Token money: Money whose face value exceeds its production costs.
USE POWERPOINT SLIDES 14-15 FOR THE FOLLOWING SECTION
Money and Banking
 Goldsmiths extended loans by creating accounts against which borrowers could write checks.
– Goldsmiths thus created a medium of exchange, or “created money.”
– Beginning of a fractional reserve system: bank reserves amount to a fraction of total deposits
– The reserve ratio measures reserves as a percentage of total claims against the goldsmith.
USE POWERPOINT SLIDES 16-17 FOR THE FOLLOWING SECTION
Representative Money and Fiat Money: Paper money represented gold in a bank’s vault. Bearer could
redeem for gold.
 Fiat money: Paper money that derives its status as money from the power of the state.
– Acceptable because the government says it is money.
– Is more efficient than commodity money.
USE POWERPOINT SLIDES 18-20 FOR THE FOLLOWING SECTION
The Value of Money: People accept these pieces of paper because, through experience, they believe that
others will do so as well.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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When Money Performs Poorly
 If inflation gets high enough, people no longer accept the nation’s money in exchange and may resort to
barter.
USE POWERPOINT SLIDES 21-22 FOR THE FOLLOWING SECTION
Financial Institutions in the United States: Earn a profit by paying a lower interest rate to savers than
they charge to borrowers.
Commercial Banks and Thrifts
 Commercial banks: Historically made loans primarily to commercial ventures. Account for seventy-five
percent of all deposits.
 Thrifts: Savings banks and credit unions that extend loans only to their members to finance homes or
other major consumer purposes.
USE POWERPOINT SLIDES 23-25 FOR THE FOLLOWING SECTION
Birth of the Fed: Bank runs of 1907 were a catalyst for the Federal Reserve Act of 1913, which created the
Federal Reserve System as the central bank and monetary authority of the United States.
 Throughout most of its history, the U.S. had a decentralized banking system. The Federal Reserve Act
moved the country toward a system that was partly centralized and partly decentralized.
USE POWERPOINT SLIDES 26-27 FOR THE FOLLOWING SECTION
Powers of the Federal Reserve System:
 To ensure sufficient money and credit in banking system to support a growing economy
 To issue bank notes
 To buy and sell government securities
 To extend loans to member banks
 To clear checks in the banking system
 To require member banks to hold reserve requirements
Banking Troubles During the Great Depression
 Federal Reserve System failed to act as a lender of last resort.
USE POWERPOINT SLIDES 28-31 FOR THE FOLLOWING SECTION
Banking Act of 1933 and 1935 passed to shore up banking system and centralize power with the Fed in
Washington.
 Board of Governors: Consists of seven members appointed by president and confirmed by Senate who
are responsible for setting and implementing the nation’s monetary policy.
 Federal Open Market Committee (FOMC): Makes decisions about the key tool of monetary policy,
open-market operations (the Fed’s purchase and sale of government securities).
 Regulating the Money Supply: The Federal Reserve has a variety of tools:
– Conducting open-market operations.
– Setting the discount rate.
– Setting legal reserve requirements.
 Deposit Insurance: Reduced bank runs by calming fears about safety of deposits.
USE POWERPOINT SLIDES 32-34 FOR THE FOLLOWING SECTION
Objectives of the Fed
 High employment
 Economic growth
 Stability in prices, interest rates, financial markets, and exchange rates
Banks Lost Deposits When Inflation Increased
 Restrictions of the 1930s made banking a heavily regulated industry.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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 In the 1970s when market interest rates rose above Federal Reserve ceilings, many savers withdrew
deposits and put them into higher-yielding alternatives, such as money market mutual funds. These funds
became stiff competition for banks’ checkable deposits which paid no interest.
USE POWERPOINT SLIDES 35-37 FOR THE FOLLOWING SECTION
Banking Deregulation
 Eliminated interest-rate ceilings for deposits.
 All depository institutions allowed to offer money market accounts.
 Deregulated state chartered savings banks.
 Gave savings banks a wider latitude in kinds of assets they could hold.
 Created a moral hazard: Tendency of bankers to take unwarranted risks when making loans because
deposits were insured.
Banks on the Ropes: In 1989 Congress approved a $180 billion bailout (in today's dollars), what was then the
largest in history; 80 percent was paid by taxpayers and 20 percent was paid by the banks through higher
deposit insurance premiums.
USE POWERPOINT SLIDES 38-40 FOR THE FOLLOWING SECTION
U.S. Banking Structure Today
 United States has more banks than any other country.
 Branching restrictions create inefficiencies since banks can’t easily diversify their portfolios of loans
across regions and can’t achieve optimal size.
 Bank holding companies: Corporations that may own several different banks.
 Banks merge because they want more customers and expect the higher volume of transactions to reduce
operating costs per customer.
USE POWERPOINT SLIDES 41-48 FOR THE FOLLOWING SECTION
Subprime Mortgages and Mortgage-Backed Securities
 Development of credit scores enabled subprime mortgages for borrowers with not-so-good credit ratings.
 Hundreds of mortgages were bundled into mortgage-backed securities.
 A higher amount of risky subprime mortgages bundled into a security required a higher interest return for
investors. Securities-rating agencies were supposed to assess risk of the financial instruments.
 Subprime market grew to a trillion-dollar industry by 2007 and renters became homeowners.
 Demand for housing and housing prices increased. Mortgage balances and monthly payments increased.
USE POWERPOINT SLIDES 49-54 FOR THE FOLLOWING SECTION
Incentive Problems and the Financial Crisis of 2008
 Two thirds of subprime mortgages originated with mortgage brokers who had incentives to get people to
apply for mortgages that the applicants could not afford. Brokers also committed fraud.
 Security underwriters and rating agencies had incentives to boost the market and to ignore risks. Credit
standards eroded.
 Between 2006 and 2008, housing prices fell an average of 22 percent. Mortgages slipped “underwater”
and defaults rose.
 Mortgage-backed securities lost value and a credit crisis ensued.
USE POWERPOINT SLIDES 55-59 FOR THE FOLLOWING SECTION
The Troubled Asset Relief Program
 October 2008 saw the Troubled Asset Relief Program (TARP). Funds were invested in institutions
deemed too big to fail.
 Banks and automakers were bailed out.
 Housing prices continued to fall and banks began to fail.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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USE POWERPOINT SLIDES 60-66 FOR THE FOLLOWING SECTION
The Dodd-Frank Wall Street Reform and Consumer Protection Act
 July 2010 sweeping regulatory changes aimed at preventing another financial crisis, authorizing 10
regulatory agencies to write and interpret hundreds of new rules.
 Remedy incentive problems by requiring more responsible behavior in mortgage markets.
 Regulation increased on banks and nonbank financial companies.
 Financial Stability Oversight Council will look for and respond to emerging systemic risks.
 Bureau of Consumer Financial Protection will write rules for banks and financial services firms.
 Critics warn about unintended consequences.
USE POWERPOINT SLIDES 67-69 FOR THE FOLLOWING SECTION
Top Banks in America and the World:
 The top U.S. bank held nearly 10 times the deposits as the tenth-ranked bank.
 The financial crisis led to bank consolidation.
 Only one U.S. bank (JPMorgan Chase) ranked among the top 10 based on worldwide assets.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 14
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CHAPTER SUMMARY
Barter was the first form of exchange. As specialization grew, it became more difficult to discover the double
coincidence of wants that barter required. The time and inconvenience of barter led even simple economies to
use money.
Anything that acquires a high degree of acceptability throughout an economy thereby becomes money. The
first moneys were commodities, such as gold. Eventually, what changed hands were pieces of paper that could
be redeemed for something of value, such as gold. As paper money became widely accepted, governments
introduced fiat money – pieces of paper not officially redeemable for anything other than more pieces of paper.
Fiat money is money by law, or by government fiat. Nearly all currencies throughout the world today are fiat
money. People accept fiat money because, through experience, they believe that other people will do so as
well.
The value of money depends on what it buys. If money fails to serve as a medium of exchange, traders find
other means of exchange, such as barter, careful record keeping, some informal commodity money, or some
other nation’s currency. If a monetary system breaks down, more time must be devoted to exchange, leaving
less time for production, so efficiency suffers. No machine increases an economy’s productivity as much as a
properly functioning money.
The Federal Reserve System, or the Fed, was established in 1913 to regulate the banking system and issue the
nation’s currency. After a third of the nation’s banks failed during the Great Depression, the Fed’s powers
were increased and centralized. The primary powers of the Fed became (a) to conduct open-market operations
(buying and selling U.S. government securities), (b) to set the discount rate (the interest rate the Fed charges
borrowing banks), and (c) to establish reserve requirements (the share of deposits banks must hold in reserve).
Regulations introduced during the Great Depression turned banking into a closely regulated industry. Reforms
in the 1980s gave banks more flexibility to compete for deposits with other kinds of financial intermediaries.
Some banks used this flexibility to make risky loans, but these gambles often failed, causing bank failures. In
1989, Congress approved a measure to close failing banks, pay off insured depositors, and impose tighter
regulations. By the mid-1990s, U.S. banks were thriving once again.
A decades-long increase in home prices, the growth of subprime mortgages, and the spread of mortgagebacked securities created the financial crisis of September 2008. Credit dried up. The government first tried to
stabilize markets by investing in financial institutions. Later, the Dodd-Frank Act of 2010, the most sweeping
reform of financial markets since the Great Depression, authorized regulators to write and interpret hundreds
of new financial rules. Banks are back to being more tightly regulated about the kinds of assets they can own
and trade. Mergers and holding companies are creating larger banks that span the nation. But U.S. banks are
still not that large by world standards. But U.S. banks are still not that large by world standards.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 14
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TEACHING POINTS
1. Students will be interested in the variety of goods that have been used as money in the past, even though
they may have a hard time believing that rocks and salt have been used as money in some economies. All
money should possess certain characteristics to some degree: it should be reasonably durable, portable,
divisible, of uniform quality, produced at a low opportunity cost, and of relatively stable value.
2. The functions of money are different from its characteristics. Money functions as (1) a medium of
exchange, (2) a standard of value, and (3) a store of wealth.
3. All voluntary exchange requires the existence of a double coincidence of wants. Thus, general
acceptability is a characteristic that is absolutely essential for anything to function as a medium of
exchange. You might ask the class about what makes our current money supply (currency and checks)
acceptable. Ask them whether credit cards are part of the money supply.
4. You may wish to talk about using money that is based on commodity value for acceptability (as opposed
to legal tender) and the implications for controlling the price level. When money was acceptable because
of gold value, major gold finds were followed by inflationary periods. Using supply and demand curves,
you can illustrate why this phenomenon occurred.
5. The history of the Federal Reserve System is discussed in this chapter. An interesting point to make is
that the Federal Reserve System is divided into 12 districts. Americans have long distrusted the
centralization of power, and therefore separate banks were set up. In the early years of this century,
however, the New York Fed became preeminent. Note that there is only one Federal Reserve Bank west
of the Rockies (in San Francisco). It is not hard to explain this; in 1914 very few people lived west of the
Rockies. Los Angeles was still relatively small. Where there is less business, there is less need for banks;
hence the historical anomaly. It is also important to point out that the original purpose of the Federal
Reserve was to be a bank for the banking system rather than a monetary policy institution. Thus, the 12
Federal Reserve banks could be thought of as branches of our central bank.
6. This chapter discusses the sweeping changes in banking law that occurred during the 1980s and 1990s.
While not explicitly named in the text, these changes included the Depository Institutions Deregulation
and Monetary Control Act (DIDMCA) of 1980, the Garn-St. Germain Act of 1982, and the Financial
Institutions Reform, Recovery, and Enforcement Act (FIRREA) of 1989.
7.
You will have to decide how much time to spend discussing banking law and institutional structure.
Remember that many students will go on to take courses on money and banking or on financial
institutions.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 14
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ANSWERS TO END-OF-BOOK QUESTIONS AND PROBLEMS
1.1
(Origins of Banking) Discuss the various ways in which London goldsmiths functioned as early banks.
Goldsmiths accepted from their customers deposits of gold, which were available to the depositors upon
request. Since the amount of idle gold on deposit tended to remain relatively constant, the goldsmiths
began to lend out some deposits to earn interest. Goldsmiths also accepted written instructions from
their depositors to transfer gold to other people—creating the first checks. Then the goldsmiths began
making loans by simply creating checking accounts for borrowers. As a result, total deposits exceeded
the value of gold actually in the goldsmiths’ vaults—the creation of fractional reserve banking.
1.2
(Types of Money) Complete each of the following sentences:
a. If the face value of a coin exceeds the cost of coinage, the resulting revenue to the issuer of the coin
is known as _________________.
b. A product that serves both as money and as a commodity is ________________.
c. Most coins and paper money circulating in the United States have face values that exceed the value
of the materials from which they are made. Therefore, they are forms of _________ __________.
d. If the government declares that creditors must accept a form of money as payment for debts, the
money becomes ________________________.
e. A common unit for measuring the value of every good or service in the economy is known as a(n)
_____________________________________.
a.
b.
c.
d.
e.
1.3
seigniorage
commodity money
token money
legal tender
unit of account
(Fiat Money) Most economists believe that the better fiat money serves as a store of value, the more
acceptable it is. What does this statement mean? How could people lose faith in money?
Fiat money is typically made from inexpensive materials, such as paper or common metals, and is not
intrinsically useful or valuable. It is token money—it is not backed by a promise to pay something with
intrinsic value. Therefore, it is valuable only as long as it is generally accepted in payment for goods and
services sold—that it operates well as a medium of exchange. If people think that others in society will
become unwilling to accept it (if they lose faith in its value), they will not accept it and it becomes
valueless.
If fiat money begins to rapidly lose purchasing power—for example, if the inflation rate were to become
very high—people would begin to lose faith in it. Money would no longer represent a stable store of
value, so people would try to replace it with goods or another currency. Inflation may become so high
that people would no longer accept it.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Chapter 14
1.4
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197
(The Value of Money) When the value of money was based on its gold content, new discoveries of gold
were frequently followed by periods of inflation. Explain.
When new gold was discovered, the increased supply would cause the price of gold to fall (i.e., the
supply curve would shift to the right). As a result, money whose value as money depended on the value of
the gold contained in it became less valuable relative to other goods. The result was an increase in the
number of units of money necessary to buy other goods (i.e., inflation).
2.1
(Depository Institutions) What is a depository institution, and what types of depository institutions are
found in the United States? How do they act as intermediaries between savers and borrowers? Why do
they play this role?
Depository institutions are financial institutions that obtain funds mainly by accepting deposits from the
public—both businesses and households. The various types in the United States are commercial banks,
savings and loans, mutual savings banks, and credit unions. They act as financial intermediaries
because they attract deposits from savers and use those funds as the foundation for making loans to
borrowers. Depository institutions act as intermediaries because they profit by paying a lower interest
rate to savers than they charge borrowers.
3.1
(Federal Reserve System) What are the main powers and responsibilities of the Federal Reserve System?
The Fed has the power to issue currency, buy and sell government securities, provide loans to member
banks (at a rate termed the discount rate), clear checks between banks, and require member banks to
hold reserves equal to a specified fraction of their deposits.
4.1 (The Structure of U.S. Banking) Discuss the impact of bank mergers on the structure of American
banking. Why do banks merge?
Bank mergers will help banks to diversify their portfolio of loans among different regions and perhaps
achieve an optimal size. Banks merge because they want more customers and expect the resulting higher
volume of transactions to reduce operating costs per customer.
4.2 (Bank Deregulation) Some economists argue that deregulating the interest rates that could be paid on
deposits combined with deposit insurance led to the insolvency of many depository institutions. On what
basis do they make such an argument?
Economists argue that the combination of deregulation and deposit insurance encouraged some banks
on the verge of failing to take bigger risks—to “bet the bank”—because their depositors would be
protected by deposit insurance. This created a moral hazard, which in this case was the tendency of
bankers to take unwarranted risks in making loans because deposits were insured.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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SUPPLEMENTAL CASES, EXERCISES, AND PROBLEMS
Case Studies
These cases are available to students online at www.cengagebrain.com.
Mackerel Economics in Federal Prisons
The economist R.A Radford spent several years in prisoner-of-war camps in Italy and Germany during World
War II, and he wrote about his experience. Although economic activity was sharply limited, many features of a
normal economy were found in the prison life he observed. For example, in the absence of any official
currency behind bars, cigarettes came to serve all three roles of money: medium of exchange, unit of account,
and store of value. Cigarettes were of uniform quality, of limited supply (they came in rations from the
International Red Cross), reasonably durable, and individually could support small transactions or, in packs,
larger ones. Prices measured in cigarettes became fairly uniform and well known throughout a camp of up to
50,000 prisoners of many nationalities.
Now fast-forward half a century to the U.S. federal prison system. Prisoners are not allowed to hold cash.
Whatever money sent by relatives or earned from prison jobs (at 40 cents an hour) goes into commissary
accounts that allow inmates to buy items such as snacks and toiletries. In the absence of cash, to trade among
themselves federal prisoners also came to settle on cigarettes as their commodity money (despite official
prohibitions against trade of any kind among inmates). Cigarettes served as the informal money until 2004,
when smoking was banned in all federal prisons.
Once the ban took effect, the urge to trade created incentives to come up with some other commodity
money. Prisoners tried other items sold at the commissary including postage stamps, cans of tuna, and Power
Bars, but none of that seemed to catch on. Eventually prisoners settled on cans of mackerel, a bony, oily fish.
So inmates informally use “macks”—as the commodity money came to be called—to settle gambling debts, to
buy services from other inmates (such as ironing, shoe shining, and cell cleaning), and to buy goods from other
inmates (including special foods prepared with items from the commissary and illicit items such as homebrewed “prison hooch”). At those federal prisons where the commissary opens only one day a week, some
prisoners fill the void by running mini-commissaries out of their lockers.
After wardens banned cans (because they could be refashioned into makeshift knives), the commodity
money quickly shifted from cans of mackerel to plastic-and-foil pouches of mackerel. The mack is considered
a good stand-in for the dollar because each pouch costs about $1 at the commissary, yet most prisoners, aside
from weightlifters seeking extra protein, would rather trade macks than eat them.
Wardens try to discourage the mackerel economy by limiting the amount of food prisoners can stockpile.
Those caught using macks as money can lose commissary privileges, can be reassigned to a less desirable cell,
or can even spend time in the “hole.” Still, market forces are so strong that the mackerel economy survives in
many federal prisons.
Sources: R. A. Radford, “The Economic Organization of a P.O.W. Camp,” Economica, 12 (November 1945):
189–201: and Justin Scheck, “Mackerel Economics in Prisons Leads to Appreciation of the Oily Fillets,” Wall
Street Journal, 2 October 2008.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
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The Hassle of Small Change
About 2.4 billion U.S. pennies were minted in 2009, and about 150 billion pennies circulated. That’s about
500 pennies per U.S. resident. Most pennies are resting in change jars, drawers, or other gathering places for
the lowly coin. Pennies are abandoned in the tiny change bins and donation cans at store counters. Many people won’t bother to pick one up on the sidewalk (as evidenced by the number you find there). The penny, like
all U.S. currency, has over time been robbed of its exchange value by inflation. Today’s penny buys only oneseventh as much as it did in the 1950s. Pennies can’t be used in parking meters, vending machines, or pay telephones, and penny candy is long gone. To avoid the hassle of small change, some restaurants, such as the Vanilla Bean Café in Pomfret, Connecticut, charge prices exactly divisible by 25 cents (including sales taxes).
That way, pennies, nickels, and dimes aren’t needed for any transaction.
The exchange value of the penny has declined as the cost of minting it has risen. For more than a century,
the penny was 95 percent copper. In 1982, copper prices reached record levels, so the U.S. Mint began making
pennies from zinc, with just a thin copper finish. Then, the price of zinc rose, boosting the metal cost of a penny in 2009 to 0.8 cents. Add to that the 0.8-cent minting cost per penny, and you get 1.6 cents per coin. So the
government loses a 0.6 cents on each penny minted, or $14.4 million on pennies minted in 2009. Nickels,
which are mostly copper, are also money losers; in 2009 they cost 6 cents to make.
Has the penny outlived its usefulness? In the face of rising metal prices, the government has some options.
First option: mint them from a lower-cost alloy. This would buy some time, but inflation would eventually
drive the metallic cost above the exchange value of the coin. Second option: abolish the penny. Take it out of
circulation. Countries that have eliminated their smallest coins include Australia, Britain, Finland, Hong Kong,
and the Netherlands. New Zealand eliminated its 5-cent coin, as well as its 2-cent and 1-cent coins. The United
States abolished the half-cent coin in 1857, at a time when it was worth 8 cents in today’s purchasing power.
Third option: decree that the penny is worth 5 cents, the same as a nickel. At the same time, the government
could withdraw nickels from circulation. With pennies worth so much more, there would be no incentive to
hoard them for their metallic value (a current problem), and it would likely be decades before the metallic value caught up with the exchange value. Rebasing the penny to 5 cents would create windfall profits for those
now hoarding pennies, but would increase the money supply by about $6 billion, a drop in the bucket compared to a total money supply of $1.7 trillion, so the move would have virtually no effect on inflation.
If the penny gets so little respect, why did the Treasury mint 2.4 billion in 2009. As noted, some people are
hoarding pennies, waiting for the day when the metallic value exceeds the exchange value. Another source of
demand is the sales tax, which adds pennies to transactions in 44 states. Charities also collect millions from
change cans located at check-out counters. And zinc producers lobby heavily to keep the penny around as a
major user of the metal. Thus, the penny still has its boosters. That’s why retailers continue to order pennies
from their banks, these banks order pennies from the Fed, the Fed orders them from the U.S. Mint, and the
Mint presses yet more pennies into idle service.
Sources: Austan Goolsbee, “Now that the Penny Isn’t Worth Much, It’s Time to Make It Worth 5 Cents,” New
York Times, 1 February 2007; Elizabeth Williamson, “Will Nickel-Free Nickels Make a Dime’s Worth of
Difference,” Wall Street Journal, 10 May 2010; and Thomas Sargent and Francois Velde, The Big Problem of
Small Change (Princeton, NJ: Princeton University Press, 2002). View the rounded prices on Vanilla Bean
Café’s menu at http://www.thevanillabeancafe.com/.
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Experiential Exercises
1. Have students visit Glyn Davies’s History of Money site at http://www.projects.ex.ac.uk/RDavies/arian/
amser/chrono.html. Ask students to read “A Comparative Chronology of Money” to check the years since
1939. How many hyperinflations are mentioned for those years? What does that tell students about the
relationship between monetary systems and economic well-being?
2. The Federal Reserve Bank of Philadelphia often runs informative articles that are accessible to introductory
economics students. At http://www.philadelphiafed.org/econ/wps/wp02.html, students can read the
Working Paper titled “Do Bankers Sacrifice Value to Build Empires? Managerial Incentives, Industry
Consolidation, and Financial Performance” by Joseph P. Hughes, William W. Lang, Loretta J. Mester,
Choon-Geol Moon, and Michael S. Pagano. Ask them to consider the numerous bank mergers of the early
2000s. Are bank mergers a good thing? What are the authors’ conclusions about this?
3. The Wall Street Journal prints several features that track key interest rates. The daily Money Rates box lists
the current prime lending rate, along with a variety of short-term rates, the weekly Key Interest Rates table
reports on Treasury securities, and a weekly Consumer Savings Rates List shows the rates paid by 100 large
banks. Ask students to look at these sources on the Money and Credit Markets pages, and determine the
extent to which all these interest rates move together.
4. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the center of the page is the Global Economic Crisis Overview. Click on the link for View Full
Overview. Though not discussed in the text, Fannie Mae and Freddie Mac played important roles in the
2008 financial crisis. What does the Overview says about these agencies?
Fannie Mae and Freddie Mac are government-sponsored enterprises that buy mortgage-backed securities
amounting to nearly one half of all mortgages in the U.S. Because of the declines in housing prices and
mortgage-backed securities, Fannie and Freddie became financially distressed and had to be bailed out by
the federal government, which placed the agencies in conservatorship, essentially declaring them bankrupt.
5. (Global Economic Watch) Go to the Global Economic Crisis Resource Center. Select Global Issues in
Context. In the Basic Search box at the top of the page, enter the phrase "TARP." Find one article in favor
of the Troubled Asset Relief Program and one against. Compare and contrast the arguments.
Student answers will vary, but will likely revolve around the essential role of the banking industry—
especially the too-big-to-fail institutions—and the disadvantages of greater government involvement in financial markets.
Additional Questions and Problems
(From student Web site at www.cengagebrain.com)
1. (Barter) Define a double coincidence of wants and explain its role in a barter system.
The term double coincidence of wants refers to a situation in which one trader is willing to exchange his
or her product for the product of a second trader, and the second trader is willing to exchange his or her
product for the product of the first trader. In this instance, they are able to agree on a direct trade. The
double coincidence of wants is essential for a barter system. Therefore, each person must be able to find
another person who has what the first wants and who is willing to directly trade for what the first person
has.
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Chapter 14
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2. (Money Versus Barter) “Without money, everything would be more expensive.” Explain this statement.
Then take a look at a Web page devoted to barter at http://www.ex.ac.uk/~RDavies/arian/barter.html.
What are some current developments in barter exchange?
The statement is true because money reduces the transaction costs associated with a voluntary exchange
system through its medium of exchange, unit of account, store of value, and standard of deferred
payment functions. However, if hyperinflation occurs, transaction costs rise as people try to exchange
money that is rapidly losing purchasing power for goods or a more stable currency. Relative prices also
become distorted. If the inflation rate rises high enough, people no longer accept money and resort to
barter. Thus, more resources must be diverted from production to exchange.
The computer has facilitated interest in barter. Bartering at one Web site on the computer lets you pay
with what you have and receive credits in that Web site’s trading dollars that you can spend on
something else now or in the future. Stanley Jevons, in 1868, bemoaned the fact that the “printing press
could bring about the double coincidence necessary to an act of barter.” He would be amazed at the
speed and facility with which the internet can search for and find a double coincidence of wants.
3. (Functions of Money) What are the three important functions of money? Define each of them.
Money functions as (a) a medium of exchange, (b) a unit of account, and (c) a store of value. A medium
of exchange is anything that is accepted by the public in general as payment for goods and services. By
functioning as a unit of account, money becomes the standard on which prices for all goods and services
are based. As a store of value, money provides a way for people to retain purchasing power over time—
it can be saved and used for later purchases.
4. (Functions of Money) “If an economy had only two goods (both nondurable), there would be no need for
money because exchange would always be between those two goods.” What important function of
money does this statement disregard?
The statement disregards the store of value function of money. With only two goods, exchange occurs
only between people holding these two goods. However, people do not always make purchases at the
same time that they sell. Money must be durable so that it can be saved while retaining its purchasing
power over time—the store of value function.
5.
(Characteristics of Money) Why is universal acceptability such an important characteristic of money?
What other characteristics can you think of that might be important to market participants?
Without universal acceptability, the medium of exchange function would not be fulfilled. A double
coincidence of wants is necessary for all voluntary exchange. The benefit of money over barter lies in the
fact that everyone wants money. Other characteristics of money include durability, portability,
divisibility, uniformity in quality, low opportunity cost, and relative stability in value.
6. (Commodity Money) Why do you think rice was chosen to serve as money in medieval Japan? What
would happen to the price level if there was a particularly good rice harvest one year?
Rice would have been a reasonable form of money in Japan since it was widely grown, easily
identifiable, transportable, storable for long periods, and divisible. If there was a bumper crop, the
money supply tended to grow, causing prices of every product to rise in terms of the rice supply.
7. (Commodity Money) Early in U.S. history, tobacco was used as money. If you were a tobacco farmer and
had two loads of tobacco that were of different qualities, which would you supply as money and which
would you supply for smoking? Under what conditions would you use both types of tobacco for money?
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Chapter 14
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Gresham’s Law asserts that the tobacco of higher quality would be used for smoking and the lower
quality tobacco would be used for money. If there were only a single tobacco price, Gresham’s Law
would take effect, and the lower quality tobacco would drive out the better tobacco. It is possible that
both types of tobacco could be used for money at the same time. This could happen if the high-quality
tobacco commanded a greater value in the marketplace than the lower quality tobacco. For example,
suppose that a bushel of corn costs one pound of low-quality tobacco. Presumably, there is an amount,
say one-half pound, of high-quality tobacco that will buy the same bushel of corn. At these exchange
rates, consumers are willing to use either type of money. Moreover, the two types of tobacco would
exchange between themselves at a specific rate, such as 2 for 1. This exchange rate would be an
equilibrium rate that the market would establish.
8.
(Bank Deregulation) Some economists argue that deregulating the interest rates that could be paid on
deposits combined with deposit insurance led to the insolvency of many depository institutions. On what
basis do they make such an argument?
When deposit rates were deregulated, banks and thrifts were free to offer any interest rate necessary to
attract deposits. Banks with liquidity problems (resulting from risky lending or poor management, for
example) could stave off shutting down by offering interest rates high enough to attract new deposits.
Depositors may not be concerned about the higher risk involved with these institutions because of
deposit insurance. Yet the high cost of attracting such funds put these institutions in an even more
difficult financial environment, resulting in the movement of deposits from safe banks to risky banks and
eventually their “disappearance” into insolvency.
9.
(Incentive Problems and the Financial Crisis of 2008) What incentives motivated the behaviors that
caused the financial crisis of 2008?
Subprime borrowers wanted to buy houses and sought mortgages. Mortgage brokers earned fees for
originating and then selling subprime mortgages. Riskier loans created larger fees. The mortgagesecurity industry paid handsome fees. Laxness of regulation and credit ratings contributed failed to limit
any of these incentives to issue larger and riskier mortgages.
ANSWERS TO ONLINE CASE STUDIES
1.
(CaseStudy: Mackerel Economics in Federal Prisons) How well do pouches of mackerel satisfy the six
properties of ideal money listed in Exhibit 1?
The plastic-and-foil pouches seem to be durable. When they can get away with it, prisoners store the
pouches in their cells. The pouches are portable, but not divisible. It is safe to assume that the pouches
are of uniform quality. The pouches have low opportunity cost, except to weight-lifters. The pouches also
appear to have a stable value. The mackerel meets five of the six properties, not a bad form of
commodity money.
2.
(CaseStudy: The Hassle of Small Change) What are three possible solutions to the problem that the
penny now costs more to produce than it’s worth in exchange?
(1) Use a lower costing metal; (2) abolish the penny—that is, take it out of circulation; or (3) take the
nickel out of circulation and declare that the penny has an exchange value of five cents.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.