Download Chapters 10 and 15 Banks and Fiscal Policy

Chapters 10 and 15
Money, Banking, and Fiscal Policy
KEY IDEAS TO KNOW:
Define money and describe its principal characteristics-stability, portability, durability,
uniformity, divisibility, and recognizability.
Describe the various forms money takes in the United States.
List common services banks and other financial institutions provide.
Explain how banks “create” money.
Describe the principal roles and responsibilities of the Federal Reserve System.
Define inflation and explain how it impacts businesses and consumers.
What is Money?
What do the following items have in common? Bronze knives, farm tools, cacao beans,
salt chunks, stone disks, fish hooks, beaver pelts, musket balls, nails and cigarettes. Well
the answer is that all of these items have been used as money! Money you say oh wise
one? Yes, money. Not money in the sense that you know it today but yes, money.
Lets think about what money really is:
Money: Anything accepted as payment for goods and services by most people in an area
at a given time.
Think about it, if most of the people in a region are willing to accept a certain item as
payment for goods and services then that item has a use as money. It is sort of like the
way cigarettes are portrayed as money in the movies. Now the reality is that these types
of money, informal money that has another basic use if you will, are not money as you
normally have thought of it. This type of money is called commodity money. The origins
of money can be traced back to ancient times. Then commodity money, money that has
an alternative use, was used. In the South Pacific and Africa, cowrie shells were the
common forms of currency while in New Guinea, it was dog teeth that were used. At
Santa Cruz, the feathers of hundreds of honey-eating birds were attached to short sticks to
make feather-stick money while in the Marshall Islands, fishhooks were commonly used.
In ancient China tea leaves were compressed into "bricks" while the Russians used
compressed cheese as their currency. Commodity money was still present during the
colonial age when many products such as gunpowder, musket balls, corn, and hemp were
commonly used.
In 1618 tobacco became the most famous type of colonial money because the governor of
colonial Virginia gave it a monetary value of three English shillings per pound. However,
fiat money, money by government decree, has come to replace commodity money. In
1645 Connecticut established a monetary value for wampum, a form of currency that the
Narragansett made out of white conch and black mussel shells. Because the Narragansett
and the settlers used wampum in trade, certain shells were made equal to 1 English
penny. In the 1700's the Governor of the then territory of Tennessee was paid a salary of
1000 deerskins a year! His secretary of state was paid 500 raccoon skins. Quite a salary
huh!
As time progressed, other forms of money were used. In some states, laws were passed
allowing citizens to print their own paper currency. Backed by gold and silver deposits in
banks, it served as currency for the immediate area. Some states passed tax-anticipation
notes that could be redeemed at the end of the year. The governments printed the notes,
which were used to pay salaries, buy supplies, and meet other expenditures until taxes
were received and the notes redeemed. The taxes though, were collected in coins.
Paper money was really first seen around the time of the Revolution. In 1775 the
Continental Congress authorized the printing of Continental Currency which had no gold
or silver backing. By the end of the war nearly $250 million had been printed and spent.
Representative money is money backed by-exchangeable for-some commodity, such as
gold or silver. It is not in itself valuable for non-money uses, but it can be exchanged for
some valuable item. Like commodity money, the amount of representative money in
circulation, or in use by people, is limited because it is linked to some scarce good, such
as gold. At one time, the United States government issued representative money in the
form of gold and silver certificates. In addition, private banks accepted deposits of gold
and silver and issued paper money, called bank notes. These were a promise to convert
the paper money into coin or bullion on demand. These banks were supposed to keep
enough gold or silver in reserve-on hand-to redeem their bank notes. Often they did not.
Money as you know it today is not commodity money. Today most money is what we
call fiat money. Fiat money is money by government decree. Wampum was the first fiat
money used in the America's. It had a set value, equal to a certain amount of gold,
established by Connecticut in 1645. Since the government of Connecticut established it
as official money it is fiat money.
The concept of paper currency was not well regarded early on. Most Americans, indeed
most people world wide, felt that paper currency was risky since it had no inherent value.
As a result most fiat money was in the form of coins. This coined money is known as
specie. Specie was well regarded because it some metallic content, either gold or silver.
Due to scarcity this then had some inherent value of its own. In fact paper currency was
not even issued until 1775 when the Continental Congress printed a very small amount of
paper currency to pay its debts.
So, why do we use money at all? Well the reality is that the use of money is very much
tied to the Industrial Revolution. As the world grew increasingly modern money became
needed. Before money was used the world was primarily agricultural. People living in
traditional economies used barter as a means of exchanging goods and services. Barter
presented great difficulty in completing transactions and in fixing value. With the
Crusades and the corresponding growth of towns and villages and increased trade money
became a necessity. Industrialization would have been impossible without money.
Money serves, therefore, three essential functions:



It is a Medium of Exchange - money is used so we can exchange goods and
services easily. In barter this is very difficult because transfer of large items and
perishable goods makes moving around a little tough.
It is a Measure of Value - money is used so we can assess fairly and consistently
the comparative worth of items. In barter this could not occur because it is
impossible to compare the value of different commodities consistently. For
example, trading two cows for a goat and a three legged dog. Whose to say what
is worth more??
It is a Store of Value - money is used so that we can save our earning for a later
date In barter this cannot occur because often items might die or rot!
Money also has eight essential characteristics.




Portability - Money is small and transportable. Imagine using certain types of
commodity money. What if Cows where accepted as commodity money. Can you
imagine walking around with a cow in your pocket??? A little difficult huh?
Divisibility - Money can be broken down into smaller or larger units of measure
to make transactions easier. Can you imagine the cow scenario? Its not like you
can rip of a leg if the whole cow wasn't necessary as payment!
Durability - Money lasts. Specie lasts forever and even paper currency is pretty
durable. In class I ripped a twenty dollar bill in half once and then taped it back
together. It was still worth the same wasn't it? Imagine trying that with a cow!
Eventually even an un dismembered cow would die, rot and stink. Not too
durable.
Stability of Value - Money, despite the influences of inflation and deflation
remains fairly stable in value. Money is not subjected to the natural forces of
weather as much early commodity was. In traditional economies when one needed
goods he would trade crops. If there was a drought, however, the value of said




crops would shoot way up. Since most money is in one way shape or form tied to
known gold reserves, it is stable in value.
Considered scarce - because people believe there is not enough cash to satisfy
their wants, it's scarceness helps give money it's value
Accepted - Whatever is used as money must be accepted as a medium of
exchange in payment for debts.
Easily recognizable - People must be able to identify the different denominations
of currency.
Tamper proof - This stops counterfeiting
Federal Reserve Notes
Denomination
Portrait on
Bill
$1
George
Washington
$2
Thomas
Jefferson
$5
Abraham
Lincoln
$10
Alexander
Hamilton
$20
Andrew
Jackson
$50
Ulysses S.
Grant
$100
Benjamin
Franklin
$500
William
McKinley
$1000
Grover
Cleveland
$5000
James
Madison
$10000
Salmon P.
Chase
$100000
Woodrow
Wilson
DID YOU KNOW?
Source: US Treasury Department
Life span of dollars
Money will be changed to foil
counterfeiters constantly. But new
bills won't last any longer than what
we use now. How long bills
circulate before they are
withdrawn:
18
months
20
$5
months
31
$10
months
45
$20
months
112
$50
months
102
$100
months
$1
HISTORY OF AMERICAN MONEY AND
BANKING
Serving the Nation’s Financial Needs
During the colonial period, England did not permit
the American colonies to print or mint their own
money. Bartering was common. Colonists used
various goods in place of coins and paper money. In
Massachusetts Bay for a time, colonists used Native
American wampum as a medium of exchange. In
the Virginia Colony, tobacco became commodity
money. Though scarce, some European gold and
silver coins also circulated in the colonies. The
Spanish dolár, later called dollar by colonists, was
one of the more common coins.
History of American Banking
The Revolutionary War brought even more
confusion to the already haphazard colonial money
The cost of making money system. To help pay for the war, the Continental
Congress issued bills of credit, called Continentals,
that could be used to pay debts. So many of these
0.8
Penny
cents
notes were issued that people often refused to accept
2.9
them. The money became so worthless that the
Nickel
cents
phrase “not worth a Continental” was used to
1.7
describe something of little value.
Dime
cents
3.7
Quarter
cents
Half
7.8
Dollar cents
Dollar 3.0
Bill
cents
After the war, establishing a reliable medium of
exchange became a major concern for the new
nation. The Constitution, ratified in 1788, gave
Congress sole power to mint coins, although private
banks were still allowed to print bank notes
representing gold and silver on deposit. Because the
history of money in the United States is so closely
Pocket Money
tied to the development of the banking system we’ll
The amount of coins and currency examine both simultaneously. Before we do, here is
in circulation per person in actual a little trivia for you. In technical terms, a "bank" is
dollars and actual money (adjusted an institution that loans money only to businesses
for inflation)
and the government, such as the Federal Reserve
Banks. What we consider a bank is actually called a
1960 $177.47 ($883.75)
"thrift institution." We have become lazy and call
1970
1980
1990
2000
$265.39
$581.48
$1,105.14
$1,404.29
($1,008.21)
($1,040.17)
($1,246.35)
($1,404.29)
all loaning bodies banks.
Banking Services
Banks and savings institutions today offer a wide
variety of services, including checking accounts,
Number of Lincoln pennies in
circulation:
interest on checking, automatic deposit and payment,
storage of valuables, transfer of money from one
106 billion
person to another, and overdraft checking.
Overdraft checking allows customers to write a
Total number of nickels, dimes,
check for more money than exists in his or her
quarters and dollar coins in
account. The bank “loans” the needed amount and
circulation:
the customer pays the money back, usually at a
relatively high rate of interest. In general, the type
52.7 billion
of services are the same across the country. The
Real value of an 1800 penny in year exact conditions of the services, however, vary from
2000 dollars:
state to state according to
each state’s banking laws.
10.2 cents
In choosing a bank or savings institution for a
checking account, you should consider the service
charges. service charges on checking accounts vary
from bank to bank and with the type of account.
$50,000
You may be charged from $.25 to $.50 for each
check you write. Some institutions offer “free
Percentage of Americans with
household income above $50,000
checking”-no per check fee or month fee-providing
who want to abolish the penny:
the balance in the account remains above a certain
minimum. If it drops below this minimum, a service
31
charge of about $4 to $6 is collected. The minimum
balance generally ranges from $100 to $500
Percentage with household income
Estimated value of a pristine,
uncirculated 1800 penny:
less than $15,000 who want the
same:
18
Total lobbying by the pro-penny
Americans for Common Cents in
1998:
$60,000
Total for the American Red Cross:
$60,000
Electronic Banking
One of the most important changes in banking began
in the late 1970s with the introduction of the
computer. With it came electronic funds transfer
(EFT), a system of putting onto computers all the
various banking functions that in the past had to be
handled on paper.
One of the most common features of EFT is
automated teller machines (ATMs). These units let
customers do their banking without the help of a
teller. A few banks have authorized customers with
home computers to use them for banking
transactions. If problems with security can be
resolved, many people may one day bank by
computer from home.
EFT Concerns
Although EFT can save time, trouble, and costs in
making transactions, it does have some drawbacks.
The possibility of tampering and lack of privacy are
increased because all records are stored in a
computer. A person on a computer terminal could
call and read or even alter the account files of a bank
customer in any city, if he or she knew how to get
around the safeguards built into the system. Another
problem for customers-but a benefit for banking
institutions-is the loss of “float,” or the time between
when you write a check and when the sum of the
check is deducted from your account.
In response to these and other concerns, the Electronic Fund Transfer Act of 1978
describes the rights and responsibilities of participants in EFT systems. For example,
EFT customers are responsible for only $50 in losses when someone illegally uses their
card, if they report the card missing within two days. If they wait more than two days,
they could be responsible for as much as $500. Users are also protected against computer
foul-ups. If the balance appearing on a person’s statement or given out by an automated
or human teller is less than the customer believes it should be, the bank must investigate
and straighten out the problem within a certain period of time
Show me the money!!!
When you think of money, you may think only of paper bills and coins. What does it
mean to have “money in the bank”?
Money in use today consists of more than just currency. It also includes deposits in
checking and savings
accounts in banks and savings institutions, plus certain other investments.
CURRENCY
All United States coins in circulation today are token coins. The value of the metal in
each coin is less than its exchange value. A quarter, for example, consists of a mixture of
copper and nickel. If you melted down a quarter - which is illegal - the value of the
resulting metal would be less than 25 cents. The Bureau of the Mint, which is part of the
Treasury Department, makes all coins. Of the currency in circulation in the United States
today, about 9 percent is in coins.
Most of the nation’s currency is in the form of Federal Reserve notes. Federal Reserve
banks issue these notes. The Bureau of Printing and Engraving, also part of the Treasury
Department, prints all Federal Reserve notes. They are issued in denominations of $1,
$5, $10, $20, $50, and $100.
Torture test: Buck better not stop here
Cold
hard cash has to stand up to heat,
humidity, folding, crumpling and an occasional
trip through the washer and dryer. So the
Bureau of Engraving and printing tortures its
paper currency. The bills are designed to
thwart counterfeiters with a polyester thread,
visible only when the bill is held up to the light,
and a line of microengraving around the
portrait that can be read with a magnifying
glass. In its Washington, D.C., laboratory, the
bureau has 600,000 sheets of experimental $50s
and 100s. Among the tests that the 19.2 million
bills must survive; Fold. A machine folds the
bills 4,000 times. Crumple. A machine
scrunches them 32 times. Weather. To
simulate environments from the Southwest's
deserts to the Northeast's winters, the bills are
exposed to heat up to 120 degrees and cold
down to -30 degrees. The humidity ranges
from 20% to 80%. Wash. Yes, the money is
laundered once, although not in a pocket. The
bills are 75% cotton and 25% linen.
The Treasury Department has also issued
United States notes in $100 denominations
only. These bills have the words United States
Note printed across the top and can be
distinguished from Federal Reserve notes by a
red Treasury seal. United States notes make
up less than 1 percent of the paper money in
circulation. Both Federal Reserve notes and
United States notes are fiat money or legal
tender.
Click on either of the links below to go to
either the US Mint or the Bureau of Printing
and Engraving if you would like more
information on either of these subject areas.
http://www.usmint.gov.
http://www.bep.treas.gov.
CHECKS
A checking account is money deposited in a bank that a person can withdraw at any time
by writing a check. The bank must pay the amount of the check when it is presented for
payment, that is, on demand. Such accounts used to be called demand deposits. Today
we call these checkable deposits, and a variety of financial institutions offer them.
Commercial banks used to be the only financial institutions that could offer checkable
accounts. Today all thrift institutions - mutual savings banks, savings and loan
associations (S&Ls), and credit unions - offer checkable deposits.
CREDIT CARDS and DEBIT CARDS
Even though many people use their credit cards to purchase goods and services, the credit
card itself is not money. It does not act as a unit of accounting nor as a store of value.
The use of your credit card is really a loan to you by the issuer of the card, whether it is a
bank, retail store, gas company, of American Express. Basically, then, credit card
“money” represents a future claim on money that you will have later. Credit cards defer
rather than complete transactions that ultimately involve the use of money.
The debit card automatically withdraws money from a checkable account. When you use
your debit card to purchase something, you are in effect giving an instruction to your
bank to transfer money directly from your bank account to the store’s bank account. The
use of a debit card does not create a loan. Debit card “money” s similar to checkable
account money.
NEAR MONEYS
Numerous other assets are almost, but not exactly, like money. These assets are called
near moneys. Their values are stated in terms of money, and they have high liquidity in
comparison to other investments, such as stocks. Near moneys can be turned into
currency or into a means of payment, cash as a check, relatively easily and without the
risk of loss of value. For example, if you have a bank savings account, you cannot write
a check on it. You can, however, go to the bank and withdraw some or all of your funds.
You can then redeposit it in your checking account or take some or all of it in cash.
Time deposits and savings-account balances are near moneys. Both pay interest, and
neither can be withdrawn by check. Time deposits require that a depositor notify the
financial institution within a certain period of time, often 10 days, before withdrawing
money. Savings accounts do not usually require such notification.
THE MONEY SUPPLY
How much money is there in the United States today? That question is not so easy to
answer. First, the money supply must be defined and agreed upon. Currently, two basic
definitions are used, although others exist. The first is called M1 and the second M2.
Both definitions include all the paper bills and coins in circulation. Measuring M1 or M2
exactly is difficult.
M1, the narrowest definition of the money supply, consists of moneys that can be spent
immediately and against which checks can be written. It includes currency, traveler’s
checks, and checkable deposits. A broader definition of the money supply, M2, includes
all of M1, plus such near moneys as money market mutual fund balances and
Eurodollars.
The Eurodollar refers to a transfer of credit in United States dollars from a United States
bank to a foreign one. Banks that deal in Eurodollars are sometimes referred to as
Eurobanks. Most of these banks are in Europe, but some are in New York City, and Asia.
1991 M1 Money Supply
$267
billion
Traveler’s $8
Checks
billion
Demand
$289
Currency
Deposits
Other
checkable
deposits
Total:
billion
$333
billion
$897
billion
HAD IT WITH YOUR BANK FEES?
Some banks offer as many as nine different kinds of accounts, says Anne Morre,
president of Synergistics, a banking research firm. The key is finding the account that
charges least for your banking pattern.
Review recent account statements. How many checks do you write per month? How
many ATM transactions do you make? How widely does your balance fluctuate? If you
write fewer than ten or so checks, a “basic” account may be cheapest. Fees are usually
minimal, but you pay a per-check charge if you go over the limit...If you never use a live
teller, and account tat offers free ATM use but charges a fee for teller transactions may
save you money. Wells Fargo and Bank of America offer such
accounts.
Compare minimum balances. With interest rates on money-market accounts below 3%, it
costs you relatively little in forgone income to keep a minimum balance in a checking
account (even a non-interest-bearing one) to avoid checking fees. Keeping
the average minimum balance of $500 in a non-interest-bearing account costs you about
$15 a year in lost interest - less than the average fee of around $60 a year...
Beware of “special” fees. Some banks charge for things like copies of checks. If you
need services such as money orders, cashier’s checks or a safe-deposit box, ask about
“packaged” accounts that include those services in your fee. But don’t pay more for a
bundled account if you don’t need the extras.
Ask about fee waivers. If you use direct deposit for your paycheck, some banks give you
a break....
Skip the middleman when ordering checks. Direct mailers such as Current ...or Checks
in the Mail... sell 200 checks for $5 to $7. Banks typically charge twice that.
MONEY SUPPLY AND THE ECONOMY
THE FEDERAL RESERVE and the MONEY SUPPLY
Congress created the Federal Reserve System in 1913 as the central banking organization
of the United States. Its major purpose was to end the periodic financial panics that had
occurred during the 1800s and into the early 1900s. Over the years, many other
responsibilities have been added to the Federal Reserve System, or the Fed, as it is
called. The jobs of the Fed today range from processing checks to serving as the
government’s banker. Its most important function, however, involves control over the
rate of growth of the money supply.
LOOSE and TIGHT MONEY POLICIES
You may have read a news report in which a business executive or public official
complained that money is “too tight.” You may run across a story about an economist
warning that money is “too loose.” In these cases the term tight and loose are referring to
the monetary policy of the nation’s Federal Reserve System. Monetary policy involves
changing the rate of growth of the supply of money in circulation to affect the amount of
credit and, therefore, business activity in the economy.
Credit, like any good or service, is subject to the laws of supply and demand. Also, like
any good or service, credit has a cost. The cost of credit is the interest that must be paid
to obtain it. As the cost of credit increases, the quantity demanded decreases. In contrast,
if the cost of borrowing drops, the quantity of credit demanded rises.
To take a look a the US Government's monetary policies click on the link below, it will
take you to The Federal Reserve Bank of San Francisco's info page.
http://www.frbsf.org/system/fedsystem/monpol/tofc.html
Balancing Monetary Policy
Loose Money
Tight Money
Policy: Recession
Policy: Inflation
1. Borrowing is
easy
2. Consumers
buy more
3. Businesses
expand
4. More people
are employed
5. People spend
more money
1. Borrowing is
difficult
2. Consumers
buy less
3. Businesses
postpone
expansion
4.
Unemployment
increases
5. Production
cutbacks.
Above is shown the results of monetary policy decisions. If a country has a loose money
policy, credit is inexpensive to borrow and abundant. If a country has a tight money
policy, credit is expensive to borrow and in short supply.
If this is the case why would any nation want a tight money policy? The answer is to
control inflation. If money becomes too plentiful too quickly, prices increase and the
purchasing power of the dollar decreases dramatically. This situation occurred during the
Revolutionary War. The supply of Continental currency grew so rapidly that notes
became almost worthless.
The goal of monetary policy is to strike a balance between tight and loose money. It is
the Fed’s responsibility to ensure that tight money and credit are plentiful enough to
allow expansion of the economy. The Fed cannot, however, let the money supply
become so plentiful that rapid inflation results.
FEDERAL RESERVE BANKING
Before you are able to understand how the Fed regulates the nation’s money supply, you
need to understand the basis of the United States banking system and the way money is
created. The banking system is based on what is called fractional reserve banking.
Since 1913 the Fed has set a specific reserve requirement for many banks. They must
hold a certain percentage of their total deposits either as cash in their own vaults or as
deposits in their Federal Reserve bank. Currently most financial institutions must keep 10
percent of their checkable deposits in the FED.
MONEY EXPANSION
Currency is a small part of the money supply. A larger portion consists of bank deposits
the public owns. Because banks are most required to keep 100 percent of their deposits in
reserve, they can use their deposits to create what is, in effect, new money.
Suppose you sell a government bond to the Fed and receive $1,000 in “new” money
because the Fed simply creates it by writing you a check. You deposit it in a bank. With
a 10 percent reserve requirement, $100 of that money must be held in reserve. However,
the bank is free to lend the remaining $900.
Suppose another customer asks the same bank for a $900 loan. The bank creates $900
simply by transferring $900 to the customer’s checking account. the bank must keep in
reserve 10 percent of this new deposit - $90, but now it can lend the remaining $810.
This $810 is in turn treated as a new deposit. Ninety percent of it - $729 - can again be
lent. The original $1,000 has become $3,439. So it goes; each new deposit gives the
bank new funds to continue lending.
Of course a bank is not likely to continue lending and receiving back the same money.
Its customers will most likely withdraw money and spend it or deposit it in another bank;
however, this does not stop the creation of money. As the money finds its way into a
second bank and a third bank, and so on, each bank can use the non-required reserve
portion of the money to make more loans.
HOW THE MONEY SUPPLY INCREASES
Money expansion may seem confusing. Lets look at a step by step example.
Round 1: Suppose you have $1000 that you take to your bank (Bank A) and deposit in
your checking account. Assume that the Fed requires your bank to keep 20 percent of its
total deposits on reserve. Your bank must hold $200 of your deposit on reserve. This
leaves the bank with $800 of excess reserves, which is not earning interest.
Round 2: Bank A decides to loan out $800 to earn interest. John Jones applies to the
bank for an $800 loan. bank A finds him creditworthy and credits his account with
$800. Mr. Jones borrowed the money to buy a machine for his business from Jackson’s
Supply Company. He write a check to Jackson’s, and the company deposits it in bank B,
which credits $800 to Jackson’s account balance. bank B’s reserves increase by $800.
Of this amount, $160 (20 percent of $800) are required reserves, and the remaining $640
are excess reserves.
Round 3: To earn profits, Bank B loans its excess reserves to Ms. Wang, who wants to
borrow $640. She, in turn, buys something from Mr. Diaz, who does his banking at Bank
C. He deposits the money from Ms. Wang. Bank C now has $640 in new deposits, of
which $128 are required reserves. Bank C now loans $512 of excess reserves to Mrs.
Fontana, who buys something from Mrs. Powers, and so on. The result is that a deposit of
$1,000 in new money that was outside of the banking system has caused the money
supply to increase to $5,000. This process is called the multiple expansion of the money
supply.