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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.