Money and Banking Chapter 11 Economics

Money Evolved…

Functions of Money Money is accepted by all parties as payment for goods and services. Money can be used to express worth in terms that most people can understand. Money holds its purchasing power until the buyer needs it.

Money in Early Societies Due to the value of tea in Asia, tea bricks were used like gold coins in China, Tibet, Mongolia, and Central Asia. The use of money developed in ancient times because it made life easier. A good like compressed tea leaves is known as commodity money. Fiat money is made valuable by government decree.

Money in Colonial America Tobacco and wampum were once accepted forms of currency. States passed laws allowing individuals to print paper currency, which was backed in local banks with gold and silver deposits. During the American Revolution, Continental dollars were issued but without gold or silver backing, which made them virtually worthless by the end of the war. Specie, or gold and silver coins, were commonly used in the colonies. Because they were in limited supply, they had more value than paper currency.

Origins of the Dollar When the nation began, the most plentiful coin in circulation was the Spanish peso. Benjamin Franklin and Alexander Hamilton differentiated the dollar system from the pesos by dividing the dollar into tenths rather than the peso’s pieces of eight.

Characteristics of Money Money must be portable, or easily transferred from one person to another. Money must be durable so it lasts when handled or stored for long periods. Money must be divisible to facilitate all types of transactions. Money must be in limited supply to retain its value.

Early Banking and Monetary Standards

Privately Issued Bank Notes A monetary standard keeps the money supply portable, durable, divisible, and limited in supply. The United States has had several standards throughout it history. Continental currency after the Revolutionary War was worthless, so Americans only trusted coins. The United States constitution gave the federal government the power to coin money and prevented the states from doing so. Private banks produced paper money By 1811 the nation had about 100 state banks, which had a charter from the state governments. People could exchange the paper notes for gold or silver. Each bank had its own currency design so hundreds of different notes were in circulation. Counterfeiting became a problem. Because some currencies did not have silver or gold backing, some merchants were wary to accept all forms of currency.

WHICH IS REAL? WHICH IS FAKE?

The Greenback Standard To finance the Civil War, congress authorized in 1861 the printing of $60 million of demand notes. They had no silver or gold backing, but the government declared them legal tender. By 1862, Congress authorized a new federal currency. Both of these currencies were called greenbacks because of their green ink. In time, people feared that greenbacks had little value, like Continental dollars, and they avoided using them. Congress then created a National Banking System (NBS) of national banks, which were privately owned but chartered by the federal government. These banks issued National bank notes, backed by the United States government bonds. State banks withdrew their notes. In 1863 the federal government issued gold certificates backed by gold, in large denominations for banks to exchange with one another. In 1886, it issued silver certificates backed by silver.

The Gold Standard In 1900, Congress passed the Gold Standard Act, making the basic currency unit, the dollar, equivalent to a specific amount of gold. It did not change the use of greenbacks or notes, but Americans could exchange them for gold whenever they wanted. The gold standard remained in effect until the Great Depression.

advantages of the gold standard People (Americans) felt safe about their money Prevents the government (US gov’t) from printing too much paper currency (devaluing it)

disadvantages of the gold standard The gold supply may not grow fast enough to support a growing economy People may decide to convert their paper to gold, thereby draining the government’s gold reserves The price of gold will respond to the market and it could lose substantial value The political risk of failure exists

The Inconvertible Fiat Money Standard Since 1934 the United States has been on an inconvertible fiat money standard. The money supply of the United States is managed by the federal government. The tangible component of modern money consists of coins and Federal Reserve notes. The intangible components include travelers’ checks, and checking and savings accounts. Modern money must also be portable, durable, and divisible.

The Development of Modern Banking

Revising the banking system The National Banking Act (1863) strengthened the nation’s financial system by creating a system of national banks. By 1907, the NSB needed further reforms as the nation experienced financial crises and recessions.

The Federal Reserve System Congress responded to the call for reform with the Federal Reserve System, or the Fed, the nation’s first true central bank—a bank that lends to other banks in need. The Fed was set up like a corporation and any bank that joined the system had to purchase shares of stock in the system; as a result, privately owned banks own the Fed, not the government. The Fed, however, is publicly controlled. The president appoints and Congress approves the Fed’s Board of Governors. Banks were overextended during the 1920’s, and many failed after the Great Depression hit in 1929. Banks did not have deposit insurance for their depositors, causing depositors’ rush on banks to withdraw funds. As a result, many more banks failed. The Federal Deposit Insurance Corporation insured customer deposits in the event of a bank failure.

Other Depository Institutions Most of the first American banks were commercial banks that catered to business and commerce. They had the authority to issue checking or demand deposit accounts. A thrift institution, on the other had, accepted the deposits of small investors but could not offer demand deposit accounts (until the 1970s).

Mutual savings banks The mutual savings banks were the oldest thrift institutions in the United States. They catered to the small wage earner, particularly those who lived in the industrial northeast and the Pacific northwest. In 1972 a savings bank introduced the Negotiable Order of Withdrawal, or NOW accounts, which were checking accounts that paid interest. Commercial banks opposed these accounts, but they proved popular with consumers.

Savings and loan associations A savings and loan association invested the majority of its funds in home mortgages. They began as cooperative clubs for homebuilders. In the 1930s, the Federal Home Loan Bank Board began supervising and regulating savings and loan associations.

Credit unions A credit union is a nonprofit service cooperative that is owned by and operated for the benefit of its members. Contributions are generally deducted directly from a worker’s paycheck.

Crisis and Reform in the 1980s Financial institutions were closely regulated from the Great Depression through the 1970s. Federal regulations included setting maximum rates of interest and restricting how institutions could lend their funds. The Reagan administration deregulated the financial system, ushering in a period of competition, crisis, and reform.

Deregulation led to more competition. Any financial institution could offer NOW accounts. All depository institutions could borrow from the Fed, not just commercial banks.

Deregulation led to a crisis among savings and loan associations, which were not experienced in competing in the marketplace. Several bad loans could force and S&L out of business because they kept only about half the reserves that commercial banks kept. Deregulation led to fewer federal inspectors, encouraging some institutions to engage in fraud, which drained the Federal Savings and Loan Insurance Corporation (FSLIC) of funds paid out in insurance claims to depositors.

In 1989 congress passed the Financial Institutions Reform, Recovery, and Enforcement Act, which abolished the savings and loan industry and its supervisory agency, the FHLBB. The FSLIC was dissolved and the FDIC took over insurance responsibilities. Some savings and loan associations survived the crisis.

In 1980s were years of more bank failures, many due to poor management. Failed banks made loans without adequate collateral, others failed to keep expenses under control, and other fell victim to the weak economy.

In 1990s were years of caution after the turbulent 1980s. Stronger federal regulations were enacted, and all financial institutions were required to strengthen their capital reserves. Banks merged with stock and security brokerage firms. By 2000 financial institutions were healthier.