Money and the Banking System
23 c h a p t e r
Money is anything that is generally accepted in exchange for goods or services. In colonial times, commodities such as tobacco and wampum (Native American trinkets, such as shells) were sometimes used as money. At some times and in some places, even cigarettes and whiskey have been used as money. Using commodities as money has several disadvantages, however, the most important of which is that many commodities deteriorate easily after a few trades. Precious metal coins have been used for money for millennia, partly because of their durability.
CURRENCY Currency consists of coins and/or paper that some institution or government has created to be used in the trading of goods and services and the payment of debts. Currency in the form of metal coins is still used as money throughout the world today. But metal currency has a disadvantage: It is bulky. Also, certain types of metals traditionally used in coins, like gold and silver, are not available in sufficient quantities to meet our demands for a monetary instrument.
For these reasons, metal coins have for centuries been supplemented by paper currency, often in the form of bank notes. In the United States, the Federal Reserve System issues Federal Reserve Notes in various denominations, and this paper currency, along with coins, provides the basis for most transactions of relatively modest size in the United States today.
CURRENCY AS LEGAL TENDER In the United States and most other nations of the world, metallic coins and paper currency are the only forms of legal tender. In other words, coins and paper money have been officially declared to be money—to be acceptable for the settlement of debts incurred in financial transactions. In effect, the government says, “We declare these instruments to be money, and citizens are expected to accept them as a medium of exchange.” Legal tender is fiat money—a means of exchange that has been established not by custom and tradition or because of the value of the metal in a coin but by government fiat, or declaration.
DEMAND DEPOSITS AND OTHER CHECKABLE DEPOSITS Most of the money that we use for day-to-day transactions, however, is not official legal tender.
Rather, it is a monetary instrument that has become “generally accepted” in exchange over the years and has now, by custom and tradition, become money. What is this instrument? It is balances in checking accounts in banks, more formally called demand deposits.
Demand deposits are defined as balances in bank accounts that depositors can access on demand by simply writing checks. Some other forms of accounts in financial institutions also have virtually all the attributes of demand deposits. For example, there are other checkable deposits that earn interest but have some restrictions, such as higher 504 CHAPTER TWENTY-THREE | Money and the Banking System Money s e c t i o n 23.1 _ What is money?
_ What is liquidity?
_ What is included in the money supply?
_ What backs our money?
Tobacco was once used as money in colonial America— in particular, in Virginia and Maryland. Tobacco was used rather than other commodities because it was resistant to spoilage. In the 17th century, colonists used wampum (polished shells) as lawful money. The ancient Chinese used chisels for money, while other societies have used fish and cattle and, of course, gold coins as money.
© Kent Knudson/Photolink/PhotoDisk/Getty One Images monthly fees or minimum balance requirements.
These interest-earning checking accounts effectively permit the depositors to write “orders” similar to checks and assign the rights to the deposit to other persons, just as we write checks to other parties.
Practically speaking, funds in these accounts are the equivalent of demand deposits and have become an important component in the supply of money. Both these types of accounts are forms of transaction deposits because they can be easily converted into currency or used to buy goods and services directly.
Traveler’s checks, like currency and demand deposits, are also easily converted into currency or used directly as a means of payment.
THE POPULARITY OF DEMAND DEPOSITS AND OTHER CHECKABLE DEPOSITS Demand deposits and other checkable deposits have replaced paper and metallic currency as the major source of money used for larger transactions in the United States and in most other relatively well-developed nations for several reasons, including ease and safety of transactions, lower transaction costs, and transaction records.
Ease and Safety of Transactions Paying for goods and services with checks is easier (meaning cheaper) and less risky than paying with paper money. Paper money is readily transferable: If someone takes a $20 bill from you, it is gone, and the thief can use it to buy goods with no difficulty.
If, however, someone steals a check that you have written to the telephone company to pay a monthly bill, that person probably will have great difficulty using it to buy goods and services because he has to be able to identify himself as a representative of the telephone company. If someone steals your checkbook, the thief can use your checks as money only if he can successfully forge your signature and provide some identification. Hence, transacting business by check is much less risky than using legal tender; an element of insurance or safety exists in the use of transaction deposits instead of currency.
Money 505 Americans know where to find pennies—in jars and fountains and on the countertops of convenience stores. What’s not known is just what ought to be done about the nation’s lowliest coin. At a House hearing, lobbyists for the penny—Americans for Common Cents—reported a poll showing that 73 percent of the American public wants the government to keep circulating pennies. The Treasury wants to do that, although the government’s General Accounting Office reported that penny production costs taxpayers over $8 million a year. The U.S. Mint disputed this, saying penny production nets the U.S. government between $17.9 and $26.6 million.
The GAO found that only about a third of existing pennies are in circulation. And a poll commissioned by the GAO showed that most Americans (52 percent) would prefer that prices be rounded to the nearest nickel. Penny backers responded with an estimate by Penn State economist Raymond Lombra, who said that rounding prices would result in overcharges costing consumers at least $600 million extra a year.
SOURCE: “Whither the Penny?” U.S. News & World Report, July 29, 1999, p. 8. Copyright © 1999 U.S. News & World Report, L.P. Reprinted with permission.
SHOULD WE GET RID OF THE PENNY?
In The NEWS What makes this paper and metal valuable? Paper and metal are valuable if they are acceptable to people who want to sell goods and services. Sellers must be confident that the money they accept is also acceptable where they want to buy goods and services. Imagine if money in California were not accepted as money in Texas or New York. It would certainly make it more difficult to carry out transactions.
© Eyewire Collection/Getty One Images Lower Transaction Costs Suppose you decide that you want to buy a compact disc player that costs $81.28 from the current JCPenney mail-order catalogue. It is much cheaper, easier, and safer for you to send a check for $81.28 rather than four $20 bills, a $1 bill, a quarter, and three pennies. Transaction deposits are popular precisely because they lower transaction costs compared with the use of metal or paper currency. In very small transactions, the gains in safety and convenience of checks are outweighed by the time and cost required to write and process them; in these cases, transaction costs are lower with paper and metallic currency.
Therefore, it is unlikely that the use of paper or metallic currency will disappear entirely.
Transaction Records Another useful feature of transaction deposits is that they provide a record of financial transactions.
Each month, the bank sends the depositor canceled checks and/or a statement recording the deposit and withdrawal of funds. In an age when detailed records are often necessary for tax purposes, this is a useful feature. Of course, it can work both ways.
Paper currency transactions are also popular in business activities in which participants prefer no records for tax collectors to review.
CREDIT CARDS A credit card is “generally acceptable in exchange for goods and services.” At the same time, however, a credit card payment is actually a guaranteed loan available on demand to the cardholder, which merely defers the cardholder’s payment for a transaction using a demand deposit. Ultimately, an item purchased with a credit card must be paid for with a check; monthly payments on credit card accounts are required to continue using the card. A credit card, then, is not money but rather a convenient tool for carrying out transactions that minimizes the physical transfer of a check or currency. In that sense, it is a substitute for the use of money in exchange and allows the cardholder to use any given amount of money in future exchanges.
SAVINGS ACCOUNTS Economists are not completely in agreement on what constitutes money for all purposes. Coins, paper currency, demand and other checkable deposits, and traveler’s checks are certainly forms of money because all are accepted as direct means of payment for goods and services. There is nearly universal agreement on this point. Some economists, however, argue that for some purposes money should be more broadly defined to include nontransaction deposits.
Nontransaction deposits are fund accounts against which the depositor cannot directly write checks—hence, the name. If these funds cannot be used directly as a means of payment but must first be converted into money, then why do people hold such accounts? People use these accounts primarily because they generally pay higher interest rates than transaction deposits.
Two primary types of nontransaction deposits exist—savings accounts and time deposits (sometimes referred to as certificates of deposit, or CDs).
Most purists would argue that nontransaction deposits are near money assets but not money itself.
Why? Savings accounts and time deposits cannot be used directly to purchase a good or service. They are not a direct medium of exchange. For example, you cannot go into a supermarket, pick out groceries, and give the clerk the passbook to your savings account.
You must convert funds from your savings account into currency or demand deposits before you can buy goods and services. Thus, strictly speaking, nontransaction deposits do not meet the formal definition of money. At the same time, however, savings accounts are assets that can be quickly converted into money at the face value of the account.
In the jargon of finance, savings accounts are highly liquid assets. True, under federal law, commercial banks legally can require depositors to request withdrawal of funds in writing and then defer making payment for several weeks. But in practice, no bank prohibits instant withdrawal, although early withdrawal from some time deposits, especially certificates of deposit, may require the depositor to forgo some interest income as a penalty.
MONEY MARKET MUTUAL FUNDS Money market mutual funds are interest-earning accounts provided by brokers who pool funds into investments like Treasury bills. These funds are invested in short-term securities, and depositors are allowed to write checks against their accounts subject to certain limits. This type of fund has experienced tremendous growth over the last 20 years.
Money market mutual funds are highly liquid assets.
They are considered to be near money because 506 CHAPTER TWENTY-THREE | Money and the Banking System they are relatively easy to convert into money for the purchases of goods and services.
STOCKS AND BONDS Virtually everyone agrees that many other forms of financial assets, such as stocks and bonds, are not money. Suppose you buy 100 shares of common stock in General Motors at $70 per share, for a total of $7,000. The stock is traded daily on the New York Stock Exchange and elsewhere; you can readily sell the stock and get paid in legal tender or a demand deposit. Why, then, is this stock not considered money? First, it will take a few days for you to receive payment for the sale of stock; you cannot turn the asset into cash as quickly as you can a savings deposit in a financial institution. Second, and more importantly, the value of the stock fluctuates over time, and as the owner of the asset, you have no guarantee you will be able to obtain its original nominal value at any time. Thus, stocks and bonds are not generally considered money.
LIQUIDITY Money is an asset that we generally use to buy goods or services. In fact, it is so easy to convert money into goods and services that we say it is the most liquid of assets. When we speak of liquidity, we are referring to the ease with which one asset can be converted into another asset or goods and services. For example, to convert a stock into goods and services would prove to be somewhat more difficult —contacting your broker or going online, determining at what price to sell your stock, paying the commission for your service, and waiting for the completion of the transaction. Clearly, stocks are not as liquid an asset as money. But other assets are even less liquid, like converting your painting collection or your baseball cards or Barbie collection into other goods and services.
THE MONEY SUPPLY Because a good case can be made both for including and for excluding savings accounts, certificates of deposits (CDs), and money market mutual funds from our operational definition of the money supply for different purposes, we will compromise and do both. Economists call the narrow definition of money—currency, checkable deposits, and traveler’s checks—M1. The broader definition of money, encompassing M1 plus savings deposits, time deposits (except for some large-denomination certificates of deposits), and money market mutual funds is called M2.
The difference between M1 and M2 is striking, as evidenced by the varying size of the total stock of money using different definitions as seen in Exhibit 1. M2 is more than four times the magnitude of M1. This means that people prefer to keep the bulk of their liquid assets in the form of savings accounts of various kinds.
HOW WAS MONEY “BACKED”?
Until fairly recently, coins in most nations were largely made from precious metals, usually gold or silver. These metals had a considerable intrinsic worth: If the coins were melted down, the metal would be valuable for use in jewelry, industrial applications, dentistry, and so forth. Until 1933, the United States was on an internal gold standard, meaning that the dollar was defined as equivalent in value to a certain amount of gold, and paper currency or demand deposits could be freely converted to gold coin. The United States left the gold standard, however, eventually phasing out gold currency.
Some silver coins and paper money convertible into silver remained, but by the end of the 1960s, even this tie of the monetary system to precious metals ended. This was due in part because the price of silver soared so high that the metal in Money 507 Currency 5 $625 billion M1: Currency 1 checkable deposits 1 traveler’s checks 5 $1,219.1 billion M2: M1 1 Savings Deposits 1 Time Deposits 1 Money Market Mutual Funds 5 $5,815.6 billion SOURCE: Economic Report of the President, 2003 Two Definitions of the Money Supply: M1 and M2 SECTION 23.1 EXHIBIT 1 coins had an intrinsic worth greater than its face value, leading people to hoard coins or even melt them down. When there are two forms of money available, people prefer to spend the form of money that is less valuable. This is a manifestation of Gresham’s Law: “Cheap money drives out dear money.” WHAT REALLY BACKS OUR MONEY NOW?
Consequently, today, there is no meaningful precious metal “backing” to give our money value.
Why, then, do people accept dollar bills in exchange for goods? After all, a dollar bill is a piece of generally wrinkled paper about 6 inches by 2.5 508 CHAPTER TWENTY-THREE | Money and the Banking System By Art Pine Yap, Micronesia—On this tiny South Pacific island, life is easy and the currency is hard. Elsewhere, the world’s troubled monetary system creaks along; floating exchange rates wreak havoc in currency markets, and devaluations are commonplace.
But on Yap the currency is as solid as a rock. In fact, it is rock. Limestone to be precise. For nearly 2,000 years the Yapese have used large stone wheels to pay for major purchases, such as land, canoes and permission to marry. Yap is a U.S. trust territory, and the dollar is used in grocery stores and gas stations. But reliance on stone money, like the island’s ancient caste system and the traditional dress of loincloths and grass skirts, continues.
Buying property with stones is “much easier than buying it with U.S. dollars,” says John Chodad, who recently purchased a building lot with a 30-inch stone wheel. “We don’t know the value of the U.S. dollar.” Others on this 37-square-mile island 530 miles southwest of Guam use both dollars and stones. Venito Gurtmag, a builder, recently accepted a four-foot-wide stone disk and $8,700 for a house he built in an outlying village.
Stone wheels don’t make good pocket money, so for small transactions, Yapese use other forms of currency, such as beer.
Beer is proffered as payment for all sorts of odd jobs, including construction. The 10,000 people on Yap consume 40,000 to 50,000 cases a year, mostly of Budweiser. In fact, Yapese drink so much that sales taxes on alcoholic beverages account for 25 percent of local tax revenue.
Besides stone wheels and beer, the Yapese sometimes spend “gaw,” consisting of necklaces of stone beads strung together around a whale’s tooth. They also can buy things with “yar,” a currency made from large seashells. But these are small change.
The people of Yap have been using stone money ever since a Yapese warrior named Anagumang first brought the huge stones over from limestone caverns on neighboring Palau, some 1,500 to 2,000 years ago. Inspired by the moon, he fashioned the stone into large circles.
The rest is history.
Yapese lean the stone wheels against their houses or prop up rows of them in village “banks.” Most of the stones are 2 to 5 feet in diameter, but some are as much as 12 feet across. Each has a hole in the center so it can be slipped onto the trunk of a fallen betel-nut tree and carried. It takes 20 men to lift some wheels.
By custom, the stones are worthless when broken. You never hear people on Yap musing about wanting a piece of the rock.
There are some decided advantages to using massive stones for money. They are immune to black-market trading, for one thing, and they pose formidable obstacles to pickpockets. In addition, there aren’t any sterile debates about how to stabilize the Yapese monetary system. With only about 6,600 stone wheels remaining on the island, the money-supply level stays put. “If you have it, you have it,” shrugs Andrew Ken, a Yapese monetary thinker.
SOURCE: Art Pine, “Fixed Assets, Or: Why a Loan in Yap Is Hard to Roll Over—Tiny Micronesian Island Uses Giant Stones as Currency; Don’t Forget Your Change,” The Wall Street Journal, March 29, 1984, p. 1. Wall Street Journal, Eastern edition [staff-produced copy only] by Art Pine. Copyright 1984 by Dow Jones & Co., Inc. Reproduced with permission of Dow Jones & Co., Inc. in the format Textbook via Copyright Clearance Center.
12 TINY MICRONESIAN ISLAND USES GIANT STONES AS CURRENCY In The NEWS © Charles O’Rear/Corbis inches in size, with virtually no inherent utility or worth. Do we accept these bills because it states on the front of the bills, “This note is legal tender for all debts, public and private”? Perhaps, but we accept some forms of currency and money in the form of demand deposits without that statement.
The true backing behind money in the United States is faith that people will take it in exchange for goods and services. People accept with great eagerness these small pieces of green paper with pictures of long-deceased people with funny looking hair simply because we believe that they will be exchangeable for goods and services with an intrinsic value. If you were to drop two pieces of paper of equal size on the floor in front of 100 students, one a blank piece of paper and the other a $100 dollar bill, and then leave the room, the group would probably start fighting for the $100 dollar bill while the blank piece of paper would be ignored.
Such is our faith in the green paper’s practical value that some will even fight for it. As long as people have confidence in something’s convertibility into goods and services, “money” will exist and no further backing is necessary.
Because governments represent the collective will of the people, they are the institutional force that traditionally defines money in the legal sense.
People are willing to accept pieces of paper as money only because of their faith in the government.
When people lose faith in the exchangeability of pieces of paper that the government decrees as money, even legal tender loses its status as meaningful money. Something is money only if people will generally accept it. While governments play a key role in defining money, much of it is actually created by private businesses in the pursuit of profit. A majority of U.S. money, whether M1 or M2, is in the form of deposits at privately owned financial institutions.
People who hold money, then, must have faith not only in their government but also in banks and other financial institutions. If you accept a check drawn on a regional bank, you believe that bank or, for that manner, any bank will be willing to convert that check into legal tender (currency) enabling you to buy goods or services that you want to have.
Thus, you have faith in the bank as well. In short, our money is money because of the confidence we have in private financial institutions and our government.
Money 509 1. Money is anything that is generally accepted in exchange for goods or services.
2. Coins, paper currency, demand and other checkable deposits, and traveler’s checks are all forms of money.
3. The ease with which one asset can be converted into another asset or goods and services is called liquidity.
4. M1 is made up of currency, checkable deposits, and traveler’s checks. M2 is made up of M1, plus savings accounts, time deposits, and money market mutual funds.
5. Money is no longer backed by gold. The true backing is our faith that others will accept it from us in exchange for goods and services.
1. If everyone in an economy accepted poker chips as payment in exchange for goods and services, would poker chips be money?
2. If you were buying a pack of gum, would using currency or a demand deposit have lower transaction costs? What if you were buying a house?
3. What is the main advantage of transaction deposits for tax purposes? What is its main disadvantage for tax purposes?
4. Are credit cards money?
5. What are M1 and M2?
6. How have interest-earning checking accounts and overdraft protection led to the relative decline in demand deposits?
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MONEY AS A MEDIUM OF EXCHANGE We have already indicated that the primary function of money is to serve as a medium of exchange, to facilitate transactions, and to lower transaction costs. That is, sellers will accept it as payment in a transaction. However, money is not the only medium of exchange; rather, it is the only medium that is generally accepted for most transactions.
How would people trade with one another in the absence of money? They would barter for goods and services they desire.
The Barter System Is Inefficient Under a barter system, individuals pay for goods or services by offering other goods and services in exchange.
Suppose you are a farmer who needs some salt. You go to the merchant selling salt and offer her 30 pounds of wheat for 2 pounds of salt. The wheat that you use to buy the salt is not money, because the salt merchant may not want wheat and therefore may not accept it as payment. That is one of the major disadvantages of barter: The buyer may not have appropriate items of value to the seller. The salt merchant may reluctantly take the wheat that she does not want, later bartering it away to another customer for something that she does want. In any case, barter is inefficient because several trades may be necessary to receive the desired goods.
Moreover, barter is extremely expensive over long distances. What would it cost me, living in California, to send wheat to Maine in return for an item in the L.L.Bean catalogue? It is much cheaper to mail a check. Finally, barter is time-consuming because of difficulties in evaluating the value of the product that is being offered for barter. For example, the person that is selling the salt may wish to inspect the wheat first to make sure that it is pure and not filled with dirt or other unwanted items.
Barter, in short, is expensive and inefficient and generally prevails only where limited trade is carried out over short distances, which generally means in relatively primitive economies. The more 510 CHAPTER TWENTY-THREE | Money and the Banking System The Functions of Money s e c t i o n 23.2 _ Is using money better than barter?
_ How does money lower the costs of making transactions?
_ How does money serve as a store of value?
_ Is it less risky to make loans of money or of goods?
Johnny Hart and Creators Syndicate complex the economy (e.g., the higher the real GDP per capita), the greater the economic interactions between people, and consequently, the greater the need for one or more universally accepted assets serving as money. Only in a Robinson Crusoe economy, where people live in isolated settlements and are generally self-sufficient, is the use of money unnecessary.
MONEY AS A MEASURE OF VALUE Besides serving as a medium of exchange, money is also a measure of value. With a barter system, one does not know precisely what 30 pounds of wheat are worth relative to 2 pounds of salt. With money, a common “yardstick” exists so people can very precisely compare the values of diverse goods and services . Thus, if wheat costs 50 cents a pound and salt costs $1 a pound, we can say that a pound of salt is valued precisely two times as much as a pound of wheat ($1/$0.50 5 2). By providing a universally understood measure of value, money serves to lower the information costs involved in making transactions. Without money, a person might not know what a good price for salt is, because so many different commodities can be bartered for it. With money, there is but one price for salt, and that price is readily available as information to the potential consumer.
MONEY AS A STORE OF VALUE Money also serves as a store of value. It can provide a means of saving or “storing” things of value in an efficient manner. A farmer in a barter society who wants to save for retirement might accumulate enormous inventories of wheat, which he would then gradually trade away for other goods in his old age.
This is a terribly inefficient way to save. The farmer would have to construct storage buildings to hold all his wheat, and the interest payments he would earn on the wheat would actually be negative because it is quite likely that rats will eat part of it or it will otherwise deteriorate. Most important, physical goods of value would be tied up in unproductive use for many years. With money, the farmer saves pieces of paper that can be used to purchase goods and services in his old age. It is both cheaper and safer to store paper rather than wheat.
MONEY AS A MEANS OF DEFERRED PAYMENT Finally, money is a means of deferred payment.
Money makes it much easier to borrow and to repay loans. With barter, lending is cumbersome and subject to an added problem. What if a wheat farmer borrows some wheat and agrees to pay it back in wheat next year, but the value of wheat soars because of a poor crop resulting from drought? The debt will be paid back in wheat that is far more valuable than that borrowed, causing a problem for the borrower. Of course, fluctuations in the value of money can also occur; indeed, inflation has been a major problem in our recent past and continues to be a problem in many countries.
But the value of money fluctuates far less than the value of many individual commodities, so lending in money imposes fewer risks on buyers and sellers than lending in commodities.
The Functions of Money 511 1. Barter is inefficient compared to money because a person may have to make several trades before receiving something that is truly wanted.
2. By providing a universally understood measure of value, money serves to lower the information costs involved in making transactions.
3. Money is both cheaper and easier to store than other goods.
4. Because the value of money fluctuates less than specific commodities, it imposes fewer risks on borrowers and lenders.
1. Why does the advantage of monetary exchange over barter increase as an economy becomes more complex?
2. How can uncertain and rapid rates of inflation erode money’s ability to perform its functions efficiently?
3. In a world of barter, would useful financial statements, like balance sheets, be possible? Would stock markets be possible? Would it be possible to build cars?
4. Why do virtually all societies create something to function as money?
s e c t i o n c h e c k FINANCIAL INSTITUTIONS The biggest players in the banking industry are commercial banks. Commercial banks are financial institutions organized to handle the everyday financial transactions of businesses and households through demand deposit accounts and saving accounts and by making short-term commercial and consumer loans. These banks account for more than two-thirds of all the deposits in the banking industry; they maintain almost all the demand deposits and close to half the savings accounts.
There are nearly 1,000 commercial banks in the United States. This number is in marked contrast to most other nations, where the leading banks operate throughout the country and where a large proportion of total bank assets are held in a handful of banks. Until recently, federal law restricted banks from operating in more than one state. This has now changed, and the structure of banking as we know it will inevitably change with the emergence of interstate banking, mergers, and “hostile” takeovers.
Aside from commercial banks, the banking system includes two other important financial institutions: savings and loan associations and credit unions. Savings and loan associations provide many of the same services as commercial banks, including checkable deposits, a variety of time deposits, and money market deposit accounts. The almost 2,000 members of savings and loan associations have typically invested most of their savings deposits into home mortgages. Credit unions are cooperatives, made up of depositors with some common affiliation, like the same employer or union.
THE FUNCTIONS OF FINANCIAL INSTITUTIONS Financial institutions offer a large number of financial functions. For example, they often will pay an individual’s monthly bills by automatic withdrawals, administer estates, rent safe deposit boxes, among other things. Most important, though, they are depositories for savings and liquid assets that are used by individuals and firms for transaction purposes.
They can create money by making loans. In making loans, financial institutions act as intermediaries (the middle persons) between savers, who supply funds, and borrowers seeking funds to invest.
HOW DO BANKS CREATE MONEY?
As we have already learned, most money, narrowly defined, is in the form of transaction deposits—assets that can be directly used to buy goods and services.
But how did the balance in, say, a checking account get there in the first place? Perhaps it was through a loan made by a commercial bank. When a bank lends to a person, it does not typically give the borrower cash (paper and metallic currency).
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