Originally items such as coins made from precious metals were used for exchange and they had a direct value based on metal content.
As time went on bills and paper money were created.
Paper money initially represented a physical value and governments would store gold, for example, and the paper represented that gold in storage.
Now money has become more abstract and factors such as faith in a nation’s economic production and potential now represent the value of money.
Medium of Exchange
Anything that is used to determine value during the exchange of goods and services.
Barter goods and money are both mediums of exchange.
The direct exchange of one good or service for another.
Barter is the earliest and most basic form of trade that breaks down into the classic “I will trade you five chickens for one goat.”
Money is anything that serves as a medium of exchange, a unit of account, and a store of value.
It is easy to carry and portable.
Money is often called currency.
A unit of account is a means for comparing the values of goods and services.
For example you can compare the price of a good in one store to the price of the good in some other store and gauge the value of that good because we have prices expressed in our money.
$25.00 $30.00 Or
A store of value is something that keeps its value if it is stored rather than used.
In essence, you can save your money and it will keep its value.
The Six Characteristics of Money/Currency
Durability: It can withstand physical wear and tear.
Coins from the Roman Empire still exist today, and old pennies turn up all the time showing examples of durability.
Portability: Money must be easy to carry and transfer.
Money is easier to carry than gold bricks.
Divisibility: Money must be easily divided into smaller denominations and amounts.
You will be able to pay specific amounts this way for a good or service.
Uniformity: Any two units must be the same in what they can buy.
The money has a specific measure everywhere in the nation.
Limited Supply: Too much will bring the value down, but not enough will increase its value.
Balance must be found and the supply limited.
Acceptability: Everyone accepts the value of money and it has the same value store to store and so on.
Sources of Money’s Value
Commodity Money: Commodities are objects and commodity money consists of objects that have value in themselves and that are also used as money.
These are the items of barter in most cases.
These items are not usually easily portable or divisible and only work in simple economies.
Representative Money: Representative money makes use of objects that have value because the holder can exchange them for something else of value.
Early representative money took the form or paper receipts for gold and silver.
To carry gold and silver around was inconvenient so paper money took its place.
Fiat Money: Money that has value because the government has ordered that it is an acceptable means to pay debts.
It is abstract and is trusted because of the United States economic production and potential backs it.
It is also called legal tender and has all six characteristics of money.
A bank is an institution that exists for receiving, keeping, and lending money.
Pre Civil War America
Before the American Revolution businesses and merchants were money lenders and keepers as was the tradition in Europe.
The major problem with this traditional system was the safety of your money.
A merchant could die or go out of businesses, or they could be untrustworthy and a depositor could lose everything.
After the American Revolution one of the goals of the new nation was a stable and safe banking system.
The Federalists in 1789 under Washington’s Secretary of Treasury Alexander Hamilton wanted a strong central government to control the banking system and wanted to create a national bank.
Thomas Jefferson and the Anti-Federalists supported a decentralized system where states controlled banking within their borders.
They also considered a federal bank unconstitutional.
In 1791 the Federalists were successful in creating the Bank of the United States with a 20 year charter.
Order and stability did result but the bank tended to only loan money to the rich.
The bank also issued representative money/bank notes backed by silver and gold.
The bank also issued loans and ensured state banks had the gold and silver for exchange. The charter was not renewed in 1811.
Chaos: After the Bank of the United States charter expired state banks began issuing different money that would not have value in another state and often states and banks could not back it.
Numerous banks were formed without any economic regard.
The Second Bank of America: In 1816 a second federal bank was created to deal with the chaos the states were creating.
The Second Bank was able to restore order and regain the publics trust over time.
The Supreme Court also found that a federal bank was indeed constitutional.
President Andrew Jackson and his party did not trust the bank and when the charter was due to be renewed he vetoed it.
The Free Banking Era: From 1830 to 1837 the “Wildcat Era” was even worse than the chaos that occurred between the First and Second Banks of America.
States created banks with no economic regard and massive amounts of currency were created that could not be backed.
Wildcat Banks on the frontier or in the middle of nowhere were opened that often failed due to location.
Fraud was common. “Take the money and run” scams occurred.
The currencies as noted were numerous and not backed.
Panic and mistrust caused “bank runs” in which great numbers of people would panic and try to redeem their money.
The Civil War and Post Civil War Era
No Bank of America was created to deal with the problems but things settled a bit after 1837.
Outbreaks of chaos continued and confusion.
Several states left the Union to form the Confederacy.
Both the North and the South issued federal currencies.
The US created the “greenback.”
During the war the US government worked to restore economic confidence and passed the National Banking Acts of 1863-64.
These acts gave the federal government the ability to:
1. Charter banks.
2. Require that banks had the assets to cover their notes and activities.
3. Created a single national currency.
A federal system was still not created.
The gold standard was adopted in 1870 to back the national currency and set the dollars value.
The government could only issue currency if they had the gold to back it and as a result the currency was a success.
The 20th Century and Banking
The Panic of 1907 resulted from several long standing New York banks failing and the need for a federal system to go with the federal currency was finally acknowledge by most US politicians.
In 1913 President Wilson’s Federal Reserve Act created the Federal Reserve System. This became the nation’s central banking system.
A central bank could lend money to banks in times of need to try and keep them from failing and help build confidence and trust in banks.
In other words it was a banker’s bank and a lender of last resort.
1. 12 regional Federal Reserve Banks were created throughout the country to help bring about organization and stability.
2. A Federal Reserve Board of Governors appointed by the President runs the system.
There are seven governors who serve staggered non renewable turns where every two years a member rotates out.
3. Each bank can issue short-term loans to banks in need.
4. The currency became a Federal Reserve Note and the Fed controls the amounts of currency in circulation and can up it and lower it as needed. They impact the money supply greatly.
5. The Federal Open Market Committee (FOMC) is made up of the seven board of governor members and five of the presidents selected from the twelve banks.
Four of the presidents rotate out and the New York President is always on the committee because of Wall Street.
The Great Depression that started in 1929 was the Feds first great challenge.
Banks were engaging in high risk loans to businesses that were failing and bank runs began again.
The runs caused the stock market to crash and the Depression began.
Trust was lost but the Fed continued to try and restore confidence.
When banks failed customers deposits were lost.
The 1933 Bank Holiday ordered by F.D.R closed all the nation’s banks and sound banks were only allowed to reopen.
Once stable, a bank could return to business or it was closed for good. More trust was restored.
Later in 1933 the Federal Deposit Insurance Corporation (FDIC) was created to insure and back customer deposits if a bank fails.
The transformation to fiat money begins.
Post Depression banking is far more regulated and through the 1960’s even more restrictions such as controlled interest rates occurred.
As a result in the 1970’s and 80’s banks and business pushed for deregulation.
Removal of regulation (deregulation) occurred as a result.
The deregulation of the 70’s and 80’s led to the Savings and Loan (S&Ls) Crisis of the 1980’s.
Fraud occurred at high levels within institutions and they were operating with inadequate capital.
Risky and bad loans were issued, and interest rates skyrocketed.
S&Ls: Institutions that originally pulled deposits of members into large funds where members could draw interest and then pull money to buy homes.
With deregulation they started to function more like conventional banks.
As a result of the crisis the 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA) abolished the independence of the savings and loan industry and restored regulation.
They still function like banks but are regulated and watched more.
Banking today is covered in the next section.
Banking today is very different from the past.
Banks today provide services unheard of in the past and transactions are no longer done with just money and currency.
Electronic banking, credit, debit, and other services have revolutionized banking.
Even with all this change the main purpose of a bank it still to take in deposits and use this money to make loans to consumers and businesses.
They also help manage the money supply.
The Money Supply
All the money available in the United States economy.
It is divided into several categories, the main two are M1 and M2.
Currency in the hands of the public, in checking accounts, and in the form of travelers’ checks.
M1 consists of assets that have liquidity, or the ability to be used as, or directly converted into cash.
They are “cash like.”
The money in a checking account is often called a demand deposit because checks can be converted to cash or used as cash and traditionally did not draw interest until the 1980’s.
Other Checkable Accounts: Checking accounts that do draw interest.
Today most accounts with larger amounts of money in them draw interest.
Often referred to as “near money,” M2 consists of everything in M1 as well as in savings accounts, small denomination time deposits such as CD’s, and money market mutual funds. M2 is not as liquid.
1. Savings accounts in return for your deposit draw interest and can be withdrawn somewhat readily.
2. Small denomination time deposits like CD’s are deposits that draw more interest but have withdraw restrictions based on time.
3. Money market mutual funds are funds that pool money from small savers (individuals for example) to purchase short term government and corporate securities.
M1 + M2 + foreign deposits
The Modern Functions of Financial Institutions
Today they help manage the money supply and provide services to consumers.
The services are:
a. Storing Money: The FDIC protects consumer deposits and the deposits are stored in secure facilities and are insured against things like theft and fire.
If the bank can not cover the losses the FDIC will.
b. Saving Money: Banks are an outlet where consumers can save money and where consumers can make their money work for them by drawing interest.
c. Checking: Checking accounts give you access to your money.
d. Loans: Banks provide loans to consumers and businesses for a fee.
How Loans Work: The Fractional Reserve System
Goober Bank takes a deposit of $10,000 from a customer.
The bank keeps 20% of that deposit to cover withdraw demands from other customers.
The leftover $8,000 is loaned to Slim Mudbag so he can by a monster truck.
Big Time Super Bank takes a deposit of $8000 from Sally Surepants who sold her ex-husbands monster truck to Slim.
The bank keeps 20% to cover withdraw demands and loans $6,400 to Johnny Rocker who uses it to buy and Dean Markley Dimebag Guitar and a Marshall stack.
Fleecem Bank takes a deposit from the Rockstore who sold Johnny Rocker, who now is known as Sluge Vomit, his equipment.
The bank retains 20% to cover withdraws and loans $5,120 to Bonnie Braniac who needs the money for test subjects at her lab.
Bonnie is arrested by police for practicing illegal operations and defaults on her loan.
Fleecem Bank will try to collect some of the money through a collection agency but they never recover the money.
Too many bad loans could cause the Fleecem Bank to go out of businesses.
Risk always exists.
A specific type of loan that is used to buy real estate is a mortgage, and it can be commercial or personal.
Banks issue cards that entitle its holder to buy goods and services based on the holders promise to pay for these goods and services and the service charges and interest fees that come with it.
Interest: The price paid for the use of borrowed money.
Interest is how banks make profit.
Principal: The amount of money borrowed.
Types of Financial Institutions
With deregulation the differences in banks have virtually disappeared and all have check writing ability now.
Commercial Banks: These banks provide services to businesses only.
Around a third of commercial banks are members of the Fed and they provide the most services and have the largest impact on the US economy.
Savings and Loans: Original institutions the pulled money of members so they could buy homes that now function similar to banks.
Mutual Savings Banks (MSBs): Owned by the depositors themselves these banks serve people who make smaller deposits and engage in smaller transactions.
Credit Unions: Credit unions are cooperative lending associations for particular groups and occupations.
Interest rates are often lower than traditional banks.
Finance Companies: Finance companies issue installment loans to consumers, such as car loans, and charge higher interest rates traditionally.
Some finance companies specialize in high risk customers and generally charge the highest interest rates of all institutions.
Computers and technology have changed banking drastically.
ATMs: Automated teller machines take in deposits and handle withdraws faster and can be placed in numerous convenient locations.
How can I help you Dave?
Debit Cards: Similar to a credit card a debit card functions more like a check and can be used to withdraw money.
Home Banking: Account managing and transfers can be done at home via the computer.
Paychecks and other payments can also be direct deposited by computer now.
Automatic Clearing Houses (ACHs): Located at Fed banks these allow consumers to pay creditors through wire transfers.
I want one million dollars wired to my account!
Stored Value Cards: Often called smart cards, SVCs are cards that carry a pre paid balance and can carry information.
They are similar to debit cards.
Some economists feel these could replace cash currency someday.
Saving and Investing
Investing promotes economic growth and stability.
Investors can profit, and combined with saving they can provide for a secure future.
Borrowers will always be looking for money!
The act of redirecting resources from being consumed today so they may create benefits in the future.
It is also the use of assets to earn income and profit.
This really only works in a free enterprise system fully.
In order to invest you need a financial system that allows for the transfer of money between savers and borrowers and documents to record everything.
The documents that prove you have an asset or a record must exist.
It will show a claim on the property or income of a borrower.
Institutions that help channel funds from savers to borrowers.
Today you have a lot of overlap between what different intermediaries can do.
Banks, S&Ls, loan associations, and credit unions take in funds and loan them out as we saw in the banking unit.
Finance companies also make loans with higher rates and higher risk.
Mutual funds are funds that pool the savings of many individuals and invest this money in a variety of stocks, bonds, and other financial assets.
Good return with less risk than doing something like stocks only.
Life insurance companies collect premiums and the policy will be paid out to one or more beneficiaries after the policy holder dies.
Insurance companies loan out the premiums collected to borrowers.
Pension funds consist of money set aside by a company and employee to be used during the retirement of an employee that can be loaned out to borrowers or used by a company to buy stocks and make profit.
Diversification is the key to all of this. You need to spread out your investments to reduce risk and get the most return.
Do not put all your eggs in one basket.
Other things to know:
A portfolio is a collection of assets and it should be diverse.
By law you will get a prospectus, or investment report, showing all pertinent information about an opportunity before you agree to it.
Liquidity exists, meaning you can move your money around or pull it out.
Intermediaries help do this.
You are looking for good returns to make this worthwhile.
A return is the money an investor receives above and beyond the sum on the money initially invested.
You must manage risk, but risk is always present.
Bonds and Other Financial Assets
A bond is a certificate sold by a company or government to finance projects or expansion.
The Three Components of Bonds
a. Coupon Rate: The interest rate that a bond issuer will pay to a bondholder.
b. Maturity: The time at which payment to a bondholder is due.
c. Par Value: The amount that an investor pays to purchase a bond and that will be repaid to the investor at maturity.
If the bond is not held to maturity buyers and sellers will be interested in the bonds yearly yield.
The yield is the annual rate of return on a bond if the bond is not held to maturity.
Buying Bonds at a Discount
Investors will often buy bonds at a discount from bondholders who need to sell them.
This is a discount from par and can happen for many reasons.
Example: Dizzy buys a bond with a par value of $1,000 with a 5% interest.
The interest rates go up to 6%, a better rate but Dizzy is locked in a 5% because that was what he could get at the time.
Dizzy wants to buy a surfboard and wants to sell the bond for money.
Nobody wants a 5% when interest is 6%. Dizzy will have to discount it to sell it.
Zonker gets the $1,000 bond with a 5% return rate for $900. The bond is discounted from par.
Investors can check a bonds quality by checking published ratings.
Standard & Poor and Moody’s are two firms that publish ratings.
Bonds attract more investors because they usually pay regular interest income and pledge to repay the amount of the bond.
Investment quality bonds are rated and ratings help investors find bonds that are as safe a possible.
The Pros of Bonds for Issuers
a. Coupon rates are set and everything is fixed for a period of time.
b. Unlike stockholders, bondholders do not own part of the company so the company does not have to share profits with them.
The Cons of Bonds for Issuers
a. Interest rates as stated before are fixed and if they go down overall the firm is still fixed at a paying a higher one.
b. If a firm is failing or unhealthy a bond can be downgraded by the bond rating firms and fewer people will be interested in them unless they are discounted.
Savings Bond: Low denomination ($50 to $10,000) bond issued by the United States government usually for the purpose of some public work.
Unlike other bonds no payment schedule exists.
Bonds are purchased for less than par value and when it matures the purchaser gets their investment back with interest.
Treasury Bonds, Bills, and Notes: The US Treasury Department offers investments with different terms and rates:
1. T Bond: Long term (10-30 years) and safe. Sold in units of $1,000 and have good return.
2. T Note: Intermediate term (2-10 years) and safe. Sold in units of $1,000 but have lower return than a T Bond.
3. T Bill: Short term (3, 6, and 12 months), extremely safe, and liquid. Sold in units of $1,000 and have the lowest return.
Municipal Bonds: A bond issued by a state or local government municipality to finance or improve public works like highways, libraries, or schools.
They are considered safe and attractive to investors.
Corporate Bonds: A bond that a corporation issues to raise money to expand its business.
They are watched very closely by the two rating firms and by the Securities and Exchange Commission (SEC).
Junk Bonds: High yield and high paying bonds that are very risky.
They have low ratings and became popular in the 1980’s and 1990’s.
They can be corporate or municipal.
Other Types of Financial Assets
Certificates of Deposit (CD): CD’s are available from Banks.
They are similar to bonds because you secure a CD and let it mature for a fixed amount of time to make profit.
They are popular with investors because they have many options on the terms of maturity and cost as little as $100.