ECON305, Maclachlan, Fall 2006 1

Money and Banking

Week 2

Introduction continued,

What is money?

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Exchanges: e.g., NYSE

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OTC markets: e.g.,NASDAQ

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money market instruments: short-term maturity, low risk, high denomination debt instruments.

Examples: Treasury bills, commercial paper, repos, banker’s acceptances.

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Equity

IssuersLow risk—is never paid back.

Level of dividend payments can be decided by managers.

Dilution of earnings for existing shareholders.

InvestorsHigher risk than bonds from same

firm. Investors are residual claimants.

Higher return, on average.

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Debt

IssuersRisk of being forced into

bankruptcy if firm cannot meet debt obligations.

Interest payments on bonds must be made every six months.

Tax advantage of interest payments.

Return paid on bonds lower than on stock. It’s a cheaper form of finance.

InvestorsLower risk than equity—even if

firm fails bond investors are first in line.

Return is lower, on average.

Cash flows every six months—good for retirees.

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Fiscal Policy

Taxing & spending.

Borrow if spending exceeds tax revenue.

Responsibility of the Treasury.

Monetary Policy

Affecting money supply and interest rates.

Responsibility of central bank—the Federal Reserve.

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Federal Funds Rate

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Fed funds rate: rate of interest that large banks charge one another for short-term loans. Transactions flow through their accounts at the Fed—hence the term.

Determined by supply and demand.

Target is 5.25%

Discount rate: rate of interest that the Fed charges banks for short-term loans.

Currently 6.25%.

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Definition

Money is anything generally accepted in payment for goods and services or in the repayment of debts.

Money = Wealth?

Money = Income?

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Functions of Money

• Medium of exchange

• Unit of account

• Store of value

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Early forms of money

Big stones of Yap

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Manillas were ornamental metallic objects worn as jewelry in west Africa

Bronze bracelets.

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Commodity Money

Intrinsically valuable

Divisible

Homogeneous

Scarce

Portable

Durable

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Examples

Amber, beads, cowries, drums, eggs, feathers, gongs, hoes, ivory, jade, kettles, leather, mats, nails, oxen, pigs, quartz, rice, salt, thimbles, umiacs, vodka, wampum, yarns, and zappozats (decorated axes).

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Cattle Paradox

“When cattle are regarded as a form of money, not only healthy cattle but also scrawny ones will be valued to the detriment of the environment supporting them and their owners.”

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Linguistic Links

• Capital, cattle, chattels have a common root.

• Pecuniary comes from the Latin word for cattle pecus.

• In Welsh da as an adjective means good but as a noun means both cattle and goods.

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Origin of Banking

• Originated in Ancient Mesopotamia (3500 BC)

• Royal palaces and temples for safe keeping grain & other commodities.

• In Egypt state warehouses for harvest led to a system of banking.

• “Checks” written on deposits.

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First Coins

Cowrie shells used throughout the world before metal coins came into existence.

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Government Minted Coins

• Advantage to the public: standardization

• Advantage to the government: seigniorage

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Coin Crisis in Ancient Greece

In 407 BC, Sparta captured Athenian silver mines and released 20,000 slaves.

Athens was faced with a silver shortage and started minting silver plated bronze coins.

Aristophanses’ The Frogs

“the ancient coins are excellent … yet we make no use of them and prefer those bad copper pieces quite recently issued and so wretchedly struck.”

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Gresham’s Law: bad money drives out good money

• Queen Elizabeth I wanted to stop debasement of the currency so began minting high purity coins.

• Her economic advisor Gresham told her the plan was flawed.

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What about the dollar coin?

Why has it not been successful in U.S. when all other countries use coins for denomination of the same and even greater value?

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CluesThe Bureau of Engraving and Printing produces

37 million notes a day with a face value of approximately $696 million.

95% of the notes printed each year are used to replace notes already in circulation. 45% of the notes printed are $1 notes.

Between the Fort Worth, Texas and the Washington, DC Facilities approximately 18 tons of ink per day are used.

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• The following information regarding the average life of a Federal Reserve Note was provided by the Federal Reserve System - please note that the life of a note depends on its denomination:

$ 1 .............. 22 months$ 5 ................ 16 months$ 10................ 18 months$ 20 ............... 2 Years$ 50 ............... 5 Years$100 .............. 8.5 Years

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Paper Money

• Banks store coins and issue receipts.

• If receipts can be transferred, they can serve as money.

• Receipts are call “bank notes”

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Early bankers: the goldsmiths

In 17th century England, savers deposited valuables in the goldsmith’s safes.

Receipts could be used as evidence of one’s ability to pay a debt.

Eventually receipts were used as bank notes.

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Credit Money

What if banker issues “receipts” to more precious metal than he has on deposit?

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Instability with credit money

If depositors worry about the soundness of the banks they will “run” on the bank.

Solution: government regulation of banks to ensure soundness.

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Problem with privately issued bank notes

Counterfeiting is difficult to control because each bank’s notes would look different.

Solution: government central bank issues bank notes.

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Origin of Fiat Money

When the government obtains a monopoly and can suspend redeemability, the link with commodity money is easily broken.

When redeemability is permanently suspended the result is FIAT MONEY.

Fiat money is government issued money with no intrinsic value.

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Seigniorage under fiat money

Consider what happens when money leaves the country.

Money supply contracts.

Fed buys Treasury securities and returns interest to the Treasury.

The U.S. public save on interest they would otherwise have to pay on their debt.

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Electronic Payment Systems

Electronic payment systems are one of the early applications of computer systems but they were used for large size transactions.

Recently with reduction in computing costs, they have been used for small size transactions.

Cost savings for every bill paid electroncially: $1

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Federal Reserve’s Monetary Aggregates

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Growth Rates of Fed’s Monetary Aggregates