Money and Banking

1. Money and Banking Week 2 Introduction continued, What is money? ECON305, Maclachlan, Fall 2006

2. Exchanges: e.g., NYSE ECON305, Maclachlan, Fall 2006

3. OTC markets: e.g.,NASDAQ ECON305, Maclachlan, Fall 2006

4. money market instruments: short-term maturity, low risk, high denomination debt instruments. Examples: Treasury bills, commercial paper, repos, banker’s acceptances. ECON305, Maclachlan, Fall 2006

5. Issuers Low risk—is never paid back. Level of dividend payments can be decided by managers. Dilution of earnings for existing shareholders. Investors Higher risk than bonds from same firm. Investors are residual claimants. Higher return, on average. Equity ECON305, Maclachlan, Fall 2006

6. Issuers Risk 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. Investors Lower 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. Debt ECON305, Maclachlan, Fall 2006

7. 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. ECON305, Maclachlan, Fall 2006

8. Federal Funds Rate ECON305, Maclachlan, Fall 2006

9. 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%. ECON305, Maclachlan, Fall 2006

10. Definition Money is anything generally accepted in payment for goods and services or in the repayment of debts. Money = Wealth? Money = Income? ECON305, Maclachlan, Fall 2006

11. Functions of Money • Medium of exchange • Unit of account • Store of value ECON305, Maclachlan, Fall 2006

12. Early forms of money Big stones of Yap ECON305, Maclachlan, Fall 2006

13. Manillas were ornamental metallic objects worn as jewelry in west Africa Bronze bracelets. ECON305, Maclachlan, Fall 2006

14. Commodity Money Intrinsically valuable Divisible Homogeneous Scarce Portable Durable ECON305, Maclachlan, Fall 2006

15. 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). ECON305, Maclachlan, Fall 2006

16. 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.” ECON305, Maclachlan, Fall 2006

17. 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. ECON305, Maclachlan, Fall 2006

18. 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. ECON305, Maclachlan, Fall 2006

19. First Coins Cowrie shells used throughout the world before metal coins came into existence. ECON305, Maclachlan, Fall 2006

20. Government Minted Coins • Advantage to the public: standardization • Advantage to the government: seigniorage ECON305, Maclachlan, Fall 2006

21. 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.” ECON305, Maclachlan, Fall 2006

22. 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. ECON305, Maclachlan, Fall 2006

23. 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? ECON305, Maclachlan, Fall 2006

24. Clues The 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. ECON305, Maclachlan, Fall 2006

25. 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 ECON305, Maclachlan, Fall 2006

26. Paper Money • Banks store coins and issue receipts. • If receipts can be transferred, they can serve as money. • Receipts are call “bank notes” ECON305, Maclachlan, Fall 2006

27. 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. ECON305, Maclachlan, Fall 2006

28. Credit Money What if banker issues “receipts” to more precious metal than he has on deposit? ECON305, Maclachlan, Fall 2006

29. 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. ECON305, Maclachlan, Fall 2006

30. 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. ECON305, Maclachlan, Fall 2006

31. 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. ECON305, Maclachlan, Fall 2006

32. 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. ECON305, Maclachlan, Fall 2006

33. 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 ECON305, Maclachlan, Fall 2006

34. Federal Reserve’s Monetary Aggregates ECON305, Maclachlan, Fall 2006

35. Growth Rates of Fed’s Monetary Aggregates ECON305, Maclachlan, Fall 2006