Money, Banking and Finance

Jeffrey Rogers Hummel Warren C. Gibson

January, 2009 (preliminary version, not for general distribution)

Cover art: “Gold Standard” c 2004 by Damon A. H. Denys Used with the artist’s permission and with the cooperation of Quent Cordair Fine Art, Napa, CA


This is an early version of a projected textbook based on classroom notes prepared by Prof. Jeffrey Rogers Hummel for the Money and Banking classes that he has taught for nearly 20 years. We believe that the bewildering array of institutions and practices that we find in today’s world can best be understood when based on an appreciation of the underlying theory and history. Because contemporary textbooks generally lack this background, we have been inspired to prepare the present volume, which, as of December 2008, is in a very preliminary form. Prof. Hummel is Associate Professor of Economics at San Jose State University. Warren Gibson is a professional engineer, a student of Prof. Hummel’s, and a lecturer in economics at San Jose State. We tentatively plan to make this book freely available online. Pending our final decision, please do not make unauthorized copies of this book. We thank the students in our classes for their patience in using this preliminary version. We also acknowledge the encouragement of our department chair, Prof. Lydia Ortega

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Some Basic Concepts of Economics I The Nature and Origin of Money xiii xvii
1 2 4 14 14 16 17 18 19 20 20 20 21 25 25 31 32 33 35

1 What is Money? 1.1 Spontaneous Order . . . . . . . . . . . . . . . . . 1.2 Indirect Exchange and the Emergence of Money 1.3 Subsidiary Functions of Money . . . . . . . . . . 1.3.1 Unit of Account . . . . . . . . . . . . . . 1.3.2 Store of Value . . . . . . . . . . . . . . . . 1.3.3 Standard of Deferred Payment . . . . . . 1.4 Credit Cards, Debit Cards, and Smart Cards . . 1.5 Where is Money? . . . . . . . . . . . . . . . . . . 1.6 The cashless society . . . . . . . . . . . . . . . . 1.7 Money in modern society . . . . . . . . . . . . . 1.8 Important terms and concepts . . . . . . . . . . . 1.9 References . . . . . . . . . . . . . . . . . . . . . . 2 The Purchasing Power of Money 2.1 Estimating the Purchasing Power of Money . . 2.2 The Demand for Money . . . . . . . . . . . . . 2.2.1 Transactions Demand for Money . . . . 2.2.2 Velocity and the Equation of Exchange 2.2.3 Portfolio Demand for Money . . . . . . iii

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iv 2.3 2.4 2.5 2.6 The Supply of Money . . . . . Important Terms and Concepts References . . . . . . . . . . . . Questions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

CONTENTS . . . . . . . . . . . . . . . . . . . . 37 42 43 43 47 48 49 50 52 58 58 58

3 Government Control of Money 3.1 Legal Tender Laws . . . . . . . . . . . 3.2 Gresham’s Law . . . . . . . . . . . . . 3.3 Monopoly Mints . . . . . . . . . . . . 3.4 Fiat Money . . . . . . . . . . . . . . . 3.5 Socialism and the Abolition of Money 3.6 Important Terms . . . . . . . . . . . . 3.7 References . . . . . . . . . . . . . . . .

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The Nature and Origin of Credit


4 The 4.1 4.2 4.3

Significance of Saving 61 Saving in a Monetary Economy . . . . . . . . . . . . . . . . . 63 Capital Goods . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Direct Finance . . . . . . . . . . . . . . . . . . . . . . . . . . 66

5 The balance sheet 75 5.1 The Flow of Funds . . . . . . . . . . . . . . . . . . . . . . . . 79 5.2 Indirect Finance . . . . . . . . . . . . . . . . . . . . . . . . . 84 6 Fractional reserve banking 89 6.1 Origins . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 89 6.2 Effects of fractional reserve banking . . . . . . . . . . . . . . 91 6.3 The Government Central Bank . . . . . . . . . . . . . . . . . 101 7 The 7.1 7.2 7.3 Varieties of Money: a Critical Comparison 111 Fiat Money Versus Commodity Money . . . . . . . . . . . . . 112 Distribution Effects . . . . . . . . . . . . . . . . . . . . . . . . 114 Net Welfare Effects of Inflation . . . . . . . . . . . . . . . . . 116

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CONTENTS 7.4 7.5 7.6 7.7 Benefits of Inflation . . A Future Gold Standard Important terms . . . . References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

v 118 121 123 123


Today’s financial system

129 . 130 . 131 . 132 . 132 . 136 . 136 . 138 . 139 . 143 . 144 . 148 . 152

8 Financial instruments 8.1 Components of the monetary aggregates 8.1.1 The monetary base . . . . . . . . 8.1.2 M1 . . . . . . . . . . . . . . . . . 8.1.3 M2 . . . . . . . . . . . . . . . . . 8.2 Other marketable instruments . . . . . . 8.2.1 U. S. government debt . . . . . . 8.2.2 Municipal bonds . . . . . . . . . 8.2.3 Government agency securities . . 8.2.4 Corporate securities . . . . . . . 8.2.5 Money market mutual funds . . 8.3 Present value and yield to maturity . . . 8.4 Risk and maturity factors . . . . . . . .

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9 Financial institutions 155 9.1 Brokers, dealers and underwriters . . . . . . . . . . . . . . . . 155 9.2 Depository Institutions and Pure Intermediaries . . . . . . . . 159 10 Market Determination of Interest 10.1 The Loanable Funds Market . . . 10.2 Real and Nominal Interest Rates 10.3 Deflation versus inflation . . . . . 10.4 Default risk . . . . . . . . . . . . 10.5 Marketability . . . . . . . . . . . 10.6 Tax Treatment . . . . . . . . . . 10.7 Special Features . . . . . . . . . Rates . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163 . 163 . 169 . 170 . 173 . 173 . 174 . 174

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.1. .2 Asset vs. . . . . 12. . . . . . . . V Non-bank intermediaries and financial deregulation 217 219 . . . . . . . Savings Banks . . . . . . . . . . . . . . . . . . . . . . . . . .4 The Jacksonian Revolution .1 Savings and Loan Associations and 13.8 Maturity . Version 0. 175 10. . . . . . .4 The Great Depression of the 1930’s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 First Bank of the United States . . . . . .1. . 197 11. . . .1 Assets . . . . . . 221 . . . . . . .1. . . . . . .1. . . . . 206 12 Banking Practice 12. . . . . . . . . 214 . . . . . . 12. . . 13. . . . Liability Management 209 . . . . . 189 11. . . . . . . . . . . . . .1 The Regulatory Structure. 220 . .1. . . . . . 187 11. . . . . . . . . . . . .3 The Second Bank of the United States . . . . . . . 214 . . . . . . . . . . .3 Creation of the Federal Reserve System . . . .vi CONTENTS 10. . . . . . . . . . . . . . . . . . .2 The Civil War (1861-1865) and National Banking . . . . . . . . . . . 177 IV Commercial Banking: History and Practice 179 11 The U. . 12. 183 11. 212 . . . . . 209 . .9 Interest Rate Controls . . .1 The Great Depression: a 2008 Reprise? . . . . . . . 185 11. .1 America’s First Central Bank . . . . . . . .4. . . . . . . . . .1. . . . . . . . . . . . . . . . 190 11. . . .3 Pension Funds . . . . . . 221 . . . .1. . .92. . 222 13 Survey of Non-bank Intermediaries 13. . . .3 Capital account . . . . . . . . . . .1. . . . . . . . 195 11. . . . . . . . . . 13. . . . . .1.6 Free Banking in Scotland . . . . . . . . . . . . copyright c Warren C. 215 . . . . . . . . .2 Liabilities . .5 “Free Banking” in the United States . . . . . . 12. . . . .4 Life Insurance Companies . . Gibson.1 Pre-Civil War: From Chartered Monopoly to “Free” Banking 183 11. . . . Experience 183 11.2 Credit Unions . . . . 194 11. . . . . S. . 199 11. . .

CONTENTS 13.5 Property and Casualty Insurance Companies . . 13.6 Finance Companies . . . . . . . . . . . . . . . . . 13.7 Investment companies . . . . . . . . . . . . . . . 13.7.1 Open-end mutual funds. . . . . . . . . . . 13.7.2 Closed-end mutual funds . . . . . . . . . 13.7.3 Exchange-traded funds . . . . . . . . . . . 13.7.4 Hedge funds . . . . . . . . . . . . . . . . . 13.7.5 Real estate investment trusts . . . . . . . 13.7.6 Private investment funds. . . . . . . . . . 13.7.7 Money-market mutual funds . . . . . . . 13.7.8 Social Security: Not an Investment Fund . 13.7.9 Diversification of Investment Companies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

vii 223 223 223 223 225 226 227 227 228 228 230 231

14 The Changing Regulatory Environment 14.1 Government Agencies That Regulate Non-bank Depositories 14.1.1 Savings and Loans . . . . . . . . . . . . . . . . . . . 14.1.2 Savings Banks . . . . . . . . . . . . . . . . . . . . . 14.1.3 Credit Unions . . . . . . . . . . . . . . . . . . . . . . 14.2 Innovation Fosters Deregulation . . . . . . . . . . . . . . . .

233 . 233 . 233 . 233 . 233 . 234


Modern central banking


15 The Money Multiplier: How Banks Create Money 245 15.1 How Base Money Gets Multiplied . . . . . . . . . . . . . . . . 245 16 The 16.1 16.2 16.3 Federal Reserve System Origins . . . . . . . . . . . . . . . . Organization . . . . . . . . . . . . Instruments of control . . . . . . . 16.3.1 Monetary Instruments . . . 16.3.2 Non-monetary instruments 16.3.3 Other powers . . . . . . . . 249 . 249 . 249 . 253 . 253 . 254 . 255

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viii 17 Targets of monetary policy 17.1 Pre-1929 . . . . . . . . . . . . . . . . . . . . . 17.2 The Great Depression and the Keynesian revolution . . . . . . . . . 17.3 Stagflation and the monetarist counter-revolution . . . . . . . . . 17.4 Monetary policy options . . . . . . . . . . . . 17.4.1 Discretionary versus rule-based policy 17.4.2 Monetary Policy Versus Democracy . 17.4.3 Free Banking . . . . . . . . . . . . . .

CONTENTS 257 . . . . . . . . . 257 . . . . . . . . . 257 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 257 257 258 259 260


Money and the world economy


18 International trade and the balance of payments

19 Exchange rates, fixed and floating 267 19.1 The traditional gold standard . . . . . . . . . . . . . . . . . . 267 19.2 Monetary nationalism . . . . . . . . . . . . . . . . . . . . . . 267 20 Other aspects of modern international finance 269 20.1 Increasing private competition . . . . . . . . . . . . . . . . . 269 20.2 The international debt crisis . . . . . . . . . . . . . . . . . . . 269

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List of Figures
1.1 2.1 2.2 2.3 2.4 Greek decadrachm coin, ca. 500 BC . . . . . . . . . . . . . . 12

Annual rates of change of three price indices. . . . . . . . . . 28 Supply and demand for commodity money . . . . . . . . . . . 38 Increased money stock in the 1920’s approximately balanced increased demand for money. . . . . . . . . . . . . . . . . . . 39 Secondary effect on the demand for money following an OPEC supply shock. . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Stock certificate. . . . . . . . . . . . . . . . . . . . . . . . . . Railroad bond. . . . . . . . . . . . . . . . . . . . . . . . . . . had negative net worth during its early growth years. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . The flow of funds . . . . . . . . . . . . . . . . . . . . . . . . . Supply and demand of loanable funds . . . . . . . . . . . . . Transaction costs drive a wedge between interest paid and interest received. . . . . . . . . . . . . . . . . . . . . . . . . . 70 72

4.1 4.2 5.1 5.2 5.3 5.4

78 80 82 85


6.2 6.3 6.4

Gold bullion stored in the warehouse of the SPDR Gold Shares Trust. The bars each contain 400 ounces of gold, valued at about a third of a million dollars. . . . . . . . . . . . . . . . . 94 Federal Reserve assets for year-end 2007 and 2008. . . . . . . 105 Federal Reserve liabilities for year-end 2007 and 2008. . . . . 107 Gold note issued by a private bank, 1874 . . . . . . . . . . . . 108


x 6.5 6.6 6.7 7.1 9.1

LIST OF FIGURES U. S. Treasury banknotes, 1880 . . . . . . . . . . . . . . . . . 109 Silver certificate issue by the U. S. Treasury, ca. 1880 . . . . . 109 Federal Reserve note, 1914 . . . . . . . . . . . . . . . . . . . . 110 Decline in purchasing power of the dollar. . . . . . . . . . . . 120 Traders on the floor of the New York Stock Exchange . . . . 157

10.1 Supply and demand of loanable funds. . . . . . . . . . . . . . 165 10.2 Yield curves for Treasury securities . . . . . . . . . . . . . . . 176 11.1 Pyramiding of reserves . . . . . . . . . . . . . . . . . . . . . . 187 11.2 A “greenback” – Civil War currency. . . . . . . . . . . . . . . 196 11.3 Dow-Jones Industrial Average, 1914-1940 . . . . . . . . . . . 201 14.1 U.S. bank failures, 1935-2004 . . . . . . . . . . . . . . . . . . 238 15.1 M1 multiplier. . . . . . . . . . . . . . . . . . . . . . . . . . . . 248

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List of Tables
1.1 2.1 Goods used as money around the world. . . . . . . . . . . . . GDP deflator, 1959-2004 . . . . . . . . . . . . . . . . . . . . . 9 30

12.1 Balance sheet of the Dartmouth Bank. . . . . . . . . . . . . . 211 12.2 Largest banks as of May, 2008 . . . . . . . . . . . . . . . . . . 216




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Some basic principles of economics
Here is a brief list of concepts, by no means exhaustive, from elementary economics: Human action is the fundamental fact of human existence – that we initiate actions which we believe will leave us better off than alternative actions, or no action. While we are very much subject to constraints and influences from the physical and social worlds, we are choosing and acting beings. A corollary of this basic fact is that only individuals act, and while it is often convenient to ascribe actions to governments, corporations, etc., the fact remains that these actions are performed by individual members of those groups, acting, of course, under the influence of contractual relationships that bind them to those groups. Time preference is a reflection of our mortality, and states that, other things being equal, we prefer present satisfaction to the same satisfaction in the future. Diversity is the fact that human beings have distinct interests, abilities, knowledge, etc. Furthermore, natural resources are unevenly located around the world. Wealth is whatever a particular person desires. Efficiency refers a person’s ability to get the most of what he wants from what he has. Scarcity is the fundamental fact of existence that gives rise to the science of economics. Much of the goods and services that we desire in this world



Some Basic Principles

are scarce, meaning we cannot get some without giving up something else. Opportunity cost is what we give up to acquire a scarce good or service. Subjective value is a corollary of human actions that the value of a good or service does not inhere in that good or service but rather in the mind of the person evaluating it. The same good or services are valued differently people, and for by the same person at different times. Values are revealed by action and are ranked, so that only ordinal numbers can be applied to them. Market prices, by contrast, are objective and measured by means of money prices. Coercion is the use or threat of violent action, usually directed against another person in order to induce an action which that person would not freely choose. Two forms of coercion may be distinguished: initiated and retaliatory. A government is a group of people that holds a monopoly of the use of force in a particular territory, which monopoly is at least passively accepted by the majority of the inhabitants of that territory. Market failure, government failure. Market failure is the idea that free markets produce outcomes that are undesirable by some standard, and must be corrected by government action. Government failure is the idea that such programs may fail to achieve the intended result or even make things worse. Normative and positive statements: a positive statement is a statement about what is, or what would be in some situation. The statement may be correct or not, but it is at least open to objective analysis. A normative statement is a statement about what should be in some situation, and is presumed to be exempt from objective analysis. Gains from trade stem from the recognition that people choose to act because they expect to be better off, and therefore when we observe people trading without coercion, we must assume that both expect to gain from the trade. Law of demand, law of supply. Each additional unit of a good or service that we acquire is used to satisfy the most urgent unfulfilled need Version 0.92, copyright c Warren C. Gibson.



which that good can satisfy. From this follows the law of demand which says that as the price of a good increases, the quantity demanded decreases, other things being equal. Likewise, supplier supply more of a good as the price increases. Elasticity refers to the price sensitivity of buyers and sellers in a particular market. When many buyers leave a market in response to a price increase, their demand is said to be elastic. If most continue to buy in spite of price increases, their demand is inelastic. The same concepts apply to the responsiveness of sellers to price changes. Stock and flow. The stock of a good is the amount that is present some place and some particular time, while the flow of that good is the rate at which the stock is increasing or decreasing. One’s assets, for example, are a stock, while one’s income is a flow. Because the flow of goods is not nearly as continuous as the flow of fluids in physics, economic flows are often expressed as amounts which have flowed during a particular time period. Interest payments, for example, are usually understood to be amount that flows in one year, as are GDP and many other flows. Public interest, public choice. The public choice viewpoint of the actions of government agents emphasizes the incentives that such people face and how those incentives are likely to influence their actions. By contrast, the public interest point of view is the popular but naive assumption that government agents always adhere to “the public interest.’

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copyright c Warren C.92. Gibson.xvi Some Basic Principles Version 0. .

Part I The Nature and Origin of Money xvii .


regulation. forty-four chickens. and oranges. Modern society would be quite impossible without it. she was to receive a third part of the receipts. printed by M. 1875. a singer of the Th´atre e eˆ Lyrique at Paris. Wolowski. five thousand cocoa-nuts. and as Mademoiselle could not consume any considerable portion of the receipts herself. besides considerable quantities of bananas. as the prima donna remarks in her lively letter. Mademoiselle Z´lie. Stanley Jevons. Money and the Mechanism of Exchange. this amount of livestock and vegetables might have brought four thousand francs. which would have been good remuneration for five songs. W. pieces of money were very scarce. and international monetary economics. it became necessary in the mean time to feed the pigs and poultry with the fruit. lemons. made a professional tour round the world. In exchange for an aria from Norma and a few other songs. It permeates everyday life and is one of the most beneficial innovations known to humankind. At the Halle in Paris. twenty-three turkeys. and gave a concert in the Society Islands. But before we can begin that journey we 1 . When counted. we will examine the theory and history of financial institutions. her share was found to consist of three pigs. central banks. In later chapters. p. Money is a fascinating phenomenon. 1. however.Chapter 1 What is Money? Some years since. In the Society Islands.

identify the defining characteristic of money and its subsidiary functions. We. Or do we? Clearly the bills and coins we carry are money. we don’t use thee and thou anymore and instead have replaced them with you. Gibson. no one in particular. Given that Shakespeare wrote in English. but money has uncanny similarities to language. It consists of sounds and symbols that represent concepts. and see how and why governments have acquired a monopoly of the business of supplying money. The Austrian economist Friedrich Hayek coined the term to refer to a “coordination that results from human action but not from human design Consider language. debit cards? Stocks and bonds? Gold jewelry? The answers are not obvious. copyright c Warren C.1 Spontaneous Order It may strike you as strange. It may seem strange to ask what money is. Language is not only our chief means of communication but also our medium of thought.2 Spontaneous Order must understand what money is and how it came about. and we will defer classification of the kinds of money until Chapter 8 at the end of Part II.92. 1. but they also are extraordinary examples of what social scientists call spontaneous order. and while the results are not perfect—witness English spelling—language works well. Not only are both pillars of civilization. why should this be? The obvious answer is because English has changed significantly. So how did language originate and evolve? Who designed the rules of grammar and spelling? Surprisingly. since most of us use some every day and therefore we know it well. Any native English speaker who has ever tried to read the plays of Shakespeare will recall how difficult this was at first. . the co-authors of this text. For instance. But are checks money? Credit cards. are currently employing this well-ordered system to transmit ideas from our heads to yours. study how its purchasing power is determined by the interaction of supply and demand. Yet no one in particular planned these and the myriad other changes in the language since ShakeVersion 0. They are organized according to complex rules of grammar and spelling into verbal and written expressions. In the three chapters of Part I we will explore how money evolved out of barter.

Words take on new meanings – “silly” once meant “sacred. We personally decide what linguistic innovations to use or avoid. Someone did actually attempt a planned language. indeed. since words are just commonly accepted sounds. copyright c Warren C. . whether Saffire approves or disapproves. but despite its simplicity and consistency compared with other languages.Chapter 1: What is Money? 3 speare wrote. The changes go on. Even today. “generally. We all. In 1887 one L. . Often differences over language can result in bloody conflicts. how do you suppose language originated? Undoubtedly the same spontaneous process. on-line) or from youth (chill out. Spontaneous order contrasts with planned order. neither intends to promote the public interest. Indeed. An architect drew up plans that structural engineers amplified. The French government. decentralized. These changes regularly fill the columns of such language gurus as William Saffire. individually make our own planned choices about language. But languages still spontaneously evolved without the guidance and beyond the direction of a single. Governments and other institutions may try to influence those choices. “bad” meaning “good”). for instance. Gibson.” while “network” has become a verb meaning to have a conversation. An Inquiry into the Wealth of Nations for the concept of spontaneous order? An individual pursuing his own private interest. hardly anyone speaks it. new words and phrases or new uses for old ones stream into our language from technology (input. he is led by an invisible hand to promote an end which Version 0. and often voluntary creations. hacker. . conscious plan.L. nor knows how much he is promoting it .92. and remain essentially spontaneous. The building in which you attend your college class is an example of a planned order. They are too complex. of course. Consider the metaphor that Adam Smith used in his 1776 masterpiece. Zamenhof invented a totally new language called Esperanto. is engaged in an ongoing but generally futile attempt to prevent the penetration of English words and phrases into the French language. who pronounce judgment on them. wrote Smith. however. the building would have been incomplete or deficient. and unless the contractors who constructed the building adhered very closely to the specifications given in the plans. as the history of Eastern Europe amply attests.

For instance.98. copyright c Warren C.92. in and of itself. which simply portray or measure these mutual gains from trade. what about the checkout lines in grocery stores or the flow of traffic in multi-laned freeways? Does any central planner keep the lines fairly even in length or the lanes fairly equally busy? Money. Voluntary trade almost always creates value and thereby adds to society’s total wealth. Both parties expect to be better off after the transaction than before. Not only does trade. In a prior economics class. unless they are cheated (in which case the trade is shown to have been involuntary) or they made a mistake. he paid $19. there can never be an equality of value. . major example of spontaneous order. and in previous economics courses. Gibson. Trade therefore always results from a reverse inequality of value. have you ever paid to see a movie that you subsequently decided you did not like? But people do not normally repeat such exchanges.” If you ponder the idea of an invisible hand as spontaneous order. The last time he purchased an Oingo-Boingo compact disc. is another. you may have learned about consumer surplus and producer surplus.4 Indirect Exchange and the Emergence of Money was no part of his intention [emphasis added]. you no doubt learned that one of the most vital forms of cooperation is trade or exchange. you can probably come up with several more examples. make society richer. and they usually say their are better off. The buyer would only give up money for the CD if he valued the CD more than the money. The reverse inequality of value is the source of the gains from trade. either party could discover she had made an entrepreneurial error.2 Indirect Exchange and the Emergence of Money We are all aware of the benefits of social cooperation. both parties to a voluntary exchange expect to be better off after the exchange takes place. but it furthermore allows us to take advantage of the diversity among people and Version 0. 1. while the reverse must be true for the seller. One of your authors is a big fan of the now-defunct New Wave musical group. as we will see. Of course. A popular misconception is that such a trade ought to be based on an equality of value between the CD and the money. In other words. But with respect to the subjective preferences of the buyer and seller.

a task that before the Internet involved far more effort than it does today. Both parties in this transaction are trading for something they expect to use directly either in consumption or production: apples to eat or for making apple pie. to complete a trade. Gibson. we would have to negotiate a price. such as the cost of an Internet connection). and sometimes other resources. Yet direct exchange usually means high transaction costs. the fewer the trades that take place. anything that reduces transaction costs unambiguously increases gains from trade and makes society wealthier. These costs might be so high. or more precisely. copyright c Warren C. It often takes time. or the goods surrendered by the seller are not part of the transaction costs. . The most basic form of trade is barter. energy.Chapter 1: What is Money? 5 their material resources. Once we found a potential seller. The seller might be willing to let it go for as little $1. is such a big fan that he might be willing to pay more than $100 for this rare record. One of the authors. in fact. an Oingo-Boingo CD to listen to. Transaction costs are in addition to the items actually exchanged (although they may include prices paid in other transactions. over and above what is directly exchanged. These transactions costs include the opportunity costs of finding a trading partner. It likewise permits specialization and the division of labor and therefore enhances production as Like so much else. Finding someone who both has an Oingo-Boingo CD and wants apples may be difficult. The Oingo-Boingo connoisseur. the buyer might bring the record home and discover that it is far more badly scratched than the seller promised. trade has opportunity costs. other things equal. negotiating the deal. direct exchange. We first would have to find someone who had the record and was willing to sell it. For instance. and monitoring its terms. Thus.92. that they dwarf all expected benefits and preclude any exchange. may exchange one hundred apples for the CD. The Oingo-Boingo fan. suppose we wished to acquire a rare Oingo-Boingo vinyl record. But neither party wishes to reveal that information. which could entail further costs in returning it and getting a refund. however. Obviously the higher the transaction costs. Finally. for example. Keep in mind that the price paid by the buyer. Or what amounts to Version 0.

But finding such a double coincidence of wants is usually very difficult.6 Indirect Exchange and the Emergence of Money the same thing. both parties must want what the other is offering. Has Jeff Penelope Ajax Apples Cookies CD Wants CD Apples Cookies There are now two potential ways of capturing some gains from trade. who can orchestrate a multilateral exchange by ordering Jeff to give Penelope the appropriate number of apples. they are no longer engaged in direct exchange. But in the process.92. The transaction costs associated with direct exchange are so severe that economists have given them a special name: the problem of the double coincidence of wants. Introducing a third person into this picture could overcome this problem. The most elegant is to assume a benevolent bureaucrat-god. Ajax owns the CD but hates apples. after which he exchanges the cookies with Ajax for the CD. Jeff wants the Oingo-Boingo CD and has extra apples he would like to sell. Everyone is better off. the number of apples someone may want in exchange for the CD may far exceed the subjective value to our Oingo-Boingo fan of listening to it. A far less elegant but more practical solution depends upon one of the three parties having some knowledge about both of the others. . so there is no double coincidence of wants. they would probably go hungry. and Ajax loves chocolate chip cookies. The three parties have reduced transaction costs and captured the gains from trade. in small economies. copyright c Warren C. Version 0. If that person is Jeff. In order for direct exchange to take place. and ordering Ajax to give Jeff the CD. Gibson. with sufficient face-to-face interaction and mutual trust. such multilateral trade has sometimes arisen voluntarily. ordering Penelope to give Ajax the appropriate number of cookies. he could take his apples and trade with Penelope for chocolate chip cookies. But even though benevolent bureaucrat-gods do not exist. If the authors of this text had to trade their economics lectures directly for food. But Penelope it turns out has a large endowment of chocolate chip cookies that she would like to dispose of in exchange for some apples.

but not all media of exchange qualify as money. rubles could not be easily converted into money that could be spent outside the Soviet Union. As a result. Yet the fact that people are already using a particular good as a medium of exchange enhances its marketability. A medium of exchange. the larger the market. And the more marketable the good. A modern example of indirect exchange without money occurred when an American firm. but it was not commonly accepted and therefore not money. making the cookies a medium of exchange. . When a medium of exchange becomes commonly accepted. Pepsico. but it realizes the benefits of multilateral exchange without recourse to a central planner. people will spontaneously gravitate toward one or two media of exchange that are commonly or routinely accepted throughout the economy. Many goods could theoretically serve as a medium of exchange. copyright c Warren C. He traded for the cookies not in order to eat them but to sell them. Marketability is a measure of the extent to which a good or service is desired in trade in a particular economy. We could rework the example in the previous paragraph using apples as the medium or using the CD. because people prefer to use as media of exchange goods that are more marketable.92. Because of exchange rate barriers. which it then sold in the United States for dollars. Gibson. something acquire not because you want to use it directly in consumption or production but only to trade it for something else you want. Vodka served Pepsico as a medium of exchange.) Version 0. after selling Pepsi for rubles. the more marketable the good. Apples and cookies have a larger market than Oingo-Boingo CDs.” That makes monetary exchange a subset of indirect exchange. used its rubles to buy Russian vodka. So Pepsico. All moneys are media of exchange. (Some writers a bit confusingly refer to indirect exchange without money as indirect barter.Chapter 1: What is Money? 7 Jeff instead has conducted indirect exchange. Observe that there are two elements to this definition of money: “commonly accepted” and “medium of exchange. the lower the transactions costs associated with buying or selling it. began exporting Pepsi-Cola to the Soviet Union before its collapse. But which of the three goods would you expect to be least likely to serve in that capacity? Probably the Oingo-Boingo CD. The process seems complicated. it has become money.

They are Version 0. Salt became money in Abyssinia. and tobacco was money in colonial Virginia. giving rise to the slang usage of “buck” to mean a dollar. Gibson.8 Indirect Exchange and the Emergence of Money One of the most significant advances in human history because it expanded enormously the gains from trade. In prisons and prisoner-of-war camps. Cowrie shells were at one time a pervasive money throughout India and Africa. never developed money and relied on barter. (The Incas of South America. cacao beans were frequently employed to even out trades of larger items. Table 1. chocolate bars. that is where the Latin word “pecuniary” comes from. and bronze emerged as money in China.92. The ancient Greeks used oxen. Packages of Kent cigarettes circulated as money in the underground economy of Communist Romania during the 1980s. All of these are examples of what is called commodity money. We still see occasional instances of this process among people isolated from an outside economy or when the official monetary system becomes defective. quills of gold dust. The ancient Aztecs of Central America had four widely accepted media of exchange: ornamental copper ax blades.) Red parrot feathers continued to serve as money in the Santa Cruz Islands until 1961. and in fact. Even in primitive economies where direct exchange remains feasible and frequent. with their centrally planned economy. strings of shells or beads. cigarettes. In medieval Iceland people used a type of wool called wadmal. in contrast. deer skins became money. and cacao (chocolate) beans. or chewing gum have evolved into money in order to reduce transaction costs and facilitate exchange. copyright c Warren C. performed the monetary function. while on the island of Yap in the South Pacific large limestone wheels called fei. One party or the other would throw in a few beans to make the price more agreeable. . the Bantu of Africa used cattle. moneys have sometimes arisen to provide greater price flexibility. Among the Aztecs. sometimes measuring up to four meters across. Further south along the frontier. woven cotton cloaks called quachtli. The North American Indians employed wampum. a vast array of goods have served as money. such as a load of firewood exchanging for an iguana.1 lists these and some of the many other exotic commodities that have served as money in various times and places. And just as many languages evolved historically.

Gibson.92. the Aztecs of Central America India and Africa southern colonies of British North America Yap Island Gilbert Islands Communist Romania France and Italy Scotland ancient Greece Sumatra Santa Cruz Islands Russia Philippines Australia Abyssinia Hawaii China West Indies Mongolia colonial Virginia Mariana Islands medieval Iceland North American Indians Fiji Table 1. Version 0. .Chapter 1: What is Money? 9 Barley Bronze Butter Cacao beans Cattle Cognac Copper Cowrie shells Deer skins Fei (limestone wheels) Fishhooks Kent cigarettes Leather Nails Oxen Pepper Red parrot feathers Reindeer Rice Rum Salt Sandalwood Silk Sugar Tea bricks Tobacco Tortoise shells Wadmal (wool) Wampum (strings of shells or beads) Whale teeth ancient Mesopotamia China Norway Mayas and Aztecs of Central America Bantu of Africa post-World War II Germany ancient Egypt. copyright c Warren C.1: Goods used as money around the world.

and while silver does tarnish. and ancient Greek (argurion). commands a market price not because it has intrinsic value but because it can somehow satisfy human desires. In some places the earliest employment of metallic moneys was to provide change for less divisible commodity moneys such as cattle. but gold and silver came to dominate because they had desirable physical properties that made them superior. economic activity is governed only by the subjective value of goods and services to specific individuals. in Mesopotamia. Gold does not corrode or degrade over time. copyright c Warren C. to facilitate transactions at varied prices. Oil. If chocolate chip cookies are commodity money. which makes gold and silver better money than chocolate chip cookies or apples. Eventually two commodities out-competed all others to become internationally accepted. Gold and silver are chemical elements and therefore all instances of pure gold or silver are exVersion 0. which makes tobacco an inferior money. the word for silver is also a word for money in four languages: French (argent). Hebrew (keseph). gold and silver. People employ them both in consumption or production and as media of exchange.10 Indirect Exchange and the Emergence of Money forms of money that are also regular commodities. Silver money goes back as far as 2500 B. So a more accurate definition of commodity money recognizes that its monetary value is closely tied to its commodity value. Commodity money is often imprecisely defined as money with intrinsic value. People prefer money to be durable. In fact. Money is convenient when it can be standardized. People want money to be divisible and fusible.C. if what is meant by “intrinsic” is some objective standard independent of people’s preferences. which gave gold and silver an advantage over cattle. it is relatively indestructible.92. . But economic activity is not governed by any such intrinsic value of goods and services. Both can be melted and formed into objects of a wide variety of shapes and sizes. Those were the two precious metals. Gibson. you must give up roughly the same quantity of other goods and services to purchase the cookies irrespective of whether you intend to eat them or spend them. considered a nuisance when it seeped out of the ground before 1859. Spanish (plata). useful in consumption goods or production goods. Other metals such as bronze in China and copper in India continued as money long thereafter.

Initially. None of these characteristics is absolutely essential for money. but the location about which we know the most was the Kingdom of Lydia. would be to small for convenient handling or even recognition. But all of these characteristics gave gold and silver an advantage because they reduced transactions costs. the talent. and gold and silver coins appeared in Persia a few hundred years later. copyright c Warren C. in the seventh century B. Coinage developed independently in several locations. Hence.C. so it can be easily verified in trade.1). origin is contested. If on the other hand the monetary commodity is too scarce. which might suffice for a small purchase. Money is convenient when it is portable. A relative scarcity that gives money a convenient value-to-weight ratio greatly facilitates the last two properties. a gram or two of platinum. And finally. in Asia Minor. But there were significant transaction costs in the form of both weighing and also assaying (determining the purity of) these metals. or count) rather than by weight. If the monetary commodity is too abundant then the amounts required for normal transactions cease to be portable. a naturally occurring alloy of gold and silver (Figure 1. which is why the stone wheels of Yap did not catch on internationally. Because coins could then circulate by “tale” (tally. and we have observed historical commodity moneys that lacked one or more of them. like platinum (coined in Russia between 1828 and 1845). and these electrum coins then circulated as a more convenient form of money. . Bronze coins in the shapes of tools and shells arose in China at about the same time. but eventually coins specified the weight. they further reVersion 0. Together gold and silver coins eventually became known as specie. This led to the invention of coins. money should be easily recognizable. Lydia’s commodity money was electrum. silver. Silver coinage may have originated in India as much as a hundred years earlier. The earliest coins probably specified only the fineness and purity of the metal. gold. and the pound—also became units of money.Chapter 1: What is Money? 11 actly the same (although both metals are often alloyed with copper to make them harder). Gibson. although such an early independent. several units of weight—the shekel. and other monetary metals circulated by weight.92. Prominent merchants with established reputations began stamping lumps of electrum with identifying marks or images.

had no mints of their own and relied upon coins minted elsewhere. copyright c Warren C. both gold and silver. would be handled in sealed purses.92. money changer. Knowing the number of coins and the weight of each makes it easier to tally the total amount of gold or silver. it was profitable to import coins from abroad. while most of the ancient Greek city-states. Gibson. new as well as old. characterized the earliest Chinese coins as well as later coinage off and on throughout Chinese history. Miscellaneous coins of various origins. banker. The exact value was indicated on the outside. A particularly intriguing example of a second-generation coinage that was mostly private occurred in Mamluk Egypt at the end of the thirteenth century. Private manufacture. Coins therefore commanded a slight premium over the equivalent weight of raw metal in the form of bullion or dust. making coinage a viable business on the market. Private mints successfully competed in the United States until they were suppressed during the Civil War. the premium tends to equal the costs of minting the coins (called brassage). This parallels the modern practice of selling high-grade Version 0. Foreign coins circulated widely in the U.12 Indirect Exchange and the Emergence of Money Figure 1.S. In long-run equilibrium. Wherever domestic mints proved insufficient.1: Greek decadrachm coin. . including Sparta. or infrequently a government official. 500 BC duced transaction costs. ca. bearing the marking of a well-known merchant. for instance. during its early years.

Workers. Driven by the mutual benefits for all who traded. . copyright c Warren C. money constantly evolves and changes. goes a long way toward explaining the high transaction costs and enormous efficiencies in the American medical market. but continued forward to present-day forms of money in ways that upcoming chapters will investigate in great detail. for example. Despite the triumph of monetary exchange in modern economies. Yet money’s fundamental function as a commonly accepted medium of exchange that reduces transaction costs and facilitates specialization and trade has remained fixed and fundamental. In short. from barter through indirect exchange and primitive commodity moneys. up to gold and silver and the minting of coins. the origin and development of money stands as a dramatic demonstration of spontaneous order. Because of an exemption in the U.Chapter 1: What is Money? 13 collectible coins in sealed packages labelled with the coin’s grade (condition). and this form of barter. Observe that every step in this evolution. direct exchange still survives in a few unique markets. with little conscious coordination and no necessary government involvement. One major non-monetary market in modern economies is not convenEmployers generally provide health insurance to their employees but not. whereas most non-cash forms of remuneration are considered taxable.92. this evolution did not stop with the emergence of specie. do not always exchange their labor solely for money wages. While health insurance has a monetary value. We will see how and why governments became intimately involved with money. 1 Version 0. for instance.1 People also often trade-in their used automobiles for new ones. lowered transaction costs and expanded enormously the gains from voluntary exchange. it is not money per se. where labor is exchanged directly for medical care. Indeed.S. Of course. rather than for money. one way of avoiding taxes altogether is with barter transactions in the underground economy. probably because this helps to overcome some of the transaction costs associated with asymmetric information in the used-car market. tax code. many employers offer their employees fringe benefits such as health insurance. car insurance because the income tax code makes these provisions tax-deductible for the employer and tax-free to the employee. Gibson.

We refer to these as money’s subsidiary functions. but they are not the most popular and are usually frowned upon. Here is one case where a double coincidence of wants is considered a good thing. This function is sometimes referred to as a standard or measure of value. You may have already guessed that what we are thinking of the market for dating. and other items or combinations of items did so. because it is a market where people tend strongly to prefer transactions with a double coincidence of wants.92. many frustrated or lonely market participants. and marriage. although nearly everyone participates in this market at some time in his or her life. But as a result. Monetary transactions do sometimes take place in this market. with long search times. The price of the CD is obviously 100 apples.3 Subsidiary Functions of Money Once money emerges as a commonly accepted medium of exchange. it usually serves three other purposes as well. sex. This is not so much a substantive difference as a semantic difference in how to best organize our thoughts.1 Unit of Account The first and most important subsidiary function of money is providing a unit of account. but we prefer to define money according to its primary exchange function. . lots of mistaken trades. Indeed.14 Subsidiary Functions of Money tionally thought of as such. and otherwise very high transaction costs (though various Internet entrepreneurs now offer services that reduce those costs). Suppose one Oingo-Boingo CD trades for 100 apples.3. 1. this market is notoriously inefficient. Although money often serves these other purposes. Gibson.2 You can appreciate it better if you keep in mind that all prices are ratios. 2 Version 0. 1. it does not necessarily have to. But then what is the price of “Value” is a poor word here since subjective value cannot be measured – this is really a price measure. copyright c Warren C. Some authors offer one or all of these three functions as alternative definitions of money. there have been notable occasions when the medium of exchange failed to provide these functions.

But more importantly. every good potentially exchanges for every other.92.Chapter 1: What is Money? 15 one apple? 1/100th of an Oingo-Boingo CD The fact that prices are ratios is clearest in the case of exchange rates. dollars per chocolate chip cookie. In a barter economy. Gibson. it establishes comparable prices for all other goods and services. Now try to calculate your profit or loss. one e of which is money. copyright c Warren C.200 $1. How do I know whether this is a worthwhile undertaking? Money accounting will tell me: Expenses Two tons of coal @ $40 500 kw-hrs electricity @ $0. 500 kw-hrs of electricity and 100 hours of labor per month. or dollars per ruby. That is why economists sometimes refer to the commodity providing the unit of account with the French word num´raire. and when your workers and vendors are paid in the same assortment. there could be 499.000 widgets.500 Total revenues $1. counting CDs per apples and apples per CD as a single price.500 prices. dollars per apple.000 goods in an economy. there would be n(n-1)/2 distinct ratio prices. Output consists of 1.12 100 hrs labor @ $12 Total expenses Revenues 1. chocolate chip cookies. the number drops from 499. Once a good becomes a commonly accepted medium of exchange.50 3 $80 $60 $1. it greatly facilitates economic calculation by allowing easy comparison of various goods and services. In the economy with 1000 different goods.500 to only 999 prices. Businesses can sum up their costs and their revenues and see whether the business is earning profits or suffering losses. Such a multitude of prices hinders economic calculation. it actually is the common numerator: dollars per CD. Thus if you are an American traveling in the United Kingdom.000 widgets @ $1. and other assorted goods or services.500 Version 0.3 Suppose I am running a business that requires two tons of coal. rubies.340 $1. which are the prices of one money in terms of another. Although some texts describe this role as a common denominator for all prices. So if there were 1. Where n distinct items are traded. Imagine manufacturing CDs that are traded for apples. . you may be want to know the dollar price of pounds or the pound price of dollars.

92. . although it is not certain that copper was yet a commonly accepted medium of exchange. The amount of silver serving as the unit of account could be either the Spanish silver dollar or the British pound sterling.16 Subsidiary Functions of Money Clearly my profit is $160 this month. the unit of account can become totally separated from the medium of exchange. Under some circumstances. a Virginia pound differed from a Massachusetts pound. Gibson. e The unit is some specific weight of the money. different colonies would define the “pound” as different amounts of silver.S. the medium of exchange is the Chilean peso. It follows inevitably from being a medium of exchange. and in fact. We also need to know how much of it constitutes one unit of that medium. but many prices are expressed in terms of the Unidad de Fomento (UF). Money. dollars. During the 1950s in the Soviet Union for certain transactions. in the British colonies of seventeenth and eighteenth-century North America. But its value was falling so rapidly and unpredictably that merchants began to quote prices in U.2 Store of Value The second subsidiary function of money is as a store of value. In this case a single medium had several units of account. During the German hyperinflation of 1923 (an episode that Chapter 3 will cover). Some pastoral societies carried out transactions in terms of livestock units even through livestock were not exchanged. For example. Thus. because money thereby separates the act of selling from buying. 1. merely an accounting unit based on a bundle of goods and services. Today in Chile. Germans continued to use the Reichsmark as money. Indeed. one medium of exchange was silver. how could accountants do their jobs without a customary unit of account? It is not enough to observe what commodity is used as a medium of exchange. The Middle Kingdom of Egypt. however.3. undoubtedly used weights of copper as the unit for domestic trade. Some anthropologists believe they have uncovered cases where a unit of account even emerged prior to money. more precisely. for instance. is the num´raire or medium of account. a constant ruble was the unit of account against changing quantities of ruble currency serving as the medium of exchange. copyright c Warren C. You can sell your labor for money Version 0.

1. though by no means the only way. Money provides the unit for expressing debts or payments due in the future.Chapter 1: What is Money? 17 today and then use the money to buy food or clothing later. Thus money provides a convenient way of saving and accumulating wealth. To the extent that you hold any commodity as a medium of exchange you cannot use it up in consumption or production. You can readily spend the money on other available goods and services at any time. .” But they are seeing only the opportunity cost and not the subjective benefit that people gain – the confidence that commodity money will retain its purchasing power. Although coins existed and were used in some exchanges. Money’s convenience as a store of value can also diminish over extended periods or when prices are rising rapidly. While using money as a store of value lowers transaction costs. As some writers put it.3.92. it is a temporary abode of generalized purchasing power. Gibson. copyright c Warren C. it can introduce other opportunity costs that are sometimes significant. commodity money is “barren. Thus hanging on to commodity entails an opportunity cost. the expense of holding them was so prohibitive that barter remained common. whereas you usually have to convert the tuna cans or paintings into money first. People can use any relatively durable good as a store of value. During the time you hold the money.1 did not actually circulate as commonly accepted media of exchange but instead were only held as stores of value. with few people buying or selling. Some anthropologists contend that several of the primitive commodity moneys listed in Table 1. When the economy is poor and markets are thin.3 Standard of Deferred Payment The final subsidiary function of money is as a standard of deferred payment. Severe inflation may therefore separate money from its store of value function as effectively as is separates money from the unit of account. This was apparently the situation in early medieval Europe between the fall of Rome and the eleventh century. individuals may find it less costly to hold what little wealth they have in goods other than money. such as cans of tuna fish or valuable paintings. Version 0. Yet holding wealth in the form of your medium of exchange reduces transaction costs.

Although the interest rate for money is the one that people almost exclusively deal with. One of the authors sometimes loans his pickup truck to his neighbor. Even if no one directly loans apples today in exchange for apples in the future. Early economies. and Smart Cards This means that money becomes not only the preferred way of paying back loans (because it is the medium of exchange) but also the preferred way of specifying the amount repaid (because it provides the unit of account).4 Credit Cards. 1. and one on chocolate chip cookies. When you make a credit card purchase. if prices are rising rapidly. And here again. even after the evolution of commodity money.18 Credit Cards. Notice that loans do not necessarily have to be paid back in money. Yet it bears mentioning because the price at which money loaned today exchanges for money in the future gives rise to an interest rate. often continued to rely on debts denominated in other goods. such as loans of seed repaid out of the crop. in terms of money. money may cease to be the standard of deferred payment even before it ceases to serve as a store of value or provide the unit of account. your credit card is a convenient way to get a loan from the bank or other institution that issued your card. . the exact amount is no longer set in advance in monetary units but determined at the time of repayment based on some index number. the interest rate on that loan is 10 percent.92. You can purchase almost anything with a credit card. Gibson. Those interest rates need not equal each other or the interest rate on money. who usually returns it with a full tank of gasoline. and perhaps another one on pickup trucks. But are credit cards money? No. Debit Cards. Often texts omit this third subsidiary function because it follows from money’s other roles. and Smart Cards Credit cards are very popular in advanced societies. Although loans may continue to be repaid with money. The significance of this seemingly subtle observation will become clearer once in Part 2. the bank Version 0. Debit Cards. it is not the only interest rate in the economy. there is still an implicit interest rate on apples. If you borrow $100 and repay $110 a year from today. or a loan of breeding animals repaid with animals. copyright c Warren C.

etc. The value that people ascribe to money or any other good or service is not an intrinsic attribute of that good.” You establish an account at the campus office and transfer an initial balance into the account. but are a temptation for some students to over-indulge. Likewise debit cards are a convenient means of transferring money from your checking account to a merchant. copyright c Warren C. that means it is a mass psychological phenomenon and therefore it ultimately resides in our heads. Gibson. Your university may issue a card that you can use to make purchases on campus and perhaps at off-campus stores as well. Version 0. and are a privacy concern to some. but they are not in themselves money. Later on you transfer money from your checking account or another source to the bank to pay down or pay off the loan. . as is its color. Such cards are sometimes called “smart cards. and may show the remaining balance on an electronic display attached to the terminal.” or they may go by a brand name such as an “Access Card. These cards reduce transaction costs. 1. size. as you would with a bank checking account.” If money is generally accepted.Chapter 1: What is Money? 19 transfers money to the merchant and that amount is added to the balance which you owe the bank.5 Where is Money? We conclude with this strange-sounding question which is a cue to repeat our definition of money as a “generally accepted medium of exchange.92. weight. Value resides in the consciousness of the valuer and is revealed when the good is exchanged in a voluntary transaction. and when. You make purchases by swiping the card through a point-of-sale terminal which deducts the amount of your purchase from your account. since the administrators may be able to track what you buy. So credit cards are a convenient means of gaining access to money. where. Behind every economic issue are diverse human beings who choose and act in pursuit of their individual goals.

6 The cashless society One of the authors regularly polls his students about how much cash they usually carry and how much use they make of debit cards or credit cards. 1. They can do so because the transaction costs associated with debit and credit cards have dropped so much that even small purchases like a can of soda can be conducted economically using cards.92. copyright c Warren C. We will defer the classification of money until Chapter 8.7 Money in modern society Although we have a clear definition of money. One or two per class usually say they carry no cash at all. identifying just what does and does not serve as money at a particular time and place. is not always easy.20 The cashless society 1. Gibson.s there is every indication that cash will continue to play at least a niche role in our financial system. relying entirely on their debit cards. particularly in an advanced society such as ours. Notwithstanding these trends. . cash shows no signs of disappearing. 1. Even in legal market. particularly the drug trade. especially from markets that are illegal.8 Important terms and concepts Reverse inequality of value Direct exchange (barter) Multilateral exchange Medium of exchange Money Coinage (minting) Bullion Unit of account Standard of deferred payment Spontaneous order Transaction costs Double coincidence of wants Indirect exchange Marketability Commodity money Specie Brassage Store of value Version 0.

1981). (New York: Academic Press. Money and the Mechanism of Exchange. camps is R.W. Hayek acknowledges that the concept goes back at least to the time of Adam Smith. 1910). Free Banking and Monetary Reform (Cambridge: Cambridge University Press. 1989).O. and Lawrence H. “Why Money?”. A. is too popular and simplistic to be of much use except for anec- Version 0. first published in 1875.W. More recent writers who elucidate the Mengerian approach in their opening chapters include J.9 References Friedrich A. Jack Weatherford. Discussions of money as a solution to the problems with barter are ubiquitous throughout economic principles and money and banking texts and can be traced all the way back to Aristotle. A famous article on money in P. 1960. Ludwig von Mises elaborates upon this explanation in his Theory of Money and Credit (Irvington NY: Foundation for Economic Education.O. The History of Money: From Sandstone to Cyberspace (New York: Three Rivers Press. MA: Blackwell. “The Economic Organization of a P.” Economica. Camp. Huston McCulloch. 1997). Unfortunately there is no recent historical or anthropological survey of the origin of money that is really good. The standard list of money’s desirable properties and its functions (using slightly different terminology) was not originated by Alchian but owes its popularity to William Stanley Jevons’ economic classic. translated a as Principles of Economics (New York: New York University Press. Economic Forces at Work (Indianapolis: Liberty Press. 159-161. 1999). 23rd ed. (University of Chicago Press. . The Theory of Monetary Institutions (Malden. But a step-by-step economic explanation of how money could spontaneously originate first appeared in chapter 8 of Carl Menger’s Grunds¨tze der Volkswirtschaftslehre (1871). 1982). A more technical and therefore more sterile presentation that emphasizes information costs is Armen Alchian’s article. reprinted in his collection. Gibson. 17 (November 1945): 189-201. White. [1912]1971). Money and Inflation: A Monetarist Approach. David Glasner.92. (London: Kegan Paul.Chapter 1: What is Money? 21 1. 2nd ed. 1977). p. copyright c Warren C. Radford. von Hayek discusses spontaneous order in The Constitution of Liberty.

Up until then the exchange of wampum had mainly finalized treaties and similar bargains. We do know for certain that North American Indians were manufacturing wampum before European contact. A Survey of Primitive Money: The Beginning of Currency (London: Methuen. fundamental confusion between wealth and money. . arguing that they often served only as stores of value or as means of payment only for specific limited transactions. A. 1927). 1996). Money: A History (New York: St. rev. Paul Einzig. (Oxford: Pergamon Press. or tribute. The best of the recent contributions is the coffee-table book based on the British Museum collection edited by Jonathan Williams (with Joe Cribb and Elizabeth Errington). and Economic Aspects. especially valuable are Arthur R. MA: Addison-Wesley. Historical. 1997).92. Burns. but that it only became widely used as money afterwards. copyright c Warren C. Among the older historical and anthropological works. Exchange and Value: An Anthropological Approach (Cambridge: Cambridge University Press. 1992). such as bride-price. ed. 2nd ed. “Some Notes on the Economics of Barter. Barter. only serve to underscore the evolutionary nature of money. Money and Monetary Policy in Early Times (New York: Alfred A. when European tools made manufacture less time consuming. One of the strongest anthropological challenges to the economic approach to money is the collection edited by Caroline Humphrey and Stephen HughJones.22 References dotal tidbits. Exactly when a good crosses the lines from pure commodity to medium of exchange and then to common Version 0. 1966). especially the contribution by Luca Anderlini and Hamid Sabourian. 1949). Glyn Davies’ A History of Money: From Ancient Times to the Present Day. Martin’s Press. (Cardiff: University of Wales Press. Primitive and Modern Money: An Interdisciplinary Approach (Reading. Knopf. This is related but not identical to the debate over whether money originated in many locations independently or defused from a few civilized centers.” These debates. Anthropologists continue to debate the authenticity of many alleged primitive commodity moneys. is pompous and rambling with such a decided bias against economics that it starts out with a gross. Primitive Money: In Its Ethnological. and Jacques Melitz. blood-price. Hungston Quiggen. Gibson. 1974). while factually more substantial. however. Money and Credit.

. Pryor. An outstanding but neglected survey of these questions with a statistical test of about sixty primitive societies that essentially confirms Menger’s account is ch. 1977). Version 0.92. The Origins of the Economy: A Comparative Study of Distribution in Primitive and Peasant Economies (New York: Academic Press. Gibson. 6 of Frederic L.Chapter 1: What is Money? 23 acceptance will of course be hazy. copyright c Warren C.

24 References Version 0. copyright c Warren C.92. Gibson. .

Yet it is helpful to have some estimate of the general purchasing power of money even though such an estimate must cross over differences in what we want to buy. It also helps us study factors that may degrade or enhance the purchasing power of money. Clearly. or at least everyone in a certain class of people. Having such estimates allows us to separate price changes due to changes in money’s overall purchasing power from price changes due to real factors. as well as factors that might seem to influence purchasing power but do not. 2. is a collection of goods and services that 25 .1 Estimating the Purchasing Power of Money Economists have devised standard “baskets” or collections of goods and services to provide a measure of money’s purchasing power. the answer depends on what we wish to purchase. These collections are used to calculate “price indices” and are intended to apply to everyone in an economy. disregarding the fact that people have widely varying spending patterns. The well-known Consumer Price Index. It is natural to ask how much we can purchase with a unit of money at a particular time.Chapter 2 The Purchasing Power of Money We acquire money for purchase of goods and services. for example.

The purpose of price indices is to observe how they vary over time so as to estimate changes in the value of money. The adjustments mentioned in the previous paragraph are intended to minimize price changes that have nothing to do with the value of money. Department of Labor. it is a simple matter to calculate the price of a basket (or “index” as it is more properly called) at a particular time and place. The items in the CPI do not carry equal weight but are assigned quantities that are supposed to represent the allocation of a typical consumer’s income. but we choose different quantities and different varieties of these basics.55 p3 =$9. copyright c Warren C. the field worker might find socks offered at a special discount which would skew the price series if no adjustment were made. but someone would have to decide whether to count the tips given to the barber. Field workers may find that cabbages are very cheap at harvest time and expensive during the winter. Here is another problem: as time Version 0.00 Quantity q q1 = 3 q1 = 2 q3 = 1 p×q p1 × q1 =$2. shelter. Gibson. and one haircut.55 Although the arithmetic is simple.00 p3 × q3 =$9. an agency of the U. how. The managers in charge of this index might choose to apply a seasonal adjustment to the price of cabbage. Some of the items in the CPI are not particularly controversial. increasing the harvest-time price and lowering the winter price in line with observations of past seasonal variations.26 Estimating the Purchasing Power of Money attempts to replicate the spending patterns of consumers. two pairs of socks. sends people into stores to write down prices of goods for sale for use in calculating the CPI. We all consume food. there are great practical difficulties in gathering prices and setting quantities.85 p2 =$2. The Bureau of Labor Statistics. The price of haircuts may not fluctuate much. We calculate the price index by multiplying each item’s price by its quantity and summing the results. and if so. In the case of socks. .00 sum: $16. we observe wide variations in people’s preferences. Consider this basket consisting of three cabbages. S. Item Cabbages Pairs of socks Haircuts Price p p1 =$0. Moving beyond the basics and toward luxury goods. In principle.92.55 p2 × q2 =$5. clothing. transportation. and other basics.

. People drawing social security benefits tend not to own personal computers so one could argue that hedonic adjustments negatively impact them. Some adjustment to reflect this fact seem in order. In addition to the consumer price index (CPI). Hedonic adjustments attempt to capture the increase in services provided by products such as personal computers. so that the price of cabbages rises. this figure would have been about 6% without hedonic adjustments. This is a very difficult estimate to make: how much more valuable is a one-GHz processor than a 250-MHz processor? Nowhere near four times as valuable for the average user. This problem is called substitution bias.92. The power of personal computers has increased dramatically since they were first introduced. It is estimated that during recent times when the CPI was running at an average annual increase of 3%. the higher price p1 will push up the CPI figure more than if that q1 had been reduced to reflect consumer cutbacks. writing a book or checking the internet. A similar problem occurs when new products enter the marketplace or old ones disappear. Gibson. are raised automatically in line with the CPI. imagine that we are in a period of rising prices and that the price of cabbages has risen a lot due to an insect infestation in the cabbage fields. copyright c Warren C. Personal computers raise another issue that has bedeviled the managers of the CPI: changing quality. For example. the contents of the basket may become less representative of what consumers actually buy. To see why this is a problem. Items are added to the CPI or deleted from it from time to time as a result. People will shift to lettuce or do without cabbages in order to stay within their budget. the BLS calculates a 1 www. notably social security payments. either by finding substitute products or just by cutting back or eliminating their purchases of that Version 0. especially for PC’s but for other goods as well.1 This is a very significant difference because many payouts. The BLS solution to this problem is “hedonic adjustments” from the Greek word for “pleasure”.shadowstats.Chapter 2: The Purchasing Power of Money 27 goes by. Personal computers and cellular telephone service are now important to most consumers but they did not exist 20 years ago. people generally consume less of items whose relative prices have risen. But if the CPI continues to assume the same quantity of cabbages.

but not always.28 Estimating the Purchasing Power of Money “producer price index” (PPI). Gibson. It is important to keep in mind the distinction between relative prices and the price level.92. in units of baskets per dollar. The purchasing power of money. these indices typically move together. The price one basket of goods and services. If all money prices in an economy were to rise by 5%.” As Figure 2. A slowing of price inflation is called disinflation. copyright c Warren C. in units of dollars per basket. however it may be constituted. the purchasing power of a unit of money declines. . its “gross domestic product. is defined as the reciprocal of the price level. the price Version 0. The fact that they generally correlate well with each other gives us some confidence in their usefulness. The absolute price level at any given time is not as interesting as changes in P that are observed over time. 1/P . which purports to represent the costs faced by typical producers. Figure 2. abbreviated PPM. A third index is the “GDP deflator” which attempts to measure the prices of all the goods and services produced in the entire national economy. is the price level P . When the price level rises.1: Annual rates of change of three price indices. A decline is called price deflation (or just deflation). A rise in the price level is called price inflation (or just inflation).1 shows.

Economists often denote nominal magnitudes by upper-case letters and real magnitudes by lower-case letters. in a fit of nostalgia. Nominal output Y .2 This particular index is set up so that the value for a particular year. it is possible for some relative prices to rise and others to fall in such a way that the price level remains unchanged. real wages – the purchasing power of those wages – are unchanged. Gibson. results primarily from increases in the money stock. .Chapter 2: The Purchasing Power of Money 29 level would also rise by 5% while relative prices would remain unchanged. (Do you see why it is logically impossible for all relative prices to rise simultaneously?) Between 1973 and 1980. Now suppose one of your authors. but selecting a different base year would not change any calculations based on this index. for example. The ocean provides a metaphor for prices which may be helpful. You can see that the year 2000 was chosen as the base year in this case. Such adjusted or “real” values attempt to remove the distortion that price inflation brings. If nominal wages are W.00 in 2007. or monetary inflation. Think of the average level of the water as the price level and the waves as relative prices. Think of price indices as estimates of the shrinkage of the measuring stick that allow us to eliminate the shrinkage from our observations. real output y = Y /P . given all the gross approximations that underlie these figures. increased.1 shows the GDP deflator for each year from 1959 to 2007. recalls that the movie admission price for adults was 50 cents in 1960 and had risen to $9. along with most other prices. Conversely. How much of this price increase is real and how much is due to the declining purchasing power of The high precision implied by the display of three digits beyond the decimal point is highly misleading to say the least. Price indices enable us to adjust observed prices – nominal prices – so as to eliminate the effects of price inflation which as we shall see. the CPI rose by 85% while heating oil rose 170% and clothing rose 40%. If nominal wages double during a time period when the price level also doubles.92. a distortion that is like a shrinking measuring stick. called the “base year. Table 2. then real wages are w = W/P . Thus the relative price of clothing expressed in terms of units of heating oil actually fell even though its nominal dollar price. Real GDP is nominal GDP divided by P . copyright c Warren C. 2 Version 0.” is 100.

its purchasing power.196 75.816 Table 2. Gibson.149 27. The market prices of marketable goods and service are determined by supply and demand.259 92.196 42. our next task is to analyze the factors that determine it.725 38.099 113.590 84. Version 0.534 28. which rose nearly forty-fold.757 49.751 21.00× 100/119.676 119. copyright c Warren C.444 86. $9.385 88.472 97.002 40.399 104. We will examine the demand for money. .131 22.911 30.726 65.38 to $7. 1959-2004 Now that we have a way to estimate money’s purchasing power. So too is the price of money.106 93.381 90.250 73. resulting in prices expressed in year 2000 dollars.187 106.0 = $2.893 24.30 Estimating the Purchasing Power of Money the dollar? Multiply each price by 100 and divide by the index value for that year.51.119 62.92.852 95.034 116.38.868 100.50× 100/21.548 54. The movie price in real terms has risen approximately threefold. In this case. the supply of money.913 26.556 81.655 69.176 23.752 45.713 71.041 21.414 96.849 34.043 59.694 78.798 22.305 109.1: GDP deflator.278 21. and their interaction. 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 20.569 21. a substantial increase but much less than the nominal price.207 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 67.8 = $7.000 102. from $2.166 31. $0.535 23.51.

We may want as much wealth as we can get.” Don’t we all want as much money as we can get? No.2 The Demand for Money In your first economics class you learned the law of demand as applied to ordinary goods and services.Chapter 2: The Purchasing Power of Money 31 2. the law of demand says that as the price of something declines. money for next year’s tuition. You also learned about upward-sloping supply curves and how their intersection with a demand curve defines the equilibrium price and quantity in a particular market. equal to the reciprocal of the price level: PPM=1/P. Such changes are represented by movements along a downward-sloping demand curve. and this is true for money. we may be quite certain or quite vague about what we want to buy and when: money to pay next month’s rent. for example. We must give up some other form of wealth to get the money to hold. decide not to buy a new bicycle right now. . Recall that money’s purchasing power is its price. The desire to acquire money to be spent immediately (or in the near future) is Version 0. Acquisition of money to hold entails an opportunity cost just as with normal goods and services. We may even hold money in anticipation of purchases by our heirs after our death. in order to maintain your checking account. Also. checking accounts. We will now apply supply and demand analysis to money. other things being equal. You may. people demand less of it. or just some money to keep on hand for unexpected opportunities or emergencies. people demand more of it. We desire money only because we can buy things with it. because we are concerned with demand for money to hold in our wallets. Gibson. Shifts of the entire curve to the left or right are caused by any number of outside influences and are usually called just changes or shifts in demand. etc. When the purchasing power of money declines (and the price level rises) we want to hold more money. other things being equal. As the price of a good rises. and we need more to acquire the same goods and services when money’s purchasing power declines. but a choice to hold additional money entails an opportunity cost. copyright c Warren C. You may be puzzled by the concept of “demand for money. Although we demand money only for what it can buy.92.

. If acquiring cash requires standing in line at a bank. This acquisition was an Version 0.32 The Demand for Money called transactions demand. Gibson. Another influence is the cost of acquiring cash. copyright c Warren C. First.S.2. More efficient clearing systems mean that less money is tied up between the time a transaction is initiated and the time it is concluded. and is called portfolio demand. other things being equal. A third and somewhat minor influence on the demand for money is the degree of vertical integration among business firms. Money desired for expenditure later is a form of saving. then the amount of money they want to hold must rise.1 Transactions Demand for Money Here we list briefly some circumstances that generally prompt people to alter their demand to hold money for transaction purposes. 2. low-income people who lack bank accounts and must rely on costly commercial check-cashing businesses will be inclined to keep larger amounts of cash relative to their monthly expenditures. In the U. However. General Motors purchased starter motors from the Dayton Electric Co. people demand more money to hold as the supply of goods and services increases. Historically. Later GM acquired Dayton Electric and renamed it Delco. Like any buyer.92. A clearing system is an arrangement among three or more individuals or business firms for offsetting payments. I will just pay you $2 and we “clear” the rest. Automated teller machines have made acquiring cash much simpler and thus provided incentive for people to maintain lower cash balances. As wealth increases and if people want to hold a constant proportion of their wealth as money. people will keep larger amounts on hand to reduce this drain on their time. Clearing system efficiencies reduce the demand to hold money. GM kept money on hand to pay for the purchases. today the Federal Reserve System operates a check-clearing organization called FedWire as a business sideline. If I owe you $10 and you owe me $8. Many years ago. They were typically jointly owned by the private banks in a particular town or region. clearing houses were private organizations that arose spontaneously on the market for the purpose of offsetting obligations among banks. Demand for money is reduced.

92. denoted by V. Of course. money usually is not exchanged between the divisions of a single business firm. In any given year. Still later. copyright c Warren C. In fact. every dollar is always in someone’s possession at any moment in time. Therefore it would be more appropriate to think of money as hopping instantly from one person to another rather than flowing smoothly like water. An economy with a money supply of ten million dollars in which total purchases in one year amounted to fifty million dollars would have an average velocity of five transactions per year. GM’s demand for money increased slightly since it then had to buy parts that were formerly requisitioned internally. but the average velocity. After the acquisition.2. At that point. would still be five transactions per year. Gibson. excluding gifts and thefts.2 Velocity and the Equation of Exchange Before discussing the portfolio demand for money we need to introduce to the concepts of the velocity of money and the equation of exchange. While GM continued to use money as a unit of account in its internal bookkeeping. “Velocity” may be an unfortunate metaphor because it likens the movement of money in an economy to the flow of a fluid in a pipe or channel. This very basic accounting identity will lead us to a valuable tool for understanding the role of money in macroeconomic Version 0. Even money in the form of checks being transported between banks (this is called “float”) remains the property of the writers of the checks until such time as it clears. 2. the amount of money spent on goods and services equals the amount received for those goods and services. . The velocity of money (or more precisely. we will use “velocity” since this is a standard term in economics. its income velocity) in a particular economy is the number of times an average dollar changes hands during a particular year.Chapter 2: The Purchasing Power of Money 33 instance of “vertical integration” because starter motors flow “upward” in the supply chain from Delco to GM. However. GM spun off its parts division into a new company called Delphi. Every dollar spent is a dollar of someone’s income. this same flow of goods no longer required money as it became simply a transfer of parts within the newly integrated firm. some dollars might remain in one person’s possession throughout the entire year while others might change hands 20 times.

economists are often more interested in changes in macroeconomic aggregates such as M. it accounts for $5 of spending. M is in dollars. P and y than in their absolute level.” To understand the expense side of the equation. The equation of exchange is not a theory but an identity. On the other side of the equation. Total spending is therefore the number of dollars (M ) times the average number of transactions (V ).” The price level is the price of one basket. The “delta” form of the equation of exchange is3 ∆M + ∆V ≈ ∆P + ∆y 3 If you are familiar with calculus. The total dollar value of the goods supplied is the value per basket times the number of baskets. V is in transactions per year. you can follow this derivation using differentials: d(M V ) = d(P y) Version 0. consider the role of one particular dollar during a year.92. we represent the total amount of goods and services purchased during the year by the symbol y. P y. and since transactions are dimensionless. But as we have said. Gibson.” y is then the number of baskets that are traded in a given year.34 The Demand for Money events. If that dollar is part of five transactions during the year. which we denote by prepending ∆. V. Equating aggregate income and expenses yields the equation of exchange MV = Py This equation is dimensionally consistent. We will work toward this tool by expressing this accounting identity algebraically as the “equation of exchange. P is in dollars per basket and y is in baskets per year. P . We now have the product M V on one side of the equation. . Thus the equation of exchange is often converted to a form that expresses a relation between changes in each of these variables. though one occasionally encounters economic theories that seem to violate it. so Py is also in dollars per year. Its exact truth follows directly from the definitions of its constituents. it is not particularly useful. As it stands. also called “real output. copyright c Warren C. MV is measured in dollars per year. Recall that in macroeconomics we attempt to aggregate all the various goods and services produced by an economy into “baskets.

Chapter 2: The Purchasing Power of Money


This form of the equation would tell us, for example, that if real output were to rise by 3% in a given year (∆y/y = 3%), velocity remained constant (∆V = 0), and if the money supply were to increase by 5% (∆M/M = 5%), then we could determine the change in the price level, ∆P by substitution: 5% + 0% = ∆P P + 3% or ∆P P = 2% Later we will see how economists have used assumptions about which of the four variables is more changeable and which can be considered constant to develop theories about how ∆M effects ∆P.


Portfolio Demand for Money

People can hold money as a form of saving. Alternative forms of savings include stocks and bonds, real estate, or even supplies of canned goods. Money is the most liquid form of savings – you can spend it immediately in case an emergency or unexpected opportunity arises. Money saved in a bank or other institution may earn interest, but the rate is usually low. Therefore one of the opportunity costs of holding money is the higher interest you could probably earn on less liquid forms of saving. Also, people are less
V dM + M dV = P dy + ydP

Dividing the left side by M V and the right side by P y (which we can do because these two are equal), and rearranging yields dM/M + dV /V = dP/P + dy/y If we change differentials to finite changes, ∆M will be the fractional or percentage change in money supply per year, corresponding to dM/M, and so on. Thus ∆M ∆V ∆P ∆y + ≈ + M V P y and we use the “approximately equal” symbol because the equation only approaches exactness as the changes approach zero. The equation is close enough for practical use when fractional changes are on the order of 10% or less.

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The Demand for Money

inclined to hold money as savings if they anticipate substantial future rises in the price level. There is a crucial distinction between money and ordinary goods and services. Goods used for production and consumption are, by definition of those concepts, used up. But when we use money, it does not cease to exist.4 Because money is not used up, it is impossible for everyone in an economy to decrease his or her money holdings simultaneously. If we want to hold less money, we do not throw it in the trash – we spend it. But since every dollar spent is someone’s dollar of income, an overall drop in the demand for money can only translate into increased velocity, as we all spend faster. Therefore the demand to hold money varies inversely with velocity. Another factor that influences the demand for money is real output, y. When there are more goods and services available for purchase, we tend to hold more money. And as we have seen, a decline in the purchasing power of money (i.e., a rise in P) leads to more demand for money. We can express the relationship of money demand MD to these three factors symbolically as P ↑⇒ M d ↓ y ↑⇒ M d ↑ V ↑⇒ M d ↓

which merely says that the demand for money goes down when the price level rises, up when real output rises, or down when velocity rises. The demand for money is one of the most studied and controversial topics in macroeconomics, and our limited discussion is intended only to provide you with a general grasp of the concept.5 It is fair to say that changes in money demand are usually quite small and rarely account for more than a small portion of the changes in price level. “Hoarding” is sometimes cited as an exceptional kind of demand for money. A dictionary definition of hoarding is “to collect or lay up for the sake of accumulation.” Hoarders of money, like the comic book character
We omit occasional accidental losses of currency. Also, central banks can increase or decrease the supply of money, but we will reserve these changes for study in Chapter 16. 5 The appendix to this chapter explains three theories of the demand for money: Fisher’s quantity theory, Keynes’ liquidity preference theory, and Friedman’s permanent income theory.

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Chapter 2: The Purchasing Power of Money


Scrooge McDuck, seem to be doing so just for the pleasure of holding them and not for any service they might render in the immediate or distant future. To identify an acquisition as hoarding, we must guess the motives of the acquirer, which is always difficult. Perhaps the hoarder derives pleasure just from contemplating the cash in his possession, his bank balance, or his stash of canned food. In any event, there is no good reason to suppose that a significant number of people behave this way, except perhaps in times of emergency. Even then, people must consume, and time preference cannot be obliterated.


The Supply of Money

The law of supply states that as the price of a good or service increases, the quantity supplied to the market also increases. The law of supply assumes a situation where there are multiple competitive suppliers. This is not the case at present since the Federal Reserve System is the sole supplier of base money. However, in an economy where gold is money, there are multiple suppliers of gold6 so that an increase the purchasing power of money elicits increased supplies. Jewelry can be melted down and converted into coinage and gold mining operations may start up in areas where mining was formerly uneconomical. The law of supply is illustrated by the conventional upwardsloping supply curve of Figure 2.3. Instead of the conventional labels P and Q, the stock of money is labelled M and its price is labeled P P M . Recalling that the PPM is the inverse of the price level P, we can write in shorthand: M s ⇑ ⇒ PPM ⇓ ⇒ P ⇑. Over the course of the 16th century, for example, the money stock increased substantially as gold and silver flowed into Europe from America. This inflow resulted in price increases estimated at 200 to 300%. But in the 1920’s in the United States, the money supply rose by about 45% and yet prices stayed approximately level. Why? Because the 1920’s were boom years, and the demand for money rose approximately in step with the supThere could be a monopoly mint operated by the government with competitive private gold miners supply bullion to the mint.

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The Supply of Money

PPM = 1/P







Money supply, M

Figure 2.2: Supply and demand for commodity money ply. We must emphasize that relationships like the law of demand and the law of supply assume that other factors remain unchanged. The law of demand for money was not invalidated by the experience of the 1920’s. Its effects were masked because other things were not unchanged: supply was rising. So both supply and demand curves rose (moving equilibrium from point A to B in Fig. 2.3, leaving the purchasing power unchanged while the quantity in circulation increased noticeably). When we study central banks in Chapter 16 we will encounter a policy proposal that central banks should adjust the supply of money so as to maintain a steady price level. This would imply an upward-sloping supply curve for money, since the quantity supplied would rise with its purchasing power (fall with the price level). However we prefer to show vertical supply curves for money to emphasize the monopoly power that central banks currently have over the money supply (Chapter 16). Our models show that PPM and P are determined solely by M d and M s , with M s usually predominant. Any effect that does not influence the Version 0.92, copyright c Warren C. Gibson.

Chapter 2: The Purchasing Power of Money






Figure 2.3: Increased money stock in the 1920’s approximately balanced increased demand for money. demand or supply of money cannot influence the purchasing power of money or the price level. This is an important result because it refutes many misconceptions about the causes of price inflation. Can oil price rises instigated by OPEC cause price inflation? Not directly; not without a change in M d or M s ! Can “consumer greed” or “corporate greed” or “reckless government spending” cause price inflation? Not without a change in M d or M s . People who are deceived by such fallacies are likely confusing relative prices with the price level. Returning to oil, Japan and Germany had very low rates of price inflation during the oil price hikes of the 1970’s, notwithstanding their total dependence on imported oil. However, OPEC price increases did have a small one-time effect on the price level. How? Supply constraints caused real output to fall temporarily, which in turn decreased the demand for money, which in turn led to a small increase in the price level (oil shock ⇒ y ⇓ ⇒ M d ⇓⇒ P ⇑ as in Figure 2.3. Thusfar our supply and demand analysis has proceeded as it would for Version 0.92, copyright c Warren C. Gibson.

the inflation-adjusted value.40 The Supply of Money PPM=1/P Ms Md M Figure 2. Most goods and services are used up in consumption or production. more telephones. Following our convention. now or in the future. md = MD /P . on the other hand. but now we come to the crucial difference. we denote real money demand by a lower-case symbol.92. If P falls. and each dollar is worth more. Once they have been put to use they cannot be reused. Money. Worn-out bills and coins are constantly being replaced.7 We acquire money not for its own sake but for the goods and services we can buy with it. Most of us are better off when there are more apples. Increases of ordinary goods and services make people better off. . is never used up. increases in the money supply confer no overall benefit on society? Why is this? The answer lies in the distinction between real and nominal magnitudes. copyright c Warren C. any other good or service. People want money for what they can buy with it. In sharp contrast. more economics lectures. 7 Version 0. This does not constitute a change in the money stock. They care about the real value of their money. at least not in total. PPM rises.4: Secondary effect on the demand for money following an OPEC supply shock. Gibson.

increases or decreases confer no social welfare.Chapter 2: The Purchasing Power of Money 41 If you as an individual want to hold more money. We thus have a net transfer of wealth from those who get the money last to those who get it first. a transition from one stock to another could have serious economic repercussions if such a change were large or sudden.92. as it is spent over and over. all money is in someone’s possession at any point in time: M S = M D . Prices rise gradually as the new money is spent and re-spent. and only slowly. the supply must provide practical amounts. We must also be aware of how any new money enters the economy. no one would want to buy an economics text with a half ton of sand. But this never happens. Thus platinum would not be practical for small purchases since no one would want to purchase a newspaper for a few milligrams of platinum. . In thinking about increases in the money stock in the context of a gold standard. you will try to increase your nominal cash holdings. does it make its way to other people. we must remember that increases gold as intended for consumption or production increase total wealth but increases in gold intended as money do not. Economists like to imagine helicopters flying overhead and dropping money to people in proportion to their current holdings. Those who first receive the new money are faced with the existing array of prices. because by the time the money reaches them. not in the physical metal. copyright c Warren C. we cannot all increase our money holdings. Early recipients gain at the expense of the later recipients. Although the new money will cause the overall price level do rise (other things being equal). prices have already risen. Another qualification is that while one money stock is as good as another (within the aforementioned limits). Those who get the money last are losers. But as we have said. Some people always get the new money first. We must qualify this statement somewhat by noting that in the case of commodity money. At the other extreme. If the nominal money supply remains fixed. This important distinction lies in the intentions of those who possess the gold. We have now been led to the important conclusion that any stock of money is as good as any other supply. this does not happen immediately. This is called the “distribution effect” or “ripple effect” of monetary Version 0. Gibson.

The helicopter scenario is only a thought experiment: new money always causes distribution effects. On the other hand. In addition to wealth transfer. inflation causes at least temporary changes in relative prices.4 Important Terms and Concepts Price level (P) Price inflation Real vs. but there will still be distribution effects. whose price will tend to rise faster than other goods.92. debtors – people who owe money – will gain because they will be able to pay off their loans with cheaper dollars. they benefit in the same way as counterfeiters. whose activities constitute a fraudulent increase in MS . This is because new money not only goes to particular people first.42 Important Terms and Concepts inflation. 2. Gibson. If people successfully anticipate the rise in prices. How does he profit from his work? Clearly he gains purchasing power without having to earn it. We are assuming here that most people will not know that new money has been created or will not understand its inflationary effect. . If it continues to circulate undetected. But they do not have to worry about being caught and imprisoned. but it is also used to buy particular things. the holder of the money at the time of discovery will lose. nominal Velocity Money stock Purchasing power of money (PPM) Relative prices Price deflation Demand for money Equation of exchange Seasonal adjustment Version 0. copyright c Warren C. the loss will be borne by all those who hold money. If the fake money is detected. since the increased money supply will have reduced its purchasing power. Only when we understand these distribution effects can we properly analyze government intervention in the monetary system. Consider a counterfeiter. it will happen more quickly. When government agents create new money.

Gibson.92. The Purchasing Power of Money (1911) 2.5 References Irving Fisher. .6 Questions Version 0.Chapter 2: The Purchasing Power of Money 43 2. copyright c Warren C.

To Fisher’s transactions motive. and Friedman’s modern quantity theory. This view was influenced by the fact that during his time money never paid interest. is associated with the quantity theory of money. We summarize three theories: Fisher’s quantity theory. The precautionary motive is seen in people’s desire to hold some money for unexpected emergencies Version 0. Fisher’s view was that people hold money solely for transactions purposes and not as a form of saving. a prominent economist of the early twentieth century. Md = k × Py Since P × y is just nominal income.92. also known as the permanent income hypothesis. The Quantity Theory of Money Irving Fisher. this suggests that nominal income is the sole determinant of the demand for money and that interest rates play no role. Gibson. Keynes’ Liquidity Preference Theory John Maynard Keynes. . and even some checking accounts (which are part of M1) pay interest. This theory begins by rewriting the equation of exchange as M= 1 × Py V and postulating that velocity is a constant. Letting k=1/V be a constant and assuming equilibrium so that the quantity demanded (Md ) equals the quantity supplied (M).44 Questions Appendix to Chapter 2: Theories of the Portfolio Demand for Money Here we go into more detail about the demand for money M d ?. in his 1936 book The General Theory of Employment Interest and Money took a broader view. in which demand is assumed proportional to income. he added a precautionary motive and a speculative motive. copyright c Warren C. whereas currently M2 money balances pay interest. Keynes’ liquidity preference theory.

Precautionary money holdings are seen as proportional to income. . In general. the consequent loss in bond value will offset or even exceed the interest paid by the bonds.Chapter 2: The Purchasing Power of Money 45 or opportunities. the average interest payable on bonds relative to interest payable on money balances (inversely related to money demand) • re − rm .” Fisher. Keynes saw the demand for real money holdings mD = M D /P as influenced by both interest rates and real income y = Y /P : i ↑⇒ mD ↓ y ↑⇒ mD ↑ Assuming M d = M and substituting into the equation of exchange. Gibson. we see that velocity is not constant but in fact is positively related to interest rates: V = PY y = . i ↑⇒ V ↑ M M Friedman’s Modern Quantity Theory of Money In 1956 Milton Friedman put forth a theory in which he assumed that money can pay interest at a rate rm . like transactions motives. Keynes saw the liquidity component of the demand for money as inversely proportional to interest rates. copyright c Warren C. If people are expecting a rapid rise in interest rates. We will see in a later chapter that the market value of a bond falls when interest rates rise. In this situation people would prefer holding money to holding bonds. “permanent income” which is the present value of expected future income (directly related to money demand) • rb − rm .92. the average relative return on equities (inversely related to money demand) Version 0. He expressed the demand for real money balances (M d /P ) as a function of five variables: • Yp . Keynes lumped all investments other than money into a single category which he called “bonds. Keynes assumed that money cannot pay interest (a correct assumption for his time) and asked what speculative motive might prompt people to hold money instead of bonds which do pay interest. Combining the three motives.

expected inflation rate relative to interest on money balances (inversely related to money demand). it takes the form V = Y f (Yp ) and if the relationship between Y and Yp is stable. and • h. copyright c Warren C. Md = f (Yp ) P which is very much like Fisher’s quantity theory equation given above. and rm would tend to rise together and thus the spreads between them would be relatively stable. while velocity is not strictly constant in Friedman’s theory. so is the velocity.92. This development would of course distort studies that focused on cash and checking-account money. a ratio of human capital to non-human wealth thought to be inversely related to money demand Friedman’s theory makes money demand less sensitive to interest rates since rb . . People began to move money from checking accounts into money market funds because those funds paid generous rates of interest with only a little less liquidity than checking accounts. re .46 Questions • πe − rm . Gibson. money market funds and other financial innovations began to skew the data.” Eliminating interest rate spreads and the h term which is not considered significant. How Stable is the Demand for Money? Going into the 1970’s there was evidence in favor of the idea of the stability of monetary demand. Version 0. After that. Also. The major determinant in Friedman’s theory is Yp and thus his theory has come to be called the “permanent income hypothesis.

al. central bankers.Chapter 3 Government Control of Money Money can be supplied by private institutions with government playing no role except perhaps indirectly through provision of police and judicial services protecting property rights and prosecuting cases of fraud. there is a “public interest” point of view and a “public choice” point of view. Furthermore. The public choice point of view considers the personal and group motivations of politicians. government can do a better job of producing money than private firms can. salary. These motivations include power. “No duty is more imperative than the duty [the Government] owes the people. Direct government involvement in money can range from mild forms of regulation or intervention to total takeover of the business of money. Up to now our discussions of money have been rather general so that it has not been necessary to distinguish between market-supplied money and governmentsupplied money. or other desirable attribute. etc. of furnishing them a sound and uniform currency”? As with any study of government activity. efficiency. et. theft. The public interest point of view holds that free markets fall short of some standard of stability. according to this view. justice. regulators. and fame. Why has government almost universally taken control of monetary systems? Why did Abraham Lincoln once say. While control of 47 . We now make that distinction.

Think of standard light bulb sizes and shapes.48 Legal Tender Laws monetary institutions may feed these appetites directly. but in 2008 it would buy only about a sixth of an ounce of silver. and the units with which it was to be measured. Food for the military. copyright c Warren C.92. 27 Britain’s monetary unit is still called the Pound Sterling.1 Legal Tender Laws A rather mild type of intervention into monetary affairs was the specification of what form of money people would be allowed to use. . Tax collectors must know what is needed by the various government agencies and then find citizens who have those goods ready for seizure (a variation of the “double coincidence of wants” problem that besets barter economies). direct appropriation of commodities such as grain or cloth) are difficult to collect. and VHS video tapes. The first motivation is tax collection. “History is largely a history of inflation. for example. right-hand-threaded fasteners. An early example was the British pound sterling. But if taxes are to be paid in government-defined money. As Nobel Prize winner Friedrich Hayek put it. Gibson.”1 3. The argument is dubious. The British government specified that one pound of sterling silver would be a standard unit of money. government would bring order out of this chaos. and usually of inflations engineered by governments for the gain of governments. The difficulty is somewhat akin to the “double coincidence of wants” problem that arises in barter. A vast army of tax collectors would be required to seize food at harvest time. was a common need. and government’s Denationalization Of Money. 2 1 Version 0. however. The public choice motivations are suggested by the ways in which in which governments enforce monetary standards. p. the primary benefit to governments is the revenue they are able to secure through debasing or inflating the money supply. these problems disappear. Markets would produce a confusing and costly array of coins of varying sizes and fineness.2 The public interest justification for such specifications is that universal standards would reduce transaction costs. in light of the numerous instances in which free markets have converged to standards. Taxes collected “in kind” (that is.

The explanation for this consequence is attributed to Sir Thomas Gresham (1519-1579). but there is nothing intrinsic in these metals to suggest that this is the correct ratio.2 Gresham’s Law Suppose two forms of money exist in a particular economy. such as gold and silver. This is called purchasing power parity and will be explored in more detail when we study foreign exchange. These early forms of legal tender laws could not force everyone to use government-defined money in their private affairs. for the simple reason that gold is more convenient for large transactions and silver for smaller ones. Gibson.Chapter 3: Government Control of Money 49 transaction costs are reduced. A gold/silver ratio price emerges in the market like the ratio prices in a barter economy. governments often decided to fix the exchange ratio by law. Can this happen without government intervention? It can be and has been. 3. an English merchant and a financial agent of King 3 The ratio is currently close to 90 to 1. was to eliminate one of the metals as a form of money. .). francs. But the main consequence of such laws. This helped them tighten control over their colonial subjects. the ratio was for many years approximately 16 ounces of silver for one ounce of gold. Version 0. The public interest justification for this action was to eliminate the transaction costs associated with varying exchange ratios between gold and silver. etc. which became the main reason for legal tender laws.3 The ratio that arises in any particular circumstance will be the ratio of the purchasing powers of each money unit. Historically. probably unintended. but they did increase its use greatly since the requirement to have government paper money money on hand when the tax collector came around made it more likely that people would use that same money in private commerce. Thus European nations found it advantageous to collect taxes from their colonial subjects in their own money (pounds. copyright c Warren C. These laws might have had few undesirable consequences had governments not used them to promote alternative forms of money.92. In situations where two forms of money circulated.

3 Monopoly Mints Coinage. Queen Mary. exported to other countries. which set a 15 to 1 ratio and drove out gold. opportunities for fraud open up. mints began to produce coins with milled edges. Gibson. copyright c Warren C. which effectively demonetized silver. and the Coinage Act of 1873. these mints were not as efficient as private mints and so governments simply outlawed competing private mints.50 Monopoly Mints Edward VI.” If the price decreed is below the equilibrium price. Like most government businesses. the reverse situation will arise. Silver will circulate and gold will disappear from circulation. This can be accomplished by clipping bits of metal off the edges of the coins or by shaking them violently in a bag and collecting the resulting gold dust at the bottom of the bag.” but this is an oversimplification that can easily lead one to conclude that something about free choice of money that would lead the “bad” kinds predominating. and Queen Elizabeth. but once coins begin to circulate by tale rather than by weight and fineness. To see how Gresham’s law works. . It will be converted to candlesticks. Three instances of this sort of intervention in the United States were the Mint Act of 1792. Gresham’s Law deals with a special case of price controls. as we have seen.92. the Coinage Act of 1835 which set a 16 to one ratio and drove out silver. Gresham’s Law might better be stated as “artificially over-valued money will circulate. suppose the equilibrium price is 15. under-valued money will not. whereupon the market ratio fell to 30 to 1. The justification for this Version 0. 15 to one for example. If the government decrees a higher price such as 16.5 ounces of silver per ounce of gold. It is often summarized as “bad money drives out good. To counter clipping. 3. One form of fraud is a reduction in the gold or silver content of coins. The little ridges you see on the edges of present-day quarters and dimes are a holdover from this anti-fraud practice. or hoarded by people who hope the government intervention will end. is a viable private enterprise. there will be a surplus of silver so that people will not want to use silver for money. Governments began to set up their own mints.

Like any monopolist. and many people did not see their incomes rise until well after prices had risen. They were thereby enjoying the same kind of benefit that a successful counterfeiter enjoys. called seignorage.D. they enjoyed enhanced revenue. S. The new money was spent by the government into a market where the price level had not yet risen. offering coins with one ounce of gold in exchange for one ounce of gold dust. On the other hand. But of course government agents did not have to worry about being caught and punished for their activities. and this often prompted governments to “call in” these coins and forbid hoarding of them. Gibson. The impacts of coin debasement were threefold. it was down to 43%. . A better explanation would point to the profits that government mints enjoyed. In the year 54 A. this coin contained 94% silver. Mint did this for a number of years.D. there were distribution effects. some mints engaged in free coinage.92. simply a silver wash over a copper coin.” The Roman denarius was a silver coin that was debased over the years. One way to do this was to simply issue smaller coins and decree that their value was the same as the larger predecessor coins. copyright c Warren C. with no charge for production.D. Governments soon realized that they could raise seignorage revenue still higher by issuing fraudulent coins themselves.Chapter 3: Government Control of Money 51 arrangement was to insure the quality of coinage and reduce fraud. First. the prominent twentieth-century economist summed up the situation well when he said that issuing money allows governments to impose pseudo-taxes “in a manner which not one man in a million is able to diagnose. Third. Then Gresham’s Law came into play as old and more valuable coins were hoarded. This transfer is very much like a tax. One hundred of the old gold coins might be melted down to make 150 newer and smaller coins. Whenever they were able to mint coins whose face value exceeded the value of the metal plus production costs (brassage). there was an increase in the money supply M s which caused the price level to rise. and by 268 A. it stood at 1%. prices rose Version 0. By 218 A. John Maynard Keynes. the net result being a transfer of real wealth to the government. The U. they were able to increase revenues by restricting output.D. It is no surprise that between 200 and 300 A.

which in most cases is negligibly small. . originated before Roman times and kept its silver content and its purchasing power roughly constant even after the fall of Rome. They began to issue irredeemable paper money.92. The French livre tournois fell from 98 grains of fine silver to 11 grains during the years from about 1200 to 1600 A. a moderate figure by modern standards. Demand for coins is fairly elastic. this form of money actually emerged out of the free market. This may not be so simple. Version 0. meaning few substitutes are available.52 Fiat Money by about 50 times. a 65-grain silver coin. Thus price inflation in Rome ran about 3% to 4% per year. The development of paper money opened up far more lucrative seignorage opportunities.D. 3. We will discuss money substitutes further in Chapter 6 but for now we will note that governments quickly found seignorage opportunity in this new form of money. In general. While paper money was a boon to governments eager to benefit from seignorage revenue. debased coins have declined in purchasing power roughly in step with the erosion of their commodity value. Fiat money is best defined as money whose monetary value has no relationship to its value as a commodity. On the other hand. They are thought to have appeared in China soon after the year 1000. Bank notes were paper certificates that could be redeemed for specie at the bank of issue. people have to be persuaded to use it before it will circulate widely. the Greek drachma.” It only took until about 1023 for fiat money to appear in China. called fiat money after the Latin word for “command. especially when substitutes are available in the form of foreign coins. Gibson. Contemporary Federal Reserve notes are essentially useless for any non-monetary purposes and they cannot be exchanged for any commodity. Although fiat money is commanded into existence. copyright c Warren C.4 Fiat Money Debased coins are still commodity money and this rather limits the seignorage available from coinage debasement. But monopoly enterprises like to sell into markets where demand elasticity is low.

legal tender laws are enacted. that money arose from prior commodity money.” In other words. and that is not enough time for us to estimate how well this system can continue to work. you will find the inscription “This note is legal tender for all debts. checks drawn on commercial banks are not legal tender. they accept it simply because they know others will accept it.Chapter 3: Government Control of Money 53 In recent times we have seen the public reject the Susan B. “it remains an open question whether the temptation to use fiat money as a source of revenue will lead to a situation that will ultimately force a return to a commodity standard – perhaps a gold standard of one kind or another. to dollar coins which are relative heavy and awkward. Milton Friedman. 259. . The entire world today operates with fiat money.S. but in almost every case. Second. If you examine a dollar bill. and they forget about its prior link to gold or silver. dollar and gold was severed. Third. The promising alternative is that over the coming decades the advanced countries will succeed in development of monetary and fiscal institutions that will provide an effective check on the propensity to inflate and that will again give a large part of the world a relatively stable price level over a long period of time. copyright c Warren C. Pure fiat standards have prevailed only since 1971. perhaps the most influential economist of the late twentieth century said. “Money Mischief” p. as we have indicated. at which time the last link between the U. Gibson.92. a check with sufficient funds behind it is so readily convertible into currency that it serves as de facto legal tender. governments make taxes payable in fiat money. At first. However. 5 Milton Friedman.4 Once people become accustomed to the paper money. This was the case with Federal Reserve notes when they were first issued in the U.5 Tecnically. Evidently people prefer dollar bills. So how can governments persuade people to use its fiat money? The answer lies in linking fiat money to pre-existing commodity money. 4 Version 0. the new money may be temporarily redeemable.S. any private debt can be extinguished by payment of federal reserve notes. public and private. even though they are dirty and ugly. Anthony and Sacagawea dollar coins even though they are fully legal tender.

copyright c Warren C. In fact. $7. Wars are the most expensive of all government activities. Predictably. the Continental Congress had no powers of taxation. fell sharply against specie: by 1/3 as of October 1775. The Continental currency became worthless and the phrase “not worth a Continental” entered the American language. The Continental episode was the first modern instance of hyperinflation.54 Fiat Money Coins can be fiat money. to finance the war? Here is what they did: 6% ($5. . The current U. often defined as rates exceeding 50% per month. In 2008. Pennies seem to disappear from circulation almost as fast as they can be minted – people throw them into jars or simply discard them. the price of copper rose high enough that it almost became profitable to melt down pennies. to 30-to-one in 1779. including labor and capital in addition to metal. the price of zinc had risen to the point where pennies again cost more than one cent to make. for example. for example. the Mint started making pennies out of zinc. How. A quarter. and 167-to-one in 1781.8 million from abroad) 78% was newly issued money Six million dollars was issued in 1775. More technically.92. the value of the currency. 1982. with a copper wash. but this particular war was in large part a revolt against taxation. coins are made of metal whose value is unrelated to their face value plus brassage. expectations play a key role in the degree to which inflation of the money supply translates into price inflation. hyperinflation is a situation where prices rise even faster than the money supply because of falling demand for money. $19 million in 1776. which is the name for extreme rates of inflation. Gibson. they often believe they are temVersion 0.S. then. In fact. The American colonies were among the first to issue paper money. We can discern three stages: 1. and after that new issues began to appear every fortnight. called Continentals. Annual proposals to abolish the penny are invariably defeated by the zinc lobby. Iron tokens circulated in ancient Byzantium. however. and their value as iron was much less than their face value. costs about five cents to make.8 million) by taxation in the form of requisitions on the individual colonies 19% was borrowed ($11 million from domestic lenders. not just paper money. When people first see price increases. At one time in the 1970’s.

the new currency was backed by lands seized from the Church.92. At first.Chapter 3: Government Control of Money 55 porary. people are eager to get rid of their money. The Confederacy issued about $1 billion. They devised new form of paper money called assignats. the loss fell mainly on the poor and the ignorant. After a time. “I’d better buy now before prices rise even more. 3.” Version 0. the assignats quickly lost value and ultimately expired worthless. A similar inflationary episode took place during the French revolution. One of the most massive hyperinflations in history occurred in Germany in the early 1920’s and 6 Andrew Dickson White.7 cents in 1862. Civil War. Thus prices in the North rose by “only” 90. 29.” Money demand begins to fall. people are trying to avoid the implicit inflation tax. “I’ll buy anything just to get rid of this depreciating currency. and the Confederate currency suffered nearly the same hyperinflationary fate as the Continentals of less than a hundred years earlier. Relative to its initial gold value.7 cents in 1865. imprisonments and death that were enacted to try to stop people from substituting other forms of money. and 1. people no longer believe the situation is temporary. and price inflation lags behind money inflation. “Fiat Money Inflation in France. As inflation races ahead. both the Union and Confederate governments issued paper money to finance the war. copyright c Warren C.6 During the U. The Union government only printed enough of its new paper “Greenbacks” to roughly double the money supply. “I’ll wait and buy after prices have fallen back to normal. Demand for money falls rapidly and price inflation races ahead of monetary inflation. . 2.676%. Gibson.S.” In effect. when the war ended.5% in four years while Confederate prices rose some 2.” Demand for money increases slightly.0 1863. As always. Many of the leaders of the revolution were men of principle and wanted to find ways to avoid the fiscal irresponsibility of the previous regime. but it gradually evolved into a pure fiat currency. Notwithstanding interest paid on some issues and draconian penalties in the form of fines. the Confederate dollar fell to 32.

(We will study central banking in Chapter 16.0 marks 2. Another hallmark of the German hyperinflation: it was the first to be engineered by a central bank rather than directly by the government. of butter 1. The lifespan of a contemporary one-dollar bill is only about 18 months. when hyperinflation had reached the third stage. Although this episode did not reach the extremes seen in Germany. More importantly. people continued to use the rapidly depreciating marks rather than reverting to barter. These are but two examples of countless instances in which governments have degraded a monetary system. Hyperinflation also visited post-Soviet Russia in the 1990’s. Gibson. Hyperinflation was ended when a new mark was introduced by dropping eight zeros from the old mark. Its magnitude can be seen in the price of butter Year 1914 1918 1922 1923 Event Before WWI After wartime monetary expansion Hyperinflation sets in Near the end Price of one lb. The political consequences of the German hyperinflation were enormous. it did prompt the authorities to undertake a currency reform in which each new ruble replaced 1. sincerely believed that the root of their problem was a shortage of money and advocated even more massive issuances of paper money. It is interesting that even during the worst of the German hyperinflation. The middle class was wiped out and the stage was set for Hitler’s rise to power.92.400 marks 6 trillion marks Ironically. the authorities. It was still convenient to use the same money that everyone else was using. copyright c Warren C. What are the benefits of paper money? Transactions costs fall because paper is more convenient than coins for larger transactions. (For smaller transactions coins are better because paper wears out faster. . expansion of the money supply was brought to an abrupt halt. This shows the huge social benefits of even a very bad money relative to no money at all.4 marks 3.56 Fiat Money is traceable to the draconian reparations imposed by the victorious Allies following World War I. This is called a currency reform. Neither did the Germans used foreign money for the most part.) But these same Version 0. not understanding the fall in M d and its consequences.000 old rubles.

A weightier argument in favor of fiat money is based on the resource cost of commodity money. so if anything there was less gold available for consumption.22 per ounce. the price of gold was freed from its prior official fixed price of $42 per ounce. the U. not fill a decayed tooth. We will consider counter-cyclical The market price of gold was about $850 per ounce in 2008.7 Fiat money can be compared to paper bicycle locks.” One troy ounce equals 31.S.92. People were acquiring gold as a hedge against rising inflation. Every ounce of gold that is used as money is an ounce that will not be worn on a lady’s wrist.S. As long as thieves respect these “locks” or believe they are unbreakable. . This control constitutes a macroeconomic tool at the disposal of policy-makers for the purpose of countering the inherent instability that some economists. “Troy ounces” are used to measure weights of gold and silver. Gibson. valued at the pre-1971 price of $42. this is not what has happened in the U. If you check the balance sheet of the Federal Reserve System online or in a financial publication such as Barron’s you will find 263 million ounces listed as an asset. The market price began to rise. copyright c Warren C. Paper money frees up these precious resources for use in satisfying important human wants. As we have seen. called “Averdupois ounces. As long as people believe in fiat money. and these are different from the ounces used in most commerce. since it went on a pure fiat money standard in 1971. not coat the connectors of a printed circuit board. it will serve its purpose without the resource costs of commodity money: the opportunity cost of commodities that sit in vaults and therefore cannot be consumed.1035 grams.Chapter 3: Government Control of Money 57 reduced costs can be had where gold and silver certificates replace coins in daily transactions. see in free markets. slowly at first. And yet. Furthermore. 7 Version 0. Shortly after that time. government continues to hold its stock of gold even though no longer has any monetary function. an then in a frenzy hit $850 per ounce in 1980. they will function without the expenses of hardened steel and keys. Defenders of fiat money point out that it allows government to control the money supply. commodity money is money that is embodied in some physical form that has consumption or production use that parallels its use as money. Such money substitutes have been offered by private banks. particular followers of John Maynard Keynes.

3. copyright c Warren C.7 References Version 0. Gibson.5 3. .58 Socialism and the Abolition of Money monetary policy further in Chapter 18.6 Socialism and the Abolition of Money Important Terms Real money supply Legal tender Bimetallic standard Brassage Fiat money Hyperinflation Real cash balances Neutrality Gresham’s law Seignorage Debasement Token coin Resource cost 3.92.

Part II The Nature and Origin of Credit 59 .


Just as we developed the concept of money beginning with a primitive barter economy. and saving adds to the benefits of exchange by providing the capital that is so necessary economic growth and prosperity. alone on his desert island. to trust. goods. Exchange can provide enormous gains in wealth. Later we will combine these concepts with the basics of money which we have just covered. He can stay alive by picking berries but he would prefer to add some fish to his diet. goods or services to us later. This will give us a foundation for understanding financial systems. we will develop the concept of saving starting from a primitive example. but in order to make one. calls to mind bank accounts or jars of pennies. as we use the word in ordinary conversation. When we extend credit to someone. Saving. but we need a more fundamental understanding. but from an economic point of view. he has to take time and energy away from picking berries. Robinson Crusoe. we provide money.Chapter 4 The Significance of Saving We are now ready to study credit and saving. That obligation is not an asset but in fact the opposite of an asset: a liability. You may therefore feel flattered when someone by extends credit to you. as we shall see in the course of this chapter. when you accept credit you assume an obligation to pay later. A person who provides credit is saving. or services in the present and trust that they will return money. The word credit comes from the Latin credare. He might accumulate some 61 . He needs a net to catch fish. faces some stark choices.

However he proceeds. explains the cost of saving. How much more is a subjective matter. We therefore choose to forgo present consumption only when we expect to receive more in the future than we have to give up in the present.62 berries before starting work on the net or he could give up some leisure by taking fewer naps. . Leisure also illustrates the diversity of people’s choices. Some people hate golf. and that same person Version 0. or grow roses. Some people use leisure time to sleep. The opportunity cost of saving is present consumption and this tradeoff involves a time element. How much more is today’s ten dollars worth to us versus ten dollars next week? Or to put it differently.92. other things being equal. When we choose to take naps. we reap direct pleasure from time and energy that we devote to these activities. Whenever we acquire scarce goods we must forgo opportunities to acquire other goods. some even read tracts on economics for pleasure. copyright c Warren C. like the benefits we get from any kind of consumption. are entirely subjective. There is a name for this “how much more:” interest. All we can say when we see someone taking leisure time is that he prefers to devote this particular hour (his marginal hour) to leisure rather than alternative productive uses of his time. some play golf. Gibson. The benefits of leisure. Foregone production is thus an opportunity cost of leisure. This simple example shows that leisure is a consumption good. These activities acquire the status of leisure only from the attitudes of the people who engage in them. Time preference. a basic fact of human life. he will have to give up something valuable in the present for the sake of increased future production. watch movies. varying from one person to another and varying over time for a particular person. how much compensation do we require to persuade us to wait? If we require an additional dollar to persuade us to delay for a month receiving $10 that is owed to us. play games. economics. and this time and energy could have been devoted to producing goods and services. or even sleep! Crusoe also reminds us of the fundamental fact of scarcity that underlies all economics. He will be saving. Time preference refers to our preference for consumption in the present over the same consumption in the future. Some people might want $2 for that delay while others might settle for fifty cents. that dollar is interest.

1 Version 0. he stops buying apples. when circumstances change.1 Saving in a Monetary Economy As our Robinson Crusoe story has shown. Gibson. the marginal subjective value of each apple declines. given that we all have differing degrees of time preference?2 For the same reason that there is only one market price for apples even though some of us like apples better than others. someone whose time preference is below average will borrow less (or loan out more).1 Notice that although interest is usually accounted for and paid in terms of money. Indeed. We say someone with a relatively strong preference for present satisfaction. As a person buys more apples. there is only one market rate of interest. it need not be. although most saving in advanced economies uses money just as most exchange uses money. I might accept one additional apple as interest to induce me to wait a month for payment of ten apples that are owed to me. How is it that there is only one rate of interest.Chapter 4: The Significance of Saving 63 might settle for forty cents next week. has high time preference. the price he is willing to pay. Notice further that interest does not give rise to time preference. In Chapter 1 we learned how indirect exchange leads to Misers have very low time preference. but no one could have zero time preference since such a person would have no preference for eating versus saving his food for future consumption. 2 There are many different interest rates corresponding to various maturities as we shall see in Chapter 8. Time preference is a basic fact of human life. 4. Similarly. like the one who requires an extra $2 persuasion to wait. and with it. money is not always involved in acts of saving. Conversely. copyright c Warren C.92. . When that price has declined to the market price. So to be more precise we should say that for a given maturity and risk level. A person with very high time preference is pejoratively called a spendthrift and a savings fanatic a miser. a person whose time preference exceeds the average time preference as reflected in the market rate of interest will borrow more (or loan out less) until the marginal value of the last loan is equal to the price paid. just the reverse. at which point he will stop borrowing. we can find a few modern examples of non-monetary saving as when a manufacturing firm adds to its inventory of finished goods.

92. When the loan term expires. you should be aware that some authors use “capital” by itself to refer to capital goods. as in “capital versus labor. but also someone who agrees to the duration and terms of the loan. use the term “capital” to represent a class of people. It is safe to say that money amplifies the benefits of saving even more than it amplifies the benefits of exchange of present goods. We will now examine the various forms of saving in a monetary economy and how savings are used for investment and consumption. One can save money and loan it to a borrower who wants to buy present goods. In fact. But saving in money form opens a conceptual separation of the acts of saving from the act of investment: the creation of capital goods. copyright c Warren C. Suppose I have been buying a daily $3 latte but decide to accumulate that money in a jar instead. the borrower can sell goods and settle the loan with money. we identify that act as both saving and investing. money solves the problem. At the end of another year he returns my money plus interest. I have saved and my neighbor has invested. Gibson.3 To add to the confusion. When we use the word “capital” by itself we will be referring to money used to purchase capital goods.64 Capital Goods the emergence of money which avoids the problem of the double coincidence of wants. Compared to someone who wants to exchange present goods.2 Capital Goods The phrase “capital goods” is synonymous with “production goods” which we have already defined as goods used to produce other goods. his investment enhances his income. After a year I loan the money to my neighbor so he can buy some tools for his machine shop. some writers. . If all goes well. Again. However. 4. the term was coined by Karl Marx. When Robinson Crusoe gathers vines to make a fishing net. capitalism’s pre-eminent enemy! We prefer the 3 Version 0. Savers face a more severe form of the problem of the double coincidence of wants. particularly those of a Marxist persuasion.” The term “capitalism” as a label for a system in which the means of production are privately owned is a poor choice since all societies beyond the most primitive employ capital. a borrower in a barter economy – someone who wants to acquire present goods in exchange for future goods – not only has to find someone willing to provide those particular goods.

no economic aspects of any goods and services are intrinsic to those goods or services. If you borrow the $15.000 you would categorize $9. bonds. You are buying a car partly for production (driving to work) and partly for consumption (family uses). we have income = consumption + ∆cash balances + investment with the understanding that the equation applies to a specific time period such as a month. term “market economy. . or contemplates doing so. We can consume it by spending it on goods and services like flowers. Even people who work for wages sometimes make capital investments. consumption and investment are flows (amounts specific to some time period). or equipment for our business. There are only three things we can do with the money we receive. These aspects always depend upon the desires and plans of the person who is putting them to use in service of some goal. bicycles or haircuts. Or we can put it in our checking account or our cash drawer. A proprietor who owns a restaurant might buy kitchen equipment. an oil well.” 4 However. a concept we will discuss later. thereby investing it. or a TV station would be purchasing a capital good. services or labor.Chapter 4: The Significance of Saving 65 Returning to the concept of capital goods. or a year. a quarter. You have made a $9. thereby adding to our cash balances.4 Our example shows that cars cannot be classified as production goods or consumption goods except by reference to the plans of the particular individuals who drive them. copyright c Warren C. notice what happens when we sell anything for money – goods. Note the ∆ indicates change in cash balances because whereas income.000 investment in a production good (60% of $15. In fact. The most direct form of investment is the purchase of a capital good – a physical asset that is a tool of production.000) and a $6. one’s cash balance is a stock.000 as an investment and $6. A wealthy investor buying a factory. We can buy shares of stock.000 as dis-saving.000 and suppose 60% of the miles you drive are for transportation to work and the rest for family purposes. Suppose you buy an automobile for $15. the Internal Revenue Service will not allow you go claim a deduction for this or any other expenses of a car you drive to work! Version 0.000 consumption purchase. Expressed as a simple flow-of-funds equation.92. Gibson.

Because of time preference. lenders require inducement in the form of interest to persuade them to delay consumption. promissory notes. credit card loans and pawnshop loans are all examples of debt-financed consumption. This is called depreciation. . etc.) as a use for savings. and represents gradual consumption of the automobile’s value. thus allowing people to start consuming the services of a house before they have accumulated enough money to Although people starting small businesses occasionally resort to credit cards or pawnshops. A credit transaction.3 Direct Finance If you want money for purchase of capital goods but don’t have it. 4.5 The vast majority of home purchases are financed by mortgages. Suppose that instead of purchasing the car you leased it for $300 per month. meaning it is capable of providing services over a significant span of time. IOU’s (“I owe you”). notes. The lender is a creditor and his right to future money or goods is an asset. as we have said. both of which charge high rates of interest. In addition to financing production goods. is an exchange of a present good (or service or money) for a claim to some other good (or service or money) in the future. The borrower is called a debtor and his obligation is a liability. Consumer loans. However. the $180 would not be an investment since that sum would simply be a payment for the current month’s use of the car. and it goes out of style.92. bonds. mortgages. If both are money. that money would be serving as a standard of deferred payment. As you drive a car. you might be able to borrow it. materials. Gibson. Credit instruments are called many things: loans. 5 Version 0. which was mentioned as one of the subsidiary functions of money in Chapter1. as a source of capital. mechanical problems arise. savings can be used to finance consumption by people who do not want to wait for their income to catch up with their desires. copyright c Warren C. bills.66 Direct Finance A car is a durable good. Debt instruments are an alternative to real investments (land. its finish dulls. You would attribute $180 of that payment (60% of $300) to the cost of driving to work and the rest to consumption.

(Remember that earnings are calculated after depreciation has been subtracted from income. Many households go through a lifetime cycle of dis-saving during early adulthood. Young people forming a household often borrow to buy a house. Borrowing for consumption or consumption of one’s savings is the opposite of saving and is therefore called dis-saving. .Chapter 4: The Significance of Saving 67 pay for it in full. If over the course of some time period. Gibson. they typically begin to consume their savings. but the lack of capital accounting for most government entities makes this difficult to estimate. the cost of a new road is fully expensed during the time of its construction rather than being depreciated over time. a business whose dividend payouts exceeded its earnings would be dis-saving. it follows that Social Security benefit payments are not dis-saving but rather a forced transfer of wealth from younger to older workers. 6 Version 0. a household saves more than it dis-saves. When we dissave. However. for example. Compulsory private retirement accounts.6 Debt instruments as an institution are quite old. During their middle years they typically pay down these debts and save for retirement. it would be a savings unit. As an example. but the merchants did not want to For example. Otherwise it would be called a dis-saving unit. But a company that re-invested its earnings in its own business or retained some of its earnings for investment in government securities. it would be called a savings unit. bills of exchange arose early in the development of mercantile societies to facilitate trade between regions. which have been proposed as alternatives to the present Social Security system. saving during highly productive middle years. Government are typically dis-saving units. etc. Tobacco grown in colonial Virginia was purchased by tobacco merchants in England. we forgo some future consumption for the sake of present consumption. and dis-saving again in retirement.) However.92. typically a year. The tobacco farmers wanted to be paid as soon as they parted with the tobacco. Payouts from pensions and annuities are dis-saving. Upon retiring from the workforce. copyright c Warren C. since Social Security deductions from paychecks are taxes and not a form of saving. would also be a form of forced savings. a car. Households are typically savings units since households are the ultimate source of capital for production. Businesses are more often dis-saving units.

they were not used by the general public.92. To the factor. . Merchants in England issued these bills in the form of written promises to pay for the goods at some specified future date. 7 Version 0. In other words. the factor would acquire title to the tobacco. Tobacco growers acquired these bills and sold them to a financier. neither party wanted to own the tobacco while it was in transit. The bills paid interest in the form of a discount. Of course. As such arrangements became more common. They did not. transportation of gold and silver across the ocean was expensive and risky. but there was very little transportation of specie.7 Notice that the story of the emergence of bills of exchange is an example of spontaneous order. Financiers engaged in this trade came to be called factors. More often. the benefit of being paid immediately exceeded the £2 he had to give up. holders of bills would sell them to importers who needed money to purchase English goods for sale in America. and profit. Thus bills of exchange resulted in a more efficient clearing system which increased net social welfare. the difference being the interest earned by the factor. They were not a generally accepted medium of exchange. those £2 were worth more than the interest income his funds might have earned elsewhere plus the risk of occasional default. who in essence made a loan that enabled the farmers to be paid immediately and the merchant to pay later. meaning that if the merchant failed to pay at the specified time. and as we have seen. The bills were secured by the tobacco. Somebody saw a profit opportunity. because although they circulated fairly widely among merchants. the risk of default. all parties gained from this arrangement.68 Direct Finance make payment until they received the goods. To the farmer. This means that a farmer might be paid only £98 for a bill which would be worth £100 when it reached England. Some imaginative person saw this unmet need as a profit opportunity and invented bills of exchange. goods flowed back and forth across the ocean as did bills of exchange. reduced the demand for money. However. Gibson. That interest would cover the opportunity cost of fronting the money. tried the idea We might ask whether bills of exchange achieved the status of money since they were widely used as a medium of exchange. A factor holding a bill could remit it to England in exchange for specie. copyright c Warren C.

they pay dividends to their owners. Limited partnerships are a hybrid type of organization. It is simply a warning to anyone who is contemplating dealings with the corporation that they cannot pursue the owners individually to remedy any failure of the corporation to honor its obligations.92. the Crown granted the British East India Company. who also exercise nominal control over the affairs of the organization in the form of voting rights. a private corporation. Of course. but enjoy certain tax advantages. 8 Version 0. This means that they are not individually responsible for the debts of the corporation. When they are successful. in today’s economy when banks grant loans to small corporations. as it might seem. In either corporations or partnerships. formation of a new corporation is a routine matter. Thus in return for assumption of some of the British government’s debt. or another partnership) who bears full liability and limited partners who enjoy limited liability like corporate stockholders. Savers may also form jointly owned organizations to acquire capital goods in the form of partnerships or corporations. In particular. Business corporations are more common than business partnerships because their owners (shareholders) bear limited liability. shares represent joint ownership of the capital goods. governments may have entered the picture later by imposing taxes or regulations on the market for bills of exchange. Limited However. a monopoly on trade with India. a corporation. Gibson. No government agent planned or implemented the idea. It is necessary to register a new corporation with a state government. In the United States at present. but this does not convey any particular privileges or sanction beyond limited liability. they typically insist that the principal stockholders personally guarantee those loans. In past times. any sort of special privilege. Individual extension of credit is just one way to save. They include a general partner (who may be an individual. Others imitated it and it became common practice.Chapter 4: The Significance of Saving 69 and succeeded.8 Partnerships lack this protection. . combining some features of a corporation and some features of an ordinary partnership. the liability limitation that the owners of corporations enjoy is not. business corporations were chartered by royal governments who typically granted monopoly privileges along with the charter. copyright c Warren C.

1: Stock certificate. Indiana. liability is signaled by abbreviations such as “Corp. This railroad bond. Stock certificates such as the one shown in Figure 4. issued in 1891. The certificate in Figure 4. copyright c Warren C. Purchasers of bonds also received elaborate certificates such as the one shown in Figure 4.” appended to company names. People contemplating doing business with corporations can decide whether or not limited liability poses an acceptable risk. ownership of shares of stock was documented by stock certificates which brokers mailed to purchasers of stock.” or “Inc.1 were usually elaborately engraved.92.70 Direct Finance Figure 4. Limited liability does not shield either employees or stockholders from prosecution for fraud or other criminal behavior. In the past. is typical of bonds issued during that era.” or “Ltd. Very few investors now receive stock certificates and instead rely on electronic records of ownership. Attached to the bond were coupons dated six months apart which could Version 0. Gibson.1 was for a railroad which was projected to serve a coal mine near Brazil. .2.

The bond promises to pay principal and interest in “gold coin of the United States of the present standard of weight and fineness. a family or perhaps a commune.000 shares may be sold for $2 each. The emergence of joint ownership as represented by partnership units and shares of stock enables us to distinguish business firms from households. When people buy and sell shares of a particular company.92. Some shares of corporate stock can be resold in markets that have developed for that purpose. be it a corporation. where some trading still takes place in a building in lower Manhattan although most is now done electronically.” Gold contracts such as this were unilaterally abrogated by President Roosevelt during the Great Depression. When a corporation is formed. shares of stock are sold to investors.9 This is called secondary trading. providing the corporation with $100. new issues are economically the most important aspect of capital markets. a This is not to say that corporate managers are indifferent to the market price of their company’s stock. The best-known secondary markets in the United States are the New York Stock Exchange. which include markets for initial shares of stock and new bond issues. In addition to shares of stock. Second. . a high market price makes it easier for companies to issue new shares of stock – secondary offerings – to finance new activities or to buy other companies. Capital markets generally. they themselves may hold large amounts of stock. 9 Version 0.Chapter 4: The Significance of Saving 71 be clipped and redeemed for interest payments. provide the financial “fuel” that powers the great engines of innovation and productivity that drive free market societies. the function of a business firm. and while the volume of secondary trading (the number of shares traded per day) dwarfs the volume of new issues of stocks or bonds. Third. Gibson. The market prices of these instruments arise out of the judgments of the buyers and sellers as to (1) the productive value of the collection of capital goods that the shares represent and (2) how other traders are likely to appraise the shares. copyright c Warren C. First. bonds and limited partnership units are also traded on these exchanges. 50. For example.000 in capital. that company is not a party to the trade. and the NASDAQ exchange which is all electronic. Both can be thought of as property-managing units. but whereas the primary function of households is to manage consumption for a single person. they may lose some of their salary or even be fired if the company’s stock performs poorly. These are called secondary markets.

2: Railroad bond.72 Direct Finance Figure 4. Version 0.92. . Gibson. copyright c Warren C.

we must recognize that all business firms are ultimately owned by households. Of course. is to manage property for production. Version 0.Chapter 4: The Significance of Saving 73 partnership or a proprietorship. True. the functions have separated. copyright c Warren C. there are still a few family businesses such as farms or restaurants where the same group acts as both a household and a firm. Gibson. . but for the most part.92.

74 Direct Finance Version 0. Gibson. .92. copyright c Warren C.

A firm’s balance sheet is a snapshot of its financial position in time which lists all its assets and all its obligations. This 75 . Here is a very basic balance sheet for a company we will call ABC Manufacturing. Balance sheets are often depicted as a “T account” where lines like the letter T are used to separate assets from liabilities.Chapter 5 The balance sheet We now introduce a basic tool of finance which is the balance sheet.5 million $5 million As you can see.000 at the end of five years.5 million $2. Credit instruments (bonds or loans) usually have a fixed nominal face value and pay a fixed nominal amount of interest.000 bond bearing 5% interest will receive five annual interest payments of $50 (or more likely ten bi-annual $25 payments) plus a lumpsum payment of $1.5 million shareholder equity). Shareholders are called “residual claimants” because they are entitled to the residual – whatever is left over after all other liabilities have been subtracted from assets. Thus.5 million credit instruments) and net worth ($2. the holder of a five-year $1. ABC Manufacturing Assets Machines & bldgs Total $5 million $5 million Liabilities and net worth Credit instruments (debt) Shares of stock (equity) Total $2. and the sum of each category must be the same – they must balance. the total assets are $5 million as are the total of liabilities ($2.

Now suppose a year has passed and ABC has prospered. This cash could be used to expand the business or it could be paid out to shareholders in the form of dividends.92. assume our company’s machines and buildings have depreciated to a value of $4 million because they have aged and suffered wear and tear. we would substitute distributions to shareholders or partners for consumption and write the equation and instead of saving.5 million. from $2. and then retire those shares in lieu of declaring dividends.76 follows from the basic rule of accounting which says that assets must always be equal to the total of liabilities and shareholder equity. copyright c Warren C. or addition to cash balances. Net worth – the equity of the stockholders – is calculated last and is the number that makes the total on the right-hand column equal to the total on the left. the company has accumulated $3 million in cash. An individual can use cash income for consumption. add reinvestment in the business (acquisition or replacement of capitals goods) plus repayment of any debt income = distributions + ∆cash balances + reinvestment + debt repayment Again we must note that each term in the equation is totaled over a specified time period such as a month.0 million $3. some of which have been retained in the form of cash balances and some used to pay down debt. In addition. much like an individual’s earnings.1 Because of distortions caused by tax laws. It has also accrued earnings (accounting profits).5 million to $5. Since businesses are not organized for the purpose of consumption. Gibson. saving.0 million $5.5 million Assets Machines & bldgs Cash Total Shareholder equity (assets minus liabilities) has more than doubled. Its earnings (income) can be used only three ways.5 million $7. The balance sheet now looks like this: ABC Manufacturing Liabilities and net worth $4. In this case. a quarter or a year.5 million Credit instruments (debt) Shares of stock (equity) Total $2.5 million $7. . 1 Version 0. corporations sometimes buy some of their own shares in the open market.

Investors did not panic when the company was technically insolvent because they were confident that it would grow its way out of this situation. Why does shareholder equity appear on the liability side of the company’s books? The word “equity” has a positive connotation which might lead you to believe it belongs on the asset side of the books but that is not correct. Amazon. which it did. They are counting on high enough future returns to overcome the negative equity and build up enough positive equity to reward their shareholders with future dividends. share repurchases. copyright c Warren C. Gibson. Young companies that are growing rapidly are sometimes in this situation ). You could think of shareholder equity as an expectation that the company will be liquidated some day. or both. . Assuming the assets have been valued accurately. not only have lost all their equity but have seen it turn negative.Chapter 5: The balance sheet 77 Of course. whereupon its assets would be sold and the proceeds distributed to the shareholders. Suppose instead that ABC’s revenues have fallen short of its expenses so that after a year there has not only been no buildup of cash but new debt has been taken on as well. whom we have characterized as residual claimants. if the firm were to close its doors at this point. things may go badly. other things remaining equal.92. We now have this balance sheet: ABC Manufacturing Assets Machines & bldgs Total $4 million $4 million Liabilities and net worth Credit instruments (debt) Shares of stock (equity) Total $5 million -$1 million $4 million The shareholders. Actually. but they would not be liable for the $1 million shortfall because corporate stockholders enjoy limited liability. Version 0. negative stockholder equity is not uncommon and it does not necessarily mean that the company must close its doors. Shareholder equity is of Each remaining share represents a slightly larger fraction of the company and thus its market value is was an example of such a company during its early years (Figure 5). the creditors would only get back $4 million of the $5 million owed to them. Stockholders would get nothing.

com had negative net worth during its early growth years.1: Amazon. Gibson.78 Figure 5.92. copyright c Warren C. Version 0. .

Preferred stock is a class of stock that pays a fixed dividend and is usually redeemable by the company at some specified date and price. Gibson. shareholder equity is the amount that makes assets balance liabilities. But their economic function – to convert savings to capital – is identical. financial institutions. Our examples show that stockholders take on more risk than bondholders but can also reap greater rewards. and QUIBS to name a few. bondholders are paid off before shareholders get anything. And if you check the stock exchange listings. A great variety of hybrid financial instruments have arisen that are neither pure bonds nor pure equity. and would appear on the asset side of their personal balance sheets. . Each is the holder’s asset and the company’s liability. The claims of preferred stockholders precede those of the common stockholders in case of bankruptcy or liquidation but are inferior to the claims of bondholders.2 depicts very broadly the flow of funds among households. QUIBS: Quarterly Interest Bonds.Chapter 5: The balance sheet 79 course an asset to shareholders. debt and equity perform the same basic economic function. MIPS. copyright c Warren C.2 Despite their differences. Stated differently. Stockholders’ equity can increase without any limit when a company prospers or can be wiped out when it performs poorly. Bondholders’ returns are more certain but they do not benefit from the company’s prosperity except in the sense that default becomes less likely.1 The Flow of Funds The diagram in Figure 5. Both are securities or financial instruments. Both provide pooling of resources to purchase capital goods and labor. At the TIGRS: Treasury Investment Growth Receipts. If the company should face bankruptcy or liquidation. though the details vary as we have seen. business firms and governments. you will find a host of hybrid issues identified by whimsical acronyms like TIGRS. Convertible bonds are bonds with attached warrants that entitle holders to purchase shares of stock at a specified price. MIPS: Monthly Income Preferred Securities. 5.92. Both are claims to capital goods. 2 Version 0.

Consumption is. either because (1) they consider them intermediate goods or (2) because such expenditures are coercively funded and therefore do not necessarily reflect the desires of the people who were taxed to provide the funds. as well as government expenditures. Corporations and households both provide savings to the capital markets. Complex as it may appear. weapons. Most government funds are spent for salaries. after all. etc.).3 Some government expenditures flow directly to individuals in the form of transfer payments (Social Security. which is households’ use of disposable personal income for consumption. copyright c Warren C. welfare programs. we are considering Gross domestic product figures are meant to provide an indication of the economic welfare of a nation. this diagram leaves out many details. which is provided by capital markets. Gross domestic product (GDP) consists of this consumption plus investment. . materials. 3 Version 0. etc.80 The Flow of Funds Figure 5. net borrowing by governments. Also.92. and individuals is not shown. the ultimate purpose of all economic activity. Government funding comes from individuals and corporations in the form of taxes. Gibson.2: The flow of funds bottom of the diagram we see the most important flow. For example. Some authors consider the inclusion of government expenditures in GNP problematic. businesses.

amounts that people want to loan and which borrowers want to borrow for purchase of equity or debt instruments in a given time period such as a year. The vertical axis must be a unit price. pension funds have been invested primarily U. S. This fund had performed quite well up until 2008. However. In recent years. . Since we are studying the market for loanable funds. meaning we neglect imports and exports. Gibson. some pension fund such as CalPERS. copyright c Warren C. Households supply most of the savings in a modern economy. but excluding secondary purchases of these instruments. The existence of financial instruments creates a market for monetary saving called the loanable funds market. so the vertical axis of our Version 0. the inducement that gets people to loan money is called interest. State and local governments are savers.Chapter 5: The balance sheet 81 a closed economy. which is a borrower on a massive scale. but what is the price of loanable funds? As in any supply/demand analysis. on average. our diagram will differ somewhat from those you learned about in your basic economics course. government obligations which meant they are loaning their savings to the federal government. have ventured into exotic investments like commodities and real estate. when it suffered a decline of about 40%. the California state employee pension fund. because most are required by law to balance their budgets and to maintain reserve assets to back their pension obligations. it is the price that demanders are willing to pay to get the goods. however. Corporations engage in saving when they use some of their earnings to expand their business or buy other companies. As we said above. Finally. such as corporate or personal savings. Like other markets for goods and services. Ordinary supply/demand diagrams show quantities of some good or service on the horizontal axis and the price per unit of that good or service on the vertical axis. the horizontal axis of our graph represents money or more specifically. This market is a conceptual device broadly conceived to include money used to purchase new issues of both stocks and bonds. Funds are supplied by savers who want to acquire those instruments and are demanded by those who issue them. some flows can be negative. or the price that suppliers want to get for supplying them. this market can be analyzed with a supply-and-demand diagram. Until recently.92.

3: Supply and demand of loanable funds supply/demand diagram will be an interest rate.4 Note that interest rates almost always refer to a time period of one year.92. . it is safe to assume that per annum is intended. represented by the symbol L. as in “a five percent mortgage. Gibson.82 The Flow of Funds Figure 5. you are paying interest at the rate of ten percent per annum (per year). expressed in percent per annum. 4 Version 0. On the horizontal axis we have the quantity of funds demanded or supplied in a given period of time such as a year. as expressed by the Latin phrase per annum. copyright c Warren C.3 shows a supply/demand diagram for loanable funds. Thus if you borrow $100 today and are obliged to repay $110 a year from now. When “per annum” or some phrase like “annual percentage” is not appended to a particular interest rate and there is no other indication of a time period.” Figure 5. On the vertical axis is the composite interest rate expressed in per cent per anThe time period for the quantity on the horizontal axis need not match the one-year time period for interest on the vertical axis.

Again. copyright c Warren C. it is the net issuance of new bonds minus payments for maturing bonds being redeemed by holders.e. represented by the symbol i. For consumers. Attempts to quantify these curves. (2) consumers who are dis-saving. . Demanders of loanable funds fall into three categories: (1) producers who want money to buy capital goods.. We are lumping funds for purchase of stocks and bonds into a single loanable funds market and thus our interest rate is some sort of composite return on stocks and bonds. these are only qualitative and hypothetical in nature. Like all supply and demand curves. spending more than they are receiving in taxes. i. We draw an upward-sloping supply curve LS representing the amounts of money people are willing to supply for purchase of stocks and bonds as a function of the composite interest rate. i. A downward-sloping demand curve LD is the amount of money borrowers wish to acquire. and (3) governments which are running deficits. Higher interest encourages savers to greater quantities of loanable funds.Chapter 5: The balance sheet 83 num. whether they represent loanable funds or any other goods or service.. Higher interest dampens demand for loanable funds. they would soon become obsolete due to changes in circumstances. all three of these are totals for a particular time period such as a year. remember that we are talking about net flows. borrowing money for present consumption.92. However. For producers. it is reasonable to assume that the law of demand and the law of supply prevail. Gibson. run afoul of the simple fact that there is no reliable way to determine how much suppliers would supply or demanders would demand at various hypothetical prices. In each case. where savers supply the funds and companies demand them. And if these numbers could somehow be determined. we could have turned things around and discussed a combined market for stocks and bonds where the roles were Version 0. so that we can confidently draw downward-sloping demand curves and upward-sloping supply curves. materials or labor for production. Instead of presenting the market for loanable funds. For government. it is new borrowing minus repayments of existing loans in a particular time period.e. this means the net of new funds raised minus capital funds returned to investors.

. After the investment (ex post) they face moral hazard (the temptation to take more risks with others’ money than they might with their own). This is very much like the retail/wholesale split that is seen in many markets. These costs drive a wedge between supply and demand and result in less saving than the theoretical equilibrium point would predict under the assumption of zero transaction costs (Figure 5. Not only is lack of information a hindrance to finding exactly the right investment. 5. In a market for stocks and bonds. but before the investment (ex ante) buyers also face adverse selection – the tendency of less reliable borrowers to seek funds. There is a great variety of risk levels. You loan your brother-in-law $100.2 Indirect Finance With direct finance. direct finance is inefficient because lenders and borrowers have difficulty finding one another – the “double coincidence of wants” problem again.92. Gibson. the market for loanable funds lets us see directly the role of a composite interest rate since that is what is shown on the vertical axis. though. Or you buy stock directly from a company through its dividend reinvestment plan. Within the confines of direct exchange. This means that suppliers of loanable funds receive a lower interest rate i1 while recipients pay a higher rate i2 . Or perhaps you buy Treasury Bonds through its Treasury Direct web site.84 Indirect Finance reversed: savers would demand these instruments and companies would supply them. this is exemplified by the emergence of specialists called brokers and dealers. a saver loans directly to a borrower. the role of interest rates would be somewhat obscured. Brokers and dealers match buyers and sellers and can be found not just in finances but in all sorts of busiVersion 0. While this would have been valid.2). maturities (time until a bond or loan is repaid) and amounts of money represented by debt instruments available for purchase in the market for loanable funds. Innovative people who devise new transaction methods are rewarded with profits if market participants perceive the benefits they receive from these new methods to be greater than the price charged by the innovator. In general. copyright c Warren C.

which were once fixed by the government.Chapter 5: The balance sheet 6 85 5 4 P 3 2 1 0 0 2 4 6 8 10 12 14 16 Q Figure 5. copyright c Warren C. bonds. In addition. brokers and dealers match buyers and sellers of stocks. Stock brokers. Gibson. In the financial world. Version 0. and other financial instruments. operating through various stock exchanges.92. mortgages. have fallen dramatically while service has improved. with greatly reduced transaction costs. restaurant supplies. . Many of them now operate on the internet. Customers using stockbrokers’ web sites now routinely see their trades completed in seconds. nesses: scrap iron. find home buyers who want mortgage loans and match them with banks and other institutions that have funds to loan. Mortgage brokers. Costs of stock transactions. match buyers and sellers of stocks. paying perhaps $10 for a transaction that might have cost $100 (not adjusted for price inflation) prior to the 1975 deregulation of brokerage commissions. customers now get free access to vast quantities of research data which was difficult to get in 1975. musicians for hire.4: Transaction costs drive a wedge between interest paid and interest received. for example.

1. Until this process is complete. but we assure you we will do our best to move forward as quickly as possible. Michael Milken was an innovator who was chiefly responsible for the emergence of “junk bonds” in the 1980’ and when they plan to pay it back. because regulators had caught up with them..86 Indirect Finance So-called “junk bonds” are a financial innovation that appeared relatively recently. . But as of Jan. This notice appeared: Prosper has started a process to register. One of the determinants of the rate of interest on a particular bond is the risk of default. Milken opened up a new avenue of finance which provided enormous benefits to the economy. prospective borrowers register. Bonds with higher risk carry higher interest rates as compensation for that risk. At this site.. Prospective lenders can bid on all or part of a particular loan request. copyright c Warren C. Interest rates are very high. promissory notes that may be offered and sold to lenders through our site in the future. yet he was convicted and sent to jail on dubious charges of securities fraud. Until we complete the registration process. we’re required to be in a quiet period and will be unable to respond to press. with the appropriate securities authorities. Gibson. and lenders are advised to invest only small amounts in many individual loans. If they are accepted as borrowing members. “high-yield bonds” is a more polite term. suggesting a high degree of risk. they can post requests for loans in which they state the amount they want. on-line services have appeared that match borrowers and lenders. we will not accept new lender registrations or allow new commitments from existing lenders . One of these is called prosper. why they need it. and their credit reports are examined by the site. blogger or other inquiries about Prosper or the registration filing until it becomes effective. A successful registration can take several months. Even more recently.92. The term “junk” is a sardonic reference to the low credit quality and consequent high interest rate of these bonds. 2009. Version 0. the site had suspended all activity.

Business loans were quite another matter. governments still use the concept to justify intervention into loan Version 0. guitars. They are willing to pay someone to do the whole job for them. Organizations that perform these services are called financial intermediaries. even with the advice of a broker or will be able to complete its registration or whether the costs and restrictions they might suffer would be enough to put them out of business. but the Church’s attitude remained. Banks in Muslim countries to this day find creative ways to skirt the continuing prohibition of interest by Islamic law.Chapter 5: The balance sheet 87 There is no way of knowing whether prosper. Many investors do not want the responsibility of choosing and monitoring a borrower. at least in the Western world. More significant than these innovations was the development of indirect finance. If they default on the loans. They borrow funds from willing lenders. Gibson. While religious strictures against usury have faded. The early merchant banks got around this restriction by offering shares rather than by borrowing money. People bring almost anything of value to pawn brokers – jewelry. golf clubs – as security for personal loans. pool the proceeds.92. Pawn brokers were an early form of financial intermediary and still occupy a niche in today’s financial scene. since borrowers were generally not poor at all. and this “spread” is the source of their income. They faced numerous government restrictions as well as a complete prohibition of interest by the Catholic Church. The interest rate that they charge to borrowers is higher than the interest they pay to lenders. While usury is mentioned in the Bible. copyright c Warren C. so that only high rates of interest would induce borrowers to lend. This hastened the development of corporations. Their services make the flow of funds in the loan market much more liquid than it would be otherwise. which usually raise most of their capital in the form of equity. These high rates of interest ran afoul of the requirement that the faithful be kind and generous to the poor. the pawnbrokers sell the security. . Merchant banks were an early form of financial intermediary that arose in medieval Italy. this prohibition probably drew its strength more from the fact that most loans were made to poor people who were likely to default. and lend to willing borrowers.

that they are set below the market-clearing rate.. as in Figure 5. blur this distinction through what is called fractional reserve banking. Flowof-funds diagrams can be used to track these flows on a national level.92. increased cash balances. direct finance.e. There are many laws that forbid a willing lender and a willing borrower to complete a transaction in various circumstances if the interest rate exceeds the legal ceiling. Like all price ceilings. Gibson.2. these limits gave rise to shortages. Version 0. provided they are binding. however. Banks. Thus far we have maintained an analytical distinction between demand and supply of money versus the supply and demand for saving or for loanable funds. and/or investment.88 Indirect Finance markets in the form of interest rate ceilings. . i. We have said that all income goes to consumption. copyright c Warren C. and indirect finance. Investment in turn can be divided into acquisition of capital goods (real investment). which we will take up next.

had good reputations. This was a natural extension of the goldsmiths’ business since they were familiar with the various forms of specie. meaning the holder of a receipt could go to the goldsmith at any time during business hours and demand to exchange it for gold or silver.1 Origins Gold warehouses began to appear in England in the 17th century. A T-account for a goldsmith (ignoring equity) might look like this: 89 . The goldsmith charged a fee for his services which the customers were willing to pay for the benefits of increased convenience and security. although deposit banking existed in China as early as 1000 AD. but the assets in storage were redeemable on demand. were an asset of one party (their holder) and a liability of another (the goldsmith). and were equipped with storage vaults. like any credit instrument. When customers left their gold or silver. These instruments had no specified maturity. As a direct outgrowth of the emergence of specie (gold and silver) as money. the goldsmith issued a paper receipt which could be used later to redeem the goods.Chapter 6 Fractional reserve banking 6. These receipts. merchants began to deposit their gold and silver with goldsmiths for safekeeping.

they asked themselves how they might put these seemingly idle resources to work. Being profit-seeking businessmen. However.000 £5.000 £5. of course. Not only were fewer trips to the goldsmith necessary but there was also less wear and tear on coins. and then presenting it to the seller who might then return it to the very same goldsmith. A more moderate course of action. but as we have seen. redeeming some specie. They became popular because they reduced transaction costs. As warehouse receipts became more common.000 Ignoring wear and tear on coins and their occasional loss in disasters and shipwrecks.92. when they function as money they are not used up as grain is. Gibson. If grain is not used fairly quickly it will rot. They circulated like money since they could be transferred from person to person – they were negotiable.90 William the Goldsmith Assets Liabilities and net worth Gold Total £5.000 Origins These services were similar to warehouse services provided for owners of commodities like grain. but with one difference. but merely pass from hand to hand. such crimes would be discovered sooner or later and they would be out of business. Version 0.000 Receipts issued Total £5. They could.000 Receipts issued Total £5. copyright c Warren C. one that may or may not have violated the expressed or implied contract between them and their customers.1 In addition. This saved the holder the trouble of going to the goldsmith. goldsmiths began to notice that specie seldom left their vaults.000 £5. his balance sheet would become William the Goldsmith Assets Liabilities and net worth Gold Loans Total 1 £2. Thus if the goldsmith from the example above were to loan out half his gold. simply embezzle it – take it and spend it for themselves. Not only are gold and silver highly durable. was to loan it out. or worse. holders of receipts who needed money to buy something would often just use a warehouse receipt to pay for it. .500 £2. Warehouse receipts thus began to function as money substitutes.500 £5.

Idle cash balances are put to work as investments. there were other and more important benefits and risks that accompanied fractional reserve banking. The goldsmith’s liabilities are all payable in gold on demand. copyright c Warren C. With competition. Our goldsmith’s assets and liabilities balance in terms of amounts. 6. he was “borrowing short and lending long. The economy as a whole enjoys a net gain from the introduction of fractional reserve banking. but the T-account fails to show an important imbalance: their time structure.Chapter 6: Fractional reserve banking 91 Now William the Goldsmith was in the credit business – he has become a financial intermediary or more briefly. but to the extent that some of the gold and silver that was released from the vaults went into consumption uses – jewelry and such – there was a real Version 0. But paper money could be used in a 100% reserve system as well. Of course.3. a banker. Leaving aside the shift to paper money. Now our goldsmith or banker has a new source of revenue: interest earned on loans.92. but the spread is held down by competition. the two developments are conceptually distinct. but his loans could not usually be called in quickly or easily. We have said that increases in the money stock confer no net social benefit. Here we have a rudimentary form of fractional reserve banking. so that although paper money and fractional reserve banking evolved more or less in parallel.2 Effects of fractional reserve banking The most apparent effect of fractional reserve banking was an increase in the use of paper money which reduced transaction costs substantially. Gibson. Customers no longer pay the goldsmith to store specie but instead are paid by the goldsmith/banker for the opportunity to loan out most of the funds they deposit. this interest must be less than the loan interest received by the banker.” and this became an important problem of bank management. half) of his liabilities. In short. Goldsmiths’ warehouse receipts came to be called bank notes like the one shown in Figure 6. some of this new income is passed on to depositors. The payment consists of interest paid on the deposit. His reserves – the gold actually remaining in his warehouse – were only a fraction (in this case. .

knowing that a few passengers usually don’t show up. Companies that provide services over the internet – including banks! – do not provide sufficient server capacity to accommodate all their online customers simultaneously. This situation is called illiquidity. for example. Bank runs have historically featured long lines of anxious depositors waiting to get into the bank. As an aside. copyright c Warren C. To be sure. other depositors will notice this and join in with demands for redemption. but since some of those assets are in the form of long-term loans which cannot easily or quickly be converted to cash. but the cost is a temporary dislocation during the time that money substitutes are expanding relative to reserves. We have listed the benefits of fractional reserve banking. which are flows. They sell more seats than are available on a flight.92. these examples are not perfect analogies because they are examples of flows whereas bank deposits are stocks. The first people in line get all their money and the last get none. typically “overbook” their flights. telephone systems. some critical number of depositors begin to doubt the ability of the bank to honor its redemption obligations. They are not completely analogous because they represent services. it may be unable to satisfy a crowd of depositors clamoring for redemption. and cafeterias offer further examples which are at least partly analogous to fractional reserve banking. and this of course is the source of the urgency. A run is usually a sudden and dramatic event and therefore quite difficult to anticipate. This gain is permanent. Airlines.2 The classic Jimmy Stewart movie “It’s a Wonderful Life” includes a dramatic bank run scene.92 Effects of fractional reserve banking net benefit. The bank may actually have sufficient assets to cover its liabilities to the depositors. If for some reason. the airline company offers compensation to anyone willing to give up his seat. 2 Version 0. . notice that in our modern economy many businesses have adopted policies similar to fractional reserve banking. as purchasing power shifts from holders of money to bankers. If they all show up. now what about its drawbacks? The primary hazard of fractional reserve banking is the possibility of a run on the bank. knowing that it is most unlikely that they all will try to log in at once. whereas bank deposits are stocks. Gibson. Roads.

a move from 100% reserves to fractional reserves increases the money stock and therefore. copyright c Warren C. Of course. such as e-gold.Chapter 6: Fractional reserve banking 93 A second hazard is the risk of insolvency. since often the circumstances of a particular borrower are unique. which are set by supply and demand. On a macroeconomic level.000 on its balance sheet. it writes off the loan. raises the price level.2). Assets can lose value for a variety of reasons. As an aside.000. but most notably when borrowers default on their loans or seem likely to do so.92. However. if a bank holds $1. Similarly. and their share prices. . note that people who fear bank runs can still obtain something like 100% reserve banking.) An illiquid bank cannot meet depositors’ demands in the short run. valued at over $21 billion at year-end 2008. other things being equal. In our example above. Online transfer services that denominate their payments in gold.3 (All large modern banks are stuck with a certain number of what are called non-performing loans. The SPDR Gold Shares Trust now holds about 25 million ounces of gold in its warehouse (Figure 6.5 cents on the dollar. it can adjust the value of these bonds to $985. These exchange-traded funds are traded on the New York Stock Exchange. Most present-day commercial banks offer safe deposit boxes for rent where one can store gold or any other small valuables. when the goldsmith made his When a bank decides that a loan will never be paid back. A bank becomes insolvent when circumstances cause its liabilities to exceed its assets. removing it from its list of assets.000 in Treasury notes which are currently trading at 98. For example. Nor do they aggregate people’s gold coins. some bank assets are actively traded which makes it easy to assign a value to them. have not been particularly successful. the iShares Silver Trust held about 220 million ounces of silver. exchange-traded funds that buy and store gold and silver bullion have been spectacularly successful. Gibson. may be more or less than the market value of their per-share bullion holdings. It is not always clear when a particular loan should be written off. 3 Version 0. but such loans amount to less than 1% of outstanding loans in a well-run bank. banks do not issue “warehouse receipts” for the “deposits” that go into these boxes. An insolvent bank cannot meet them in the short run or the long run. In contrast. which would be a further cost saving under true 100% reserve banking. This adjustment process is called marking to market. valued at some $2 billion.

1: Gold bullion stored in the warehouse of the SPDR Gold Shares Trust.000. You may see this more clearly if you envision the bank loaning out its own notes instead of loaning out gold – the result is identical.000 £100. The bars each contain 400 ounces of gold. Either way. and if gold is lent out. some of it will be deposited in exchange for banknotes. .000 £100.500.000 Notes Total £100. some will be returned for redemption in gold. 4 Version 0.92. as it once did. Consider now a hypothetical economy in which gold in circulation as money amounts to £1. The aggregate balance sheet for these banks (excluding capital which will be discussed later) is Aggregate bank balances in a gold economy Gold Total £100.4 Suppose banks hold £100. If banknotes are lent out. first loan.000. In our example we assume a pound stands for a certain weight of gold. the money stock went up by £2.000 Now banks as a whole reduce their reserve ratio from 100% to 20% – they issue new loans until they reach a point where the gold they hold equals to £ is the symbol for the British pound sterling.94 Effects of fractional reserve banking Figure 6. the market will approach the same equilibrium in which some of the new money is in banknote form and some is in specie form. copyright c Warren C. valued at about a third of a million dollars.000 of that sum and have issued banknotes 100% backed by that gold. Gibson.

000 prior to the expansion and was then increased by £400. . however. private banks create money. the greater the amount of new money that is created when new deposits are made.400.000 £400. Private banks cannot. Gibson. The balance sheet becomes: Aggregate bank balances in a gold economy Gold Loans Total £100. create money on a whim as government central banks can.000.000 in notes for the same total of £1. since they are not available for use as a general medium of exchange.000 Previously issued notes Newly issued notes Total £100. when deposits shrink and and there are no excess reserves. on average. We can get the same sum by observing how much money is in circulation after the expansion: £900. all deposits are converted to reserves. other things being equal.000 = 20%.000 £500. the borrower counts that $90 as part of his money stock. or £100.000 £400.000 – the amount of the newly issued notes. Note that reserves are not counted as part of the money stock.Chapter 6: Fractional reserve banking 20% of their total liabilities. What has happened to the total money stock? It was £1. copyright c Warren C. Furthermore. $100 has been converted to $190 through the bank’s fractional reserve practice.000 £500. If $90 of that deposit is loaned out. Private banks create money when they increase their deposits and loan out all but a fraction of those funds.92.000/£500. The lower the reserve ratio.000. We have now uncovered an important insight: in a fractional reserve system. Banks usually do not hold much in the way of “excess reserves” which are reserves above and beyond the statutory minimum.000 in specie and £500.000 95 The aggregate reserve ratio for these banks is equal to the gold in reserve divided by total notes outstanding. They can only do so when they attract new deposits and choose to loan out some of these deposits rather than adding them all to reserves. because they forgo interest income on these funds if they do. Also note that 100% reserve banking does not increase the money stock since under this rule. Someone who deposits $100 in a bank counts that $100 as part of his money stock. banks must call in some loans Version 0.

electronics firms – face declining costs. at least for the short run. There is another way to look at the benefits of fractional reserve banking. But since gold. What happens to the price level when fractional-reserve banking replaces 100% reserve banking? The increased money stock causes a rise in the price level and a decline in the purchasing power of money. Under a gold standard. Recall that we are posing a situation where fractional reserve banking arises spontaneously on the market without any government involvement. copyright c Warren C. conventional accounting profits equal to the going rate of interest. usually do so gradually. Everyone benefits. Recall that commodity money entails resource costs. . as we are assuming here.92. However. Users of gold – jewelers. society as a whole benefits. dentists. it could be very disruptive. called their spread. institutions that arise via spontaneous order. The difference between the interest they charge on loans and the interest they pay on deposits. Profit-seeking bankers have discovered a way to reduce the cost of the monetary system and enjoy enhanced profits. Now we might ask whether private banks enjoy gains from money creation comparable to the seignorage that governments and central banks enjoy when they create money. If a single bank were to introduce fractional-reserve banking in a formerly 100% reserve market. the rise of fractional-reserve banking frees up some gold for consumption that otherwise would have been used as money. and when they do so they shrink the money stock. The answer lies in the fact that private banks operate in a competitive market. the PPM is the price of gold. and spreads would tend toward an equilibrium level of zero economic profits. is used for consumption as well as for money. The resource cost of gold sitting idle in banks is an opportunity cost because that gold cannot 5 That is.96 Effects of fractional reserve banking in order to maintain required reserves.5 Subsequent increases in loan volume would yield approximately this same level of profits. it would enjoy a one-time boost in profits. But competing banks would follow suit. or any commodity money. In other words. Gibson. Of course. and competitive pressures transfer some of that benefit to consumers. Version 0. if a transition to fractional-reserve banking were sudden. is the primary source of banks’ profits.

much as the receipt you get from the dry cleaner represents your ownership of the suede jacket you left there for cleaning. . First.92. However. governments have interjected themselves heavily into the banking industry as we shall see in subsequent chapters. they are redeemable. If you carry large amounts of negotiable banknotes you may find their bulk to be inconvenient. you may be robbed. that entitle the person receiving the check to redeem it for money at the bank on which the check was drawn.” meaning whoever physically possessed the check. In the past. The first checks were made out to the “bearer. Whereas a banknote is a liability of the bank of issue and will always be redeemable as long as the bank has sufficient specie in its vault. sometimes called drafts. The check can be drawn in any amount that is less than the check-writer’s current account balance. paper is more convenient than gold because it is lighter in weight and can be folded. checks were generally accepted only by payees who knew the payer’s reputation or had some conVersion 0. but bearer checks have one important distinction vis-a-vis banknotes. Though they are mere paper and ink. Thus there is a greater risk of not getting your money when you accept payment in the form of a check rather than banknotes. Second. the last word in convenience. The holder of such an account can write checks. Bank notes are also spendable by their bearer. not involving government action. and worse. Finally. however.Chapter 6: Fractional reserve banking 97 be used to adorn women. or coat the connectors of printed circuit boards. copyright c Warren C. Profit-motivated banks began to offer a solution to this problem in the form of checkable deposit accounts. Banknotes are not. they represent a promise to pay specie on demand. Gibson. they are negotiable. Banknotes have several features that make them attractive as money. meaning they can be exchanged from one person to another without any noticeable transaction costs. Gold released from bank vaults can of course fulfill these functions. a check is a liability of the account holder and is only redeemable as long as the bank is liquid and the account holder has sufficient funds in his checking account. Notice that the advent of fractional reserve banking is yet another example of spontaneous order. fill teeth. The paper and ink used to create money substitutes constitute very small resource costs and electronic transfer systems are even more efficient.

Fifty years ago. the answer is almost certainly no. banks have also instituted steep penalties for “bouncing” checks.98 Effects of fractional reserve banking tinuing relationship with the payer such as an electric utility has with its customers. There are two sources of redemption that tend to “discipline” banks against excessive issues of new liabilities. Technically such checks can be negotiated somewhat like bearer checks. These penalties tend to discourage people from writing bad checks (colloquially called “rubber” checks). Jones can write “pay to the order of Brown” on the back and sign his name and then use the check to pay Brown. But this seldom happens because the amount Jones wants to pay Brown is not likely to be equal to the amount of the check that Smith wrote the check for. Also. People will increase their redemptions of Bank A’s notes or hasten to cash checks drawn on Bank A if they have doubts about its liquidity or worse. . not to the bearer. copyright c Warren C.92. stores did not accept checks in payment for purchases. and so on. Consider Bank A. We will discuss modern mechanisms for clearing checks in Chapter 12. Could unregulated fractional-reserve banks create new money without limit? Could they cause hyperinflation – a collapse in the value of money and a runaway acceleration of price inflation? Absent government interference. Brown then takes the check to the bank for redemption. The first is that in the long run banks would not be able to issue more notes and deposits than the public wants to hold.e. not as long as their notes and deposits remain redeemable. If Smith writes a check payable to Jones. its solvency. Gibson. such doubts can Version 0. Such checks can only be redeemed by the person or firm to whom they are made out and this makes it relatively safe to send checks in the mail. whether in the form of bank notes or deposits. Nowadays we almost always make checks payable to a particular person or business firm. a note-issuing bank that maintains fractional gold reserves. As we have seen. Now electronic check validation systems have been invented to make this form of payment much more attractive. Anyone holding a note issued by Bank A can take it to that bank and demand gold. Anyone holding a check drawn on Bank A can likewise present it for redemption in gold.. Or Brown could endorse the check over to Green. returning checks for which the account holder has insufficient funds. provided the account on which the check is drawn has sufficient funds. i.

These redemption activities are called clearing. and its viability is upheld by historical episodes in Scotland. 7 Do not confuse reserves with reserve requirements. If that level is too high. Second. S. fractional reserve banking. as we have not yet introduced government into the picture. clearing houses arose which specialized in offsetting the obligations among the various banks within a particular geographic area. causing a run on the bank. The banks whose managers are most skilled at reducing the risk of a run will be able to reduce reserves and thereby increase profits. their profits will suffer. nearly all such banks functioned as fractional reserve banks. Bank B will take these to Bank A and present them for redemption. copyright c Warren C. banks. We will say more about reserve requirements in our study of central banking in Chapter 12. Gibson. If they suffer a run and they have no insurance or other strategy for mitigating the run. While reserve requirements are imposed on some kinds of accounts at U. and vice versa. Sweden. there are no government-imposed reserve requirements in Canada or Switzerland. Canada and elsewhere. they risk a run. they go out of business and the bank owners lose their investment and the employees likely lose their jobs. again raising the possibility of a bank run.Chapter 6: Fractional reserve banking 99 spread like a virus from person to person. . such as Bank B. and in order to increase the efficiency of clearing operations. We must emphasize that these are purely market phenomena. Historically. This arrangement – competitive issue of banknotes and deposits by private unregulated banks – is called free banking.92. people may deposit banknotes and checks from Bank A into another banks. once established. While the price level is necessarily higher under fractional-reserve banking than under 100% reserve banking. So the willingness of customers to hold banknotes and deposits plus the competition of other banks and the possibility of adverse clearings serve to restrain banks against excessive increases of the money stock. If it is too low. 6 Version 0. The latter are minimum amounts of reserves that governments force banks to hold. So fractional-reserve banks have an incentive to hold an optimal level of reserves.7 Those who are most successful over time acquire a reputation which enhances their prospects of continued success. does not lead to sustained price inflation In the normal course of business Bank A will have some of Bank B’s notes and checks that it wants to redeem.6 Banks are in business to make a profit.

may be the best option in a bad situation. But perhaps depositors have some obligation to inquire as to the soundness of any bank with which they do business. The possibility of bank panics calls forth a public-interest justification for government regulation of banks. which in the U.5). but what about a contagion of bank runs. and in fact banks in the U. they can rely on information obtained from specialists who are. government agencies that regulate banks. . including banks that are quite solvent. Individual bank runs are one thing. known as a bank panic? A panic might arise if all banks had inflated their liabilities in concert. In our subsequent study of international banking and finance. This is unsupported by historical experience. the Federal Deposit Insurance Corporation and the Comptroller of the Currency. the most important government regulatory institution in all nations is its central bank. They further argue that fractional reserve banking is inherently unstable.S. The Federal Reserve System will be examined in detail in Chapter 16. to the point where overall confidence in the system broke down. But any doubts about fraud could easily be cured by full disclosure on the part of the bank. If they are not personally capable of evaluating a bank.8 The threat of bank runs constitutes a powerful and healthy discipline constraining the actions of managers of unregulated banks. They constitute a form of market discipline imposed on poorly managed banks which though painful to some. Later we will encounter two U. and elsewhere are now heavily regulated. Central banks will be our next topic.S. 8 Version 0. we will see how discipline could be imposed by foreign banks demanding redemption. Of course. as do the bank’s shareholders if it is forced to cease operations. and in some countries they are governmentowned. is the Federal Reserve System. depositors suffer when a run erupts.S. copyright c Warren C. Some advocates of “hard money” argue that fractional reserve banking is fraudulent.100 Effects of fractional reserve banking partly because reserve levels did not normally fluctuate much. A world-wide panic is difficult to imagine but is theoretically possible.92. Gibson. since the same money seems to be in the possession of both the depositor and the loan recipient (Section 7. just as liquidation or bankruptcy may be the best option for a failing business firm. However. Or some natural disaster might spread fear and distrust and lead to a run on all banks.

Gradually. The solution hit upon by governments was to monopolize banking just as they had earlier monopolized the business of minting coins. government seignorage revenue began to decline. copyright c Warren C. having been chartered by the Crown to finance English wars. As we have already mentioned. we see that bank-created money is not part of the seignorage “tax base” and so the government misses out on some of the easy revenue it might otherwise have enjoyed. The first was a grant of a monopoly on note issues. But what exactly is a central bank? A private institution whose clients are ordinary commercial banks – a banker’s bank. Central banks were allowed to stop fulfilling their contractual obligation to redeem their banknotes on de- Version 0. this situation constitutes a major incentive that gives rise to the creation of central banks. But two other privileges emerged as the most important. It commenced operations in 1694. Recalling that seignorage is effectively a tax on cash balances. which had become accustomed to seignorage as an easy source of revenue. Sometimes governments insist that taxes be paid in notes issued by its central bank. the possibility of bank panics provides a public interest justification for these institutions. could be called a central bank. The Bank of England was one of the first central banks.3 The Government Central Bank Fractional reserve banking. With an increasing share of the new money entering an economy now coming from private fractional reserve banks outside of government control. But for our discussion. a second privilege was granted.92. we will define a central bank as any bank that enjoys some monopoly privilege conferred by a government. Central banks have enjoyed a variety of privileges over time.Chapter 6: Fractional reserve banking 101 6. From a public choice point of view. The Bank loaned money to the government in return for special privileges. and the government was able to recapture the seignorage that had been lost when fractionally backed private notes were issued. Gibson. at least in relative terms. The means to accomplish this new monopoly was a central bank. Private banks we forbidden to engage in this business. posed a problem for governments. created by private banks in a process of spontaneous order. .

In a purely fiat money system. Central bank ($ billions) Assets Liabilities Loans Total 850 850 Currency Reserves Total 775 75 850 Currency belongs on the liability side of the central bank’s balance sheet. or it will trade worn-out bills for new ones. gaining for governments a second way to issue fiat money in addition to direct issues of fiat money by the government Treasury. Now assume the private banking system is represented by this highly simplified balance sheet. . but that is all. such as that shown in Figure 6. physical assets and equity capital: Private banking system ($ billion) Assets Liabilities Reserves Loans Total 75 675 750 Deposits Total 750 750 Version 0. Gibson. This is because fiat money cannot be redeemed or exchanged for anything but more fiat money. copyright c Warren C.2. All the nations of the world now have fiat money systems and notes issued by central banks constitute almost the entire money stock. the Fed. Let us examine simplified and rounded-off versions of the balance sheets of the central bank. reserves are simply bookkeeping entries rather than currency or specie.102 The Government Central Bank mand. the central bank becomes a de facto government agency. We will add complications later. Reserves are assets of private banks and liabilities of the central bank. Through this process. which omits vault cash. but it is unlike any liability of a private firm. Such banknotes thereby ceased being true bank notes and became fiat money instead. and private banks using 2005 figures.92. The central bank may accept your fiat money and give you different denominations in exchange.

Thus silver and gold continued to play a diminishing role in the U. the Federal Reserve System did in fact issue redeemable gold notes. Hence there is no wealth effect or welfare gain from money creation. where it is multiplied by the process we have seen. a fractional-reserve policy reduces resource costs. Recall that under a gold standard. This shows that when a central bank issues more fiat money under fractional reserve banking.S.” We prefer “money stock” because we are referring to the total existence at any particular time. Gibson. 9 Version 0.Chapter 6: Fractional reserve banking 103 In this situation the total money stock9 consists of $750 billion in deposits plus $760 billion in currency in the hands of the public (the $5 billion in vault cash does not count) for a total of $1. They are not part of the money stock because they cannot be spent. they are not a medium of exchange. . What happens if a central bank promises to redeem some or all of its notes for specie? Early in its history. The diagram below shows that fiat money consists of currency plus reserves. and that deposits are a multiple of reserves. but there are nevertheless distribution effects. use the term “money supply. Note a potential source of confusion here in that reserves are a form of fiat money but they are not part of the money stock. and we reserve “supply” to denote flows. money system between Some authors. Central banking can exist without fiat money. copyright c Warren C.525 billion.92. there is a multiple expansion of the money stock since some of the new money makes its way into banks. and the Treasury redeemed its notes for silver prior to 1933. Under a fiat money standard. fractional reserves do not entail any such saving because there are no resource costs. particularly financial journalists.

Gibson. money and gold.104 The Government Central Bank the Fed’s 1916 inauguration and the 1971 severing of the last link between U.7% (not the ratio of reserves to total assets which would be 3/42).0 and the private banking system is represented by this simplified balance sheet: Private banking system ($ billion) Assets F. In this intermediate situation there were actually three tiers or levels of money.S. At the top level. notes & gold Loans Total 3 39 42 Liabilities Deposits Total 42 42 Notice the reserve ratio is reserves divided by loans = 3/39 = 7.R.0 4. copyright c Warren C. Finally.5 4.92.5 2.0 Fiat money Total 4.5 ) Gold in circulation Federal Reserve notes Subtotal (potential reserves) Subtract actual reserves Currency Add deposits Total money stock 3 4 7 -3 4 42 46 Version 0. we have the money stock represented by these figures (refer to the diagram on the previous page for the source of these numbers): Total money stock (monetary gold: 4. . we have the Fed’s simplified balance sheet looking like this Central bank ($ billion) Liabilities Assets Gold Loans Total 1.

4.2: Federal Reserve assets for year-end 2007 and 2008.92.2 and 6.071 Inflation compensation 5.680 1.904 Source: Federal Reserve Table H.037 2. Treasury 475.701 Figure 6. We have chosen not to use the usual T format. repurchase agreements. The decline is due to open-market sales of some Version 0. i.423 Notes and bonds.688 Dec 2007 11.3 present consolidated Federal Reserve balance sheets for 2007 and 2008. term auction credit.e.711 925.102 Net portfolio holdings of Maiden Lane LLC’s 73.037 2.984 36.723 Securities held outright 495.925 Items in process of collection 979 Bank premises 2.921 Bills 18.200 1.911 4. .200 1.597. copyright c Warren C.627 78. so as to highlight the drastic changes that took place during 2007 and 2008.134 66. The most significant items are these • “Treasury securities held outright” are securities (bills.057 Total assets 2.1 0 0 (192) 2. Figures 6.708 Repurchase agreements 80.S.146 740.Chapter 6: Fractional reserve banking Dec 2008 11.923 186. These sums represent debt that has been monetized. and other loans 1.491 Notes and bonds.265.916 470.750 4..936 Federal agency 19.219 Other loans 193. Gibson.000 Term auction credit 450. bonds) that the Fed has acquired by open market operations (section 16. notes.1).3.630 105 Gold certificate account Special drawing rights certificate account Coin Securities. nominal 410.219.629 U. inflation-indexed 41. paid for with newly created money.892 0 56.194 Other assets 620.627 740.874 Net portfolio holdings of Commercial Paper Funding Facility LLC 334.

• Three LLC’s have been set up under the name “Maiden Lane. . an insurance company that had expanded into this and other forms of derivative securities. The Treasury has recently borrowed much more than it needs to meet Version 0. The second was used to purchase mortgage-backed securities from American International Group. Gibson. The most important liabilities are these • “Currency in circulation:” technically this item belongs on the liability side but in fact.” The first advanced funds to JPMorgan to acquire Bear Stearns. There is no actual or potential obligation to pay anything as there is with ordinary liabilities.92.” • “Commercial paper LLC” is a limited liability corporation that was set up in the fall of 2008 when the market for commercial paper dried up. Most of this item is collateral that has been accepted for loans made to depository institutions under the new Term Auction Facility. copyright c Warren C.106 of these securities. • “Other Federal Reserve assets” are primarily securities denominated in foreign currencies. • “Deposits other than reserve holdings” consists mostly of funds that the Treasury has deposited at the Fed to support bailout operations. Federal Reserve Notes are not redeemable for anything but more such notes. a “temporary” program to assist depository institutions that are “in generally sound financial condition” and “are expected to remain so over the terms of TAF loans. threatening corporations which rely on them for short-term financing as well as money market funds and other institutionss that buy them as safe. short-term assets. The third purchase collateralized debt obligations from AIG. an investment bank that was on the brink of failure. The Government Central Bank • “Term auction credit” is an item that barely existed in 2007.

92.Depository institutions -. But it also likely reflects banks’ wariness about making loans in a recessionary environment.034 860.168 88.753 Dec 2007 849. This gold reserve is valued at $42.365 21.227 107 21.984 819. both required and excess.728 2.223.22 per Version 0.071 16.221 (2. Another interesting Fed asset is its gold stock.517 Figure 6.058 289. Gibson.716 88.325 1.352 1.404 118. Excess reserves skyrocketed at the end of 2008.317 1.190 14.152 21.4. Treasury.241. thereby making them more attractive to hold than they formerly were. • “Reserve balances” are commercial bank reserves.248.Foreign official -.085 (2.S.076 0 42.471) 31.Other Deferred availability cash items Other liabilities and accrued dividends Total liabilities Capital accounts Capital paid in Surplus Other capital accounts Total capital Source: Federal Reserve Table H. current expenditures. supplementary financing account -. This was in part due to a policy change whereby the Fed pays interest on reserves. This is a holdover from the time prior to 1965 when some Federal Reserve notes were redeemable in gold. .U. general account -.S.600 42.537) 33.U.1 Dec 2008 853.Chapter 6: Fractional reserve banking Liabilities Federal Reserve notes Reverse repurchase agreements Deposits -. valued at $11.3: Federal Reserve liabilities for year-end 2007 and 2008.076 21.000 106.673 2.247 1. copyright c Warren C.846 4.216.123 259. Treasury. taking advantage of its opportunity to do so at historically low rates.041 million.

4: Gold note issued by a private bank. . Gibson. copyright c Warren C. Version 0.8 billion rather than a paltry $11 billion. 1874 ounce which was the arbitrary price that the government fixed just prior to severing the last link between the dollar and gold in 1971. would be worth about $126.92. The government is holding about 261 million which at today’s market price of about $485 per ounce.108 The Government Central Bank Figure 6.

Treasury banknotes. Gibson. 1880 Version 0. ca. copyright c Warren C. S. .92.Chapter 6: Fractional reserve banking 109 Figure 6.5: U.6: Silver certificate issue by the U. 1880 Figure 6. S. Treasury.

7: Federal Reserve note. 1914 Version 0.92.110 The Government Central Bank Figure 6. copyright c Warren C. Gibson. .

Fiat money can be (a) created and spent directly by the government. They were high-powered because of their redeemability but were also inside money since they were a Fed liability. outside money is not always identical to high-powered money.Chapter 7 The Varieties of Money: a Critical Comparison In Chapter 6 we saw how banks “pyramid” money on top of reserves of fiat money or commodity money. Thus. which issues $200 in new banknotes covered by those coins. The new banknotes are money substitutes or inside money. We Actually. High-powered or outside money can be either commodity money or fiat money. 1 111 . You then deposit them in a bank. or conceivably (c) issued by private institutions. High-powered money is also called outside money because it lies outside the banking system. suppose you possess ten $20 gold coins: this is high-powered or outside money. while money substitutes are called inside money. Federal Reserve notes were once redeemable for gold. These forms of money have the power to be multiplied when they are deposited in a bank.1 Fiat money comes in two forms: bills (notes) and coins. Economists refer to both fiat money and commodity money as high-powered money because they have the “power” to be multiplied when they enter the banking system. Contrast high-powered money with money substitutes which are issued by banks and are redeemable on demand for high-powered money. (b) issued by the Central Bank.

At this writing.53 cents per nickel. This is not enough time to assess the long-term viability of the fiat-money system. it had not passed the Senate. 7.112 Fiat Money Versus Commodity Money will use the term currency to refer to these two forms collectively. These are issued by American Express and other private companies and are used by people who plan to travel to foreign countries where their U. But as we saw in Section 6. travelers’ checks are counted as part of the money stock.S. In 2008. 3 In Hong Kong and Scotland. for example. they are only spent once.S.3 The closest thing we have to private banknotes are travelers’ checks. .1 Fiat Money Versus Commodity Money Only about 35 years have elapsed since the whole world embarked upon a pure fiat money regime. Since it costs a little over three cents to produce and distribute a new quarter. The mint faced a similar situation in the 1970’s when pennies were mostly copper and the price of copper rose sharply. government has According to the Bureau of the Mint.S. Travelers’ checks are essentially unregulated and unlike traditional banknotes. the House passed a bill providing for steel cents and nickels. but a very small part. while dimes and quarters still provide positive seignorage. and the Fed’s only involvement is in the distribution of coins to banks. In the U. Fiat money theoretically saves the resource costs associated with commodity money. copyright c Warren C.92. although some writers reserve the term currency for paper money.. the Treasury gains about 22 cents in seignorage revenue for every quarter. our paper money. in contrast to coins.2 This seignorage revenue is remitted to the Treasury by the Bureau of the Mint.3 the U. Gibson. As we shall see. However. In the U. we can make a few observations that shed some light on the system. However. coinage costs as of 2007 were 1. banks issue deposits but they are not allowed to issue either banknotes or coins.S. private banks currently issue banknotes.67 cents per penny and 9. as we have said. Thus pennies and nickels may now cost more to make than their face value – negative seignorage. today. they represent government fiat money and therefore are economically speaking not any different from banknotes issued by a central bank. It responded by changing the composition of pennies to zinc with a thin copper coating. is issued by the Federal Reserve while coins are minted by the Treasury. money is not accepted. 2 Version 0.

Gibson.Chapter 7: The Varieties of Money: a Critical Comparison 113 retained its stash of gold at Ft. requiring years of exploration. Another important distinction is that money provides the government with a tool to control the economy which it lacks under a commodity money standard. and environmental restoration. Why is sustained inflation undesirable? We have said that any reasonable stock of money will serve as well as any other. If money were In 1966 Alan Greenspan published an essay. the market value of that gold at this writing is about $126 billion. 4 Version 0. Your appraisal of this situation will depend on whether you believe government control of the economy is desirable or even possible.” in which he stated that “gold and economic freedom are inseparable” and “in the absence of the gold standard. This hoard. since gold mining is a very laborious and expensive process. . “Gold and Economic Freedom. One can speculate that the American public still views this gold as some sort of indirect assurance of the value of its money. permitting. mining operations. That gold could presumably be sold and the proceeds distributed to taxpayers or used to pay down the national debt. but problems arise during the transition to a different (usually larger) money stock. fiat money can be created in any quantity at virtually no cost so that there is no limit to the amount of price inflation that is possible under a fiat money standard. Fed chairman Alan Greenspan answered. copyright c Warren C. there is no way to protect savings from confiscation through inflation. amounting to some 261 million ounces. “in times of extreme economic crisis gold has been the only means to settle accounts.” Greenspan was evidently saying that the U. if someone should find an economical way to convert base metals into gold – the age-old goal of alchemy – there could be high inflation under a gold standard. Knox that was once required as legal backing for Federal Reserve notes.4 Whatever the reason. By contrast. gold stock still served as some sort of emergency reserve or implicit backing. Of course. When asked in a Congressional hearing why the government continued to hold gold given that it was no longer need to back the money stock.” He recently stated that he stands by this essay. and gold might lose its position as a favored medium of exchange.S. Sustained inflation is unlikely under a gold standard.92. seems to serve no purpose.

and this makes it more difficult to raise capital for expansion of production. Fixed incomes are incomes that cannot easily be changed in response to price inflation. Gibson.” Social security payments are automatically adjusted at the beginning of each year using a formula tied to the Consumer Price Index. 7. copyright c Warren C. or “the cost of living. and they can be quite disruptive. there are always distribution effects associated with increases in the money stock under either a fiat standard or a commodity standard. But money is not neutral. Stung by such losses. creditors may be reluctant to engage in further lending. Demand for Version 0. Those who hold bonds will experience declines in the purchasing power of both their interest and principal payments. . In contrast. other things being equal. In particular. providing some relief to holders of these assets. People on fixed incomes suffer losses under inflation. loans may be tied to some price index (indexation) or they could be denominated in terms of gold or some foreign currency. Typically. the real value of these assets and liabilities will drop proportionately. such as precious metals or shares of mining stocks. many people’s wages are adjusted annually and those adjustments can and usually do include a component that accounts for inflation. Let us examine them in some detail. People who depend on investments for income suffer from inflation in varying degrees. If inflation becomes severe. lenders ask higher interest to compensate for anticipated future inflation. Most assets and liabilities are priced in nominal terms which means that when the PPM drops. stock prices and dividends may rise in response to inflation.114 Distribution Effects completely neutral – that is. Some asset categories actually do well under inflation. if it had no influence on real factors in the economy – even the transition period would not matter.2 Distribution Effects The first effect of an increase in the money stock is an increase in the price level P and a concomitant drop in the purchasing power of money (PPM).92. Thus debtors gain and creditors lose. However. Or they may demand an inflation premium in their next loan.

That exaggerated income will be fully subject to corporate income tax. but the last people get it only after prices have fully adjusted upward. such strategies will have mixed success. as mentioned.92. Some people get the new money first. This phenomenon is sometimes called the “ripple effect” of new money. Depreciation schedules can be adjusted appropriately. and substantial resources may be consumed in the process of devisVersion 0. The next people to get it face only a small rise in prices. copyright c Warren C. When prices are rising. Buildings and equipment wear out and have to be replaced or refurbished.Chapter 7: The Varieties of Money: a Critical Comparison 115 precious metals rises under inflation since many people see them as financial havens. The loss in value (depreciation) appears on the expense side of a firm’s income statement. Accountants must estimate the yearly decline in the value of buildings and equipment as they age. . Under a fiat standard. Gibson. which amounts to a stealth tax increase caused by inflation. A further effect of inflation is price distortions or changes in relative prices. Of course. estimating depreciation is a tricky proposition. Inflation gives rise to an implicit tax on cash balances. as if it were dropped by helicopters. it is also known as the Cantillon effect after the 18th Century economist of that name. If people correctly anticipate inflation. can build inflation hedges into the terms of their loans. People can divert their savings into precious metals. The result is that some business firms’ reported income may be overstated because of the failure to adequately account for price inflation in the depreciation schedules. They can spend the money before prices have risen. Depreciation is an important item in accounting for any business firm. Creditors. it is not distributed uniformly to all prior holders of money. At best. to use a metaphor favored by economists. some of the value of the cash in your pocket essentially leaks out and is lost or transferred to other market participants or to the government just as if it had levied a tax on that cash. When new money is created. they can dodge its effects in some circumstances. “Fixed” incomes can be adjusted for inflation. the nominal replacement cost of a particular machine may be much higher than was estimated when its depreciation schedule was established.

which form the ultimate foundation of capitalism.3 Net Welfare Effects of Inflation As mentioned. 7. Precious metals are often cited as such investments. some effects cannot be avoided even if they are fully anticipated. leading to the ironic situation of a greater resource cost under a fiat money standard. The process engages all the hidden forces of economic law on the side of destruction. and while the process impoverishes many. an important part of the wealth of their citizens. diamonds. By a continuing process of inflation. etc. become so utterly disordered as to be almost meaningless. silver. and does it in a manner which not one man in a million is able to diagnose. Gibson. than might occur under a fractional-reserve gold standard. As the inflation proceeds and the real value of the currency fluctuates wildly from month to month. Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. it actually enriches some. and virtually everyone must hold some cash balances. in the form of gold. There is no subtler. all permanent relations between debtors and creditors. secretly and unobserved. . Version 0. copyright c Warren C. Furthermore. and the measures they take consume time and resources. As Lord Keynes put it. Lenin was certainly right. The drop in purchasing power of cash balances is unavoidable. and the process of wealth-getting degenerates into a gamble and a lottery.116 Net Welfare Effects of Inflation ing and carrying out such strategies. government can confiscate. but they confiscate arbitrarily. Financial firms and large corporations hire experts to try to predict future price inflation. By this method they not only confiscate. people try to protect themselves from anticipated inflation. held by fearful investors. Distortions due to the ripple effect are very difficult to avoid since the ripple process is nearly invisible. no surer means of overturning the existing basis of society than to debauch the currency.92. Individuals buy expensive newsletters which purport to know what investments will do well under inflation.

A recession results. canned foods. 6 This is a brief sketch of Austrian business cycle theory. it is seen that there has been no change in time preference at all and the investments made on this assumption are revealed to be unsustainable. An ironic example of such a project would be a new gold mine.Chapter 7: The Varieties of Money: a Critical Comparison 117 Even industrial materials such as copper. and finally environmental restoration after the lode has been exhausted. nickel and zinc may be held as inflation hedges. A new gold mine requires many years of exploration.92. permit seeking. Because it is very difficult to anticipate inflation over long periods of time. Later. Gibson. A gambling mentality begins to crowd out the focus on production that is more prevaThe time and money that people spend in efforts to avoid the effects of price inflation are sometimes called shoeleather costs.6 When inflation is anticipated. it will generate a temporary decline in interest rates. when the monetary expansion is recognized and interest rates reverse course. Business owners’ attention is partly diverted away from managing their business and into inflation-watching. etc. Some people get rich by successfully anticipating inflation. the supply of new gold may drop just as inflation has pushed up demand for it. assembling equipment and workers. longterm contracts are avoided or negotiated at higher costs. copyright c Warren C. people sometimes add clauses to contracts to attempt to compensate for it. people may acquire almost any asset with some durability just to get rid of their money: paper towels. And in fact during hyperinflation. Business people can easily be fooled into thinking this decline represents an overall drop in time preference (though they may not use that exact term) and will respond by shifting assets away from consumer goods toward producer goods. . 5 Version 0. Projects which by their physical nature require long startup times are more difficult to finance. pencils. a phrase which we believe tends to trivialize a quite serious issue. and most especially into projects that take the most time to mature and are therefore most sensitive to interest rates.5 Inflation has serious effects on productive activity. With financing for long-term ventures hard to come by. When an expansion of the money stock is unanticipated. digging and processing ore.

How significant are these effects? Under mild inflations such as we have experienced in the U. Relative price changes are important and sometimes subtle signals that guide a market economy. silver. whether cash or demand deposits. This was the case in 1980. it can be hard to tell whether the rise in a particular price simply reflects the overall price level or whether there has been a relative price change. Inflation was halted soon after that and the prices of inflation hedges collapsed. The German hyperinflation of 1920-23 virtually destroyed the middle class in that country and helped pave the way for the rise of Hitler and the Nazis. Relative price changes call for a different responses – basically. which was explained above. They thereby lose some of the convenience of money holdings. gold prices. 7. that they would otherwise enjoy. We should not lose sight of the benefits people accrue from holding money for unexpected purchases or as a way of saving.4 Benefits of Inflation Notwithstanding all the pernicious effects of inflation that we have outlined. . these costs are low. People eagerly anticipate the latest announcements of “money supply” figures. One estimate puts the figure at $15 billion per year. shifting of assets to different lines of production.. This is because business people are most closely attuned to prices in their own specialty than to overall prices. the tentative Version 0. which is about $50 per person. The government is the economy’s biggest debtor and therefore has the most to gain from reduction of the real value of its debts. Gibson. when much chatter at cocktail parties was about gold.118 Benefits of Inflation lent under a stable monetary regime. savings are wiped out and monetary calculation becomes very difficult. In an inflationary environment. and diamonds. For income earned in 2008. People hold less money when they anticipate inflation. copyright c Warren C. for example. One incentive is seignorage. General price inflation carries no such implication. Under hyperinflation. governments face strong temptations to generate inflations. A third effect is bracket creep. or whatever indicator has captured the public’s attention.92. Another is slow-motion debt repudiation.S.

100 to $131. although Congress has passed a last-minute one-year patch in each of the last several years.650 in 2007. dollar since 1959 as measured by Version 0. people drift into higher income brackets and thus pay higher rates. Gibson.100 From $65. its price level history demonstrates fiat money’s inflationary bias. They are a lot like the effect of a dose of cocaine – a temporary high followed by painful consequences. . The $16. It should be no surprise that the record shows more inflation under fiat money than under commodity money. has not suffered hyperinflation since the Revolution (excluding the Confederacy). Figure 7.050 bracket boundary for 2008 was $15. There have been proposals to eliminate or reform the AMT but nothing has been done as of this writing. S. copyright c Warren C.Chapter 7: The Varieties of Money: a Critical Comparison 119 federal individual income tax schedule for a married couple filing jointly was as follows Income up to $16. for example. and while these effects may seem positive.92.050 From $16. The AMT is a separate parallel income tax regime which takes effect when one’s income reaches a certain level.300 to $357. The AMT is fiendishly complex and makes planning very difficult for high-income individuals. This is called bracket creep. Actually. We will have more to say on this topic in subsequent chapters.050 to $65. With the progress of inflation and because the AMT brackets are not indexed for inflation.S. they do not endure and in fact are almost always reversed in the long run. and its effect is to partially eliminate some deductions like charitable contributions.700 Above $357.450 to $200. the tax codes have been modified so that most of these brackets are indexed to inflation.700 10% 15% 25% 28% 33% 38% These ranges of income are called tax brackets. A major exception is the alternative minimum tax. Although the U. As nominal incomes increase. In the short run.4 shows the decline in purchasing power of the U.300 From $200. even though the real value of their income may be unchanged. a burst of inflation can reduce unemployment and lower interest rates.450 From $131. more middle-income Americans have been snared in the AMT net.

As you can see.92. is exactly what happened during much of the nineteenth century in the U. That. we would have expected continuing gradual declines in the price level. may be a small price to pay avoid the devastation of inflation. copyright c Warren C. both the Consumer Price Index and the Producer Price Index.1: Decline in purchasing power of the dollar. While price levels can only be estimated roughly for these early years. the best figures we have show an approximate rise in the price level for those 264 years of approximately zero! The costs of the inflations we have experienced following the transition to fiat money must be weighed against the resource cost of commodity money. Compare England under commodity money during the period from 1650 to 1914.S. Version 0. a 1959 dollar has lost all but about 15 to 20 cents of its value since that time. This means that had there not been any increase in the money stock. Note also that most of these years were years of advancing productivity.120 Benefits of Inflation Figure 7. Resource costs. though real. in fact. . Gibson.

we find that resource costs could be quite modest. or $160 billion. Suppose. 7. See chapter 8. Under a gold standard with fractional reserves and no central bank. Then 100 million ounces ($160 billion divided by $1. Compare this to the 261 million ounces that actually sit idle in Ft.Chapter 7: The Varieties of Money: a Critical Comparison 121 Fiat money can be compared to paper bicycle locks. that following a transition to a fractional-reserve gold standard. we should also assess the impact on consumers of gold of a rise to $1. Paper locks will work just as well as steel locks as long as everybody believes in them. 8 7 Version 0. take the M2 figure of $6. Knox. Both inflation and interest rates were relatively low during his tenure as Fed chairman. for no apparent reason except distrust of the fiat money system.5 A Future Gold Standard If we consider the use of money substitutes under a gold standard. .7 You would need about210 million ounces. our present M1 money stock. But paper bicycle locks don’t usually work in the long run and fiat money may not either. Suppose further that this additional demand for gold had driven the price to $1.600 per ounce from its present $900 per ounce.92. If money substitutes were totally deregulated. copyright c Warren C. what sort of system might arise? What would “monetary freedom” look like? Here are three predicM1 and M2 are two ways to measure the money stock. Fiat money can work well as long as people believe in it.600 per ounce) would have to sit idle in bank vaults. Money substitutes could function very well with only a residual amount of gold backing them. To be fair. which as this was written amounted to about $1.8 Thus it is entirely possible that an actual gold standard could entail roughly the same or even lower resource costs than a fiat money standard. and on the whole it did work rather well during the Greenspan era. were backed by gold in the amount of about 10% of M1.592 billion and back 5% of that with gold. Gibson. for example. the level of reserves can sink as low as public confidence will allow.600 per ounce. Gold and silver sitting “idle” in vaults may be the sort of monetary restraint necessary to protect us from our rapacious politicians. Or if you prefer.600 billion.

copyright c Warren C.92. Banks could further boost confidence by means of insurance or mutual assistance contracts. predict a commodity standard with fractional reserves.122 A Future Gold Standard tions from prominent free-market monetary theorists: • The late Murray N. Gibson. Of course. winner of a Nobel Prize. he envisions privately issued fiat money with competition serving to prevent abuses. He does not see gold as a viable basis for money. the market would ultimately pick a winner from among these or other as yet unforeseen possibilities. • Lawrence White and George Selgin. Resource costs would be driven down to the point where the marginal benefit of one more unit of reserves would approximately equal the marginal benefit realized in terms of increased confidence or marketability. leaders of the contemporary “free banking” school of thought. He denounced fractional reserves as fraudulent and inflationary. . Rothbard was an advocate of “hard money” who predicted a return to a traditional commodity standard with 100% reserves. A small group of Austrian economists continues to advocate this position. Version 0. They see no fraud as long as there is full disclosure to depositors and they believe the market would value the reduced resource costs enough to overcome any reticence about fractional reserves. • The late Friedrich Hayek. • Others have suggested that a “basket” of commodities be specified as currency backing. represents a variant of the free banking school. Instead.

Chapter 7: The Varieties of Money: a Critical Comparison 123 7.6 Important terms Saving Capital Finance. dis-saving unit Factor Corporation New York Stock Exchange Balance sheet Junk bonds Fractional reserve banking Bank panic Insolvency 7. direct and indirect Bills of exchange Specie Partnership NASDAQ Stock Exchange Loanable funds Usury Bank run Illiquidity Free banking Resource costs Credit Interest Durable and non-durable goods Savings unit.92. Gibson. copyright c Warren C. .7 References Version 0.

92. copyright c Warren C. . Gibson.124 References Version 0.

Part III Today’s financial system 125 .


We will examine the intricacies of the financial markets in terms of instruments. In many areas. metals. 9 Version 0. First. partnerships. and the markets in which they are traded. a bewildering variety of financial instruments. exchange-traded funds. mutual funds (open-end and closed-end). fuels. money-market funds. preferred stocks. Second. Gibson.9 This provides an incentive for innovators to devise ingenious ways to circumvent regulations. annuities. like markets generally. currencies. financial indices) and more – in short. .127 Having covered the fundamentals of the financial system. convertible and conventional).92. bonds (corporate and government. foreign currencies. you will find listings for common stocks. our financial sector is one of the most heavily regulated – more so than Japan’s. governments and market innovators are constantly trying to leapfrog each other in an endless round of regulations and sidestepping innovations. financial markets are heavily regulated. guaranteed investment contracts and commodity futures (agricultural. financial markets in offer rewards to those who innovate new financial products that investors are willing to buy. options. bank deposits. copyright c Warren C. institutions that create them. we are ready to study the interaction of money. lumber. If you look through the “Market Week” section of Barron’s weekly newspaper. All this variety results from two basic incentives. for example. intermediation and credit through fractional reserve banking. While markets in the United States are some in respects the freest in the world.

92. . Gibson.128 Version 0. copyright c Warren C.

Treasury bond. But if you hold contemporary one-dollar bill. It appears there simply as a formality. If I own a U. it is not so easy to identify just what particular instruments fit that definition in a give time and place. Although its definition – a generally accepted medium of exchange – is conceptually simple. We will now look carefully at what actually constitutes money in our present economy. it is your asset but nobody’s liability.1 Federal Reserve notes are outside money as are Treasury coins. the Fed is not obligated to redeem its notes for anything except more notes. 1 129 . the account balance is my asset and the bank’s liability. and how its various forms are summarized in standard monetary aggregates. with the exception of outside money. Notwithstanding the fact that outstanding currency appears on the liability side of Federal Reserve’s balance sheet. Money is the most basic financial instrument.S. The one-dollar silver certificates the authors used in 1960 were their asset and the Treasury’s liability.Chapter 8 Financial instruments All financial instruments. are someone’s asset and someone else’s liability. it is my asset and the Treasury’s liability. which is a Federal Reserve note. If I have a checking account at Citicorp.

and indeed there is presently a great deal of currency in circulation. endorse it over to a third party. . No one category serves best for every kind of economic analysis.92. But the task of identifying just what is and is not generally accepted as a medium of exchange in our current society is not so simple. Credit cards are not money but rather a means of obtaining a loan from the bank issuing the card. As an exercise. relying on their debit cards for all purchases.130 Components of the monetary aggregates 8. as we have seen. You might think of currency as the most evident form of money. and for some analyses. your debit card. copyright c Warren C. What else besides currency serves as money in our society? Checks are used to complete a substantial number of transactions. but in fact a check is not money. your credit card. That person will most likely deposit it in his checking account but could.1 Components of the monetary aggregates Our definition of money is conceptually simple: a generally accepted medium of exchange. Economists have devised several categories of money ranging from narrow to broad. but it is not now because such coins are no longer used as a medium of exchange. or on-line transfers. Chances are the your currency transactions are a minority of the total. exchange it for currency or perhaps. This is because our economy has progressed far beyond the earliest forms of money. The three major categories which we shall describe the three most common classifications: the mone- Version 0. Most of us keep more money in our checking accounts than in currency. instead. calculate how much currency you spent last month and how much you spent using checks. A gold coin minted by the U. Some students in one of the author’s classes report that they carry no cash at all. where people used only cattle or cigarettes or gold coins for exchange. any category will do.S. where the money actually resides in the form of an electronic record. to the payee – the person to whom the check is written. they are used to effect a transfer from one person’s checking account to another’s. but in fact most transactions are carried out using other forms of money. Mint in 1900 was once money. but rather an order to transfer money from the writer’s checking account. The narrowest category is the most liquid. Like checks. Debit cards are not money either. broader categories are less liquid. Gibson.

Nowadays banks store a great deal of currency in ATM machines.1. the Treasury. In September. which are dollars held by U.000). The latter categories are not important for our purposes. These variations are not important for our purposes. M3 was a category that was discontinued a few years ago. Bank reserves are vault cash3 plus deposits held at the Fed by private member banks. 5 Bank reserves were about $16 billion in 1950.5 There are versions of the monetary base that vary slightly in their makeup. 2 Version 0. and they are actively traded on secondary markets.4 Bank reserves are not really money because they do not circulate. M1. and M2. 3 Vault cash is so named because at one time it consisted primarily of currency stored in bank vaults. It consists of currency in circulation (paper notes issued by the Federal Reserve System and coins issued by the Treasury) plus bank reserves. which is where most of their customers get their cash. It added more assets to M2 including (1) large certificates of deposits (face value exceeding $100. and perhaps mainly. Gibson. 2008. or the International Monetary Fund. Other variations on these categories are sometimes used. M3 assets were negotiable but not redeemable. though some private individuals continue to track it. (3) Eurodollars.3 trillion. and (4) money-market mutual fund shares held by corporations. One of these is “money of zero maturity” or MZM. no paper is involved. This was partly in response to the Fed’s new policy of paying interest on reserve balances but also. 4 Reserves are held at the Fed in electronic form. (2) repurchase agreements.1 The monetary base The monetary base consists entirely of outside money – money that has not been multiplied by entering the fractional-reserve banking system. Reserves can also be held by foreign central banks. residents in overseas branches of American banks. These assets are best thought of as potential money. the monetary base consisted of $880 billion of currency (vault cash plus currency in circulation) plus $571 billion in bank reserves for a total of $1.2 8. At year end 2008. . copyright c Warren C. which is to say that they are not a medium of exchange.92. rose as high as $37 billion in the 1980’s and dwindled to about $9 billion in August. or REPOs for short.S.Chapter 8: Financial instruments 131 tary base. Vault cash is not counted in any of the monetary aggregates since it is not in circulation. bank reserves began to skyrocket. due to the reluctance of the banks to lend in uncertain times.

We lose very little if we streamline our definition of M1 to include just 1. an early form of interest-bearing checking account that appeared in the 1970’s. Transaction deposits consist primarily of demand deposits (checking accounts) but also include certain interest-bearing checking accounts that. Travelers’ checks Notice that M1 and the monetary base overlap since both include currency in circulation. (2) travelers’ checks.92. Reserve balances are part of the monetary base but not M1. Savings deposits consist of bank passbook accounts and statement accounts.1. and (4) money-market deposit accounts. which are almost identical to bank checking accounts.2 M1 The next category of money is called M1. checking account balances are part of M1 but not the monetary base.. 8. excluding vault cash). Gibson. people who opened savings accounts were given a little Version 0. Each of these requires some explanation. (3) retail moneymarket mutual funds. having peaked at about $10 billion in the 1990’s and since dropped below $6 billion. It consists of (1) currency in circulation (i. (2) small certificates of deposit. ATS accounts (“automatic transfer service”) and Credit Union share draft accounts. In the past.132 Components of the monetary aggregates 8.e. Traveler’s checks that have been issued but not yet used are counted in M1. Checking account balances 3. are actually directly spendable. Travelers’ checks are sold to people who plan overseas travel. But they have lost market share to credit cards in recent years and therefore constitute only a very small part of M1. This minor category includes NOW accounts (“notice of withdrawal”). . Currency in circulation 2. and have one attractive feature which is the ability to replace them if they are lost or stolen. although technically not redeemable on demand.1.3 M2 The next category is M2 which includes everything in M1 and four more items: (1) savings deposits. copyright c Warren C. and (3) so-called transaction deposits.

Only certificates of deposit in amounts of $100. Bid and ask prices are available and a sale can be effected very quickly. Thus a holder of an M2 asset can exchange it for spendable money at any time. Gibson. but now many savers buy them through brokerages and hold them in their accounts without any paper document. They are not intended to be redeemed before maturity but they usually can be. five years. Money-market mutual funds are funds run by mutual fund companies like Vanguard or Fidelity. Certificates of deposit are bank savings instruments with specified maturities such as six months. 6 Version 0. redeemability means the issuer will provide outside money or a different form of inside money in exchange for the asset on demand. The term “retail” means that they are marketed to individuals rather than to large institutions. These funds are discussed more fully in Section 8. The fact that one can write checks on the assets in a money market fund make them seem like spendable money but Even small CD’s bought through brokers are sometimes negotiable.6 Negotiability means they can be exchanged from person to person.Chapter 8: Financial instruments 133 book with blank pages called a passbook. They would take their passbook to the bank and the teller would accept deposits or pay out withdrawal requests and write the amount of the transaction and the new balance in the passbook. etc. The common attribute of the four asset classes that M2 adds to M1 is that they are not negotiable but are redeemable. . Statement savings accounts are like passbook accounts except they substitute a written periodic statement to the saver instead of a passbook. Originally. $100. They accept customers’ money and use it to buy debt instruments having maturities of 90 days or less. copyright c Warren C.5 Money-market deposit accounts are similar to money-market mutual funds except that they are offered by banks and they are insured by a federal agency. with a penalty typically in the form of a partial loss of interest. Passbook accounts have all but vanished.000 was until recently the the largest deposit that is covered by FDIC insurance (more about which later).2. these were represented by paper certificates.92. but they remain in the definition of M2.000 or less are counted in M2. one year.

350 $1. we should consider them potential money. the first two categories which together constitute bank reserves are not really money since they are not generally accepted media of exchange.92.516 $800 $571 $1.927 $800 $410 $300 $6 $1.371 To repeat. While the table above might seem to include every asset that could conceivably be proposed as money. 2008 the figures for these monetary aggregates were as follows (amounts in billions): Monetary base: Currency Reserves Total M1: Currency: Demand deposits: Other checkable deposits: Traveler’s checks: Total M2 Savings deposits Small time deposits Retail money market funds M1 Total $4. copyright c Warren C. not actual money.516 $7. Liquidity. As of November. Treasury Version 0.007 $1. there are other fairly liquid assets that might appear to be candidates for classification as money but are not. Gibson.134 Components of the monetary aggregates technically they are not.054 $1. But if we are to adhere to our definitions and categories. The assets that M2 adds to M1 are less liquid than those in M1. This could be a source of confusion since they are counted in dollars and otherwise may give every appearance of being money. you will recall. is a term that denotes the degree to which an asset can be exchanged at low transaction cost and at a predictable price. .

the Fed issues weekly preliminary estimates along with revised figures for previous periods. The latter figure is easy to come by. The Fed issues weekly estimates of the value of each of the monetary aggregates. are counted in M2. Gibson.92. Note that financial publications use the term 7 Yet money-market fund balances. seasonally-adjusted figures are often issued. Because of all this uncertainty. As we move into M2. if you hold Treasury securities or shares of stock. you can sell them and get your money in three days. To calculate the monetary base. the Wall Street Journal. This is done by computing a normal seasonal variation and then subtracting that variation from the raw figures. But Treasury securities. but currency moves in and out of bank vaults all the time. the figures are even more difficult to come by. so estimates must be used. In summary. copyright c Warren C. Sometimes it is desirable to eliminate these seasonal fluctuations from the data in order to bring into better focus changes that might be caused by other factors. and here again money is constantly flowing in and out of these accounts. are never considered a form of money. Money stock figures can be found in Barron’s. Money stock figures are not easy to calculate in practice.7 Likewise if you hold shares of stock that are listed on a major exchange. They are available in huge quantities and have short maturities which means that their market values fluctuate only slightly and hence they are very liquid. To estimate M1. Version 0. In addition to revised figures. even in its broadest sense. but these are only estimates for a variety of reasons. the Fed needs to find the level of bank deposits. and numerous web sites.Chapter 8: Financial instruments 135 bills trade in a very liquid market. which often invest in Treasury bills. Shares of stock are therefore even farther from money on a liquidity scale. the Fed also needs to know how much currency is in circulation (not in bank vaults) and the levels of member bank reserve holdings at the Fed. There are certain times of year when people demand more currency – Christmastime in particular. which means that estimates must be used. but the price you will receive may vary a lot and you have to pay a brokerage fees. while they are highly liquid. they are certainly part of your wealth and are a lot more liquid than your house but they are still not part of your personal money stock. .

it is safe to assume that “money stock” and “money supply” mean the same thing. government is the world’s largest debtor. and capital markets. and there was a time when a lot of money was moving out of M1 into M2. 8. They all fall into one of two broad aggregates. We will look at a few that are highly visible because they have large secondary markets. . M3 is no longer available. So generally speaking M2 may be preferable but in many situations it doesn’t much matter.2 Other marketable instruments There is an immense variety of loans outstanding and we cannot even list all of the varieties.92.2. copyright c Warren C. Thus if you pay 99.S. We must take extra care not to let these problems of terminology mislead us. government debt The U. the former M3 or some other variety? There is no one definition that is best for all situations. M2. 8. and their yield to maturity takes the place of direct interest payments. they do not always produce tidy categories or terminology.” We prefer the term “money stock” because “supply” implies a flow instead of a stock. money markets.1 U. S. with maturities over one year. These include 1. Gibson. money market mutual funds are part of the “money market” but not the only part. 180-days and one-year maturities.8 for a Treasury bill that ma- Version 0. It issues perhaps the best known and most widely held debt securities. Treasury bills are issued in 90-day.136 Other marketable instruments “money supply. M1. The term “money markets” is most unfortunate because these are not markets where people “buy and sell money” as the name might imply. To add to the confusion. They do not issue separate interest payments but instead are issued at a discount. When institutions evolve spontaneously. Which is the true money stock: the monetary base. This would have distorted any calculations based on M1. with maturities of one year or less. but not M2 since M2 includes everything in M1. However.

Treasury securities are subject to federal income tax but are exempt from state and local income tax.26 for a note whose discount amounts to an annualized yield to maturity of The Treasury will debit the purchase price from your bank account and deposit interest payments into your account (except for Treasury Bills which are issued on a discount basis). Individuals can easily buy Treasury securities directly from the Treasury at a special web site. duration one to 10 years. You can also buy them through a broker in which case your interest payments will be added to your cash balance at the brokerage and you will pay the broker a commission on the transaction. http://www.26%). Although none of these instruments is negotiable.8 × 100% = 0. Treasury bonds and savings bonds are also available in inflation-adjusted forms. meaning they cannot be redeemed from the Treasury before maturity. Treasury notes.Chapter 8: Financial instruments 137 tures in 90 days (one quarter of a year) you annualized interest rate is approximately 4× 100 − 99. 3. These pay interest twice a year. Version 0.92. copyright c Warren C. notes and bonds. 3.g.8% per annum 100 Treasury bills are quoted in terms of their yield (e. Gibson. After you have kept it 30 years it will stop paying interest. they are quite liquid because there is an active secondary market for bills. 2. These are available in small denominations and are not negotiable. Interest accrues over time and is paid when the bond is cashed in.. 4. the interest these securities pay is lower than that available from non-indexed securities. If you cash a savings bond within one year after you buy it you will forfeit some of the interest. Savings bonds. duration 10 to 30 years. The Treasury adjusts the principal value of the bonds periodically in line with the Consumer Price Index. Because of this feature.treasurydirect. These also pay interest twice per year. . Treasury bonds.

counties. . a recent issue of Barron’s reports a yield on the Dow Jones Bond Index of 6. For example.” Issuers include not just municipalities as the name would imply but also state governments. Most funds buy only the bonds of a single state and market them This spread does not fully reflect the Muni tax advantage for most buyers.61%. There is a fairly wide variation in the quality of these issues and there are occasional municipal bankruptcies. For example.2.80% suggests that other factors are at work. 8 Version 0.14% on an average corporate bond.2 Municipal bonds State and local governments issue debt securities collectively known as “municipal bonds” or just “munis. school districts. someone in the 25% tax bracket would take home 75% of 6. or 4. But it would be an exaggeration to call them perfectly safe. etc. government securities are considered extremely safe because of the government’s taxing power and (to a lesser extent) its seignorage privilege. copyright c Warren C.80% on the Bond Buyer Municipal Bond Index. California in the 1990’s or the City of Vallejo. as evidenced by the fact that large institutions can buy insurance to protect a portfolio of Treasury securities against default. As compensation for this difference. perhaps wariness about munis’ credit quality. Gibson. California in 2008. The cost of this sort of insurance is very low. As in corporate bankruptcy. This is especially true for high-income individuals who pay a high marginal income tax rate.138 Other marketable instruments U. They are popular because of the expertise of their managers and the diversity of their holdings. 8. Because of the tax exemption they offer. muni bonds almost always pay less interest than corporate (taxable) bonds of the same quality and maturity.8 There are mutual funds that specialize in municipal bonds. and maturity. such as Orange County.S.92. but increased about sixfold during the latter half of 2008. coupon. The fact that the average muni yielded 5. These securities are exempt from federal income tax and usually from state income tax for residents of the states in which they are issued. holders of bonds issued by these agencies may get some of their investment back or none. water districts.14% versus 5. muni bonds are more valuable than a taxable bond of the same quality.

Although outright loans are sometimes granted. the Treasury sometimes subsidizes loans directly.Chapter 8: Financial instruments 139 to residents of that state who then enjoy full exemption from state as well as federal income tax on the dividends paid by these funds. Nearly all state and local capital projects are financed by bond issues. It is probably safe to say that the average voter does not think about the interest cost of the bond issues that he votes on.2. government is not just the economy’s biggest debtor but also one of its largest intermediaries. First. with about 50. Muni bonds vary widely in quality. Gibson. meaning that projects are essentially paid for more than twice over. .S. and local governments often find that it pays to provide purchasers of their bonds with insurance which they can obtain from private firms. Outstanding municipal bond securities amounted to nearly $2 trillion at year-end 2008. while munis were yielding 4% or more. There are even muni money market funds – funds that buy only muni bonds due in 90 days or less. There are three classes of intermediary functions that the government engages in. thereby raising the quality of their issues and lowering the interest that they pay.3 Government agency securities The U. State and local governments can get in local difficulty. so as to maintain a one dollar share price. 8. loan guarantees are more common. In theory. California declared bankruptcy in 2008.92. Rating agencies rate muni bonds. For Version 0. high-quality muni bonds should yield less than Treasury securities because interest on the latter is subject to federal income tax while the muni bond interest is tax exempt to borrowers who live in the state where the bond is issued.000 separate issuing agencies ranging in size from tiny school districts to the State of California. Yet such was the magnitude of the “flight to quality” at year end 2008 that short Treasuries were paying essentially zero for the shortest maturities out to about 3% on 20-year bonds. copyright c Warren C. as when the City of Vallejo. Total interest payments on a 30-year bond paying 3% per annum will add up to more than the entire principal.

Gibson. to people who borrow money to buy homes. Here are some of the major agencies and government-sponsored enterprises. copyright c Warren C. – The Federal National Mortgage Association (FNMA or “Fannie Version 0. there are organizations called government-sponsored enterprises which issue stock and bonds to the public. The government does not directly guarantee the obligations of the GSE’s but it is considered likely that Congress would bail them out if they got into difficulty. through an intermediary bureau called the Federal Financing Bank. direct or indirect. . Any possible defaults would likely occur after these politicians had left office. Third.140 Other marketable instruments example. there are a large number of special subsidiary agencies that borrow money and re-loan it for purposes that are allegedly underserved by private markets. the airlines borrowed from private banks which were assured that the government would make good on the loans if the airlines defaulted. A bit of spontaneous order has entered this picture in the form whimsical names like Fannie Mae which evolved from nicknames used by traders to terms used by organizations themselves. and this indicates that market participants believe that GSE securities are very nearly as secure as Treasuries. and customers of the airlines in this case – get what they want with no immediate cost to the taxpayer. • Mortgage credit institutions have been set up in response to the notion that the social benefits of home ownership will not be fully realized unless governments provide some sort of subsidy. These are government agencies that often borrow from the Treasury. The liability assumed by the Treasury is called a contingent liability since the Treasury will have to expend funds only if the beneficiary of the loan guarantee fails to perform. Loan guarantees are attractive to politicians because they appear to offer something for nothing. No government funds were loaned. Markets have priced their securities to yield interest only a little higher than what ordinary Treasury securities yield. Second.92. employees. the Air Transportation Stabilization Board offers loan guarantees to airlines that have suffered financial losses as a result of the terrorist attacks of 9/11. Favored constituencies – the owners.

its securities enjoy the explicit full faith and credit of the U. It borrows at low rates and uses the proceeds to acquire mortgages. Unlike Fannie Mae and Freddie Mac. – Government National Mortgage Association (GNMA or “Ginnie Mae”) is another mortgage organization. government. There have been proposals in Congress to reduce the size of Fannie Mae and Freddie Mac because of the enormous taxpayer bailout that might be necessary should one of these institutions fail.92. – The Federal Home Loan Mortgage Corporation (“Freddie Mac”) is also a GSE that acquires mortgage loans and it has also grown enormously. with assets approaching $x. presumably because private markets under-produce loans to farmers relative to some supposed ideal level. • Institutions related to savings & loan associations and to provide indirect assistance to home buyers: – Federal Home Loan Banks Financing Corporation – Federal Housing Administration • Several government institutions provide agricultural credit. copyright c Warren C. S. Fannie ??? Mae engages in elaborate hedging and derivative operations. In addition to issuing straight bonds and stock. It has grown enormously and now boasts assets of $x trillion. . but it is not owned by stockholders as Fannie and Freddie are. A more likely explanation lies in the political power of the representatives of the agricultural states. Gibson. The plethora of arcane financial derivatives that they use has also generated concerns. – The Federal Housing Administration provides mortgage insurance to borrowers whose credit is not good enough for conventional loans. – Farm Credit Banks Version 0.Chapter 8: Financial instruments 141 Mae”) is a former government agency which was converted to a GSE.x trillion.

– The Export-Import Bank provides loans and loan guarantees to firms which export goods and services. Fannie Mae and Freddie Mac. Fannie and Freddie spent heavily on lobbyists and campaign contributions so as to help deflect any questions about the lavish salaries paid to their executives or the high leverage ratios that they employed. navigation. The conditions of the time may or may not have justified their creation. The two largest government-sponsored enterprises. foreign holders of their debt and equity securities assumed that they enjoyed the backing of the federal government even though there was no such explicit guarantee. copyright c Warren C. it seems these agencies can only grow larger over time. – Federal Agricultural Mortgage Corporation (“Farmer Mae”) Others • Others – Student Loan Marketing Association. These measures proved inadequate. a GSE that buys student loans from the private banks that issue them.142 Other marketable instruments – Farm Credit Financial Assistance Corporation. – The Tennessee Valley Authority issues securities to finance its flood control. and power generation activities in the areas around the Tennessee River. Gibson. while retaining their special mission to support the housing market. In July Fannie and Freddie saw their stock prices fall by almost half. started out life as government agencies but then were privatized. to their stockholders on the one hand and to their special mission on the other hand. In particular. The dual loyalties of these institutions. In response. Regardless of the fact that conditions have changed greatly since that time. In 2008 Fannie and Freddie suffered massive losses as the housing market began to unravel. may have been the key to their failure. taking down mortgage-backed securities with it.92. . and on September Version 0. the Treasury announced an increase in the GSE’s line of credit at the Treasury and other measures. Some of these agencies in this partial list were created during the Great Depression.

copyright c Warren C. often managers or employees of those companies. the regulator of Fannie and Freddie announced his intention to place them under a “conservatorship. This is called “going public. In fact. 2007. . The extent of future taxpayer losses. with fractions of a cent expressed in thirty-seconds. Fannie Mae stockholders.4 Corporate securities Corporate stocks (part of the capital market) are the largest single class of financial instruments.92. Daily trading on the New York Stock Exchange averages well over one billion shares. The Government National Mortgage Association was never privatized and did not suffer from the problems that brought Fannie Mae and Freddie Mac to grief. with an active secondary market.” meaning it is not available to the public but only to limited groups of individuals. There are two basic kinds of bonds: debentures. and mortgage bonds backed by assets such as buildings and land. While the stocks of publicly traded companies are well known.” The Securities Exchange Commission which regulates stock trading in the United States has strict rules that must be followed by companies that go public. Growing companies that want additional capital can issue stock in an initial public offering (IPO). 8. Corporate bonds (also part of the capital market) are another important source of capital for corporations.Chapter 8: Financial instruments 143 7 of that year.2. Preferred stockholders fared somewhat better. the dollar volume of daily bond trading dwarfs that of stocks. If you look at bond prices in the Wall Street Journal you will see numbers Version 0. which are general-obligation bonds. if any.” The Treasury pledged up to $100 billion for each organization in return for $1 billion in senior preferred stock yielding 10% per annum. however. and NASDAQ turnover is even higher. Gibson. A fairly small number corporate bonds are traded on the New York Stock Exchange and elsewhere. bond prices are quoted in cents per dollar of face value. For historical reasons. there are thousands of corporations whose stock is “closely held. saw their shears plunge to less than $1 per share from %80 in January. amounting to about $10 trillion at year-end 2005. A cap on the size of their portfolio of mortgagebacked securities was also imposed. is unknown at this time.

Thus a bond with a $10. which means it will be purchased from the institution that created the mortgage and bundled with other mortgages into a fund that is financed by issuing shares. they are not subject to government regulation. Large corporations with good credit such as General Electric can bypass banks and borrow money directly thus reducing their transaction costs. Stock prices were switched from fractions to decimals a few years ago but the bond markets have yet to follow suit. chances are it will be securitized. Bankers’ acceptances (part of the money market) are bank-guaranteed bills of exchange. Government guarantees are an additional advantage of mortgage-backed securities. Gibson. A banker’s acceptance is simply a piece of paper that announces the bank’s willingness to guarantee a debt instrument of a business firm.837. copyright c Warren C.. securitized.2. Commercial paper is not backed by collateral. they provide an interesting chapter in the history of money and Version 0.e. An addition.4 trillion in mid-2008 before declining.98375. which as a decimal is 0. and paper whose maturity is less than 270 days. Banker’s acceptances are actively traded and are widely held by money market funds. 8. Mortgage-backed securities are a relatively new development. This provides a strong incentive to securitize these assets. i.000 face value is quoted at 98:30 and thus is trading for $9.50.144 Other marketable instruments like 98:30 which means the bond trades for 98 and 30/32 cents per dollar of face value.5 Money market mutual funds Money-market mutual funds are a central feature in today’s financial landscape. . Commercial paper (part of the money market) is a relatively new type of financial instrument. Nowadays if you take out a mortgage. Yet defaults or other problems were very rare in this market prior to the crisis of 2008. amounting to some $3.92. Mortgages are not very marketable since they represent such a wide variety of properties and borrowers. They are a contingent liability of the bank that issues them. perhaps because there is much less public awareness of bond trading as compared to stock trading. when the Fed stepped in to buy up distressed commercial paper.

Gibson.000 you receive three months later consists of your $9.Chapter 8: Financial instruments 145 banking. At the same time. a constant one-dollar share price.92. online transfer privileges. they began to view these balances as part of their personal money stock. meaning that purchasers buy the security at a discount from par. you pay $9. financial world around 1970. low minimum balances.000. the Treasury raised its minimum for purchase of Treasury Bills from $1.960 principal plus $40 representing interest. but were subtracted from the fund’s income prior to distributions to shareholders.000 3-month Treasury bill for a quoted price of 99. How is it that MMMF share prices are kept at exactly $1. Thus if you buy a $10. and most importantly. The value of such a security. Short term securities are issued in discount form. multiplied by four to make an annual Version 0. copyright c Warren C. They offered rates of return comparable other short-term rates. a time when interest rates were rising but Regulation Q prevented banks from offering competitive rates on savings accounts. shareholders were owners of equity stakes in a mutual fund. and in recent years.S. a high degree of safety. putting them out of reach of small savers. . Indeed. intended to limit the expense associated with clearing many small checks.960. Technically. and mainly because of the constant one-dollar share price.000 to $10. or municipal securities such as revenue anticipation notes. Most funds later added check-writing privileges.00. no less? The answer lies in the short maturity of the instruments that MMMF’s hold.6. Efficient and affordable computer systems enabled the operators of successful funds to meet expenses and clear a profit by charging shareholders a fraction of one percent of their fund balances. These charges were not levied directly. Money market mutual funds (MMMF) appeared in the U. usually with a minimum amount like $100 or $250. The rate of interest is thus $40 divided by $9.960 and the $10. Clever entrepreneurs stepped into this breach and invented money market funds which had several new and attractive features. small money-market fund balances were added to the definition of the M2. but for all practical purposes. the check-writing privilege. no more. Treasury Bills. which could be commercial paper. depends on two things (assuming unchanging risk): their maturity and the prevailing short-term interest rate.

But suppose the short-term rate of interest jumps from 3% to 3.70 (1 + 0.035)29/365 This would be a problem because of the way MMMF’s keep their share price at $1. Gibson. The next day’s value will be PV = $10. 000 = = $9. there had been only one instance of breaking the buck until 2008 when a second instance occurred. copyright c Warren C.001.00 They do so by computing the value of their holdings at the close of business each day and crediting the increase to the shareholders in the form of additional shares. Its value almost inexorably rises daily as maturity approaches.61 percent per annum. they are not typically not reported until a monthly statement issued or the account is closed. ETF’s.000 to $10. 972. Breaking the buck would be a severe blow to the reputation of such firms. 960) × 100% = 1. perhaps because Version 0. 975. barring a sharp overnight jump in interest rates.92.146 Other marketable instruments rate of 4 × ($40/$9.03)30/365 This security’s value will march in nearly a straight line toward $10.000 new shares to its shareholders. The value of an instrument with a short maturity is dominated by the time remaining to maturity.73 (1 + i)n/365 (1 + 0.000.0 percent per annum.000 discount instrument has 30 days to maturity in an environment where the short term interest rate is i = 3. Specifically. But because such an event is exceedingly unlikely and because management would very likely step in to cover such a temporary loss. it is essentially a non-issue.” During the entire history of MMMF’s. Its market value is PV = FV $10. Thus if a fund has ten million shareholders and the market value of its holdings has increased from $10. and other financial products. 000 = $9.000. it will credit 1. Most MMMF’s are managed by large firms that offer a range of mutual funds.5% overnight. suppose a $10. . Although new shares are issued nightly. The failure of a MMMF to maintain a one-dollar share price is called “breaking the buck. An overnight drop as illustrated above would be a problem because technically the funds cannot take shares away from shareholders.000 overnight.

such as those that prevailed at the end of 2008.9 The yield was sure to drop because with an average duration of 55 days. which would cut into its earnings. Version 0. or phasing out the fund. leaving others to get little 9 10 Wall Street Journal. whose September 2008 bankruptcy caused the market for those securities to dry up. Others invest solely in U. We might ask whether MMMF’s are run-proof.92.Chapter 8: Financial instruments 147 many MMMF shareholders are at best dimly aware that they are equity investors in a fund whose fortunes can rise and fall. in early January the yield on Schwab’s $34 billion Treasury Money Market fund had sunk to an astonishing 0. Perhaps the biggest threat to MMMF’s is sustained ultra-low interest rates. wherein those first in line may get all their bank deposits converted to cash. typically commercial paper and short-term notes. One of this firm’s MMMF’s dropped to 97 cents on the dollar. Most invest in a mix of corporate and government securities. 2009 Provided the reside in the state where the securities are issued. copyright c Warren C. and their shareholders are exempt from state income taxes on the dividends they receive. Holdings.02% after operating expensese of 0. . the fund’s portfolio didn’t yet reflect the recent drop in Treasury rates to essentially zero. All money market funds share the structure outlined above but within those confines there are several varieties.6% were deducted. Therefore.S. whereupon the Reserve Fund marked their value to zero on their books. and the firm imposed a seven-day waiting period for redemptions. 15. firms will absorb losses in their MMMF for some period of time in order to avoid breaking the buck. This left Schwab with a choice of waiving fees. Treasury securities. Jan. They certainly are not subject to the first-come-first-serve aspect of a classic bank run. Gibson. Another stood at 91 cents on the dollar – hardly a catastrophic loss at a time when the stock market averages were dropping by larger larger percentages in one day. Sill others invest in short-term municipal securities and their shareholders enjoy exemption from both state and federal income tax10 In Chapter 6 we discussed the phenomenon of bank runs. The Reserve Primary Fund held short-term securities issued by Lehman Bros. For example.

00 share price. the prevailing rate when you buy it. along with general market unrest led many investors. How do we calculate present value and yield to maturity? Suppose you invest $100 at 5% for a year. the Treasury announced it would guarantee most money market funds against losses up to $50 billion for a period of one year. It is likely that this guarantee will be extended after the year is up. Why is this? Suppose you buy a $10. One more year like that. copyright c Warren C.05)×$110. If we call the initial $100 the present value (P V ) and the final value after n Version 0. Gibson. In the case of a MMMF failure. e.92.000 bond that is due in five years and pays interest at a rate of 5% per annum. At the end of the year you get $105 and you reinvest that at 5% for another year. in September 2008.05) × $105 = $110.g. including one of your authors. You then discover that the market rate of interest for such bonds has risen to 6%.25 = $115. a run on a particular MMMF or all funds as a whole could produce a great deal of distress as funds rushed to dump securities in order to meet redemptions. unless you offer the bond at a discount price – something less than $10. to move their MMMF fund assets either to insured bank accounts or to MMMF that invest solely in Treasury securities. 8. and it gives your bond a yield to maturity that makes it competitive with comparable new bonds. . maturing in three years. You hold on to the bond for two years.000. That lower price is called the discounted present value of the bond. and you have (1+. all shareholders would receive the same percentage of their funds. the Lehman Bros. No one will buy your 5% bond when they can get a 6% bond with the same credit quality on the market. bankruptcy. 92 cents per dollar invested. In fact. happily collecting your $500 interest payments.3 Present value and yield to maturity We have said that the market value of a debt instrument varies inversely with market interest rates.76. but then decide to sell it rather than wait three more years for it to mature. Let us say it pays $500 in interest at the end of each year. the the failure of the Reserve Primary funds to maintain their $1. In response.25..148 Present value and yield to maturity or none. after which you get (1 + . Still.

05×3 = $116.06 1. Gibson.5% twice a year? This is called semi-annual compounding and we use the same formula but set i = 0025 and n = 6 for six 6-month periods instead of n = 3 for three years: F V = $100 × 1.05/52)3×52 = $116. 632. suppose our $10.76 We have assumed that the interest for each year is not paid until the end of the year.92. banks offered more frequent compounding to be competitive. .053 = $115.97 Compounding weekly (52 weeks per year) the return would be F V = $100 × (1 + .Chapter 8: Financial instruments years the future value (F V ).18 These differences are trivial in today’s low interest rate environment. Suppose instead of 5% paid annually. $100 × e0. What market value for this bond will make its yield to maturity equal 6%? We calculate the present value of the three remaining interest payments plus the present value of the principal.000 5% bond has three years to run but market rates of interest for bonds of this duration and quality are now 6%.063 The limiting case is called continuous compounding for which the formula is F V = P V ∗ ein where e is the base of natural logarithms.06 1.0256 = $115. using not the 5% bond coupon but the 6% prevailing rate: PV = 11 $500 $500 $10. 000 $500 + + + = $9. copyright c Warren C. the relationship is PV = FV (1 + i)n or F V = P V (1 + i)n 149 where the interest i must of course be a decimal value. Yield to maturity reflects both the stream of future interest payments and the rise or fall in the value of the bond as it reaches maturity.70 2 3 1.06 1. In the example above. F V = $100 × 1.183 Version 0. Thus for a $100 three-year loan or bond at 5%.11 The yield to maturity of a bond or other debt instrument is important when its market value has risen or fallen. you get paid 2. but in 1980 when interest rates were approaching 15%.

928 $5. The table below shows what happens to the market price of various 5% bonds of equal quality but varying maturities as interest rates rise to 6% and then 10%.000 $10.287 Version 0.632. The payments are computed so that after the last monthly payment has been made (the 360th on a 30-year loan). its value falls.000. If we know F V . as do spreadsheet programs. Bonds with longer maturity are more sensitive to interest rate fluctuations than those of shorter maturity. P V .579 $9.264 $8. While they typically have a fixed maturity date. Applying the present-value formula to a stream of 360 fixed monthly payments P. We have seen how a bond’s market value is related to the spread between its coupon interest rate and the prevailing market rate for bonds of the same maturity and quality.906 $9. Many calculators have this function built in. .92. If the market rate rises above the bond’s coupon rate. and n and wish to solve for the interest rate i we have a difficult problem which can only be solved numerically. conventional mortgages have a fixed monthly payment which is part interest and part principal. The rise or fall brings the bond’s yield to maturity closer to the prevailing interest rate.150 Present value and yield to maturity So the bond should sell for something close to $9.000 $10. and vice versa. Market price of a hypothetical 5% bond Maturity 1 5 10 30 yr yr yr yr Market rate 5% 6% $10.545 $8. Gibson. copyright c Warren C.624 10% $9. Mortgage loans are structured somewhat differently than bonds. we would have a loan value of LV = P P P P + + + ··· + 2 3 (1 + i/12) (1 + i/12) (1 + i/12) (1 + i/12)360 where we have used i/12 in the denominators because we need a monthly interest rate. the principal has been reduced exactly to zero.000 $9. If you repeat this calculation using a 4% going rate of interest you should come up with a present value that is greater than $10.000 $10.105 $6.

copyright c Warren C. the 30-year bond declines very steeply as the market interest rate rises and the one-year bond is not very sensitive at all. What if the payments extend to infinity? Such bonds actually exist. a rise of the market interest rate from 5% to 10% has knocked almost half the value off a 30-year bond. They got their name from the fact that they were used to em consolidate a number of previous bond issues. Assuming a constant annual interest payment P . Gibson. what happens to the present value of the stream of payments as the maturity of the bond increases? It goes up. Doesn’t the sum of an infinite number of terms have to be infinite? No. obviously. In contrast.92.Chapter 8: Financial instruments 151 As you can see. Consider again the present value of a steam of interest payments. this is one of many infinite series that converges to a finite value which is easily shown to be P V∞ = P P = n (1 + i) i n=1 ∞ This table shows present values of a stream of 5% annual interest payments for varying numbers of years: Consols were first issued in 1751 in England by Henry Pelham’s Whig government. . In fact. Such extreme price fluctuations can be a problem for people who are risk-averse but they are an opportunity for people who want to speculate on changes in interest rates.12 If the bond matures in N years with annual interest i. though they are now rare. leaving aside the present value of the principal. They are called perpetual bonds or consols. Why is this? The total return from a 30-year bond is made up mostly of interest payments so its present value is very sensitive to interest fluctuations. a one-year bond’s return consists primarily of principal so it is not much affected by interest fluctuations. we can write the present value of the payment stream as N P P VN = (1 + i)n n=1 Now let N become infinitely large. 12 Version 0.

4 Risk and maturity factors The price of a bond depends on two other factors which we have not yet considered. yield 4. Version 0. much more so than if it ceases paying dividends to stockholders or if its stock price drops a lot. The lower grades.154. 1.597.75%. the Bank of America bond due Dec. 1. are Moody’s and Standard & Poors.67 Risk and maturity factors 8. labeled “not investment quality. was priced above par at 104. in contrast. They each have ratings systems that identify the credit quality of bond issuers as shown below.8%.39 $4.S.085%. a reflection of the difficulties in which this bank found itself at that time. 2017. First is its quality. Bankruptcy is often the next step for such companies. with a coupon interest rate of 5. On the other hand.” are commonly called “junk bonds. . for example.45 of Feb. They try to pick junk bonds that they consider undervalued and they diversity into a wide range of issues so that they can sustain default by a small number without excessive adverse effects on their overall portfolio. copyright c Warren C. reflecting not only Wells Fargo’s sounder condition but also the short maturity of that bond. was trading at 57 for a current yield of 15. Bond investors typically do not have the time or expertise to evaluate a company’s financial soundness and so they rely on experts.840. A company that defaults on its bonds is in very serious trouble. The Wells Fargo 6. some funds specialize in junk bonds. or conversely to default on it.92. Two prominent bond-rating firms in the U.166.867.” Some institutions are not allowed to invest in junk bonds or avoid them as a matter of policy.02 $2.48 $3. 2011.940.47 $4. the reward they seek for themselves and their investors is high income and manageable risk. Of course. Gibson. At year-end 2008.152 N 10 20 50 100 ∞ P VN $1. reflecting estimates as to how likely the bond issuer is to pay the principal back when it comes due.

Baa Ba B. Caa Ca. CCC D Investment Grade Not investment grade 153 In 2008 these organizations came under fire for some questionable ratings and for allegedly improper relationships with some of the institutions they were evaluating. Version 0. CC. C Standard & Poor’s AAA AA A BBB BB B. A Baa-1.92. . copyright c Warren C.Chapter 8: Financial instruments Moody’s Highest quality High quality Upper medium Medium Speculative Highly speculative Default Aaa Aa A-1. Gibson.

154 Risk and maturity factors Version 0.92. . Gibson. copyright c Warren C.

dealers and underwriters A financial broker is a person or firm who matches buyers and sellers of financial instruments (mainly stocks and bonds) but does not take title to either the funds or the securities being traded.1 Brokers. wealth. A financial dealer is a person or firm which acquires an inventory of stocks or bonds or other financial assets for resale to or on behalf of its customers. scrap iron.Chapter 9 Financial institutions Savers are very different in terms of time preference. In response to the wide variety of savers’ needs. truck transportation – even marriage brokers! None of them take title to the goods or services that they broker. institutions. Dealers purchase their inventory and offer it for sale to their customers. age. Brokers operate in many other markets: real estate. oriental rugs. 155 . There are also dealers in used cars. risk preference or aversion. such as money markets or junk bonds. 9. We will take a broad look at the categories of institutions that server savers and investors. but which found favor with investors once they became known. As in markets generally. and antique furniture. income. etc. innovators have devised products that no one anticipated. financial entrepreneurs have developed a vast array of financial services. and markets.

156 Brokers. San Francisco and elsewhere. It was an association of firms which handled the stock of companies too small to be listed on the New York or other exchanges.” NASDAQ is an all-electronic trading operation that evolved out of the old over-the-counter market.92. The New York Stock Exchange still conducts some trading on its floor in its iconic lower Manhattan headquarters building. Philadelphia. dealers and underwriters While the conceptual distinction between these two kinds of financial institutions is clear. it was a mark of distinction for a corporation to have its shares listed on the NYSE. Gibson. Cincinnati. and its floor operations may some day be discontinued. Trades in many minor stocks were handled by brokers contacting other brokers by telephone in what was called the “over-the-counter” market.1 At one time. when a computerized system called the National Association of Securities Dealers Automated Quotation System (NASDAQ) was implemented. many financial firms offer both brokerage and dealership functions as we shall see. most stock trades were conducted on the floor of the New York Stock Exchange with lesser exchanges operating in Boston. the New York Stock Exchange is moving more into electronic trading. Stockbrokers are a well-known class of brokers. copyright c Warren C.1). These were bustling trading floors where most trades were conducted face-to-face. Specialists were stationed at posts around the floor and were responsible for completing trades and maintaining an inventory of shares to help maintain orderly markets (Figure 9. Stock brokerage firms conduct their business mainly through stock exchanges. All major brokerage firms are members of the New York Stock Exchange and other exchanges. while over-thecounter issues were largely small and speculative and therefore somewhat suspect. But now some major corporations such as Microsoft and Intel retain their NASDAQ listings. Fifty years ago. Individual stockbrokers work for stock brokerage firms such as Merrill Lynch or Charles Schwab. 1 Version 0. The NASDAQ exchange was once known as an “over-the-counter” operation. appears to function just like the older exchanges. This evolved into the present-day highly sophisticated exchange which essentially lives in cyber-space. and to the average investor. but much of the volume has moved to its electronic operations. . Transactions were conducted by telephone until the 1970’s. As this is written. The former American Stock Exchange was acquired by the NYSE and renamed “NYSE Alternext.

they are acting as dealers rather than brokers Deregulation has allowed banks to establish stock brokerage operations in recent years. but they also offer access to vast quantities of Version 0. copyright c Warren C. However. Not only do they offer nearly instant execution of trades.Chapter 9: Financial institutions 157 Figure 9. These prices are known as the bid and ask prices.1: Traders on the floor of the New York Stock Exchange Specialist members of the exchanges act as dealers for the stockbrokers. But at this time the market is still dominated by large firms such as Merrill Lynch and Charles Schwab.17 and bid $83. and each of them handles the shares of only a few firms. thereby assuming some market risk. and some mutual fund companies such as Fidelity and Vanguard have established brokerage operations. and their income is derived from the spread between the price at which they offer to buy shares and the price at which they offer to sell them. Specialists are dealers because they hold inventories of the stocks in which they specialize. stockbrokerage firms often hold stocks for their own account which they may trade with their customers. Practically all brokerage firms let their customers trade through their internet web sites. When the do so. For example. the specialist in IBM stock may ask $83.02 at a particular moment. . and some are on-line only. Gibson.92.

Brokers and dealers are part of the secondary market. They do not engage in indirect finance and they do not issue financial instruments of their own. these being the essential economic attributes of banks. Firms that participate in primary markets are called underwriters. underwriters usually form syndicates (groups of underwriters). Morgan Stanley. For large issues. Gibson.S. where the terms of a policy were written up and then insurers wishing to participate would write their names under the description. the U. (The term “underwriter” originally referred to the provision of insurance. During the crisis of 2008 Lehman This term stems from the early days of insurance underwriting in England. This is unfortunate terminology since these firms are not banks in the sense in which we use the term.2 A single firm may have a brokerage division as well as an underwriting division.158 Brokers. Primary financial markets are markets where newly issued instruments are sold to investors. Major underwriting firms include Goldman Sachs. Secondary markets are markets where investors trade existing instruments among themselves. Underwriters also handle muni bond issues. . Supposedly each risk-taker would write his name under the total amount of risk that he was willing to accept. Underwriting is the process by which investment bankers raise investment capital from investors on behalf of firms issuing securities. So while they are best classified as brokers – matching buyers and sellers – underwriters as risk-takers have some of the attributes of dealers. either equity or debt (shares of stock or bonds). These firms are commonly called investment banks and their business is often called “investment banking” instead of underwriting. copyright c Warren C. Underwriters are called investment banks partly because at one time banks had departments that provided underwriting services. dealers and underwriters investment information. Smith Barney (now being sold off by Citigroup).) Modern underwriters advise firms on issuance of new securities and find buyers for their securities. During the Great Depression. in which each member firm assumes the responsibility and the risk of marketing its specific allotment of shares. and in many countries they still do.92. and the recently bankrupted Lehman Brothers. and at much lower prices than in past years. 2 Version 0. government forced banks to divest themselves of their underwriting operations.

and credit unions. meaning they were owned by their Although these functions are often combined in a single firm. runs money market funds. 9.3 Pure intermediaries include insurance companies (life. Notwithstanding all this expansion. Insurance companies collect premiums on the policies they write and invest the proceeds in portfolios of stocks. savings and loan institutions.92. Schwab also issues credit cards. stockbrokers can now offer most of the services of banks. Just as banks have been allowed to start brokerage operations. real estate. Gibson. . and casualty). 3 Version 0. copyright c Warren C. They draw on these funds when their customers present claims for insured losses. and state and local government pension funds.2 Depository Institutions and Pure Intermediaries Intermediary institutions are classified as “pure” intermediaries and depository institutions. Many of these were mutual associations. Savings and loan associations were originally set up to provide mortgages to individuals who wanted to buy homes. savings banks. all of these institutions perform basically the same functions and their names and legal constitutions are largely accidents of history. etc. property. we must bear in mind the conceptual difference between dealers and brokers. so we will assume firms perform purely one function or the other. bonds. Pension funds invest in the same sort of assets for the benefit of retired employees to whom they have guaranteed certain retirement benefits.Chapter 9: Financial institutions 159 Brothers was allowed to fail and other investment banks were allowed to convert to deposit banks. it is important to keep them conceptually separated. and provides cash withdrawals from ATM’s. At present. These two firms have almost completely overlapped each other’s markets. private pension funds. Charles Schwab owns a bank that issues insured deposits and offers mortgages and other loans. Wells Fargo is an example of a bank which has expanded into brokerage and insurance. Depository institutions consist of banks. For example.

Closed-end funds issue a certain number of shares initially but do not issue further shares. Gibson. . People who buy stocks as investments should not put all their money in the stock of a single company but should spread the risk over several stocks. Credit unions provide many of the retail services that commercial banks offer.92. Open-end funds stand ready to sell new shares and redeem existing ones on demand. the price of the shares is exactly the same as the net asset value. The savings and loan crisis of the 1980’s eliminated many S&L’s. This is hard for small savers to do. “Where people are worth more than money” is an economically meaningless statement. but they can buy a small number of shares in a well-diversified mutual fund. copyright c Warren C. Someone who wants to acquire shares of a closed-end fund must buy them from an existing owner of shares. There are two points of view regarding credit unions.” A “public choice” point of view would stress the exemption from income taxes enjoyed by credit unions. Because closed-end funds do not generally issue new shares. Open-end funds can be purchased through brokers and banks or directly from the fund companies that issue them. Mutual funds are aggregations of savers’ funds that are used to buy stocks and bonds. Customers also benefit from the expertise of the fund managers and the research information which they have available.160 Depository Institutions and Pure Intermediaries customers. A “public interest” point of view is represented by statements on the National Credit Union Association’s web site. each offering dozens of mutual funds. as is “a person’s desire to repay (character) is considered more important than the ability (income) to repay. For this reason. Savings banks were generally mutual organizations of depositors and borrowers in a local region. but only people who belong to some affinity group – such as employees of a particular company – may become customers (“members”). Fidelity and Vanguard are two such firms. Many closed-end funds are listed on the stock exchanges. Mutual funds are classified as open-end and closed-end. Version 0. The net asset value of a single mutual fund share is equal to the total value of the fund’s holdings divided by the number of shares outstanding. The benefits of aggregation include diversification and expert management.

Yet another class of financial firms are those that provide consumer financing such as car loans or personal loans. but they do issue “creation units. ETFs do not issue new shares in small amounts.92. Allied Capital is such a firm. depositories accept deposits. foreign securities. making loans to hundreds of small businesses and paying high dividends to its shareholders. but what are deposits and how do they differ from other financial instruments? They Version 0. except that ETFs typically buy a fixed basket of assets. We have already discussed money-market mutual funds which buy shortterm debt instruments. Recently. ETF’s now outnumber closed-end funds. commodities. Like closed-end mutual funds. Premiums and discounts reflect market judgments of the future values of the fund’s holdings. That is. Gibson. Initially ETFs were focused on common stocks but a vast array of new ETFs have arisen to track specific industries. commercial buildings. Firms have also been set up to provide working capital to small start-up companies. and retail buildings) or mortgages.” large blocks of shares. keep their share price at $1. Real estate investment trusts (REIT) were formed for the purpose of providing some of the tax advantages of real estate investing to small savers. REITs can only hold real property (apartments. Exchange-traded funds are very much like closed-end mutual funds. Unlike corporations. Household Finance Corporation is one of the largest such companies. whereas before only wealthy investors could enjoy these benefits. etc. and these spreads can get as high as 25%. Of course. all but eliminating the distinction between ETFs and closed-end mutual funds. 10% one way or the other is not unusual. Depository institutions are distinct from other financial institutions in three important ways. regulators authorized actively managed ETFs. copyright c Warren C. . to insititutional investors who wish to acquire them. They pay no corporate income tax provided they distribute most of their income to shareholders. such as those included in the Standard & Poors 500 Index. the shares either trade and a premium or a discount to their net asset value. and offer conveniences like check-writing and on-line transfers.Chapter 9: Financial institutions 161 gaps usually open between their net asset value per share and their market value per share.

so their expansion or contraction also effects M2. This insurance only provides protection against fraud or misappropriation. copyright c Warren C.162 Depository Institutions and Pure Intermediaries are short-term debt instruments which are available on demand at a fixed nominal value – they are redeemable on demand. Gibson. What about money market funds? They look a lot like deposits because they are. the money supply is increased or decreased when depository institutions gain or lose money. Investments held by stockbrokers are insured by the Securities Investors Protection Corporation. Credit unions have their own government deposit insurance agency. we have a blurring between the deposits of banks and the shares of moneymarket funds which technically are equity shares. not against loss of investment value. at least de facto. though recently a few Credit Unions. In 2004 and 2005 there were some prominent corporate bankruptcies that allowed private corporations to unload their pension obligations onto the PBGC. Version 0. an agency of the federal government. have chosen to switch their business to a private deposit insurance company. interestingly. Finally. But technically. Money market funds are usually not insured nor are they subject to reserve requirements. redeemable on demand. Here is a case where the distinction between debt and equity has become quite blurred. Here again. bank deposits are insured by the Federal Deposit Insurance Corporation. As we have seen. not debt.92. . money market shares are equity. another government agency. Secondly. What about money market funds? Retail MMMF assets are counted in the M2 money supply. deposits are important because they are a form of money substitutes (inside money). Private pension funds are backed by the Pension Benefit Guaranty Corporation. Government regulators also require a minimum level of reserves to back bank deposits.

Recall that we have described interest in its most general sense as an incentive that must be offered to induce someone to forgo present consumption in exchange for future consumption. These could be commercial or government bonds or bills. or even 163 . commercial paper. We want to focus on interest rates that are determined by competitive buying and selling of securities in markets. Although our analysis will refer to bonds and interest. 10. it is meant to encompass equities and dividends as well. Time preference is the basic fact of human existence that gives rise to interest. Savers enter these markets with funds ready to purchase securities and borrowers enter with securities to offer.1 The Loanable Funds Market Consider an abstract market for securities of unspecified type.Chapter 10 Market Determination of Interest Rates Now that we know something of the components of the financial system – instruments and institutions – we can take a more detailed look at the interest markets they create and the variety of interest rates that are found on those markets. Supply and demand analysis works in these markets in just as in markets for ordinary commodities with slight differences.

The intersection marks an equilibrium quantity of funds supplied and the interest rate at which they are supplied. Just as 50 cents in cash may induce me to part with my apple. First. i. 5% annual interest may induce me to part with $1. The upwardsloping supply curve indicates that people will be more willing to loan more as the interest rate rises. Gibson. We call these savings “loanable funds” – funds ready to be used to purchase securities. We know which way they slope and Version 0. But we will defer that approach for a moment and instead reverse the point of view and look at the demand and supply of the savings coming into the market in search of securities to purchase. what would be the price of those funds? The answer lies in the definition of interest. But it would be entirely unsatisfactory for us because our definition of money is so much broader. The downward-sloping demand curve indicates that people will want to borrow more as interest rates decline. Bear in mind that the quantity axis on this graph represents flows. other things being equal. ours are purely notional. We amalgamate all these into a single abstract category in order to to a first-level analysis of the supply and demand forces that determine interest rates. quantities per unit time. quarters or years.164 The Loanable Funds Market shares of stock.” The money they are talking about is money to be invested – what we call loanable funds – and so for their purposes that phrase is satisfactory. other things being equal. While we should have no problem identifying the dollar amount of funds offered (in a particular time period) as the quantity variable.”) Supply and demand curves for loanable funds are shown in Figure 10. We will insist on identifying interest as the price of loanable funds and avoid the phrase “price of money. (Note that financial publications often refer to interest as “the price of money. . Interest is the price of loanable funds. We might be tempted to draw demand and supply diagrams relating the quantity of those securities to their price. copyright c Warren C.1.e. like all supply and demand curves. Interest is expressed in percent per annum.92. We must sound several notes of caution.000 of my savings for a year. Quantities of loanable funds are the dollars flowing through this market in any convenient time period: typically months.

Gibson. changes in tax laws. copyright c Warren C. but rather than treating these as exogenous to a single supply/demand graph we would segment the market for loanable funds into many markets.1: Supply and demand of loanable funds. each representing a particular combination of maturity and quality. . The loanable funds approach may seem counter-intuitive. Also. but we have no grounds to attempt precise descriptions of the curves themselves. We could turn the market for apples upside down and look at the supply of applepurchasing funds in terms of the price that those funds command. or increased wealth. While that is a legitimate and useful tactic. we know from observation (or can imagine knowing) where they intersect. This is a legitimate approach which some authors follow. but we adopt the loanable Version 0. we must not lose sight of all the other hidden variables that influence interest rates. Second. which would be the number of apples per dollar. Then the supply of loanable funds would become the demand for bonds and vice versa. there are many other influences on the supply and demand for loanable funds that are exogenous to this picture – they are assumed to remain unchanged so that we can isolate the interaction between price (interest rate) and quantity.92. Among these might be price inflation. we have seen that credit quality and maturity are major determinants of interest rates.Chapter 10: Market Determination of Interest Rates 165 Interest rate S D Loanable funds Figure 10.

The prices of durable consumer goods which mete out their services over a long span of time are also interest-sensitive. The prices of those capital goods that require the most time to bear results will be most sensitive to interest rates. We will also examine the supply of money under a fiat money regime such as we have now as well as a free banking regime.166 The Loanable Funds Market funds point of view because we are trying to explain how interest rates are determined by market forces and a loanable funds diagram shows interest rates explicitly on the vertical axis. resulting in more loans at a higher interest rate. is no different from the function of other free markets. Stated differently. Borrowers seek low rates. This is especially true Version 0. they will strongly prefer consumption and will require high interest to persuade them to save. Think of capital goods: goods capable of producing consumption goods in the future. An increase in the demand for loanable funds. Gibson. Another example would be the relationship between the sale price and the rental price of a house. When a temporary shortage of loanable funds arises. this analysis leaves unanswered the question of what causes shifts in the demand for money. We will have more to say about that in later chapters. Lenders seek the highest returns for their funds consistent with their time horizon and risk tolerance. Conversely. The tendency of the loanable funds market to move toward equilibrium. but never reaching it because of ever-changing circumstances. when more people want to borrow. a rise in interest rates induces lenders to lend who were not quite willing to lend at the old rates. If we bear in mind that interest arises from time preference we see interest not just in the loanable funds market but in almost any economic activity that spans a significant amount of time. Of course. borrowers who were only marginally interested in borrowing leave the market. These responses tend to eliminate the shortage. would shift the demand curve to the right. With loanable funds diagram in front of us we can imagine how changes in exogenous variables shift the curves and move the equilibrium point. resulting in more loans at a lower interest rate. if people in the aggregate are highly oriented to the present. The concept of profit can be a source of confusion. More savers offering their funds will shift the supply curve to the right. . copyright c Warren C.92.

whether for labor. and all plans are perfectly coordinated – this so-called evenly rotating economy – never comes about. But only temporary profit opportunities! Profits are essential to the functioning of markets as are losses. We live in a world of constant change offering new profit opportunities to those alert entrepreneurs who can devise the best adaptations to changing conditions. which is the same as saying that accounting profits will tend toward the going rate of interest. unlike profits. Pure profit is always less than accounting profit. If firms are earning positive pure profits (economic profits) in a particular market. and pure profits will rise to zero. not until you have paid yourself the going wage for apple-sellers. the opposite is true if firms are suffering negative pure profits (losses). and the income tax authorities all regard profits as the residual after all expenses have been paid. If you ponder this fact you may be struck with the harshness of competitive markets.Chapter 10: Market Determination of Interest Rates 167 in a sole proprietorship.92. assuming there are no disruptions such as new technology. prices will rise. where all markets are at equilibrium. Any income left after paying yourself that wage is profit. Interest. business people. is not dissipated by competition: it is permanent. materials. . you may be happy when you have sold enough to pay the cost of the apples plus expenses. Economists define profits (or losses) as the residual after all opportunity costs have been subtracted from income. copyright c Warren C. Why? Because time flows one Version 0. If you go into business buying apples at wholesale and selling them at retail. Even the most successful firms must constantly battle the market’s relentless gravitational downward pull on their profits. by contrast does not go to zero. Economists include the interest that could have been earned on the capital invested in the business. Of course. this imaginary state where all profits have vanished. Gibson. Of course. or depreciation of capital assets. Interest. This is called pure profit or economic profit as distinguished from accounting profit. competitors are drawn in and prices drop. Losses are less evident because those who suffer sustained losses must leave the market relinquish control to entrepreneurs who are more skillful or luckier. But you are not yet earning profit. in which case firms will shift production to other goods. driving those profits toward zero. Economists view profits somewhat differently. Accountants.

Many Enron employees bought stock. buys a $5. for example. typically two weeks or half a month. who gets the present consumption that we forgo? In the case of a consumer loan. if we neglect expenses. Some goes to owners as profits and they consume those profits.000 corporate bond.168 The Loanable Funds Market way. But the owners must wait until the goods are sold before receiving any income. However. When we save money and loan it out. bearing in mind that the end purpose of all production is consumption. The life insurance company. having been encouraged to do so by management just months ahead of the Version 0. The suppliers pay for materials and labor. a worker who has substantial savings invested in company stock will not only lose his job but those savings as well. Saving requires that we forgo present consumption for the sake of increased consumption. A key aspect of this little analysis is the fact that workers are paid at the conclusion of each work period. there would be no need for a capitalist to provide savings because the workers would have done so and they would earn the interest. So let us trace it through. .500 and its suppliers $2. In the case of business investment. You buy a life insurance policy for $5. copyright c Warren C. And so on with their suppliers. If workers were willing to wait for their pay until the goods had been sold. so time preference is one way.000.92. You loan your brother-in-law money to buy a Chevy which he pays you back after five years. it is not so obvious who gets the present consumption that you as a lender forgo. most of the money goes to workers who use their wages for present consumption. It is convenient to subtract consumer loans from total lending in order to study the connection between saving and investment. The bond issuing company buys $5. workers and stockholders could invest part of their income in which case we would further trace their savings and ultimately find workers and owners consuming.000 worth of capital goods – machine tools. the borrower gets the present consumption. Of course. The machine tool manufacturer pays its workers $2. Of course. plus interest. You take the money and buy a Cadillac and park it next to his five-year-old Chevy. Ultimately. workers who are so inclined can often buy stock in the company they work for. financial advisors discourage too much of this since if the company fails. Gibson. and interest derives from time preference.500.

if the inflation rate is 12% and the nominal rate is 10%. we need a formula for real interest rates. Nominal magnitudes are not adjusted. In order to accurately assess what happens to interest under price inflation. Gibson.1 Version 0. 1+r = r = 1+i 1+p 1+i i−p −1= 1+p 1+p PV (1 + i) 1+p For example. 169 10. the real rate is 0. Earlier we distinguished real and nominal magnitudes of wages. Real magnitudes are adjusted for inflation. If the market rate of interest is i then P V dollars become P V (1 + i) dollars in nominal terms after one year.92.0182 1 + 0. the purchasing power of P V dollars is reduced to P V /(1 + p) after one year. If prices have doubled.2 Real and Nominal Interest Rates Having distinguished profit from interest. meaning the rate of return adjusted for the declining purchasing power of money.12 − 0. With respect to interest rates. and are called that because in many situations we are interested in relative price changes so we strip away the change in price level – price inflation – to reveal the relative changes that are due to other factors: real factors. copyright c Warren C. The real rate of interest r is the rate that when applied to our initial amount P V yields its reduced purchasing power increased by the nominal rate of interest: P V (1 + r) = Solving for r.Chapter 10: Market Determination of Interest Rates company’s collapse. we now need to distinguish between real and nominal interest rates. suppose you loan out $100 and get back $110 a year later. prices. and suffered this way. If the rate of price inflation is p = ∆P/P per year. . income and cash balances.10 r= = 0. you have suffered a substantial real loss – a loss in purchasing power.

making calculations all the more problematic. this is a problem facing anyone who contemplates lending money in an inflationary environment – some estimate must be used. In some respects this is true but in some important respects it is not. • People who hold cash or bonds see the real value of their holdings increase. Nevertheless. They are. When interest rates are high. Projection of real interest rates into the future is even less exact because we must rely on estimates of future price inflation rates.82%. to the extent that deflation has not been accounted for in their agreed-upon interest rate – the reverse of the situation under inflation. but in reverse. . Gibson. In particular. the precision of the exact formula is misleading because price inflation is typically changing rapidly in such circumstances. 10. based on arbitrarily chosen baskets of goods and services. Fortunately. which even expert prognosticators have difficulty with.82% for the example – close enough. It is true that under deflation: • Creditors gain at the expense of debtors. futures contracts on interest rates provide this information. With an inflation rate that is much less than 100% (p << 1). • People devote resources to seeking protection against the adverse effects of deflation as they do under inflation Version 0. after all.170 Deflation versus inflation or 1. copyright c Warren C. it is reasonable to drop the 1 + p in the denominator leaving the approximate formula r ≈i−p which gives 2% instead of 1. You might think that deflation would call forth all the effects of inflation.92.3 Deflation versus inflation Price deflation refers to a declining overall price level and is the opposite of price inflation. Calculation of real interest rates for past periods is inexact because price indices are inherently imprecise. also the reverse. the money markets distill the collective estimates of all the market participants and this collective wisdom is about as good as it gets.

Although the dire consequences of deflation as we have sketched them are theoretically possible. 1 Version 0. The incentive to save would evaporate and money would cease to function as a standard of deferred payment.Chapter 10: Market Determination of Interest Rates 171 One major difference is that deflation is rarely both severe and sustained. in reality they almost never happen. it is difficult. To begin with a gold standard regime. Some investors were obviously willing to forgo all interest on such bills. In other words.g. but why would they pay the borrower to hold their money? The very slight negative rate could be considered a fee paid for safekeeping of funds for which there was no better alternative. this situation can be temporarily self-reinforcing. In the first case people don’t need to worry much about it and in the second case there is not much they can do about it since it hits almost without warning. In response. it is usually mild. Moreover. people would lose all reason to make financial investments. funds above the bank insurance limit. at least for a time. Gibson.. If sustained. Let us return to the concept of the real rate of interest. Assume that price deflation is the result of a declining money supply. To compensate for inflation. But nominal interest rates cannot go lower than zero. the velocity of circulation declines. e. This increases price deflation further. lenders demand higher interest rates. the obvious strategy is to hold more money since the purchasing power of money is rising. people increase their portfolio demand for money.92. No matter what happens to the purchasing power of money and no matter how much you trust the borrower. To compensate for deflation. If severe. But if you see deflation coming and want to protect yourself. the interest rate on certain Treasury bills dipped ever so slightly into negative territory. Why not? Suppose someone wants to borrow $100 from you and proposes to return $99 after one year – interest at negative one percent per annum. . to envision a situation where the stock of monetary gold would fall steeply and For a brief intraday period in late 2008. as opposed to simply keeping the $100 in your pocket during the whole year?1 Thus if nominal interest rates should fall very close to zero. what could possibly induce you to accept such a deal. though not impossible. This is just the opposite of the inflationary situation where expectations cause velocity to rise which in turn makes prices increases run ahead of money supply increases. borrowers demand lower interest rates. it is usually sudden and sharp. copyright c Warren C.

92. Also. some of the gold required by the new cancer cure would be drawn out of non-monetary stocks of gold (such as meltdown of jewelry) and some would be diverted from supplies that would otherwise flow to consumption. especially when adjusted for the power of those computers. since governments do not ordinarily have anything to gain from contractions of the money supply. But equilibrium would return as new mines opened up or as people figured out how to recycle some of the gold used in the new treatment. And while many early computer manufacturers have been driven out of the business as a result of fierce competition (even IBM Computer engineers like to say that if automobile manufacturing had progressed at the rate at which computers have progressed. the process might require a significant one-time transfer of gold to new machines that effected the cure.000 miles per gallon! 2 Version 0. which would further strain the Treasury. Also note that under a gold standard. In order to reduce the stock of money. Deflationary shocks under a government fiat money regime are even more difficult to imagine. outstanding debt would have to be paid off with more valuable money. First. the Treasury or the central bank would essentially have to burn some of its incoming tax revenue. Gibson. Both of these effects would reverse themselves under a situation where the government was deliberately reducing the money stock. Prices of personal computers have plummeted in recent years in both real and nominal terms. We must not confuse declines in the overall price level – price deflation – with declines in particular relative prices. the existence of a consumption market would soften the effects of the new demand on the market for monetary gold. . someone discovered a cure for cancer that required significant amounts of gold.172 Deflation versus inflation suddenly.000. In either case. In either case. Suppose. There are two possibilities. a deflationary shock would occur as gold was converted from monetary uses to clinical uses suddenly and in significant quantities. for example. a Rolls Royce would cost $1 and get 1. Recall that when they increase the money stock.2 Very few people complain about this situation. Or it might involve ongoing injections of gold into cancerous tumors. copyright c Warren C. governments gain seignorage revenue and devalue their outstanding debt.

92. continue to earn respectable profits in spite of rapid price declines. copyright c Warren C. including overseas investors who have recently been absorbing a great deal of U.5 Marketability Some bonds are more marketable than others. A borrower who defaults on a loan is often forced into bankruptcy.S. . there are limits to how much taxation people are willing to bear. Gibson. meaning it is easier to find buyers for them. since a bond is a legal obligation as contrasted with a share of stock which carries no promise about either dividends or the share price. 10. such as Dell.Chapter 10: Market Determination of Interest Rates 173 sold its personal computer operation in 2004). government bonds are considered nearly riskless because they are backed by the power of taxation and by the government’s unlimited power to print money. 10. While there are no legal limits. most of those that remain. Likewise. Investors buying bonds from companies perceived to be more likely to default will require more interest which can be thought of as default insurance. though their shares of stock will likely become worthless. U.4 Default risk The first factor that affects the risk of a loan or bond is its nominal risk – the risk that the borrower might not pay the interest due on the bond and perhaps even fail to pay all or any of the principal at maturity. government debt. If the borrower is a corporation. This situation is called default and it is a serious matter. for example. When adverse events occur after a bond has been issued. keep a close watch on the volume of debt that is monetized (purchased by the Fed using newly created money). Bonds issued by IBM. the market price of that bond will drop as a result of the increased risk brought about by those events.S. are actively traded Version 0. since in bankruptcy the claims of bondholders have priority over those of stockholders. As we have indicated. its stockholders are not liable for bond defaults. the financial markets.

The conversion price and term are fixed at the time of issuance. though not quite as easily as stock prices.174 Tax Treatment and their prices are easy to obtain from brokers. that are attractive to investors and induce them to accept lower rates of interest. perhaps not marketable at all. 10. exchange for shares of stock in the company issuing the bond. at his option. Some investors see the high yield as compensation for the risk of Version 0. Convertible bonds are bonds that the holder may. muni bonds (issued by states and various local government agencies in addition to municipalities) government obligations are exempt from state and local income taxes. However. Those individuals who are taxed at the highest rate will get the most benefit from this exemption. Gibson. and therefore even if that company’s prospects were just as sound as IBM’s.7 Special Features Some bonds carry special features. at which point all of those funds are taxed as ordinary income. as we have indicted. One way to compare taxable bond income to muni bond income is to compute the after-tax yield of each class using one’s personal tax bracket. Favorable tax treatment is a bonus that results in a lower rate of interest compared to a taxable bond of the same quality and maturity.92. sometimes called sweeteners.6 Tax Treatment Most bond interest is subject to federal and state income tax. . copyright c Warren C. It makes no sense to buy muni bonds in a tax-deferred account such as an IRA since no tax is paid on any income in such accounts until funds are withdrawn in retirement. Such a bond would not be as marketable. 10. its bonds would pay higher interest as compensation for lack of marketability. and the prospect of being able to acquire shares that have risen above the conversion price makes these bonds attractive. consider a bond issued by a small and obscure company. In contrast. The value of the tax exemption on muni bond income depends on the tax bracket of the purchaser.

8 for Treasury securities as of January of several recent years is based on rates quoted for bills. Gibson. Warrants are a kind of call option. i.. meaning the mortgage holder has the right to “put” it back to the lender (or more likely. Some bonds are accompanied by warrants which entitle their holders to buy shares of the company’s stock at a certain price. a bond’s maturity date is the date when its principal is to be returned to the lender (or maturity may refer to the time remaining until this date).e. people require higher interest rates to induce them to lend for a longer period of time. etc.92. The yield curve shown in Figure 10. one year. This means that after some specified date. Such provisions are a benefit to the company and thus require somewhat more interest to make them attractive to buyers. the firm to which the mortgage was sold) at any time. 10. the issuer has the right to repurchase the bonds at some specified price. These Version 0. and should be thought of as a snapshot at any particular time. Note that these are not time history plots. copyright c Warren C. assuming other factors are equal. etc. and bonds.Chapter 10: Market Determination of Interest Rates 175 conversion. where short-term rates exceed long-term rates. and may be callable by the company at 25. starting five years after their issuance. each curve is a snapshot taken in different years and showing the yields available on securities due in three months. which is a plot of interest rate versus maturity. Sometimes bonds (and more commonly.8 Maturity As we have indicated. Yield curves are most commonly show interest rates on Treasury securities. A particular yield curve is specific to bonds of a certain. preferred stocks) are callable. Active markets for bonds of various maturities give rise to a yield curve. Rather. . notes. Most mortgages can be (and usually are) paid off in advance of their maturity without any penalty to the borrower. They grant their holder the right to call away shares of stock from the writer of the option (which is the company in the case of warrants). call them in. For example. This is a kind of put option. This situation is called an inverted yield curve. tax treatment. As a rule. The yield curve for 2007 slopes down slightly. preferred stocks are usually issued at $25 per share.

A drawback of this theory is that over a long period of time expectations of falling rates should be about as common as expectations of rising rates. interest rates of different maturities tend to move together.176 Maturity 6% 5% 4% Interest rate 3% 2% 2009 2008 2007 2006 2005 6 mo 2 yr Maturity 5 yr 10 yr 30 yr 1% 0% 3 mo Figure 10. The preferred habitat theory strikes a balance in assuming that bonds of Version 0. The pure expectations theory holds that different maturities are perfect substitutes so that the yield curve reflects expectations of future short-term rates. Gibson. Each lender and each borrower. as in the figure above. In any event. copyright c Warren C. The segmented market theory holds that different maturities are not substitutes at all. economists have long been fascinated with yield curves and have struggled to devise theories explaining them. Here are four. But as an empirical fact. has his own preferred maturity and there is little entrepreneurial arbitrage between the markets for different maturities. . says this theory.2: Yield curves for Treasury securities are rare and are thought by some to be a harbinger of an economic downturn. and yet the yield curve nearly always slopes upward.92.

it is essentially charging a rate higher than 5because you are only getting $800. The intent of the regulation was to increase the interest spread for banks thereby granting them quasi-monopoly profits. In addition to black markets.000 net and your $50. the short end of the maturity spectrum is their “preferred habitat.9 Interest Rate Controls As we saw in Chapter 5. shortages arise. 10. i. This amounted to a choke point in the flow of savings through intermediaries. Gibson. This means that if the bank loans you $1 million at a government-imposed ceiling rate of 5you to keep at least $200. In the U. banks and other lenders have devised numerous ways to avoid usury laws. Usury laws set a maximum legal interest rate. lenders may require compensating balances. a reduction in savings via intermediaries below the level that would have prevailed with no controls and the likelihood that competition would have forced banks to pay some interest on checking accounts. Its main effect was financial disintermediation. .Chapter 10: Market Determination of Interest Rates 177 different maturities are only imperfectly substitutable.000 = 6. Some of these savings moved to direct finance Version 0.e. and when this rate is below the rate that clears the market.S.” Their cost of borrowing is thereby raised substantially.” The liquidity premium theory says that lenders will accept lower interest rates for shorter maturity.92. copyright c Warren C..000 in a noninterest-bearing checking account. a rule known as Regulation Q made it illegal to pay interest on checking accounts from the time of its adoption in 1933 until its repeal in 1986..000/$800. The riskiest borrowers are shut out of the market and so they turn to the black market – suppliers of credit commonly known as “loan sharks. That is.25 Governments sometimes impose ceilings on the amount of interest banks pay. For example. people slightly prefer shorter maturities and require higher interest rates to induce them to go longer. This explains the normal upward-sloping yield curve but not inverted curves. usury laws have been common throughout history.000 annual interest payment represents a rate of $50. The theory says that on the whole.

copyright c Warren C. Version 0.92. . disintermediation does just the opposite. Gibson.178 Interest Rate Controls and some were lost altogether. Thus if intermediation increases the efficiency of the flow of funds.

Part IV Commercial Banking: History and Practice 179 .


establishment of branch offices. the government has controlled entry into the business. the businesses which banks may or may not engage in. In return. Gibson. copyright c Warren C. the kinds of assets they may hold. today. even following the deregulation of the 1980’s and 1990’s. and the maximum interest rates they may pay.S. and the kinds of liabilities they may incur. relieving banks to some extent from the harsh discipline of competition. At various times. and to some extent presently.92.181 Commercial banking is perhaps the most highly regulated industry in the U. government has bestowed upon the banking industry the status of a cartel. . Version 0.

92.182 Version 0. Gibson. copyright c Warren C. .

Chapter 11 The U. Experience The present state of the banking industry – a confusing combination of restrictions. beginning with the Revolutionary era. Transatlantic trade was the most highly developed aspect of the economy. special privileges and free-market operations – is not something anyone would have designed. We will focus on the evolution of banking in the U. The best way to make sense of the current situation is to trace its history.1.S. Bills of exchange. such as wampum and tobacco. and those silver and gold coins that did circulate were mainly of Spanish origin rather than British. were an innovative alternative to the problematic 183 ..1 America’s First Central Bank Prior to the Revolution the American economy was fairly primitive. Many people used primitive commodity forms of money.1 Pre-Civil War: From Chartered Monopoly to “Free” Banking 11. as we saw in Chapter 4. This trade was facilitated largely by bills of exchange rather than flows of money. 11. This will help us appreciate the various forms of banking and will enhance our understanding of business cycles. Plantations were largely self-sufficient and what exchange there was often took the form of barter. and provide some insight into the emergence of central banking. S.

He was imprisoned for three years for bankruptcy following 2 1 Version 0. the Continental Congress took steps to restore stability and to better finance the revolution. the Bank of North America. had to approach the government for a charter.3 The Bank of North America was spearheaded by Robert Morris. The traditional usage. refers to coercive elimination of rivals through government action. Gibson. 3 See Section 5.184 Pre-Civil War: From Chartered Monopoly to “Free” Banking shipment of specie across the ocean. Mercantilism was a very influential political philosophy in all the major European countries from about the sixteenth to the eighteenth century. . we must realize that these were the waning years of the age of mercantilism. 4 Morris at one time functioned as a one-man de facto bank. That is to say. the notions of incorporation and monopoly went hand-in-hand. The other kind of monopoly which we might call “efficiency monopolies” are very rare and when they do arise. there is no historical record of them charging the monopoly price that is theoretically possible. To answer that. a signer of the Declaration of Independence and a wealthy merchant. though perhaps not as strong as in Europe. issuing notes backed by his own personal credit. Examples of the latter type of monopoly would be the East India Company of the 17th and 18th centuries or the electric utility companies of present times. In Chapter 3 we mentioned the creation and demise of the Continental currency during the Revolutionary War.” This book was just beginning to command attention when the Bank of North America was started in 1782 so it is safe to say that mercantilist sentiments. But it was also America’s first commercial bank. Following the financial chaos surrounding the Revolutionary hyperinflation. banks like almost any other major business at the time. The modern sense of “monopoly” refers to a firm that eliminates its rivals through competition.2 above. copyright c Warren C. and received its most serious challenge in the form of the laissez faire ideal which Adam Smith set forth in his 1776 book “The Wealth of Nations. which applies to the era of Mercantilism.2 Thus.92. In 1781 they chartered America’s first bank. Mercantilism was an open alliance between merchants and the state in which governments granted charters that conferred monopoly privileges.4 Despite its We will study central banks in Part VI. We might ask why this bank required a Congressional charter. They intended this bank to function as a central bank1 and patterned it after the Bank of England. were still influential in America at the time.

wanted to open a competing institution. Version 0.2 First Bank of the United States In 1789 the U. it did not work out as intended. While monopoly note issue was not one of them. At one point it hired people to urge noteholders not to present them for redemption – a tactic that only worsened confidence. a large nationwide commercial bank that was recently acquired by Wells Fargo.92. 11.1. it held Federal government deposits. Constitution took effect. however. The process of state bank chartering was fraught with politics and favoritism. it was the only bank allowed to establish inter-state branches. Experience 185 monopoly privileges. President Washington’s Secretary of the Treasury.Chapter 11: The U. S. After the transformation of the Bank of North America. He had to disguise it as a corporation intended to provide New York City with wholesome water. S. Alexander Hamilton. After just a year of operation Morris gave up his Congressional Charter and continued to operate under a charter from the state of Pennsylvania. and was merged into today’s Wachovia Bank. replacing the prior Articles of Confederation. copyright c Warren C. in 1794 opening the Manhattan Company as a bank subsidiary. Congress granted the new Bank a twenty-year charter. In 1784 the Bank of New York and the Bank of Massachusetts began operation under state charters and by 1800 fully 29 state-chartered banks were operating. all banks were for a time state-chartered. Aaron Burr. . a Republican opposition leader and future Vice President. The result was the Bank of the United States. The bank became known as the First Pennsylvania Bank. and its notes could be used to pay unsuccessful land speculation and died in poverty and obscurity. For example. This bank was one of the ancestors of today’s JPMorgan Chase. The charter granted a number of special privileges. was eager to to establish another central bank in part to help pay off the lingering Revolutionary War debt but also to bring the nation’s nascent financial system under central government control. It drew criticism for issuing too many notes relative to its species holdings. the Bank of New York was created by leading elements of the dominant Federalist Party. Gibson. later known as the First Bank of the United States.

equal to the amount of gold and silver reserves divided by the sum of notes and deposits outstanding. no internal Sometimes called the Democratic Republican Party and unrelated to the modern Republican Party 5 Version 0. Banking was a divisive political issue at this time.5 4. America’s largest corporation.5 5. where a bank’s liabilities are a multiple of its reserves. The Federalists.186 Pre-Civil War: From Chartered Monopoly to “Free” Banking taxes (i..e. . internal taxes. copyright c Warren C. wanted frugal government. the reserve ratio.2 0.5 $23.92.5 = 42%. they held public legal tender status). the result being a 72% rise in the price level between 1791 and 1796. Gibson. tariffs.5 One fifth provided by the Federal government This balance sheet provides some insight into banking practice at the time. in its time. In addition. free trade. As of 1809. It was. the government provided part of the Bank’s equity capital.5 8.0 2. a large standing army and a large national debt.1). was 5/13 = 38% and the ratio of capital to equity was 10/23. and those reserves are in turn a multiple of another bank’s reserves (Figure 11. The Republicans. The term pyramiding is used for such situations. securities Due from state banks Loans Total a 0. Thus the ratio of private banks’ aggregate liabilities to the reserves held by the second bank would be a much smaller number. as of 1809 (Amounts in millions) Liabilities Assets Land & buildings Specie reserves U. and they stood for a powerful central government.0 $23.0 0. For example. Although this reserve ratio is high by present-day standards. other banks used these notes as a basis for further expansion.5 Equitya Retained earnings Notes Deposits Total 10.5 led by Thomas Jefferson and James Madison.8 15. its simplified balance sheet was as follows: First Bank of the United States. were the pro-bank party. S. led by Washington and Hamilton.

This left the U. copyright c Warren C. with no central bank. in which no candidate received a majority of the Electoral College so that the outcome had to be determined by the House of Representatives. by which time Madison was President.S.92. the charter of the Bank of the United States was allowed to expire in 1811. As part of this program. with each state’s delegation getting one vote. another war crisis meant another banking crisis.Chapter 11: The U.3 The Second Bank of the United States As so often happens.6 Soon specie reserves were inadequate to cover liabilities and once again. about 200 new state banks were chartered. and he set about dismantling the Federalist state. only state banks. The War of 1812 was financed largely by borrowing and in response to the new demand for loans.1: Pyramiding of reserves taxes. Gibson. 11. Version 0. Jefferson became President. a predecessor of today’s Citibank. and a reduction or elimination of government debt. militia rather than a standing army. The Republicans won the dramatic election of 1800. the banks were allowed to take their cue from the Bank of England and suspend specie 6 Including the City Bank of New York. Experience 187 Figure 11.1. . S.

Thus the War of 1812 was financed mainly through privately issued fiat money as the U. continued to borrow and pay out unredeemable private bank notes. but had to make its purchases mainly in the East where the money had depreciated much less. S. as of 1832 (Amounts in millions) Liabilities Assets Land & buildings Specie reserves State bank notes Loans Total 3 7 3 66 $79 Equity Notes Deposits Total 35 21 23 $79 Here we see a lower reserve ratio than in the First Bank.188 Pre-Civil War: From Chartered Monopoly to “Free” Banking payments. but only by expanding its own notes which state banks then used as reserves. copyright c Warren C. With specie payments suspended. In response to this situation. many of whom could no longer make their installment payments.92. the Second Bank of the United States was formed in 1816. Its balance sheet as of 1832 was as follows: Second Bank of the United States. 7/44 = 16%. Only the Second Bank’s notes were receivable in payment of taxes. in addition to a great deal of credit extended to purchasers of public lands. 7 Version 0.7 Tariffs were the only federal taxes levied at the time. much like the First Bank only bigger. the notes of many banks began to trade at a discount. . The primary justification for the Second Bank was to help state banks resume specie payments. This was especially problematic for the Treasury which received payments from public land purchasers largely in depreciated currency. During its first three years of operations it did so. Gibson. and very few people paid these taxes. with actual gold obtainable only from the Second Bank – another instance of pyramiding. After the war it was generally agreed that banks must return to making specie payments but it was difficult to see how this might be done in light of the great expansion of credit during the war.

8 Specie payment was suspended. for the first and only time in American history. as Jackson was a rugged frontiersman. which was also a period of economic contraction.1. ending the monopoly privileges of incorporation which as we have seen were a holdover from the Mercantilist era. It is no exaggeration to call the victory of Andrew Jackson and his party a revolution. Van Buren recruited war hero Andrew Jackson to run for President.e. yet despite the fact that tariffs and land sales were the only sources of federal government revenue. These positions led to the famous “Bank War” which pitted Jackson against Second Bank President Nicholas Biddle. Jackson and his followers also advocated “hard money. and put several Congressman as well as Supreme Court Chief Justice Economic “booms” generally coincide with monetary expansion and “busts” with monetary contraction. Jackson and his party favored free trade and low tariffs. Biddle was an astute politician.Chapter 11: The U.92. The Whigs replaced the Federalists as defenders of banking and government intervention. 11. Gibson. copyright c Warren C. In opposition. the Panic of 1819. in sharp contrast the Eastern elite (typified by Adams) who had dominated American politics up to that time. So important was the issue that it led to a new political alignment. S. specie or note issue fully backed by specie – no fractional reserves. and Jackson won a sweeping victory over incumbent John Quincy Adams in the pivotal Presidential election of 1828. We will study macroeconomic cycles further in Chapter 17. Martin van Buren of New York forged a new Democratic party to carry on the tradition of laissez faire. prominent Whigs included Henry Clay.” i. the panic ended fairly soon and specie payment was soon resumed. But the episode left a bad taste and opposition to the Second Bank mounted. John Quincy Adams and Daniel Webster. They wanted to abolish central banking which they viewed as the root of inflationary mischief.4 The Jacksonian Revolution Jackson’s victory was a cultural shift as well as a political shift. One shift was the rise of the concept of general incorporation. the national debt was paid down to zero in January 1835. . but because the government’s control of the economy was quite limited. Experience 189 It was not long before America’s first modern bank panic hit. 8 Version 0.

In his veto message he denounced the bank as a “hydra-headed monster. But the “free banking” of this time was not altogether free. However. Some states set up monopoly state-run banks which were essentially miniature central banks while others continued to allow multiple chartered banks. it struggled on for a while as a private bank. finally failing in 1841.” In response. tried a form of deposit insurance called a “Safety Fund” which was not successful.” The veto stood but the Bank’s charter still had four years to run. Such was the general distrust of banks that nine states. 11. came to be called “free banking.5 “Free Banking” in the United States As of 1836. and branching within many of the states was likewise prohibited. Biddle called Jackson’s veto statement “a manifesto of anarchy. Six states tried note insurance and New York. meaning that no longer would a charter entail monopoly privileges. But Jackson was even more skillful at the game of patronage. four years in advance of the expiration of its charter. exemplified by Michigan in 1837 and New York in 1838. copyright c Warren C. taking hard money doctrines to an extreme position.” This entailed general incorporation of banks. Anyone could get a bank charter if they met certain requirements. Private banks issued notes and accepted deposits with their reputations and ultimately their survival serving as the restraints on overissue of either notes or deposits.92. the Federal government had no role at all in bank chartering or regulation. Jackson was re-elected in 1832 and in 1833 he withdrew federal funds from the Second Bank (firing two Secretaries of the Treasury in the process) and deposited them in various state banks which critics called his “pet banks. Unincorporated banks were not allowed to issue notes. Gibson. in 1829.1. The most common arrangement.” After the expiration of the Bank’s charter in 1836. paralleling other industries.190 Pre-Civil War: From Chartered Monopoly to “Free” Banking John Marshall on the bank’s payroll. State governments mandated capital/asset ratios and conducted examinations of banks’ books. Jackson vetoed the bill. They imposed reserve requirements and prohibited Version 0. No interstate branch banking was allowed. state governments remained very active in bank affairs. . outlawed banking altogether. When Congress re-authorized the Second Bank in 1832.

These organizations acted Version 0. copyright c Warren C. Experience 191 issuance of small-denomination notes so as to lessen competition with U.92. This meant that state governments could issue bonds at will and force banks to treat them almost as if they were “as good as gold. thereby reducing transaction costs substantially. bankers were generally rather careful about keeping enough reserves to maintain confidence. but perhaps more importantly.S. So although private banks could create money out of nothing by issuing new bank notes. actually work? Private banks issued notes that were redeemable for gold or silver on demand. other banks which had acquired large stocks of the notes of an over-issuing bank might present them for redemption. redeeming them for coins. this was the freest banking era the U. S. Private clearinghouses arose to settle obligations between banks.Chapter 11: The U. become concerned and call for redemption in large numbers (a “bank run”). How did this system. That competition largely served to regulate the circulation of privately issued banknotes. . Gibson. Their charters spelled out the activities that banks were allowed to pursue. and bringing the coins back home would be a very inefficient operation. has ever had. S. Although banks issued notes in excess of the reserves they held – fractional reserve banking – there was no problem as long as there were not too many simultaneous demands for redemption. token coins. Despite all these restrictions. which seems so strange from our modern perspective. Transporting these notes to the banks of issue.” Of course in many cases they were not. Of course this theory describes purely free banking and does not contemplate government interventions such as the requirement that state bonds be accepted as reserves. their redemption obligation severely restricted their ability to do so. During this time banks were constantly receiving notes issued by competing banks. and this was a de-stabilizing influence.” Because a free bank’s reputation is its most valuable asset. A surge in redemption demands by other banks is called “adverse clearing. and it was a time of considerable competition. And finally and perhaps most importantly many states required banks to accept state government bonds as reserve assets. seeing a large increase in notes. Not only might depositors.

”9 Clearinghouses evolved to provide more services than just note exchange. John J. This was especially problematic for merchants who did not want to alienate their country customers by refusing or discounting their notes. Boston was the hub of commercial and cultural life in Massachusetts and consequently a large volume of banknotes from banks outside Boston – “country banks” – were spent in the city. commented in a moment of candor that the Suffolk Bank did its job “as safely and much more economically than the same services can be performed by the government. and note brokers took on the job of exchanging the notes of various private banks. increased the overall efficiency and stability of the banking system. The system worked so well that many years later the U. and some have criticized free banking on this ground. 1903. Some of them cleared checks and guaranteed note values. “A History of Banking in the United States. But we must remember that 9 John Jay Knox. Version 0. These notes circulated at a discount not only because the soundness of those banks was uncertain but also because the transportation costs associated with redeeming them for specie were substantial. the directors of the Suffolk Bank offered a service whereby they would accept the notes of country banks at par. Gibson. occasionally. Seeing a profit opportunity. much like the establishments in today’s airports that exchange foreign currencies. Brokers were much less efficient and less convenient than clearinghouses. clearinghouses. for coins. whether organized for profit or as non-profit associations of member banks. copyright c Warren C. They provided incentives for banks to honor their redemption obligations while at the same time reducing the transaction costs and resource costs of banking – the amount of specie that had to be maintained as “idle resources” in support of redemption obligations.” New York. Knox. A notable example of a clearinghouse operation was the Suffolk Bank clearing system which operated from 1819 to 1859.S. In general.92. The Suffolk Bank earned income from this arrangement primarily by loaning out the deposited funds at interest.192 Pre-Civil War: From Chartered Monopoly to “Free” Banking like bankers’ banks. places where bankers could take notes of other banks and exchange them for their own notes or. In some cities there were no clearinghouses. Comptroller of the Currency. provided those banks would maintain funds on deposit without interest. .

This put pressure on American exporters and banks.851. Gibson. and the impact of bank failures was lessened greatly when Federal deposit insurance was instituted in the 1930’s. S. after all. as would be expected even under pure free banking.000. knew that if he continued to offer redemption when his competitors did not. not a trivial sum. State governments. not market failure. But under government control. should any banker balk at the propriety of this arrangement he would likewise place himself at a distinct competitive disadvantage. Yet this is less than the loss in purchasing power suffered due to the 2% inflation in just one year.Chapter 11: The U. authorized by state governments. But upon examination. Again. his bank would likely be drained and he would be out of business. depositors often suffered substantial losses in purchasing power. The free banking system in the United States came to be called “wildcat banking” by its critics. Which was greater? An estimate of all the losses to noteholders due to bank failures during the entire free banking epoch amounted to about $1. Note brokers were thus the next best solution given the prohibition of branch banking. The Bank of the United States had engaged in heavy cotton speculation and the falling price of cotton prompted it to Version 0. seeing suspension as fraudulent and immoral. Even the most scrupulous banker. as we have indicated. and clearinghouses can only arise where there is a sufficient number of banks located reasonably close by. . 1860. He thus faced great pressure to join in the unscrupulous activity.92. Suspension of specie payments was. suggesting that private note-issuing banks were reckless and irresponsible and that only centralized government control could prevent a catastrophic market failure. copyright c Warren C. many of the problems of the free banking system turn out to be examples of government failure. Of course some banks did fail. What of these? The 1837 panic was triggered by a credit contraction instituted by the Bank of England in response to inflation and gold outflow in Britain. This of course provided bankers with a strong incentive to purchase state government debt since they could pyramid notes and deposits on top of these bonds as if they were gold. under government control. Bank panics erupted in 1837 and 1857. forced banks to hold state government bonds as part of their reserves. Experience 193 prohibition of nationwide banking retarded the growth of banking in remote locations.

The partners who owned a bank typically bore unlimited responsibility for its liabilities. “The Theory of Monetary Institutions. In any event. The loan-deposit interest rate spread is the source of bank profits.1.” Blackwell.194 Pre-Civil War: From Chartered Monopoly to “Free” Banking suspend specie payments. Gibson. The 1857 panic was triggered by overexpansion and once again resulted in a government-sanctioned suspension of specie payments. . A nationwide clearinghouse operated and all the banks accepted each other’s notes at par. There was only one significant bank failure during that era – the Ayr Bank – which resulted in only modest losses to its customers. which was highly competitive as attested to by the modest spread of one to two percentage points between loan and deposit interest rates. Free banking came to an end with the enactment of Peel’s Act in 1844 Lawrence White. from 1716 to 1844. Scotland is much smaller than the United States and has no equivalent of American State governments. Both of these panics ended quickly and were far less severe than the Great Depression of the 1930’s. Many of the ills that critics might expect to beset free banking were absent from Scotland. 83..10 The populace was served by more branch offices per capita than either England or the United States. Such clauses served the interests of both banks and noteholders as they helped prevent bank runs. the private note-issuing banks of Scotland could open branches anywhere in the country and were not obliged to accept government bonds as reserves.6 Free Banking in Scotland The most highly developed system of free banking held sway in Scotland for fully 128 years. copyright c Warren C.92. and its low value suggests intense competition. This of course was a major incentive for bank managers to act prudently and served as a partial private alternative to deposit insurance. 10 Version 0. but they were outlawed in 1765. with interest added during the time of delay. p. in contrast to the U. No single bank grew to dominate the market. 11.S. Bank notes were typically protected by “option clauses” allowing the bank to delay redemption payments. In 1716 the Bank of Scotland lost its monopoly on note issue and a number of private free banks arose to take its place. and these facts probably made it easier for free banking to arise in that country. 1999.

Peel’s act was a result of hard money sentiments. And under the new system there were two serious bank failures. Perhaps the U. though the Treasury was still obligated to make interest payments in specie. budget surpluses were the norm. We will never know. Congress declared that this would be the first and only issuance of this kind but this promise was soon forgotten. As part of the Legal Tender Act of 1862. Notwithstanding heavy new taxes (including the first U.7 million per day. The cost of the Civil War to the Union government alone was about $1.2 The Civil War (1861-1865) and National Banking During peacetime the U. Congress authorized $150 million in Greenbacks (Figure 11. with repeated issues bringing the total to about Version 0. and were not backed by specie.2). Ironically. These were declared to be legal tender for all debts.S. Prior to the Civil War. tried to get private banks to purchase the new issue with specie. In the fall of 1861 Secretary of the Treasury Salmon P. . a former Jacksonian. free banking was ended abruptly by the biggest crisis in the entire history of the Republic: the Civil War. amounting to a few million dollars annually – about 1. in 1857 and 1878. copyright c Warren C.S.92.S. because U. Except during wartime or panics. Gibson. Chase (whose name survives in today’s JPMorgan Chase bank) attempted to float a massive $150 million bond issue but because Chase. income tax) and massive borrowing. Experience 195 which extended the central banking powers of the Bank of England to Scotland as well. the total national debt stood at $66 million. banking system would have evolved in the direction of Scottish free banking. public and private. part of the war burden was financed by issuance of new paper money called Greenbacks. and because confidence in the private banks was beginning to erode.S. 11. S. government had minuscule budgets.Chapter 11: The U. most of it run up during the Mexican-American war of 1848. specie payments were suspended both for private banks and for the Treasury itself with respect to its notes.5% of GDP versus more than 20% currently.

transforming it into a government-managed paper currency. in fact each proposed new bank had to gain the approval of the Comptroller of the Currency.11 whose office administered regulations and restrictions on their activities. unique in that no other business firms were federally chartered. These notes had to be backed by government bonds and were guaranteed at face value. a stupendous sum relative to the size of the economy.” Version 0. National banks could not issue their own notes. This system created a market for national debt which. It established a system of nationally chartered banks. Gibson. but it accomplished this end by impos11 Pronounced “controller. copyright c Warren C. The National Banking Acts of 1863.92. and 1865 effectively monetized this war debt. had reached the staggering sum of $2. With limitations on federal power still taken seriously. Congress did not see fit to outlaw notes issued by state-chartered banks. by the end of the War.2: A “greenback” – Civil War currency.8 billion. $415 million in 1864. but instead were required to distribute U. 1864. Bank Notes supplied to them by the Comptroller.196 The Civil War (1861-1865) and National Banking Figure 11.S. While this system used general incorporation and was nominally open to free entry. .

but instead of a central bank.S. Notes were now fully insured but conversion of deposits into notes involved a contraction of the money stock which had not been the case with private note issue. Gibson. Thus a dual banking system was established in which national banks could issue notes and accept deposits while state banks could only accept deposits. the last a severe episode in which banks were once again permitted to suspend specie payment.Chapter 11: The U. That is because U. they could still accept deposits. Conventional wisdom views this movement as a populist uprising in opposition Version 0. S. it created a system of many tightly regulated national banks. an entirely new source of illiquidity arose. was part of a broad political movement called progressivism. national banks were required to maintain minimum levels of reserves to back their deposits. Still no branching was allowed with the exception of some established branches that were “grandfathered” in. and have we have seen. Experience 197 ing a prohibitive 10% tax on such notes. The presumed benefit of reserve requirements was to improve the soundness of banks.3 Creation of the Federal Reserve System The establishment of the nation’s third central bank. . private deposits were pyramided on top of those notes so conversion of deposits to notes involved a reversal of the pyramiding which does not happen when deposits are converted to private notes. The new national banking system did not eliminate financial instability and the banks did not fully return to specie payment until 1875 – ten years after the end of the war – at which time Greenbacks were made fully convertible into gold. both of which pyramid on top of specie. And in fact. This set an ominous precedent for taxing something into oblivion that could not be explicitly prohibited. And while state-chartered banks could no longer issue notes. Reserve requirements became a fixture of banking regulation in the twentieth century. 1893 and 1907 all saw bank panics. 11. but a cost had to be paid in terms of reduced liquidity. the Federal Reserve System. Among other regulations. The National Banking Acts established a currency monopoly. notes served as reserves.92. copyright c Warren C. Panics continued under the new system. The years 1873.

as it is commonly called. much of the Progressive movement was actually led by big business. In addition. copyright c Warren C. There was substantial lingering distrust of central banking in the minds of the public at the time. The primary justification for the new central bank was the need for an elastic currency. e. To allay suspicions. . partly due to Democratic victories in the 1910 congressional elections. all superficial variants of a single national currency. It took longer than expected to line up support for the bill. a private institution is a mistake. And while academics and intellectuals lent support. 12 Version 0. Support for a central bank was drummed up at a series of well-publicized conferences.” providing a safety net that would preclude disastrous bank runs and bank panics. P. the Fed took over the functions of the Until recently. Control of the banking system was a key element of their plans. A draft bill for the new Federal Reserve System was worked out at a secret meeting of top business and banking leaders in 1910 at a private island off the coast of Georgia. But to say that these arrangements made the Fed. Morgan.92. The new Federal Reserve System was also to act as a “lender of last resort. A for New York or L for San Francisco. silver and Greenbacks. Thus Federal Reserve Notes provided a new basis for money creation since private banks could pyramid their assets on top of them. The member banks did not own the Fed in any real sense because they could not sell their shares and they exercised no real control of its policies or operations. in an attempt to establish monopoly cartels and escape the harsh discipline of free-market competition. The new Federal Reserve Notes could be used as bank reserves along with gold. but the Federal Reserve Act was passed by Congress in December 1913. particularly the Wall Street firm of J. particularly at harvest time. one that could respond to seasonal fluctuations in the demand for cash holdings.198 Creation of the Federal Reserve System to monopoly big business.. Gibson. Joining meant purchasing shares of “stock” which paid a six percent annual dividend.g. As the Fed ramped up its operations. the System was organized as a network of semi-autonomous regional banks.12 National banks were required to join the System and state banks were given the option to join. Each regional bank issued its own notes. Federal Reserve notes were marked with a letter indicating the branch that theoretically issued them. national banknotes were phased out.

Individual businesses routinely fail due to bad management. a severe wartime price inflation resulted – the worst since the Revolution. The Fed came upon the scene just in time to facilitate U. but there is no reason why this downturn should have spread to the entire economy. Credit for the recovery is perhaps due to the inability or unwillingness of either the Fed or the Harding Administration to step in with macroeconomic remedies. The Fed provided a national clearinghouse function which had not evolved privately mainly because of the prohibition of interstate branch banking. International gold payments were suspended and the money stock was expanded substantially.92. Gibson. participation in World War I. Individual sectors of the economy have their ups and downs like the peaks and troughs in the ocean. The Great Depression of the 1930’s would make prior business cycles seem trivial by comparison. All three terms refer to the same basic phenomenon which we shall call a depression. Profits and losses pervade the market economy. clusters of business failures. copyright c Warren C. and price deflation. Predictably. erroneous predictions. But why would almost all businesses be struck by a wave of simultaneous losses? It is no explanation to say that managers were simultaneously afflicted by some mysterious lapse in judgement. As the 1920’s drew to a close.S.” Later this term was replaced by “recession. Some false signal must have Version 0. There were no bank panics during this time. The peaks and troughs in the ocean do not account for a drop in the average water level.4 The Great Depression of the 1930’s The term “panic” is rather scary and was replaced by the milder “depression. and the depression ended quickly. 11.Chapter 11: The U. falling output.” an even softer term. Experience 199 many private clearinghouses that had arisen since the Civil War. . S. or just bad luck. Depressions are economy-wide phenomena characterized by high unemployment. Agriculture had entered its own depression prior to 1929. This was followed by an equally severe business depression in 1921-22. the country was about to experience its worst depression ever.

Following the inflation of World War I. much like the crash of 1987 which was steeper than that of 1929 but had few long-term consequences. The stock market boom worried many observers including Fed policymakers. Yet prices remained roughly constant. money stock prior to the Great Depression. who throttled back on the money supply during 1928-29. This was because output increased substantially during the Roaring Twenties due to new technology and a rising population. That signal could only come through money because money permeates the economy like nothing else.S. Figure 11. Let us begin with the levels of the U. . standing at $46 billion in 1929. The economy might have recovered starting in 1930. due in large part to technological advances such as automobiles and radios. Gibson. but in the following months the crash began to look like a one-time event with no great significance for the economy as a whole. but in October of that year the first of three massive waves of bank failures struck. followed by the reversal that took the average all the way down to 1914 levels during the depths of the Depression.3 shows. the M2 money stock stood at about $32 billion. During each of these waves. followed by a substantial recovery to 1937 and then another reversal. One relative price permeates the entire economy: the interest rate. which is the price of loanable funds. We must look to money to find answers to the mystery of the Great Depression. Not until the 1950’s did the DJI exceed its 1929 highs. It shrank by about 10% during the Depression of 1921-22. resulting in increased demand for money that roughly matched the increased supply (Figure 2.3 shows the tremendous rise of the Dow Jones Industrial Average from about 1929 to 1929. Recall the distinction between relative prices and the price level.92. Over the next decade it grew at an annual rate of about 4.) As Figure 2. the price level remained roughly constant because of increasing demand to hold money.200 The Great Depression of the 1930’s permeated the economy and led businesses into systematic errors.3. Changes in the money stock only affect the price level in the long run but in the short run they affect relative prices as well. The stock market crashed in October 1929.6%. copyright c Warren C. This increase was due to the healthy gains in real output that occurred during that decade. panic spread Version 0.

but its name suggested to many that it was some sort of official bank. A bank is illiquid if it has insufficient cash or other highly liquid assets to meet short-term demands for withdrawals. irrespective of liquidity.5% of its liabilities despite having to Version 0.000 banks had failed – a truly astonishing number. are insufficient to cover its liabilities.3: Dow-Jones Industrial Average. Experience 201 contagiously and by the end of the Great Depression fully 9.92. 1914-1940 To understand these events we must underscore the distinction between illiquidity and insolvency.Chapter 11: The U. Insolvency means that a bank’s total assets. copyright c Warren C. A bank is insolvent if its liabilities exceed its assets. The bank was able to pay off 83. Insolvency is generally a more serious matter than illiquidity and can be more difficult to pinpoint since it often depends on assigning a value to loans whose prospects for collection are uncertain. in some cases lacking only a few pennies on the dollar. Not only was this the largest bank to fail up to that time. S. Figure 11. Many of the banks which failed – closed their doors and failed to pay off some or all of their deposits – were merely illiquid. with $200 million of deposits. . The most dramatic example was the December 1930 failure of the private Bank of United States in New York City. Gibson.

000 of these never reopened. 309. Although the holiday lasted just six days. a policy nearly unique among Milton Friedman & Anna Jacobson Schwartz. op. and the government’s response to it. since there were no restrictions on branch banking. but had to stop all operations and literally close their doors. most of them nationwide in scope. was a one third collapse in the M2 money supply. prohibition of branch banking. While Canada also suffered from the depression. . p. 1933 and confirmed retroactively by Congress a few days later. counterparts. This breathtaking fall. and most notably there were no bank failures. aside from countless personal tragedies. so vulnerable? What was the trigger that started the chain of failures? And what was the response of the Fed. It could easily have been saved by a merger or other means but a plan to do so fell through at the last minute. the banks’ lender of last resort? Basically – nothing! Said President Hoover.14 The main consequence of all these bank failures.S.13 The waves of bank failures that swept the U.S. more than 5. Gibson. Several questions suggest themselves.202 The Great Depression of the 1930’s liquid some assets at “fire sale” prices.000 banks did not reopen their doors right away and over 2.S. (Recall there were some 9. during the Great Depression amounted to the worst bank panic in U.S.92..) The Canadian story provides strong evidence of the ill effects of the U. was the key element in the Great Depression. During this time banks were not only forbidden from honoring withdrawal requests.000 failures in the U. history and indeed in world history. There no reserve requirements and there was no central bank. from about $45 billion to $33 billion in 1933. Canadian banks enjoyed much more freedom than their U.” A comparison with Canada is instructive. There were only a handful of banks in that country. since Canadian culture and institutions are quite similar to those of the U. The problems climaxed with a “bank holiday” declared by Presidential fiat on March 6. “A Monetary History of the United States. it experienced a relatively mild 13% contraction of its money supply. 13 Version 0. 1857-1960. 330. copyright c Warren C. 14 Friedman and Schwartz.S. Why was the commercial banking system.” Princeton. after 20 years of operation under the Federal Reserve. p.S. 1963. “I concluded [the Reserve Board] was indeed a weak reed for a nation to lean on in time of trouble. cit.

Unemployment got as high as 25% of the labor force during the Great Depression. And when Keynes’ “General Theory of Employment Interest and Money” was published in 1936. How can money explain unemployment? The answer lies in its impact on wage rates. since any Fed mismanagement would be amplified throughout the banking system. copyright c Warren C. When the money supply falls. The U. Conceptually. In labor markets. the rate of unemployment can be divided into a natural rate. surpluses mean unemployment. Institutional unemployment results from interventions such as minimum wage laws or union privileges.S. The rest of unemployment is cyclical unemployment. government policy toward prices in general and wage rates in particular was to prop them up. The Smoot-Hawley tariff was enacted in 1930 just as the depression Version 0. . it diverted attention away from changes in the money stock and toward increases in demand for liquidity. which became available only in 1963. Unemployment amounts to a surplus in the labor market. The natural rate includes frictional or search unemployment that results when unemployed people take time to find a good job rather than accepting the first offer that comes along. and a cyclical or disequilibrium rate which can be positive or negative. S. Massive unemployment. prohibition on note issue exacerbated the situation as did the centralization of reserves at the Fed. to find a job. Experience 203 industrialized nations. associated with the business cycle and of primary interest to macroeconomists. In addition many people held emergency government “makework” jobs whose productivity was dubious at best could therefore be called under-employed.92. Why did the Federal Reserve fail to act? One explanation is a lack of reliable statistics on the money stock.” This was the basic cause of unemployment during the depression. or as economists describe it. as we have said. Wage rigidity was accomplished largely by means of legislation that granted special privileges to labor unions.Chapter 11: The U. In addition. During the depression. was a key feature of the Great Depression. particularly M2. Gibson. or not motivated at all. the Fed watched interest rates rather than the money stock. which is always positive. prices must also fall or else unsold surpluses accumulate. It also includes people who are collecting welfare payments and are thus less motivated. make them “rigid downward.

Herbert Hoover. effectively spreading the depression world-wide and helping to sew the seeds of fascism and war in Europe. that figure was about 14% in the U. Hoover said. government policy had been to do essentially nothing but cut its own expenditures. the Panic of 1837. and later became the Hoover Dam again.K..204 The Great Depression of the 1930’s was getting underway.S. Here are statistics showing the changes in various aggregates: Version 0.S. including the Hoover Dam in Nevada. exports amounted to only about 5% of its domestic GNP. 1933 but with his Republican predecessor. This tradition was reversed during the Great Depression and the reversal began not with Franklin Roosevelt who took office in March. We might have done nothing. Hoover’s administration spent more on such programs than in the previous 30 years. Gibson. Campaigning for President in 1932. That would have been utter ruin.92. which was renamed the Boulder Dam when his reputation sagged. wiping out a great deal of the mutual gains from trade. about as much as it fell between 1929 and 1933. During the period 1839 to 1843 the money stuck fell by 34%. It is ironic that Hoover is often condemned as a do-nothing president. Germany and France. It is instructive to compare the Great Depression to an episode mentioned earlier.. Instead we met the situation with proposals to private business and to Congress of the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic. The Smoot-Hawley tariff had more drastic effects on these countries than on the U. While U. In response to earlier depressions. copyright c Warren C. . international trade fell by 60% from 1930 to 1932. This act raised tariff rates to their highest level in American history. Predictably.

000 fine. went off the gold standard when Roosevelt. First.Chapter 11: The U. The price of gold for international settlements was arbitrarily raised from $20 to $35 per ounce. Thereafter. notwithstanding declines in the money stock and in investment.S. S. the U. The bad news was that they were forcefully employed in the business of getting shot at. Not only was there full employment during this depression but output actually increased by 16%. Version 0. In summary. with some industrial and numismatic exceptions. The good news was that many men were no longer unemployed. The prohibition of gold ownership remained in effect until 1974. Note that a full-employment depression of 1839 to 1843 was something that could not be explained by Keynesian theory. forced all citizens to surrender their personal holdings of gold. The true end to the Great Depression came only with the partial freeing of the economy after the war’s end. So how did it end? World War II began. the Great Depression was a prolonged maladjustment to deflation that resulted from monetary contraction. This is indicative of the fact that contractions are not uniform but hit the loan market first. . there was no government interference to make prices rigid downward. using patriotic exhortations. and then later lead to business failures.92. Gibson. possession of gold. and the military draft absorbed fully 22% of the pre-war labor force. copyright c Warren C. more so than in the Great Depression. In other words. Experience 1839-43 -34% -42% -23% -23% +21% +16% 1929-33 (M2) -36% (M1) -34% -31% -42% -91% -19% -30% 205 Money stock Prices Number of banks Real gross investment Real consumption Real GNP Notice that prices fell sharply during the 1839-43 episode. New contracts denominated in gold were forbidden and those already in effect were abrogated. was made a crime punishable by ten years in jail and a $10. Let us examine some of the financial consequences of the Great Depression.

economy was officially deemed to have entered a recession in December 2007 and remained in that situation at year-end 2008. Interest paid on time deposits and savings deposits was fixed by Regulation Q. In the popular press. Even after it ends. The Securities Exchange Commission (SEC) was set up in 1934 under the guise of protecting small investors from fraudulent or misleading practices by brokers. corporate managements. as we shall see when we examine the S&L crisis of the 1980’s and the financial crisis of 2008. as witness the $50 billion Ponzi scheme run by Bernard Madoff that collapsed in 2008. The insurance did indeed eliminate bank panics but gave rise to solvency problems in their place.4. (There has been no evidence that the SEC has actually made securities less risky.1 The Great Depression: a 2008 Reprise? The U.92. Second. . Banks were prohibited from paying interest on demand deposits (checking accounts) and on inter-bank deposits. which as we shall see became very problematic in the 1970’s. comparisons with the Great Depression abound. with many forecasters predicting a continuation through and perhaps beyond 2009. 11. thus transforming that industry into a cartel.) In 1933 the Glass-Steagall Act split investment banking and commercial banking asunder. The justification was that cut-throat competition was to blame for bank panics. Commercial banks were prohibited from engaging in stock market transactions. Gibson. and investment bankers. Securities markets and particularly the stock markets were subject to new regulations. copyright c Warren C.S.500. Will history repeat itself? Of course we cannot answer this without knowing how much worse the current downturn might get or how long it will last. the government reduced competition in the banking industry by regulating interest rates. it will take years to develop a proper assessment. we venture to outline some differences between then and now: Version 0. Nevertheless.206 The Great Depression of the 1930’s In 1933 the Federal Deposit Insurance Corporation (FDIC) was established to guarantee bank deposits up to $2.

they have lurched from one program to another.92. . but has rendered them harmless to most bank depositors. in particular. • Financial markets around the world are tightly interconnected. this does not mean that the risks of bank failures have been eliminated. Information is available in much greater quantities and is nearly instantaneous. other industries such as the automobile business. • Thus far the 2008 recession has been nowhere near as severe as the Great Depression. rather. At this writing. Policymakers must be aware of international reactions to their programs. No Fed official. they have been socialized. whereas in the 1930’s they generally ignored international repercussions and got away with it. and to a lesser extent. S. could be excused for saying he didn’t know what was happening to the money stock. Gibson. Indeed. Version 0. Experience 207 • We live in a vastly more sophisticated time. has declared his firm intention to avoid the monetary deflation that the Fed of the 1930’s allowed to happen. making it very difficult to give any sort of assessment. copyright c Warren C. for example. Capital flows across borders in amounts and speeds that would have been unimaginable in the 1930’s. • The federal government has intervened massively in the banking sector. the monetary base skyrocketed during 2008 and the wider M1 and M2 are following along. in contrast to the peak figure of 25% during the 1930’s.Chapter 11: The U. • Federal deposit insurance has not eliminated bank failures. Unemployment. the insurance sector. • Fed chairman Ben Bernanke. However. is still in single digits. a student of the Great Depression.

. copyright c Warren C.92.208 The Great Depression of the 1930’s Version 0. Gibson.

338 500 The establishment of a new bank requires permission of either a state chartering authority or the Comptroller of the Currency. There was substantial deregulation during the 1980’s and 1990’s but the basic concepts of government control remain undisturbed. for 209 .com. in part because the state and federal chartering agencies are in competition with one another. There were until recently strict limits on the activities in which banks could engage.Chapter 12 Banking Practice 12. Presently. There has been some relaxation of requirements recently. numbering as follows (2005 figures): Charter National State State State Fed member yes yes no no FDIC-insured yes yes yes no number 2001 935 4. There are four categories of banks.1 The Regulatory Structure. They were forbidden to sell stocks and bonds or insurance. The Great Depression created the basic regulatory structure that we have today.startabank. And in fact. at least one clever entrepreneur has created a business in helping people start banks – www. there are four categories of banks.

Citicorp. By omitting one or the other of these activities. Small branches have been established in retail stores. banks at one time could establish branches only within a single county.427 banks in the country. copyright c Warren C. example. airports. Texas with its outright prohibition had many of them. Bank mergers are subject to review by their regulatory agencies. Version 0. Single-bank holding companies also arose as a way of avoiding prohibitions on non-bank activities such as insurance and stock brokerage. and sometimes by the Anti-Trust Division of the Justice Department. Wells Fargo. banking system relative to countries like Canada. products that many large banks now offer through affiliates or subsidiaries. Penney all took advantage of this loophole.210 The Regulatory Structure. The disestablishment of many regulations came about largely as a result of successful efforts to sidestep them. Standalone automated teller machines are also common. In Ohio. Gibson. established to control the stock of individual banks. which was closed by Congress in 1987. Bank holding companies. Originally no interstate branching was allowed and many states restricted or prohibited branch banking entirely. These restrictions have been almost entirely eliminated and so we now have several large nationwide banks including Citicorp. At one time. Bank of America and Wachovia. Merrill Lynch. So-called “non-bank banks” were organizations that took advantage of the definition of a bank as a business offering both commercial loans and deposits.S. was the largest of these.92.C. “non-bank banks” were able to avoid regulations on interstate banking. First Interstate Bancorp being the largest. out of 12. . and other previously unthinkable locations. which merged with Travelers’ Insurance to form Citigroup. One one occasion a bank in Texas built a tunnel under a street so it could set up operations on the other side without technically establishing a branch. Sears Roebuck and J. American Express. and as a result the smaller of the state’s 88 counties were stuck with small and inefficient banks. In 1900. First Nationwide. We have already commented on branch banking restrictions and how they weakened the U. were the most common tactic. only 87 had any branches at all.

12.834 deposits Money market deposit accounts 40. Indian Head is one of four large bank holding companies in the state.720 156.644 530 7.242 other liabilities Total liabilities 148. bonds and stocks Loans Bank premises and other assets Total assets 1. It was chartered in 1865 by the Comptroller of the Currency. the Dartmouth National Bank.003 7.071 5. Treasury 690 Deposits of states and political 602 subdivisions Passbook and statement savings 4. NH.584 3. In 1985.1 shows the balance sheet of a typical small bank. NH.497 6. purchased the Dartmouth National Bank. Version 0. Gibson.2 A Commercial Bank’s Balance Sheet.710 101.509 to repurchase Large denomination time de6.286 7.863 156.632 3. . which serves Hanover.619 Deposits of U. a town of approximately 8.000 5. Table 12.1: Balance sheet of the Dartmouth Bank. the Indian Head Corporation. exchanging shares of its own stock for shares of stock in Dartmouth National.093 Equity capital Common stock Surplus Undivided profits and capital reserves Total equity capital Total liabilities and equity capital 200 1.000 residents.956 211 Liabilities ($ thousands) Demand deposits 18.92.230 posits Mortgage indebtedness and 2.Chapter 12: Banking Practice The Dartmouth Bank Assets ($ thousands) Cash in vault Balances at FRB Checks in process of collection Balances at correspondent banks Federal funds sold Certificates of deposit Treasury notes and bonds Government agency issues Municipal bonds Mortgage-backed securities Corporate notes.551 4. a bank holding company in Nashua.660 8. copyright c Warren C.640 4.007 Small denomination time de32.727 posits Securities sold under agreement 11. S.091 5.956 Table 12.633 NOW accounts 30.

Sometimes banks hold excess reserves out of prudence – anticipation of larger withdrawals than the minimum level of reserves would reasonably support. “Vault cash” consists of cash in the bank’s vaults. Cash items are reserves in an economic sense since they pay no interest. But in recent years. for example. reserve balances at the Fed paid no interest either.212 The Regulatory Structure. teller drawers. Notice that required reserve balances at the Fed differ from the ordinary reserves that households or businesses might maintain – “rainy day” funds that we might tap in an emergency. Gibson. but banks are free to maintain higher levels. as they must for any solvent bank.1. “Excess reserves” are thus the difference between actual and required reserves. 2 This is a form of pyramiding and raises the question as to whether such inter-bank deposits should be counted in the money stock.1 “Balances at correspondent banks” arise when banks open demand deposit accounts at other banks.1 Assets Following standard accounting practice. but that changed in 2008. The Dartmouth Bank has no branches in Boston. Bank reserves cannot be tapped for any reason other than a decreased deposit base. Until recently. 12. copyright c Warren C. Electronic images could be transmitted instead. However some consumer groups objected to this change because it meant that recipients of checks were no longer required to physically forward checks for clearing but could directly debit the writer’s account via electronic means. While bank regulators mandate minimum levels of reserves for certain types of deposits. 1 Version 0.92. resulting in much a much speedier clearing operation and correspondingly lower assets in this category. Since assets exceed liabilities. . and automated teller machines. so it might maintains deposits at the Bank of Boston to facilitate check clearing.2 The Bank of Boston would record Dartmouth’s deposit account as a liability. “Checks in the process of collection” are checks on their way to the Fed where they will be added to the bank’s deposits. assets are listed on the left-hand column and liabilities on the right. banks have tended to loan their excess reserves to other Starting in 2004 it was no longer necessary to physically transport paper checks to the Federal Reserve. there is positive equity capital and the sum of liabilities and equity capital equals total assets. Vault cash plus “balances at the FRB” (Federal Reserve Banks) constitute the bank’s legal reserves.

and those that are directly negotiated and carry unique features. sewer districts. A bank’s lowest advertised rate is called its “prime rate. cities. and it was until very recently the target that the Federal Reserve used in conducting its open market operations. At the time this snapshot of Dartmouth’s finances was taken. This sum appears as an interest-earning asset on the bank’s balance sheet. but not corporate stocks. Business loans (commercial and industrial) are the most important category. it had loaned out (“sold”) $7 million of fed funds to other banks.). Version 0. but bank loans generally fall into one of several categories. The “corporate stocks” mentioned on the Dartmouth balance sheet are actually shares in the Federal Reserve. Banks are not allowed to hold ordinary common stocks as assets. a quasi-government agency. agricultural loans. This market for interbank loans is called the “Federal funds” market.Chapter 12: Banking Practice 213 banks whose reserves were temporarily inadequate. as we will see in Chapter 16. copyright c Warren C. Other investments include treasury securities. counties. Secondary reserves are liquid assets like CD’s purchased. Another bank with net Fed Funds borrowings would record a liability in the appropriate amount. called investments. municipal bonds (issued by states. treasury bills. commercial paper and banker’s acceptances. All of these loans bear different interest rates. this term is less meaningful than it once was as competition has driven some banks to advertise “sub-prime” rates. . The fed funds rate is a very sensitive interest rate indicator. which the bank was required to buy when it became a member of the Fed. Dartmouth’s loan portfolio appears as a single line item. etc. Gibson. A Federal Reserve regulation limits margin loans 50% of the value of the stocks purchased. Other categories include loans to financial institutions. Bank assets generally fall under one of two broad categories: instruments with secondary markets. mortgage-backed securities. and some corporate debt. a somewhat misleading name since neither the Federal government nor the Federal Reserve System is directly involved.92.” However. and shares of “stock” in the Student Loan Marketing Association. government agency issues (mainly bonds). real estate loans (mortgages) and margin loans (loans advanced through brokers to their customers for stock purchases).

6% for Dartmouth) is a measure of its solvency. Small time deposits (under $100.000) have a fixed maturity. the item labeled “bank premises and other assets” captures the current depreciated value of Dartmouth’s land. Money market deposit accounts pay variable interest and have varying maturities. In 2008. 12. Finally. furniture. . trading all but ceased in certain asset classes such as mortgage-backed securities. If its capital should all be exhausted the bank would be insolvent. Just as a bank’s reserve ratio measures its liquidity. Government deposits are another form of demand deposits. All of these items are counted in the M1 money stock. The remaining types of liabilities can be called managed liabilities in that management can control them directly rather than relying on customers to open accounts. buildings. Gibson. etc. 12.956 or 5.1. a bank’s capital-asset ratio (equal to 8.214 The Regulatory Structure.92. the sources of funds for the bank. many banks began to experience capital shortfalls.1. we have the capital account. making it all but impossible to mark them to market. copyright c Warren C. the Treasury purchased shares in Version 0. For this and other reasons. In response.3 Capital account Lastly. many bank assets became hard to evaluate. Regulators require banks to maintain certain minimum levels of capital relative to assets. Demand deposits are the bank’s checking account liabilities.2 Liabilities Now we consider liabilities. NOW accounts were an early form of interest-bearing checking accounts that are now obsolete.863 divided by 156. Savings deposits (passbook and statement varieties) are time deposits with fixed interest and variable maturities. An asset subject to the “mark-to-market” rule must appear a bank’s balance sheet at its current market value. In the financial crisis of 2008. though they can pay interest. This represents the money the original investors put into the bank plus accumulated profits and must be equal to total assets minus total liabilities. All of these count as part of the M2 money stock.

Chapter 12: Banking Practice 215 a large number of banks. these borrowings can be costly if overdone. While FDIC relieves them of worries about bank runs. 12. was their only strategy. and following the practice in recent failures. Should the bank fail. And they must always watch their liquidity because although they can borrow fed funds to cover shortcomings. Version 0. they trade off income versus risk in the securities they buy. Managers must maintain enough liquidity to meet Fed requirements. Gibson. But stockholders are wiped out in a bank failure. prior to deregulation. the FDIC will make all insured depositors whole. copyright c Warren C. . to honor withdrawal requests without embarrassment. Similarly. This was a time when banks were once largely sheltered from competition by government regulations. hoping this would keep them solvent and active in the loan market until the crisis somehow ended and the Treasury could redeem its investments. collect interest at 6%. and be on the golf course by 3PM. They tried to find borrowers who would pay high interest but be unlikely to default.2 Asset vs.92. and likely the holders of the bank’s bonds as well. Bank managers trade liquidity versus earnings. which made it possible – indeed necessary – for banks to vary the interest rates they offered in order to attract deposits. which. Thus if liquidity began to slip banks had the option of attracting more liabilities in addition to selling assets. Liability Management The art of managing a deposit bank like the Dartmouth Bank consists basically in balancing risk versus reward. management focused almost entirely on asset management. Wags devised the “3-6-3” rule for bank management: pay interest at 3%. making it unnecessary for them to worry about competing for funds. probably uninsured depositors as well. they are nonetheless strongly beholden to the stockholders who want generous dividends and an ever-rising stock price. But this happy state was rudely interrupted by deregulation. They do not want to leave any more resources idle than is necessary to provide sufficient liquidity because profits will suffer if they do. At one time.

(Charlotte. Liability Management Nowadays banks engage in both asset and liability management.221 493.199.S. Inc.848 1.S.478 1.2 lists the ten largest U. (New York) Wells Fargo (San Fransisco) HSBC North America Inc.743.642.2: Largest banks as of May. NC) JPMorgan Chase (Columbus. 2008 Version 0. (Charlotte. they were getting many questions from politicians and journalists as to why they had not speedily loaned out the new government capital. (Atlanta) Table 12.862 808.323 595.575 750. banks by assets as of May. At year-end 2008. NC) Taunus Corp. ($ million) $2. copyright c Warren C.151 178. 2008. Table 12. OH) Wachovia Corp. IL) U. Gibson. (Prospect Heights.010 241.781 205.92.986 Citigroup (New York) Bank of America Corp. we might add a third category of management: political management. .216 Asset vs. They pay close attention to the yield curve and to economic forecasts. This information is already outdated as Wells Fargo has acquired Wachovia. With most medium and large-size banks having taken Treasury money – in some cases neither needed nor wanted – it has become increasingly necessary to watch the political winds. (New York) Suntrust. Bancorp (Minneapolis) Bank of the New York Mellon Corp. And in light of the events of 2008.

Part V Non-bank intermediaries and financial deregulation 217 .


” • Credit unions (9. is an institution that helps those who seek debt or equity capital and those who seek to invest their savings to find each other – “middlemen” if you will.300 in the U. as you will recall. S&Ls and savings banks are called “thrifts. Depository institutions include • Commercial banks such as Citicorp or Wells Fargo (which currently number about 8. Collectively.Chapter 13 Survey of Non-bank Intermediaries A financial intermediary. Recall also that banks (and bank-like institutions) are distinguished from other intermediaries by the fact that they accept deposits payable on demand.S. run by a declining number large corporations and most governments as an employee benefit 219 .) • Savings & loan institutions and savings banks such as Downey Savings (1.500) Non-depository institutions include • Life insurance companies such as New York Life • Property and casualty insurance companies such as Allstate • Private pension funds.400).

they were allowed to pay higher interest on deposits than banks. • Real estate investment trusts such as BRE Properties. Shares of these trusts typically trade on stock exchanges. the first savings and loan institution. and by the 1830’s there were many such institutions. was formed in 1816. In 1983 it made an initial public offering as a corporation and did business business as Washington Mutual Bank even though there was nothing “mutual” about it. i. Their key feature was that they were owned by their depositors and typically made loans for home purchases. 1 Version 0. When these institutions came under federal regulation. the depositors do not own This institution got into distress largely as a result of dubious mortgages. An example of the evolution of this type of institution is provided by the now defunct Washington Mutual Bank. . The rationale for this differential is that home ownership is a good thing but does not draw enough funding in a free market.220 Savings and Loan Associations and Savings Banks • State and local government pension funds • Consumer finance companies such as Household Finance • Investment companies such as Fidelity or Vanguard offering open-end mutual funds. thus justifying government intervention. A public choice interpretation of this situation would point to the large number of votes that might be influenced by mortgage subsidies. 13. or “WaMu” as it styled itself. Its name was changed to Washington Savings & Loan in 1908.1 The Washington National Building Loan and Investment Association was organized in 1889 to provide funds for rebuilding in the wake of a disastrous fire that swept Seattle in that year. the Philadelphia Savings Fund Society. and was acquired by JPMorgan Chase in 2008 in a deal arranged by the FDIC. closed-end mutual funds and exchange-traded funds. there was considerable distrust of banking in the early years of the United States. Partly as a result of this..e. Gibson. copyright c Warren C.92.1 Savings and Loan Associations and Savings Banks As we have indicated.

92. This was partially undone by legislation passed by Congress in 1998. they have expanded into home loans. Banks consider credit unions an irritation because of their exemption from income taxes. copyright c Warren C. credit unions began with savings accounts and consumer loans. checking accounts. The number of credit unions has declined from about 24. Partly as a result of that crisis.000 currently. It was a commercial bank with its deposits insured by the FDIC and its shares traded on the New York Stock Exchange. . insurance. In recent years.Chapter 13: Survey of Non-bank Intermediaries 221 the bank. Banks scored a victory in 1998 when the Supreme Court reined in the definition of eligibility for credit union membership. 13. These programs are offered primarily because the income tax code makes them more advantageous than compensating employees entirely in cash and letting them engage whatever retirement savings plans they might choose. 13. in an effort to keep pace with bank competition. We tell this story below. The main difference is that they are non-profit organizations and their customers are called members. largely as a result of mergers and consolidations. A crisis struck the savings and loan industry in the 1980’s which took many years and a great deal of tax money to solve.2 Credit Unions Credit unions are very much like banks.3 Pension Funds Employees of most businesses and nearly all governments exist retirement programs as part of their compensation. Members are supposed to share some common bond such as working for the same employer. Total assets of credit unions are a small fraction of bank’s aggregate assets. the number of savings and loan associations has declined from around 6. and money orders.300 in 1960 to about 1. And credit unions have a vague mandate to promote thrift among their members. Originally. Version 0.000 in 1969 to about 8.100 today. credit cards. Gibson.

The business or government agency invests the money in a fund that is almost always managed by a professional manager. Pension funds usually include focus on bonds and stocks but may also purchase real estate and other more unusual investments. The aggregate value of these assets is now about $3. and often suffer losses on their underwriting business (premiums minus payouts). . They collect premiums which are invested mainly in bonds and mortgages. Companies that participate pay insurance premiums and submit to certain regulatory rules.4 Life Insurance Companies Life insurance companies provide insurance against the financial consequences of early death. Many life insurance companies make all their profits from the income on their investment portfolios. largely the result of bankrupt companies dumping their pensions. offer retirement programs such as 401k’s. the PBGC sought an increase in premiums to cover an $11. The corporation or agency is responsible for seeing that the fund is adequate to meet future obligations. which allow employees to make their own investments. Most government agencies and some of the larger corporations offer pensions. Gibson. At year-end 2008. American International Group is a large insurance company that suffered Version 0. This has brought into question the adequacy of PBGC assets relative to potential liabilities. Funds are contributed by the employer.2 billion shortfall. generally as a part of bankruptcy proceedings. In 1974 Congress established the Pension Benefit Guaranty Corporation for the purpose of insuring private pensions. Recently. 13. but to some extent in stocks as well. The benefits they receive in retirement depends on the performance of the investments they choose. But smaller businesses. copyright c Warren C.222 Life Insurance Companies A pension is a kind of retirement program that provides retired employees with fixed periodic (typically monthly) payments – an annuity. and increasingly even large businesses.92. and employees can typically add contributions that are taken out of their paychecks.5 trillion. and in return the PBGC guarantees the fund against failure or shortfalls. a number of companies such as United Airlines have dumped their pension obligations onto PBGC.

By far the most common type of investment fund is the so-called open-end mutual fund. hedge funds and real estate investment trusts. Those that are organized as corporations have share capital as well. treasury securities and corporate and municipal bonds. especially U.S. 13. Consequently. Shares of such funds are purchased directly Version 0.Chapter 13: Survey of Non-bank Intermediaries 223 a liquidity crisis in 2008 resulting in an $85 billion line of credit provided by the Federal Reserve system in exchange for warrants to purchase about 80% of the company.1 Open-end mutual funds. 13. Gibson. 13. exchange-traded funds.7 Investment companies Investment companies pool investors’ funds and invest mainly in domestic corporate stocks and bonds but also in government securities. foreign currencies and commodities. These businesses raise funds by issuing commercial paper or bonds. for example.92. pioneered in 1924. 13.5 Property and Casualty Insurance Companies These companies insurance against loss from fire. Many companies offer several of these kinds of products. closed-end mutual funds. they hold more liquid assets than life insurance companies. foreign securities. theft and accidents. copyright c Warren C. General Motors Acceptance Corporation.7. .6 Finance Companies Finance companies loan money to people for purchase of durable goods such as automobiles or furniture. They bear more risk than life insurance companies because disasters such as Hurricane Katrina can expose them to large and unpredictable losses. is a subsidiary of General Motors Corporation that makes loans to purchasers of GM cars. Their principal offerings are open-end mutual funds.

Funds vary widely in their investment objectives. they are always open to new investors.92. etc. or Latin American companies. This figure is calculated at the end of every business day. retailers. But at least one fund deliberately targets “sin” stocks like tobacco and alcohol. It reopened just in time to experience a precipitous decline. More exotic funds may buy precious metals or commodities or may engage in short selling. the Dodge and Cox Stock Fund was one of the largest and most successful mutual funds. some focus on shares of technology companies. Thus a buy order placed over a weekend will be executed late Monday afternoon. Some buy a broad range of stocks. The management company will issue new shares to anyone at any time and will redeem shares upon demand – that is. and all orders to buy or sell shares are executed after that calculation is complete. of up to 9%. 2 Version 0. Since these documents are filled with mandated legal jargon. fund managers perceive that their funds have gotten so big that they have become difficult to manage. Their asset choices are constrained by regulations such as a requirement (for most funds) that no more than 5% of their assets be invested in a single stock. copyright c Warren C. 3 Defined as the sale of borrowed securities in anticipation of a price decline. energy companies. Funds keep a certain amount of cash on hand to meet redemption requests but beyond that they generally put excess cash to work in new investments.3 All funds issue a government-mandated prospectus which discloses the fund’s objectives and its past performance. however.2 The sale or redemption price is equal to the fund’s net asset value which is the market value of all the fund’s assets divided by the number of shares outstanding. Others buy bonds of various maturities and qualities. . Mutual funds generate fee income for their owners. for Sometimes. it was common for funds to levy sales charges. though they typically allow existing shareholders to continue purchasing new shares. In the past. For example.224 Investment companies from the fund company or through brokers or dealers. European. and was closed to new investors for several years. Some funds advertise themselves as “socially responsible” and will not purchase shares of companies like tobacco manufacturers. Gibson. who generally seek advice about mutual funds from financial publications or internet sources. they are of little use to investors. Some buy mainly stocks of Asian. called a loads. They therefore close their funds to new investors.

The market price of closed-end fund shares is determined Many funds like to discourage trading in and out of their shares. investors wishing to acquire shares in a closed-end fund must buy them from existing shareholders. which is one of the reasons they are led to mutual funds which have full-time professional managers. so that with the exception of a few specialized funds. . Not only do these funds out-perform most actively managed funds. 13. most broadly based stock mutual funds do not perform as well as the averages.. and these vary widely from fund to fund. funds that do not levy any direct sales charges. most are no-load funds. Gibson. Ironically. index mutual funds have gained in popularity.4 They are left with management fees as their income source. Once launched. however. and to do so. but there are far fewer of them compared to open-end funds. these funds do not issue new shares nor do they redeem existing shares. As a result.2 Closed-end mutual funds Closed-end mutual funds differ from open-end mutual funds in one key respect: they issue issue a fixed number of shares in an initial public offering and put the proceeds to work in whatever investments they have chosen to specialize in.e. 4 Version 0. Individual investors typically lack the time or motivation to research stocks. Unlike loads. however. these funds generally accrue to the benefit of the remaining shareholders rather than being paid to management.Chapter 13: Survey of Non-bank Intermediaries 225 buying their shares. Many closed-end funds are listed on the NYSE and other exchanges and are bought and sold through stockbrokers. they may charge a back-end fee for redemption of shares held less than some specified period like one year. Many of these are based on the Standard & Poor’s index of 500 stocks (the S&P 500) meaning that they hold all 500 of those stocks in their portfolio. Front-end loads are fees charged at the time shares are purchased and back-end loads are charged when shares are sold.7. weighted the same as they are weighted in the S&P 500: by market capitalization. Closed-end funds vary widely as do open-end funds. just like individual shares. Instead.92. Competition has driven loads out of the market for the most part. but they also have very low expenses since they have no need for research departments or active managers. copyright c Warren C. i.

unlike open-end funds. etc. The spread between market price and NAV may be one deterrent to these funds. 13. They do not need a cash buffer to meet redemptions nor do they have to worry about possible short-term unpopularity of their investments. Deviations of 10% above and below NAV are common and 20% or 25% deviations are not unknown. However. They can also be sold short.92. Version 0.7. Recently. further narrowing the distinction between these funds and closed-end mutual funds. bonds. An advantage of closed-end funds is that the managers do not have to worry about redemption requests. The SPDR managers must make occasional trades due to companies entering or leaving the S&P 500. They can be considered a blend of closed-end funds and open-end index funds. These are called exchange-traded funds (ETF’s) and like closedend funds. with very few exceptions.3 Exchange-traded funds A third class of investment funds is closely related to closed-end mutual funds but has been growing rapidly. they are traded on the stock exchanges. not just once a day as with open-end funds. the total value closed-end funds has always been a small fraction of the total of open-end mutual funds.226 Investment companies by supply and demand and is not necessarily equal to the fund’s net asset value. they trade on the stock exchanges and have a market prices that typically vary from net asset value. ETF’s are available in almost the same range of specialties as are mutual funds: stocks of all kinds. but this happens infrequently. Unlike mutual funds (open or closed) they do not change their portfolios once they commence operations. on of the most popular ETF’s is the so-called “spider” fund (exchange symbol SPDR) which is just like an S&P 500 index mutual fund except that it is closed-end. . largely at the expense of open-end mutual funds. actively-managed ETF’s have been authorized. Like closed-end funds. commodities. Gibson. The deviations may be in part a reflection of investors looking beyond the NAV and discounting the future prospects of the fund’s holdings. A minor advantage to investors is the ability to buy and sell them throughout the day. For example. copyright c Warren C.

apartments.92. a leading weekly investment publication. Hedge fund operators charge not only an annual fee but take a large percentage (typically 20%) of any gains they achieve. such as concentrating funds in just a few securities.4 Hedge funds Yet another class of investment funds are hedge funds. It is not clear that the additional fees that these funds charge are warranted by the returns they produce. I may purchase a contract for delivery of Euros at that time in order to pin down the price and avoid the risk that the Euro may decline relative to the dollar. Furthermore. Their objective is to reduce risks via diversification. others have not. leveraging (use of borrowed money). instead focusing on other exotic and often risky trading strategies. “Hedging” is the practice of taking a position in opposition to some other position that one holds so as to reduce risk. and it is questionable whether hedge funds on average are worth the high fees they charge. many socalled hedge funds now engage in little or no actual hedging. thus perhaps defeating the purpose of hedge fund investing. and short-selling. Hedge fund managers are free to engage in risky behavior that mutual fund managers are not allowed to engage in. There is also a listing of “funds of funds. For example. Barron’s. Only individuals with high net worth are allowed to buy them because government regulators believe that less wealthy people must not be allowed to take big risks with their capital. copyright c Warren C. However.7. if I am an American and someone is obligated to pay me Euros a year from now. but diversification also tends to drive returns toward average values.” which are funds that invest in shares of various hedge funds. prints a monthly summary of the performance of several hundred hedge funds (in addition to fairly extensive mutual fund coverage). hedge funds are lightly regulated.Chapter 13: Survey of Non-bank Intermediaries 227 13. Gibson.5 Real estate investment trusts Real estate investment trusts were authorized by Congress in response to a perceived inequity in the tax laws which allowed wealthy individuals to derive special tax benefits from ownership of real estate (houses.7. 13. While some hedge funds have been highly successful. . Version 0.

5 because they are included in the M2 money stock. This was a time when Regulation Q imposed a cap on the amount of interest that banks could pay on savings deposits. They were discussed in Section 8.7 Money-market mutual funds Money-market mutual funds are open-end mutual funds that invest in safe. Investors began to “disintermediate. REITs operate under special restrictions and in return enjoy favorable tax treatment. Gibson. 13. These arrangements typically involve a generous amount of “hand-holding” which of course is reflected in high fees. As long as they conform to these restrictions.). any economist can explain how they work and why investors like them.” i. copyright c Warren C. it raised Version 0. yet as far as we know. shift funds out of banks in search of yields that might at least keep up with price inflation.7. etc. But because the Treasury was swamped with small orders. just as mutual funds pay no corporate income tax.. and land).e. Many funds hold only real estate or only mortgages although some hold both. REITs. no economist predicted them prior to their emergence around 1970. Interestingly enough. People with large amounts to invest (typically $5 million or more) sometimes hire managers to select investments tailored to their personal circumstances (age. risk tolerance. During this inflationary time. The only good alternative to savings accounts at the time was Treasury Bills which could be purchased in multiples of $1. They must stay nearly fully invested and must distribute at least 90% of their earnings in the form of dividends. were created so that small investors could enjoy the same advantages. as they are called. They are restricted to two categories of investments: real property and mortgages on real property.7. They operate like closed-end mutual funds and are traded on the stock exchanges. market interest rates rose far above those caps.6 Private investment funds.2. 13. they are not subject to any corporate income tax. short-term debt securities.000.228 Investment companies commercial buildings. . REIT’s usually provide above-average rates of return but they vary widely in quality and some can be quite volatile.92.

The $1. Retail MMMF balances are so liquid that they are counted as part of the M2 money stock. MMMF balances can be treated like bank accounts and in fact. Typical MMMF assets include commercial paper. thus shutting out most small investors. and bonds with shorter maturities experience lower variations. has almost never been violated. MMMF dividends are always paid in the form of new shares credited to each shareholder’s account. while not guaranteed. Version 0.00 share price. copyright c Warren C.Chapter 13: Survey of Non-bank Intermediaries 229 the T-Bill minimum to $10.2) which makes their dividends exempt from federal income taxes. At this time smart entrepreneurs conceived of a mutual fund that invested only in very short-term debt instruments. For all practical purposes. There are now several hundred money-market mutual funds. it would be extremely unlikely that the market value of MMMF assets could drop enough to generate negative yield to maturity which made it possible to maintain the share price at exactly $1. bankers acceptances and government securities. and it is likely that management malfeasance was to blame in these isolated instances. Because of their ultra-short maturity. The rest is in funds that specialize in very shortterm muni bonds (see Section 8. Money-market mutual funds are subject to regulations with regard to maturities (90 days or less) and credit quality. Recall that bond prices vary inversely with yields. Most also offer on-line transfers to and from commercial banks free of charge.” as this is called.7 trillion of this is in funds whose payments are fully taxable. while the MMMF yield would vary with market conditions. Only one or two instances of “breaking the buck. About $1.2.00. . Most muni MMMF’s specialize in issues of a single state which makes their yield exempt from state income taxes in that particular state. Gibson. most funds allow shareholders to write checks on their accounts (subject usually to a minimum amount of $100 or $250 per check and a limited number of checks per month). have been recorded. totaling over $2 trillion in assets.92.000.

requiring higher taxes.” Independent Review. more borrowing. Young workers would be allowed to divert some of their social security “contributions” into private accounts that would func5 E Version 0. “The Anatomy of Social Security and Medicare. As the “baby boomers” begin to retire. Summer 2008 Payouts taxable to those with medium or high income. holds a portfolio of securities. we see a problem: it appears that the left hand is lending money to the right hand. Because of massive tax increases enacted at the behest of the Greenspan social security reform commission. But a closer look shows this is not an investment fund in any meaningful sense. First. the “contributions” it receives are compulsory: they are taxes. Congress can change the benefits at any time.8 Social Security: Not an Investment Fund We mention Social Security here because on superficial examination it might seem to be an investment fund. or lower expenditures than would otherwise be the case. This will strain the federal budget. Second.5 dgar K. Bush proposed partial privatization of Social Security. the assets of the Social Security Trust Fund are problematic. no one is entitled to any particular benefits. But if we recognize that the Social Security System is an integral part of the same Federal government that issues Treasury securities. average returns are far less than might reasonably be expected from private investments. Browning.92. it will shift gradually to a position as a net seller of bonds.7. copyright c Warren C. while the left hand continues to claim it is holding an asset. as by law it must. the Social Security System currently takes in more than it pays out. Nearly everyone agrees that government securities are absolutely safe in that the dollar amounts of principal and interest will be paid (but of course with no guarantee of the purchasing power of these payments).230 Investment companies 13. Thus it might seem that the Social Security System is being prudent in limiting its investments to Treasury securities. It has therefore been a net buyer of Treasury bonds and has helped fund general expenditures. Furthermore. and pays out benefits to retirees. In his first term. which then spends it. typically on the order of 1. Gibson. President George W.5% per annum. Most importantly. It receives payments from workers and their employers. .

A visit to the Vanguard site shows a little less diversification: they offer traditional fund products including open. probably with some success. for example. bonds. A visit to the web site of Wells Fargo Bank. mutual funds) but also full banking services through the Charles Schwab Bank and a link to a commodity trading firm. Gibson.. and a full line of insurance products. Wells Fargo is attempting.7. copyright c Warren C. reveals not only the usual panoply of bank products (checking and savings accounts. those walls have become nearly invisible to investors. All of these firms make strong appeals to retirement investors as this is a major source of income which could be enhanced should any privatized options to Social Security ever be enacted.and closed-end mutual funds and exchange-traded funds in addition to annuities and brokerage services. annuities.9 Diversification of Investment Companies While banking functions remained separated from other investment activities by regulatory walls. mortgages) but also brokerage services. to position itself as a one-stop financial services center. Charles Schwab was one of the first discount brokers. The proposal got nowhere and is unlikely to receive serious consideration in light of the stock market meltdown of 2008.Chapter 13: Survey of Non-bank Intermediaries 231 tion much like IRA or 401K accounts. 13. but not insurance. which took down many people’s 401-k or other retirement investment accounts. . A visit to their web site shows not only the traditional brokerage products (stocks. CD’s. While the insurance products are represented by links to other web sites. Version 0.92.

.232 Investment companies Version 0. copyright c Warren C.92. Gibson.

2 Savings Banks Savings banks are institutions that generally fall midway between banks and S&Ls. Treasury Department. 14.Chapter 14 The Changing Regulatory Environment 14. Most credit unions are 233 . All federally chartered S&Ls have their deposits insured by the FDIC as do most state-chartered S&Ls.2. are non-profit associations and are therefore exempt from corporate income tax.S. part of the U. as explained in Section 13. 14. Both are supervised by the Office of Thrift Supervision.1. They are required to hold only relatively high quality assets.1. Most savings bank deposits are insured by the FDIC.1 Savings and loan associations can be chartered by the federal government or state governments.3 Credit Unions Credit unions.1.1 Government Agencies That Regulate Nonbank Depositories Savings and Loans 14.

but rising again in 1979-81 to a peak of around 15%. and thus checking services. were losing business to foreign banks.92. • Thrifts were highly regulated as to their asset mix. In particular. junk bonds. Gibson. • Thrifts were allowed to pay higher interest on their time deposits and savings deposits under Regulation Q (although prior to 1966. 14. easing off in 1976. anyone earning 3% in a bank account when purchasing power was declining at a 10% or 15% rate was suffering substantial losses. gold and silver. interest paid by thrifts was not constrained). We might well describe this arrangement as an oligopoly (control of a market by a few participants) or a cartel (collusion among a group of suppliers to control a market). copyright c Warren C. These were times of serious price inflation. Banks. a federal agency. but especially S&Ls. the new money market mutual funds. A few have chosen private insurance in lieu of NCUA insurance. however.234 Innovation Fosters Deregulation insured by the National Credit Union Administration. Version 0.2 Innovation Fosters Deregulation At one time commercial banks and thrifts had a tidy market-sharing arrangement in that government regulation protected them from competition. diamonds. They were confined mainly to mortgage loans. first hitting double digits (11%) in 1974. All depositories were hit by disintermediation – withdrawal of deposits by savers eager to find higher rates to compensate for price inflation. • Banks had higher capital requirements. This arrangement persisted for a number of years. . Clearly. but the rising interest rates of the 1970’s knocked them out of this happy equilibrium. and thrifts enjoyed some tax advantages. • Commercial banks enjoyed a monopoly on demand deposits.

“share draft” accounts. Finding regulatory loopholes became a matter of survival for depository institutions. Regulation Q was phased out over six years. and for credit unions. Congress and the regulators listened. with the remaining balance earning 5% or more per annum. banks were withdrawing from the Federal Reserve – 300 of them in the prior six years. One of the authors disintermediated some of his savings during that time. followed soon thereafter by the same permission in New York State. nationwide. In response. This innovation let the proverbial cat out of the bag. Version 0. This bank and others in Massachusetts and New Hampshire had won permission from the courts to issue what were for all intents and purposes interest-bearing checking accounts. called NOW (Notice of Withdrawal) accounts. These developments precipitated massive regulatory overhaul. and soon they too were allowed to issue NOW accounts. not just nonmember banks but also S&Ls. Though a resident of California. were permitted to issue interest-bearing checking accounts: NOW accounts. The author had an account on which he could write checks. ATS accounts (Automatic Transfer Service). and just about anything that people thought might hold its value against the ravages of inflation. he opened an account at the Coolidge Bank in Boston.Chapter 14: The Changing Regulatory Environment 235 collectibles. Furthermore. In 1980. • The monetary control part was in part a response to the Fed’s declining control over the M1 money supply. as depositors fled from M1 to M2 assets. . Commercial banks and S&Ls in New England were incensed. copyright c Warren C. the Act provided these powers: – The Fed gained control of reserve requirements for all depositories. Gibson. consisting of three parts • All federally regulated depository institutions.92. Congress enacted the Depository Institutions Deregulation and Monetary Control Act (DIDMCA). canned goods. real estate. savings banks. and credit unions – The Fed was authorized to enter the check-clearing business and to charge a fee for this service.

these funds had come seemingly out of nowhere to provide safe. decided to exercise forbearance. convenient market-rate returns to small and large savers. S&Ls borrow short and lend long. To begin with. Germain Act was passed in 1982. This act allowed savings and loans and savings banks to make loans other than mortgages. one that had been engineering by the Federal Re1 Prior to 1934. The problem was particularly acute for S&Ls because they were making mostly mortgage loans of up to 30 years’ duration. such as commercial loans and consumer loans and even “junk” bond finance. This led to the first S&L crisis.000 level that had been established in 1974.) In addition to disintermediation woes. which can largely overcome this problem. (NOW and ATS interest rates were subject to a 5. giving them time to The Garn-St.236 Innovation Fosters Deregulation – Deposit insurance was raised to$100. Like banks.25% ceiling until 1986. But DIDMCA did not solve all the problems of depositories. . By 1982 fully three quarters of S&Ls were insolvent and the industry as a whole had a negative net worth of about $150 billion.1 Variable-rate mortgages. a severe recession hit the country in 1981-82. most mortgages were written for only three to five years. a period during which prices in general had increased only about eight times. To make matters worse. This is a special problem when interest rates are rising because they must offer higher rates to new depositors while stuck with low-interest long-term rates.000 to $100. DIDMCA had phased out Regulation Q and raised deposit insurance from $40. As we have seen. S&L’s were suffering from interestrate risk. Version 0. Money market mutual funds had entered the picture and were sapping the deposits away from traditional institutions.000 per account from the $40. Gibson. were prohibited until 1979. instead of closing them down. Regulators. most S&L managers lacked expertise in these areas. assuming assets marked to market.000 per customer. This was an explosive mix. The agency that provided insurance to S&L’s. copyright c Warren C.92. Thus deposit insurance had increased 40-fold since 1933. the Federal Savings and Loan Insurance Corporation (FSLIC) had insufficient personnel and insufficient expertise to oversee these new activities.

279. The FDIC was given greater authority to borrow and was told to raise insurance premiums with a goal of achieving an insurance fund equal to 1. the Federal Deposit Insurance Corporation Improvement Act (FDICIA) in 1991. In response. Finally. By 1991. many S&L assets turned sour. especially in Texas. Losses mounted to the point where over half of the S&L’s. They loosened capital requirements and stretched accounting principles. receiving an average of 85 cents on the dollar. Congress enacted yet another piece of legislation. FIRREA was making progress but the FDIC was running out of funds. The cost of his bailout was approximately $150 billion. The Resolution Trust Corporation (RTC) was set up to clean up the wreckage of insolvent S&L’s. p. some of which came from the assets of the Federal Home Loan Banks but mostly from the sale of new government debt. bank managers would have been much more circumspect in their operations. The FDIC became the sole provider of deposit insurance. Hesitating to close insolvent S&L’s. were insolvent by the end of 1982. It seized assets of about 750 S&L’s and sold about 95% of these assets. by some estimates. The Federal Home Loan Bank Board and the FSLIC were abolished and a new Office of Thrift Supervision was established as a bureau of the Treasury Department. copyright c Warren C.Chapter 14: The Changing Regulatory Environment 237 serve in order to choke off the inflation that reached historic levels. but the providers of this insurance would have incentives to watch Version 0. As a result. FSLIC regulators chose further regulatory forbearance. Without it.92. The situation was allowed to worsen so that by 1989 it had reached crisis proportions. FIRREA tightened capital requirements.25% of insured deposits. . but with one fund for banks (the Bank Insurance Fund) and one for thrifts (the Savings Association Insurance Fund). Of course. The real bailout came in 1989 with the passage of the Financial Institutions Reform. they might have sought private deposit insurance. A half-hearted measure called the Competitive Equality in Banking Act was passed in 1987. Recovery. and Enforcement Act of 1989 (FIRREA). Gibson. What can we learn from the S&L crisis? Was it a market failure? Lax regulation? Too much regulation? Moral hazard was a direct and inevitable consequence of deposit insurance.

management was partially protected form bad consequences of heavy risks. risk-based premiums. lacked many of these sound principles. while deposit insurance Version 0. Gibson. being politically motivated. . Government insurance. First.92. co-insurance.1: U. depositors were relieved of all responsibility for seeing to the soundness of the people who invested their money – all they had to do was locate the FDIC sticker on the door. They deal with them by various means: deductibles. bank failures.) In contrast. (Just the threat of withdrawal would be sufficient in many cases. The FDIC charged a uniform premium of 1/12 of one percent per year on insured deposits. 1935-2004 Source: FDIC their insured banks carefully and to withdraw insurance from banks that went too far. the FDIC and FSLIC insured all banks and S&L’s with little or no attention to the risks they were taking. Thus. copyright c Warren C.238 Innovation Fosters Deregulation Figure 14.S. Private insurers face moral hazard problems. Further. and regulations that purchasers of insurance must agree to.

the too-big-to-fail idea. Germain. they increased this pressure by making loans at low rates. with little to lose. Some were paying high interest rates with new deposits – a quasi-Ponzi scheme. and asset values seemed to rise. It is certainly possible that better management of the FSLIC might have lessened the damage. thrifts seemed to recover and the forbearance strategy seemed to be working. deposit insurance. facing incentives to increase risks dramatically. a regulator is unable or unwilling to do its job. This led to the second thrift crisis. an inevitable consequence is that the customers and stockholders cease worrying about the regulated aspects of those businesses.” becomes the general attitude. But many of these assets were dubious. and the FSLIC failure. copyright c Warren C. These three aspects of the situation. . But it is also possible that market oversight would have prevented the crisis from getting started at all.92. When governments set regulatory standards for banks or any other industry. but perhaps emotionally invested in saving them. as in the case of the FSLIC. you have the kind of disastrous situation that gave birth to the zombie S&L’s and precipitated the general collapse.Chapter 14: The Changing Regulatory Environment 239 solves the liquidity problem – insuring that depositors can get their funds – it creates a solvency problem. Gibson. To add a new metaphor. One commentator labeled the worst institutions “zombie S&L’s. They offered high interest on insured deposits thus putting pressure on their solvent competitors. Thus minimum standards tend to become maximum standards because the lack of consumer oversight removes incentives to do any better than the minimum.” technically insolvent institutions that were still in business. and. On the other side of the balance sheet. high-risk assets. as so often happens in regulatory regimes. Factors exacerbating the situation included brokered deposits. Regulation Q. After the passage Garn-St. When. generous accounting principles. all suggest that the S&L crisis was a massive govVersion 0. the zombie S&L’s were like black holes sucking solvent S&L’s toward obliteration. “The government will take care of it. regulators who too close to the institutions they were supposed to be regulating – not necessarily corrupt. Interest rates eased.

yet there can be no assurance that some other crisis may arise out of government regulation..240 Innovation Fosters Deregulation ernment failure and in no way a market failure. Yet another piece of legislation would be required before the S&L crisis could be laid to rest. which established a separate insurance fund for S&Ls called the Savings Association Insurance Fund (SAIC). like risk-based premiums. Canada and most other countries had no restrictions on branch banking. The Financial Institutions Reform. they did not have the same problem with bank runs as the U. which is also under Version 0. Assets of insolvent thrifts were turned over to a new government agency. Economists disagree about many things but they are nearly unanimous in calling for some kind of deposit insurance reform. 4 and 5 being problem banks. and thus enjoyed a less fragmented banking system. Also. the Federal Home Loan Bank Board was abolished and its regulatory functions were turned over to the new Office of Thrift Supervision. . • Modified the regulatory structure once again. Most notably. One reform has been instituted – risk-based deposit insurance premiums. Recovery and Enforcement act of 1989 (FIRREA) did the following: • Instituted the largest bailout in history up until that time – ultimately totaling $160 billion of which $132 billion was borne by taxpayers. Gibson. yet beforehand. had experienced in the Great Depression. Also. copyright c Warren C. To be sure. thus giving bank managers an incentive to “clean up their act” and stay out of the lower categories. part of the Treasury Department and analogous to the Comptroller of the Currency. The FSLIC was abolished and its functions were taken over by the FDIC. which ultimately disposed of them. foreign banks generally faced fewer restrictions on their activities nor were deposit banks kept separate from investment banks.92. It is instructive to ask how deposit insurance fared in other countries. and the rate of bank failures is back down to “normal” levels. No other countries adopted deposit insurance until the 1960s or 1970s.S. the Resolution Trust Corporation. Insured banks are ranked from 1 through 5. Their insurance premiums are charged accordingly. some lessons have been learned.

. • Thrifts were re-regulated. They were required to divest junk bonds and to increase their real estate holdings from 60% to 70% of assets. Higher capital requirements were instituted for banks. copyright c Warren C. Other FHLBB functions were turned over to the Federal Housing Agency. Gibson. including prison terms of up to twenty years. • Harsh penalties were meted out to some of the more notorious players.92. and bank holding companies were permitted to purchase solvent as well as insolvent thrifts. Version 0.Chapter 14: The Changing Regulatory Environment 241 Treasury.

242 Innovation Fosters Deregulation Version 0.92. copyright c Warren C. Gibson. .

Part VI Modern central banking 243 .


Chapter 15 The Money Multiplier: How Banks Create Money 15. i. Omitting travelers’ checks which are a minor component of M1. Our task is to derive a money multiplier km that shows how base money is multiplied when it enters the economy as M1 money. we want to find km such that M 1 = km B. we can write M1= C + D. The split between C and D is determined b individuals’ aggregate desire to hold currency versus their desire to hold demand deposits. Recall that the M1 money supply consists of currency in circulation. The variables we use are 245 .1 How Base Money Gets Multiplied We now examine the “money multiplier” that operates in a fractional reserve banking system such as we now have. People tend to hold less currency when they increase their use of credit cards and debit cards. Automatic teller machines also reduce the demand for currency since it is easier to get cash from these machines than to get it by standing in line inside a bank branch. demand deposits and travelers’ checks.e. We can express this as a fraction c = C/D.

Then C = 0. r ≥ rr Now base money B consists of currency C and reserves R. Assume that banks hold no excess reserves. Since most banks of any size hold demand deposits far in excess of $45. copyright c Warren C. B = C + R. A single commercial bank with no currency in circulation.4 million.92. Then km = 1 C+D B Actually no reserves are required for the first $6.6 to $45. . 3% for amounts from $6. Consider three cases: 1. We now develop the latter assumption. and 10% above that. the result is the same 3.4 million. Call the currency/deposit ratio k = C/D. B = R and km = M/B = D/R = 1/r Thus km = 1 1 1 M =B× ∆M = δB × r r r ¯ where ∆ means “change in” and r is an average reserve ratio. reserves are accounts kept at the Federal Reserve for the benefit of commercial banks. M = D.e. the average reserve requirement is very nearly 10%. Thus ¯ for example. Gibson. i. a fourfold mulitplication of base money into M1 money. 2. Currrency is introduced. As we have seen. Banks are required to maintain reserves in the amount of at least 10% of their demand deposits.1 We will call this 10% figure (which as we will see is set by the Fed) rr .6 million in demand deposits.246 B C R D M1 rr r How Base Money Gets Multiplied base money currency bank reserves deposits M1 money stock required minimum reserve ratio r = D/R banks’ average actual reserve ratio. r = 1/4 results in km = 4. With multiple depositories but still no currency. Version 0. their actual reserves are equal to the minimum required reserves.

Again.2 + 10. If they find themselves holding a temporary excess they can loan those funds to another bank which is in need of reserves to meet its requirement. $3.1 the multiplier is c+1 = 0. Gibson.2. such as expected heavy withdrawals or expected forthcoming loan opportunities. Then c = C/D = 1/5 = 0. copyright c Warren C.33. or borrowing federal funds. or $0.2 + 0. we are assuming that banks hold no excess reserves.67 in new currency and the rest. . With r = 0.1 = 4 c+r Thus every new dollar of base money results in $4 of M1 money (1/6 of that. Excess reserves allow them to accommodate either of these contingencies without calling in loans. in new demand deposits).92. Version 0. offering higher interest to draw more deposits. Excess reserves are costly for banks because they earn no interest. How significant is this multiplier? Suppose the public wants to hold $5 in demand deposits for every $1 in currency. so banks maintain them only when they see a good reason to do so.Chapter 15: The Money Multiplier: How Banks Create Money C D + B B C+D C+R C/D + D/D C/D + R/D k+1 k+r 247 = = = = so that k+1 k+1 ∆M 1 = ∆B k+r k+r Thus we see that the money stock is a function of three variables: M1 = B • B – controlled by the monetary authorities (or by market factors in the case of a gold standard) • r – controlled by banks (but subject to r ≥ rr ) • k – controlled by the public Thus base money becomes M1 money through a multiplication process.

currency. have led to increasing demands for currency in recent years.1: M1 multiplier.92. copyright c Warren C. along with overseas demand for U. Figure 15.S. But demand from drug dealers and others eager to hide their transactions. Gibson. Currency is becoming less important in ordinary daily transactions as people find credit cards and debit cards increasingly convenient.248 How Base Money Gets Multiplied Figure 15. Version 0.1 shows an estimate of the M1 multiplier which has been declining steadily in recent years. . This bank-to-bank loan market is called the federal funds market. The currency/deposit ratio is entirely determined by the preferences of the public. Clearly the Federal Reserve does not have complete control of the M1 money stock since the money multiplier which converts base money into M1 contains terms that are outside the Fed’s control.

Legally. P.2 Organization The legal structure of the Federal Reserve is not economically important and we explain it here partly because some people on the fringes of economics use it as a basis for silly conspiracy theories. The Fed commenced operations in 1913. the decision to start a central bank was probably reached at a secret conference organized by J.Chapter 16 The Federal Reserve System 16. held in 1910 at his private island off the coast of South Carolina. commonly called “the Fed.1 Origins In the United States.” is the central bank. A public choice viewpoint of the creation of the Fed would point to the private interests of the House of Morgan and his allies in business and politics. 16. such as harvest time or Christmastime. The public interest justification for the creation of the Fed was the need for an “elastic” currency. Morgan. arguably the most powerful Wall Street financier of his time. and contract at other times. one whose supply could expand during times of greatest need. While legally authorized by Congress. the Fed is owned by private member banks like Citicorp or Bank of America. following legislation passed in 1912. the Federal Reserve System. These banks are 249 .

While the Fed earns profits on its operations.250 Organization required to buy shares of Federal Reserve stock and that stock pays them a fixed 6% yearly dividend.” When buys bonds in the New York bond market. Gibson. From an economic point of view. We shall return to the effects of new money on the economy subsequently. is loaned out. it cannot distribute those profits to its “owners” except through the 6% “ dividend. . the Fed pays with money that never existed before. This activity is some ways similar to counterfeiting which is of course illegal. Let us now focus on the functioning of the Fed. We must emphasize that the Fed really does create new money “out of thin air. These are typically Treasury Bills that were first purchased by a commercial bank or other private party. and this constitutes about one sixth of the total federal debt (not counting debt in the hands of Federal agencies like the Social Security Administration). When it does so. copyright c Warren C. through its open-market operations. the Fed should be thought of as a government agency. because in essence it has been taken off the market and replaced with newly created money.92. Instead. What does the Fed do with the Treasury securities that it acquires? It holds them and collects interest on them from the Treasury and it presents them for redemption when they come due.” The member banks’ ownership of “ stock” does not give them the right to vote out the management as the stockholders of an ordinary corporation could. the Fed buys Treasury securities from New York bond dealers. Fiat money issued by the Fed or any other central bank. the Fed held about $800 billion worth of Treasury securities. The interest on $800 billion worth Version 0. Member banks may not sell their shares of Fed stock and the dividend cannot be changed. The Fed does not actually lend money directly to the Treasury. rather than being spent directly by the government. As of 2006. thereby making it easier for the Treasury to issue new bonds into the market. But this stock bears little resemblance to the shares of private corporations. albeit an agency with some very special obligations and privileges as we shall see. This $800 billion worth of debt is said to have been monetized. it reduces the supply of these bonds in the private market.

1 Version 0. . A remnant of that independence could be found on notes issued up until about 2002. When the Fed was created.1 and since then all paper money has been issued by the Fed. the Fed sets its own budget. The public-interest defense of this arrangement is that it helps the Fed maintain its independence from political pressures since Congress cannot use the threat of budget cuts to wield undue political influence. However. Gibson. One of the Fed’s main spending priorities is hiring economists either for its staff or as consultants.Chapter 16: The Federal Reserve System 251 of securities amounts to a lot of money. There is an important condition attached to the legal requirement that the Fed return its interest earnings to the Treasury. such as A for New York and L for San After 1965. This money flowing into the Treasury can be viewed as an indirect form of seignorage. one-dollar bills were silver certificates. Also. These certificates were discontinued when all silver was removed from U. To the extent that the Fed is unaccountable to the people’s elected representatives. its twelve branches were more independent than they are today. The Fed is allowed to deduct its operating expenses from the amount remitted to the Treasury.S. although this is not as significant to the Treasury as the Fed’s “soaking up” of supplies of Treasury debt so as to clear the way for more new debt. its annual interest income on its $800 billion holdings would be about $24 billion. the Fed is required by law to return these interest earnings to the Treasury. which bore a letter indicating the Federal Reserve district that issued that particular note. The law also grants the Fed a monopoly on note issue. coins in 1965. the Fed can diffuse opposition to its policies or its existence. it is undemocratic. though they are legal tender. However. the flip side of independence is accountability. do not circulate as money. the freedom to set its own budget gives the Fed incentive to spend lavishly on salaries and facilities. In other words. copyright c Warren C. if the average interest rate on the Fed’s holdings were 3%. All other Federal agencies must compete for Congressional appropriations during each year’s budget cycle. the U. By so doing. issued by the Treasury and redeemable on demand for the silver coins that circulated then. silver and platinum “coins” which. the Mint has issued gold. Mint issued half dollars containing 40% silver for a few years. When the authors were young. In recent years. but these did not circulate. For example.92. S.

two-dollar bills were. But we must remember that private banks also create money via the fractional reserve system. requires in addition that all holders of all debts. which you will recall requires that all taxes be paid in that money. Moreover. and the Fed deducts the amounts from the private bank’s account at the Fed. These banks can request shipments of fresh bills from the Fed at any time. they cannot force the public to accept particular forms of it.252 Organization Francisco. Some of this money is converted to notes as requested by private banks in response to customer demands. Canada solved its one-dollar problem by simply discontinuing its one-dollar bill. but these have also failed to catch on and are generally appear only as change returned by government-owned vending machines in post offices. but higher-denomination bills last somewhat longer. issuance of Federal Reserve notes does not in itself represent creation of new money. These stories show that even when governments monopolize the issuance of money. public and private. First.2 We have seen that the Fed can create new money at will through its open-market operations. it had a two-dollar bill in circulation which was not plagued by superstitious rejection as U. Then in 1997 the Mint tried issuing brass-colored coins bearing the likeness of Sacagawea. One-dollar bills typically wear out in less than two years.” 2 Version 0. 3 Thus we see printed on all our paper currency. The earliest Federal Reserve notes showed the district of origin quite prominently as you can see in Figure 6. “This note is legal tender for all debts. train stations. However. Anthony one-dollar coins. . The bills are actually printed by the Bureau of Engraving and Printing.3 We can envision two tiers of money creation. a separate government agency.92. Gibson. accept central bank money in payment of these debts. New Susan B. Under our present system. and in a stronger form.3. smaller than the silver dollars of earlier years. but the public did not accept them because they were easily confused with quarters. they now use the central bank’s notes as reserves because these notes usually enjoy the government’s legal tender sanction. the central bank issues new money and then private banks pyramid One-dollar bills have been a headache for the monetary authorities for a number of years. were issued in 1979. The money that the Fed creates in open-market operations is in electronic form. etc. copyright c Warren C. public and private.S. Private banks also return worn bills to the Fed for replacement with fresh bills.

It is generally set at a rate somewhat higher than the Federal Funds rate. 16.Chapter 16: The Federal Reserve System their monetary expansion on top.25%. Discount Rate The Fed’s other two monetary control powers are not much used.1 Monetary Instruments Open market operations The Fed has three powers that influence the money supply. The discount rate does Version 0. Unlike the Federal Funds rate. .24% and the discount rate is 6. For example. The speeches of the Fed Chairman are carefully dissected by financial commentators searching for clues about future policy shifts. One is the discount rate. We have already discussed open-market operations in which the Fed buys Treasury securities using newly created money. and these targets are widely publicized. on the entire global economy. copyright c Warren C. 253 16. Markets eagerly await the results of regular meetings at which the Fed may decide to change course in its conduct of monetary policy. which is the rate at which the Fed stands ready to loan reserves to member banks. Gibson. S. As a result the discount rate does not play a direct role in the conduct of monetary policy.92.25%. or sells them and effectively destroys the money it receives. the average rate for recent transactions is 5. the Fed actually sets the exact discount rate that it wants.3 Instruments of control The Federal Reserve System has a great deal of influence on the U. that is.3. But the public is less aware of the fact that the Fed achieves its targets by manipulating the money stock through open market operations. For the last several years the Fed has announced target Fed Funds rates. in the Federal Funds market. as this is written. the Fed Funds target rate is 5. economy and indirectly. But the Fed prefers that member banks obtain needed reserves by borrowing them from other commercial banks.

254 Instruments of control serve as a sort of “circuit-breaker. which in percentage terms was more severe than that of 1929. It was thought that margin buying contributed to the severity of the 1929 stock market crash. This has been set at 10% for many years and while reductions in this requirement could increase the money supply. and brokers typically borrowed from banks. it banks would want to borrow from the Fed’s Discount Window rather than in the Fed Funds market. Version 0. Margin requirements In addition to its monetary control authority. so the Fed was given the authority to set minimum margin requirements. but it has remained at 50% since 1974.” in case for some reason a sudden demand for Fed Funds were to drive the Fed Funds rate substantially higher than the target rate. . These are relatively insignificant at present. copyright c Warren C.92.3.2 Non-monetary instruments The Fed has acquired miscellaneous other powers as a result of historical circumstances. Gibson. Stockholders in this position are very vulnerable to price declines. the Fed is empowered to set margin requirements for stockbrokers. Note that the 50% requirement was in effect at the time of the 1987 crash. Reserve requirements The third discretionary power that the Fed wields is the reserve requirements for demand deposits. This practice is called “buying on margin. currently 50%. Between 1934 and 1974 the Fed changed this figure 22 times. because a drop of just 10% in the price of their stock would wipe out their equity and they would get a call from their broker (a “margin call”) demanding that they put up more money or have their position sold out. some people bought stocks using borrowed money.” They put up as little as 10% of the purchase price. and vice versa. During the speculative boom of the 1920’s. 16. this tool is considered rather blunt in comparison to open market operations. borrowing the rest from the broker.

For a brief time in 1980 the Fed was given some control over consumer credit. President Carter blamed consumers’ overuse of credit cards for the high rate of price inflation at that time.3.3 Other powers At one time.Chapter 16: The Federal Reserve System Regulation Q 255 As we indicated in our discussion of banking. At one time the Fed also had some control of down payments by home buyers. copyright c Warren C.92. Version 0. Gibson. under Regulation Q. This regulation was administered by the Federal Reserve but has been abolished. the federal government at one time limited the amounts of interest that banks could pay on savings accounts. 16. .

92. . copyright c Warren C. Gibson.256 Instruments of control Version 0.

and it was thought that the price level would rise in concert with the money supply. The Currency School of thought of mid-nineteenth century England was dedicated to hard money and opposed to fractional-reserve banking.Chapter 17 Targets of monetary policy 17.3 Stagflation and the monetarist counter-revolution Monetary policy options 17. free bank257 . However. We will add a third option. This school also advocated the “real bills” doctrine which held that short-term loans for productive business purposes should be the basis of currency.4 Two ways of conducting monetary policy are currently recognized. Actual policy can be a blend of these two. the quantity theory of money held sway. there was disagreement about other aspects of banking. The Banking School thought that limited fractional-reserve banking was acceptable.1 Pre-1929 Prior to 1929. 17.2 The Great Depression and the Keynesian revolution 17.

It requires first that targets be selected for price inflation and real output growth. Gibson. Whether the chosen rate was 2%. which is not widely known or discussed but which has theoretical and historical underpinnings that we believe merit examination. The money supply should be increased at some fixed annual rate. Friedman has backed away from his proposal for a strict rule. . Friedman’s extreme rule ran afoul of the shifting characteristics of the monetary aggregates during the 1970’s.92. conditions might have changed so much as to make the policy counter-productive. the monetary base. he cited the “long and variable lag” between the implementation of a monetary policy change and the time when the change effects the economy. offered almost as much liquidity and higher interest than checking accounts. This posed a problem for the Friedman rule since someone must decide whether the specified percentage increase is to be applied to M1.4. Economic slowdowns would be met with injections of new money while booms would be countered by monetary restraint. 17.1 Discretionary versus rule-based policy The concept of monetary policy as a tool for managing the economy gained currency during the Keynesian revolution. 4% or some other number mattered less than a commitment to keep that rate constant. copyright c Warren C. By the time a change takes hold. 3%. It also requires an estimate of a desurabke long-term equilibrium real fed-funds rate. at one time advocating strict rules for monetary policy. according to Friedman. As a result of this problem. These three numbers are then combined with observed Version 0. The Taylor rule is an alternative targeting rule for interest rates. which are counted in M2. a computer would be adequate for the conduct of monetary policy. money-market mutual funds. said Friedman. In particular. M2. As his main justification for this position. Under this regime. Milton Friedman took an opposing point of view. Deregulation opened up new substitutes for traditional M1 money holdings (cash and checking accounts). meaning that the monetary authorities should stand ready to react to macroeconomic events as needed and should not be bound by any strict rules.258 Monetary policy options ing. or some other measure. Keynesians advocated an activist monetary policy.

And if the Taylor rule were ever to be enshrined as official policy. Some have suggested that Chairman Alan Greenspan has been following this rule although there has been no public commitment to do so. Half of the “output gap” which is the difference between potential and actual output. the Taylor Rule tracks fairly well with the Fed Funds rate. in our democracy all departments of the government are supposed to be accountable to the people’s elected representatives. What is the right balance beVersion 0. Gibson. Also. So the Fed is to some degree independent of political pressures and in some ways not. which suggests that they are at least mildly beholden to him. enables it to “do the right thing.2 Monetary Policy Versus Democracy We have seen that the Federal Reserve System is independent of Congress and the President in one important respect: it sets its own budget.4. What is the right degree of independence? Independence shields the Fed from short-term politics and thus. at least in theory.Chapter 17: Targets of monetary policy 259 values of price inflation and real output growth. ∆P/P 3. This rule implies that both price inflation and output growth are important and should play a role in the target formula.” On the other hand. Four terms are added to get the desired fed-funds target rate: 1. copyright c Warren C. 17. during the period from 1960 to 2003. . the Fed Chairman is required to testify periodically before Congress. The long-term target real fed funds rate (2% is usually selected) 2. 4. There would also be pressure from economists who think their proposed improvements on the Taylor rule should be written into policy.92. Half of the “inflation gap” which is the difference between the actual rate of price inflation and the target rate. there would be substantial political pressure to modify or abolish it in recessions or inflationary periods. The rate of price inflation. the Chairman and the other members of the Fed Board of Governors are appointed by the President. However.

the reality was that banks were by no means entirely free during that time. but particularly economic problems.3 Free Banking Free banking. Basically. is in its pure form a situation devoid of government involvement in monetary affairs. This question brings up the more general conflict between democracy and the Keynesian idea that fiscal and monetary policy rules can be derived from correct economic theorizing and that the government’s job is therefore simply to implement correct policy.4. This of course clashes directly with both the theory and practice of democracy. copyright c Warren C. The name “wildcat banking” has become associated with this time for that reason. . the theory is that elected representatives should have ultimate control. And in practice. there are other possibilities. thereby leaving those Version 0.260 Monetary policy options tween independence and accountability? There will probably never be a definitive answer to this question. One form of government control was the common prohibition of branch banking. as we have seen. They would hold whatever reserves seemed best able to attract customers and preserve their reputations as sound institutions – while specie seems a likely candidate. the term “free banking” has been associated with the experience of the nineteenth century. Clearinghouses could be independent profit-making companies or non-profit associations of banks. which prevented stronger city banks from expanding into rural areas. Competitive pressures would constrain them against excessive issuance of banknotes or expansion of loans relative to reserves. However. They have substantial incentives to intervene in such things as monetary policy. or at least to give the appearance of having held the monetary authorities accountable. To repeat. a time when the rate of bank failure and fraud was not insignificant. congress people are constantly urged to “do something” about real and imaginary problems of all sorts. Gibson.92. Private banks accept deposits as they do now. they could not over-issue relative to the public’s demands to hold their notes or deposits. but in addition they would issue their own name-brand banknotes (or perhaps an electronic equivalent of paper banknotes). 17. In the United States.

A further intervention was the requirement on the part of many state governments that state-chartered banks hold state government bonds as part of their reserves. The delay was of limited duration and the notes were to bear interest during that time. A more instructive historical episode was that of Scotland during the time period 1715-1844. Competing private banknotes circulated freely throughout Scotland. which among other things gave the Bank of England. and there was only one significant bank failure in all that time. the Ayr Bank.Chapter 17: Targets of monetary policy 261 areas for small. This gave the bank an option to delay redemption of its notes in case a run should begin to develop. Version 0.92. copyright c Warren C. dominion over Scottish banking as well. However. Gibson. which had long since established itself as England’s central bank. This episode came closer to pure free banking and the results were on the whole quite good. One of the precautions taken against bank runs was the “option clause” which was attached to banknote issues. under-capitalized or mismanaged banks. option clauses were outlawed in 18xx and the entire free banking period in Scotland came to an end in 1844 with the passage of Peel’s Act. .


Monetary policy options

Version 0.92, copyright c Warren C. Gibson.

Part VII

Money and the world economy


Chapter 18

International trade and the balance of payments



Version 0.92, copyright c Warren C. Gibson.

fixed and floating 19.1 19.Chapter 19 Exchange rates.2 The traditional gold standard Monetary nationalism 267 .

92. . copyright c Warren C.268 Monetary nationalism Version 0. Gibson.

Chapter 20 Other aspects of modern international finance 20.2 Increasing private competition The international debt crisis 269 .1 20.

56 Breaking the buck. 103 Bankers’ acceptances. U.Index Alchian. 28 municipal. 174 Livre Tournois. 95. 56 drawbacks of. 57 fractional reserve. 129 special features. 19. 162 Brassage. 28 Amazon. 99 copper.S. 89 Civil War. 19. 57 merchant. Denarius. 138 Corporations. 47 maturity. 103 corporate. 163 tax treatment. 96 fractional reserve. 57 Bonds Susan B. 29 Balance 164 270 . 29 Aristotle. 97 debasement of. 92 Central bank. 70 Bank runs. Anthony.. 134 Certificates of deposit. 19 central. 79 Anderlini. 91 Coinage Act of 1873. 74 marketability. 87 Barron’s Business and Financial Weekly. 136 Burns. 22 Sacagawea. 121. 92 Coins Banks Chinese. 77 Bank panics. 59 market value of. Luca. 162 Counterfeiting. 19 63. 61 benefits of. 86 Continental Congress. 73 silver. 134 junk. 133 Commercial paper. Arthur. 57 earliest. Armen. 98 Capital. 103 Bills of exchange. 124 Banking Checks. 57 Barter.

Paul. 131 Federal Deposit Insurance CorporaGreenspan. 121 Financial intermediaries. 29 tion. 98 French revolution. 71 Government National Mortgage Association. David. 111 Goldsmiths.INDEX Credit. 61 creation of money by. 9 Deflation. Robinson. 174 ration. 28. 169 Fisher. 148. 67 Credit cards. . 113 Einzig. 146 credit unions. Alan. 85. 170 Financial instruments. 102 Fidelity. 148 Federal Home Loan Banks Financing Gresham’s law. 59 271 Glasner. 72 indirect. 55. 22 indirect. 131 Hoarding. Glyn. 124 Depreciation. 60 Friedman. 9 Credit unions. 101 Inflation gold holdings of. 61 function of. Irving. 131 Hyperinflation Federal Reserve System. 93. 10. 67 Currency. 89 Goods durable. 49 Free banking. 107 Version 0. 132 Hayek. 28 Gold. 111 tion. savings. 117 gold. 29 Equation of exchange. 170 Finance direct. Milton. 101 German. 118 Federal Home Loan Mortgage CorpoHedge funds. 132 note issue monopoly. 132 Hugh-Jones. 28 Debit cards. 50. Gibson. 173 Export-Import Bank. 177 Crusoe. Caroline. 42 Federal Housing Administration. 12. 12 Exchange-traded funds. 122 Davies. Friedrich. 100 Confederate. 160 Deposits.92. Stephen. 57 Corporation. 107. 29 Federal National Mortgage AssociaHumphrey. 38 Exchange direct. copyright c Warren C. 86 Finance companies.

122 Monetary base. 113 distribution effects. 22 Money market mutual funds. 31 purchasing power of. 21 supply of. 54 Liquidity. 51 standard of deferred payment. 49 modern quantity theory of. 113 distortions caused by. 170 Interest. 112 net welfare effects of. 175 Mortgage-backed securities. 104. 36 emergence of. 24 subsidiary functions of. 28 Mint Act of 1792. 9. 123 Money INDEX benefits of holding. 118 high-powered. 111 Insolvency. 83. 108 liquidity preference theory of.92. William Stanley. J. 108 paper. 111. 124 M3. 25 store of value. 56 Mises. Gibson. Huston. 28 Melitz. 123 M2. 29 Menger. 117. 41 purchasing power. Carl. 111 creation of by private banks. 115 commodity. 151 Loans Risk default. 68. 134. 49 Legal tender laws. 43 transactions demand. 170 Version 0. 28 Keynes. 125 Loanable funds. 12 fiat. 37 unit of account. Ludwig von. 94 demand for. copyright c Warren C. 57. 58 portfolio demand for. 165 Jevons. Jack. 115 sustained.272 as a tax. 28 Monetary aggregates. 125 Money-market mutual funds. 118 hard. 159 Interest rates controls. 125 Money-market deposit accounts. 114 inflation incentives for. 43 quantity theory of. 156 real rate of. 93 Insurance companies Life. 50 outside. 49 stability of demand for. 134 Mutual funds. 63. John Maynard. 161 McCulloch. 148 Money stock calculation of values. 127 M1. 147. 170 Property and casualty. . 125.

Stockbrokers. Gibson.INDEX closed end. 165 preferred habitat theory. 137. 170 Weatherford. Murray N. Hamid. Hungston. 174 Resolution Funding Corporation. Jonathon. 28 Real estate investment trusts. 169 Shakespeare. 67. A. 170 132 Pepsico. 164 expectations theory. 130 Seignorage. 139 Version 0. 10 Stock. copyright c Warren C. 133 Pension Benefit Guaranty Corpora. 164 segmented market theory. R. 164 liquidity premium theory. 28 White. 132 Rothbard. 24 Present value. 23 economic. 170. 132 Pound sterling. 11 Order Specie. 54 Transaction costs. 19 planned. 50 Tennesee Valley Authority. 128 Price index. 31 Profit Underwriting. 137 Treasury securities. 15 Tale. 177 Securities Vanguard. 28 Yield curve.92. 28. George. 177 Savings banks. 11 Spyders. 154 Unidad de fomento. 118 Non-bank intermediaries. 164 Yield to maturity. 29 Saving. 172 open-end. 173 spontaneous. 10 Smith. Lawrence. 171 273 government agency. 170 Savings and loans. Adam. William. corporate. 148. 154 Usury. 72. 148 Student Loan Marketing Association. Jack. 155 Savings and loan associations. 29 Radford.. A. 87 Quiggen. 145 accounting. . Pension funds. 56 Selgin. 173 Sabourina. 144 tion. 118 Williams. 170 Velocity of money. 118 S&P 500 index. 164 inverted. 19 Permanent income hypothesis. 38 Washington Mutual..

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