CHAPTER 13
MONEY AND THE FINANCIAL SYSTEM
In this chapter, you will find:
Learning Outcomes
Chapter Outline with PowerPoint Script
Chapter Summary
Teaching Points (as on Prep Card)
Solutions to Problems Appendix
Experiential Assignments
INTRODUCTION
This chapter begins with an explanation of barter and then traces the evolution of money from commodity
money to fiat money. Money is shown to serve most importantly as a medium of exchange but also as a
LEARNING OUTCOMES
13-1 Identify three functions of money and six qualities of the ideal money.
Money fulfills three important functions: a medium of exchange, a unit of account, and a store
13-2 Explain what is meant by a fractional reserve banking system.
Banks can make loans based on customer deposits. These loans, in effect, become money. The
13-3 Describe the Fed, summarize its two mandated objectives, and outline some of its other goals.
The Federal Reserve System, or the Fed, was established in 1913 to regulate the banking system and issue
13-4 Describe subprime mortgages and the role they played in the financial crisis of 2008.
Subprime mortgages are loans to home-buyers with not-so-good credit ratings. Prior to the financial crisis
of 2008, hundreds of subprime mortgages would be bundled together and sold as a mortgage-backed se-
curity. The feeling at the time was that housing prices would continue to rise, so if any of these risky bor-
Chapter 14 Money and the Financial System 190
CHAPTER OUTLINE WITH POWERPOINT SCRIPT
USE POWERPOINT SLIDE 2 FOR THE FOLLOWING SECTION
The Evolution of Money
• Barter: Goods are traded directly for other goods.
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The Earliest Money and Its Functions: Any commodity that acquires a high degree of acceptability
throughout an economy becomes money. Its three functions are:
USE POWERPOINT SLIDES 9-11 FOR THE FOLLOWING SECTION
Coins:
• The quantity and quality control problem addressed by coining precious metals.
• Token money: Money whose face value exceeds its production costs.
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Money and Banking
• Goldsmiths extended loans by creating accounts against which borrowers could write checks.
– The reserve ratio measures reserves as a percentage of total claims against the goldsmith.
USE POWERPOINT SLIDES 14-15 FOR THE FOLLOWING SECTION
Representative Money and Fiat Money: Paper money represented gold in a bank’s vault. Bearer could
redeem for gold.
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The Value of Money: People accept these pieces of paper because, through experience, they believe that
others will do so as well.
When Money Performs Poorly
Chapter 14 Money and the Financial System 191
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Financial Institutions in the United States: Earn a profit by paying a lower interest rate to savers than
they charge to borrowers.
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Birth of the Fed: Bank runs of 1907 were a catalyst for the Federal Reserve Act of 1913, which created the
Federal Reserve System as the central bank and monetary authority of the United States.
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Powers of the Federal Reserve System:
• To ensure sufficient money and credit in banking system to support a growing economy
• To issue bank notes
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Banking Act of 1933 and 1935 passed to shore up banking system and centralize power with the Fed in
Washington.
Board of Governors: Consists of seven members appointed by president and confirmed by Senate who
are responsible for setting and implementing the nation’s monetary policy.
USE POWERPOINT SLIDES 30-32 FOR THE FOLLOWING SECTION
Banks Lost Deposits When Inflation Increased
• Restrictions of the 1930s made banking a heavily regulated industry.
USE POWERPOINT SLIDES 33-34 FOR THE FOLLOWING SECTION
Banking Deregulation
Chapter 14 Money and the Financial System 192
• Eliminated interest-rate ceilings for deposits.
• All depository institutions allowed to offer money market accounts.
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U.S. Banking Structure Today
• United States has more banks than any other country.
• Branching restrictions create inefficiencies since banks can’t easily diversify their portfolios of loans
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Subprime Mortgages and Mortgage-Backed Securities
• Development of credit scores enabled subprime mortgages for borrowers with not-so-good credit ratings.
USE POWERPOINT SLIDES 46-51 FOR THE FOLLOWING SECTION
Incentive Problems and the Financial Crisis of 2008
• Two thirds of subprime mortgages originated with mortgage brokers who had incentives to get people to
apply for mortgages that the applicants could not afford. Brokers also committed fraud.
USE POWERPOINT SLIDES 52-56 FOR THE FOLLOWING SECTION
The Troubled Asset Relief Program
• October 2008 saw the Troubled Asset Relief Program (TARP). Funds were invested in institutions deemed
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The Dodd-Frank Wall Street Reform and Consumer Protection Act
• July 2010 sweeping regulatory changes aimed at preventing another financial crisis, authorizing 10
Chapter 14 Money and the Financial System 193
USE POWERPOINT SLIDES 64-65 FOR THE FOLLOWING SECTION
Top Banks in America and the World:
• The top U.S. bank held nearly 10 times the deposits as the tenth-ranked bank.
CHAPTER SUMMARY
Barter was the first form of exchange. As specialization grew, it became more difficult to discover the double
coincidence of wants that barter required. The time and inconvenience of barter led even simple economies to
use money.
The value of money depends on what it buys. If money fails to serve as a medium of exchange, traders find
other means of exchange, such as barter, careful record keeping, some informal commodity money, or some
other nation’s currency. If a monetary system breaks down, more time must be devoted to exchange, leaving
less time for production, so efficiency suffers. No machine increases an economy’s productivity as much as a
properly functioning money.
A decades-long increase in home prices, the growth of subprime mortgages, and the spread of mortgage-
backed securities created the financial crisis of September 2008. Credit dried up. The government first tried to
stabilize markets by investing in financial institutions. Later, the Dodd-Frank Act of 2010, the most sweeping
reform of financial markets since the Great Depression, authorized regulators to write and interpret hundreds
of new financial rules. Banks are back to being more tightly regulated about the kinds of assets they can own
and trade. Mergers and holding companies are creating larger banks that span the nation. But U.S. banks are
still not that large by world standards. But U.S. banks are still not that large by world standards.
TEACHING POINTS
1. Students will be interested in the variety of goods that have been used as money in the past, even
though they may have a hard time believing that rocks and salt have been used as money in
Chapter 14 Money and the Financial System 194
some economies. The ideal money should possess certain characteristics: it should be durable, portable,
divisible, of uniform quality, produced at a low opportunity cost, and of relatively stable value.
3. All voluntary exchange requires the existence of a double coincidence of wants. Thus, general accepta-
4. You may wish to talk about using money that is based on commodity value for acceptability (as op-
5. The history of the Federal Reserve System is discussed in this chapter. An interesting point to make is
that the Federal Reserve System is divided into 12 districts. Americans have long distrusted the centrali-
zation of banking power, and therefore separate banks were set up. In the early years of this century,
6. This chapter discusses some recent sweeping changes in banking laws. While not explicitly named in
7. You will have to decide how much time to spend discussing banking law and institutional structure.
Remember that many students will go on to take courses on money and banking or on financial institu-
tions.
SOLUTIONS TO PROBLEMS APPENDIX
1. (Functions of Money) What are three functions of money?
2. (Ideal Money) What are six qualities of the ideal money?
Chapter 14 Money and the Financial System 195
3. (Origins of Banking) Discuss the various ways in which London goldsmiths functioned as early
banks.
Goldsmiths accepted from their customers deposits of gold, which were available to the depositors
4. (Types of Money) Complete each of the following sentences:
a. A product that serves both as money and as a commodity is ________________.
b. Most coins and paper money circulating in the United States have face values that exceed the
value of the materials from which they are made. Therefore, they are forms of _________
__________.
c. If the government declares that creditors must accept a form of money as payment for debts, the
money becomes ________________________.
d. A common unit for measuring the value of every good or service in the economy is known as
a(n) _____________________________________.
a. commodity money
5. (Fiat Money) Most economists believe that the better fiat money serves as a store of value, the more
acceptable it is. What does this statement mean? How could people lose faith in money?
6. (The Value of Money) When the value of money was based on its gold content, new discoveries of
gold were frequently followed by periods of inflation. Explain.
When new gold was discovered, the increased supply would cause the price of gold to fall (i.e., the
Chapter 14 Money and the Financial System 196
7. (Depository Institutions) What is a depository institution, and what types of depository institutions
are found in the United States? How do they act as intermediaries between savers and borrowers?
Why do they play this role?
Depository institutions are financial institutions that obtain funds mainly by accepting deposits from
8. (Depository Institutions) Explain why a bank typically holds as reserves only a fraction of its deposit
liabilities? In light of this arrangement, why is it important that depositors have confidence in their
bank’s health?
Banks can make loans based on customer deposits. These loans, in effect, become money. The
banks has created a deposit for the borrower. Thus, the total claims against the bank now consist
9. (Federal Reserve System) What are the main powers and responsibilities of the Federal Reserve
System? What are its two mandates and some of its other goals?
The Fed has the power to issue currency, buy and sell government securities, provide loans to
10. (Subprime Mortgages) What are subprime mortgages, and what role did they play in the financial
crisis of 2008?
Subprime mortgages are loans to home-buyers with not-so-good credit ratings. Prior to the fi-
nancial crisis of 2008, hundreds of subprime mortgages would be bundled together and sold as a
11. (Bank Deregulation) Some economists argue that deregulating the interest rates that could be paid
on deposits combined with deposit insurance led to the insolvency of many depository institutions.
On what basis do they make such an argument?
Chapter 14 Money and the Financial System 197
Economists argue that the combination of deregulation and deposit insurance encouraged some
Experiential Assignments
1. Have students visit Glyn Davies’s History of Money site at
2. The Federal Reserve Bank of Philadelphia often runs informative articles that are accessible to intro-
ductory economics students.
3. The Wall Street Journal prints several features that track key interest rates. The daily Money Rates box
lists the current prime lending rate, along with a variety of short-term rates, the weekly Key Interest Rates