The US Monetary System: History, Functions, and Structure

Posted on Aug 31, 2024 in Economy

Lesson 1: The Basics of Money and Banking

The Federal Reserve System (Fed)

The Federal Reserve is the privately owned, publicly controlled, central bank of the United States.

Key Monetary Concepts

Barter Economy

A barter economy is a moneyless economy that relies on trade or barter.

Commodity Money

Commodity money is money that has an alternative use as an economic good, such as gunpowder, flour, or corn.

Fiat Money

Fiat money is money by government decree. It has no alternative value or use as a commodity.

Specie

Specie refers to money in the form of gold or silver coins.

Monetary Unit

A monetary unit is the standard unit of currency in a country’s money supply, such as the American dollar or the British pound.

Three Functions of Money

  1. Medium of Exchange: A medium of exchange is something accepted by all parties as payment for goods and services. Throughout history, various materials have been used, including shells, tobacco, gold, silver, and salt.
  2. Measure of Value: Money serves as a measuring stick to express worth in terms that most people understand. In the United States, this worth is expressed in dollars and cents.
  3. Store of Value: This feature allows purchasing power to be saved until needed. You can spend money now or save it for later.

Characteristics of Modern Money

  1. Portability: Modern money is lightweight, convenient, and easily transferable, whether in currency, checks, or electronic deposits.
  2. Durability: Coins last about 20 years, and paper currency (a $1 bill) lasts about 18 months in circulation. The Sacagawea dollar coin aimed to increase durability.
  3. Divisibility: The penny allows for small purchases, and checks can be written for exact amounts.
  4. Scarcity: The Fed monitors and controls the money supply to prevent excessive growth.

Understanding Money Supply

Demand Deposit Accounts (DDAs)

DDAs are accounts whose funds can be withdrawn by check or debit card.

M1

M1 is a narrow definition of the money supply, focusing on its role as a medium of exchange. It includes coins, currency, checks, demand deposits, and traveler’s checks.

M2

M2 is a broader definition, including M1 plus savings deposits, time deposits, and money market funds, reflecting money’s role as both a medium of exchange and a store of value.

Lesson 2: Historical Development of US Banking

Growth of State Banks

After the Constitution, states controlled paper currency, leading to about 100 state banks by 1811.

Problems with Early Currency

  1. Lack of Uniformity: Each bank issued notes with different sizes, colors, and denominations, creating confusion.
  2. Over-Issuance: Banks could print more money at will, leading to inflation.
  3. Counterfeiting: The variety of notes made counterfeiting a significant problem.

By the Civil War, over 1,600 banks issued more than 10,000 types of currency.

The National Banking System

The Civil War led to the creation of national banks and a more unified system.

National Bank

A national bank is a commercial bank chartered by the National Banking System.

The Gold Standard

Gold Standard

The gold standard defines a currency unit as equivalent to a specific amount of gold. The Gold Standard Act of 1900 set the dollar at 1/20.67 ounce of gold.

Advantages of a Gold Standard

  1. Increased Security: People feel more secure with gold-backed currency.
  2. Controlled Money Supply: It limits the government’s ability to print excessive money.

Disadvantages of a Gold Standard

Limited gold supply can restrict money supply growth and hinder economic expansion.

Banking and the Great Depression (1929)

Bank Run

A bank run occurs when depositors rush to withdraw funds, fearing bank failure.

Lesson 3: Modern Financial Institutions and Services

Credit Unions

Credit unions are nonprofit cooperatives offering banking services to members.

Corporations and Stocks

Corporation

A corporation is a legal entity separate from its owners, with rights and responsibilities like an individual.

Stock

Stock represents ownership in a corporation. Shareholders are those who own stock.

Types of Banks

State-Chartered Bank

These banks receive their charter from the state where they operate.

Financial Products

Certificates of Deposit (CDs)

CDs are time deposits with a fixed interest rate for a specific term.

Reserve Requirement

This formula determines the amount of funds banks must hold in reserve.