MONEY FINANCIAL INSTITUTIONS,

AND THE FEDERAL RESERVE

Without money, our complex exchange economy would grind to a halt. Without financial intermediaries like banks, insurance companies, and savings and loan associations to link savers and investors, the circular flow of income would stagnate. Thus, regulation of the supply of money and of the financial intermediaries provides a major channel for government control of aggregate demand. This chapter explains how our monetary and banking system works. Chapter 12 focuses on monetary policy—on how the mone tary authorities can help us achieve stable eco nomic growth without unemployment or inflation.

Money and Near-Monies

Think for a minute about what life would be like under a barter economy. Suppose you have a pig. But what you really want is a spool of thread, two new shirts, a movie, and a newspaper. You hear that B down the road has made some shirts. But unless B happens to want some pork chops, you’re still out of luck. Your neighbor, C, wants a pig, but he has only lumber to trade. If you’re lucky, you may be able to get lumber from C and swap that to B for shirts. But it’s going to take some fancy haggling to work out a fair trade with such indivisible products, even if you all have a basic desire to swap.

But with money as a medium of exchange and as a standard unit for quoting exchange prices, it’s easy to avoid this kind of difficulty. Money is a universally accepted unit of purchasing power, freely spendable and easy to store if you want to postpone spending your income. When you hear the word money, you think of coins and paper bills. But for hundreds of years cattle served as money in the ancient world. In the Late Roman Empire, small, square pieces of leather were used. Two hundred years ago, hides and wampum beads served as money in North America. Only recently has the world widely adopted the coins and paper notes that we now use; and today we are moving away from them to bank checks except for small transactions. Money cannot be defined merely in terms of the substances that we use for it at any time.

A useful definition of money must be based on what money does, not on what it looks like. Actually, around 80 per cent of all payments in the United States today are made by bank checks, only about 20 per cent by currency (i.e., coins and paper money). We have become so accustomed to using bank checks as money that for practical purposes payment by check is the equivalent of payment by currency, even though the’ check is a “credit” instrument that is good only if the bank will pay the sum indicated.

Money, therefore, is defined here as the total of currency and bank checking deposits, since these two constitute the nation’s generally acceptable media of payment. The top part of Table 11-1 shows the amount of these two major types of money in existence in 1967. It is very important to note that the bulk of our money is bank checking deposits, not currency, and that the great bulk of our payments are made by bank checks.

Only a thin line separates actual money from a variety of “near-monies,” shown in the bottom half of the table, that are readily convertible into currency or checking deposits. Bank savings deposits, savings and loan shares, shortterm U.S. government securities, U.S. savings bonds redeemable on the owner’s demand, and the cash surrender value of insurance policies are probably the most important of these near-monies. But there are many more that are only a little less easily convertible, including the great mass of longer-term government bonds.

Any of these near-monies serves one function of money reasonably well—that of a store of value. In one way, they are better than money, for the holder receives interest on most nearmonies and none on money itself. Balanced against this, the near-money must be converted into actual money before it can be spent. This always involves some inconvenience or delay, and sometimes a risk that the near-money can be converted only at a loss—for example, when government securities must be sold before maturity. The factors that induce ‘people and businesses to shift back and forth between money and near-monies often play an important role in determining how well the economic system works.

As of Jan. 1, 1967. Currency shown is that held by the pub-
ic outside banks. Only government securities redeemable on
demand or due within one year are included. Data from Federal
Reserve Bulletin and Life Insurance Fact Book.

Part A: Private Financial Institutions and the Money Supply

Many kinds of private financial institutions have developed over the years to meet people’s changing needs. Some of these, such as savings and loan associations and insurance companies, receive long-term savings and channel them on into real investment in buildings, equipment, and the like. Others, such as the ordinary (“eommer cial”) banks, serve as depositories for both currently used funds and longer-term savings.

Banks

There are now about 13,000 “commercial” banks in the United States, which accept both “savings” (or time) accounts and “checking” (or demand) accounts. The presumption is that savings accounts represent funds put in the bank for relatively long periods of time, while checking deposits are funds that you may want to use promptly. Thus banks generally feel freer to make long-term loans when their savings deposits go up than when their checking accounts increase. Technically, banks can require depositors to give 30 or 60 days’ notice before withdrawing savings deposits, but they almost never do. Actually, the dividing line between savings and checking deposits is not very sharp once the funds have been deposited in the bank. But there is one fundamental difference: Checking deposits are spendable money, since depositors can write checks on them. Depositors cannot write checks on savings deposits. A savings deposit can be spent only by withdrawing it in the form of hand-to-hand currency or by transferring it to a checking account.

Harking back to the circular income flow diagram in Figure 4-2, it’s obvious that saved funds have to be matched by equal investment or government spending if money income is to continue to flow smoothly through the economy. Do the financial “intermediaries” succeed in connecting up savers with borrowers who will spend the savings back into the income stream? Sometimes they do, and sometimes they don’t. Often the commercial banks actually increase or decrease the nation’s money supply by their own actions, as we shall see below.