Money and Banking Before the Civil War What is Money 3 functions –Unit of Account A way to communicate prices Dollar was a nickname for a peso Used in.

Money and Banking

Before the Civil War

What is Money

• 3 functions– Unit of Account

• A way to communicate prices• Dollar was a nickname for a peso• Used in international trade so became a unit of

account• Even though pounds, shillings and pence were

common currency

• Medium of exchange– What is used to pay for transactions– Colonial period had many: gold and silver

coins (specie), commodity money, notes issued by colonies and states

– Constitution gives federal government the right to mint coins. Also government determines what can be used to pay taxes

• Store of value– Used to save, transfer income from the

present to future– Used in borrowing, transfer income from

future to present

• Money should perform all 3 functions– Not the same as either income or wealth

Why do we care about money?

• Reduces the cost of transactions compared to barter.

• Money supply effects inflation

• Inflation is a rise in all prices– Different than relative price– Measure by CPI (cost of purchasing a fixed

basket of goods)

Equation of Exchange

• MV=PY or M=kPY where k-1/V

• M is money supply

• V is velocity (how fast money turns over)

• P is price level

• Y is real income or real gpd– Real vs nominal – Real is what is actually produced

• Accounting indenity

Quantity Theory of Money

• MV=PY

• If V and Y are constant there is a direct relationship between the quantity of money and the price level

• Increases in the money supply causes inflation.

• Concern with inflation after experience during Revolutionary war.

Quantity theory of money

• What if just V is constant, then increase in money might cause increase in Y at least in short term

• Decrease in money might cause decrease in Y

• If money supply is not growing rapidly enough might reduce growth of Y

Money in Early National Period

• Bimetallic Standard– Set up by Alexander Hamilton first Secretary

of Treasury– Justification is to increase the money supply– Foreign silver and gold coins accepted

• Silver content of Spanish dollar is unit of account• Equal weight of gold = 15 time weight of silver

Bimetallic Standard does not work

• Why? Value of gold to silver is fixed

• Market value fluctuates

• Once market value moves away from fixed ratio, anyone can make money buying up one or the other currency, only one will circulate

• Gresham’s Law

Example

• Mint ratio says 1 oz = 15 oz silver– Gold coins would have 1/15 the metal of silver– Bank will exchange at this ratio like 1 $ = 10

dimes

• What happens when the market price of 1 oz of gold increases to 16 oz of silver? Can you figure out how to make money?

Example

• Take the 1 oz gold , buy 16 oz of silver in Europe

• Take the 16 oz of silver to mint and get silver coins with the same value as 1 and 1/15 oz of gold

• Everyone will do this and gold goes out of circulation

• Gresham’s Law-Bad money drives out good.

• As supply of gold increased after gold rush in 1840 most silver disappeared from circulation

• Was gold and silver coins the only money?

• No, Banks create money

Banks in Early National Period

• Financial Intermediaries are financial institutions through which savers can indirectly provide funds to borrowers.

Banks– take deposits from people who want to save

and use the deposits to make loans to people who want to borrow.

– pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans.

Bank notes

• Banks also had the right to issue bank notes or bank money

• Promise to pay the holder specie on demand

• By 1860 there were more than 9,000 different kinds of bank notes circulating

• Used like money (medium of exchange)

Problems with bank notes

• Counterfeiting

• Notes usually traded at a discount– Distance – Size and reputation of bank

Types of Banks

• State Banks– In some states banks chartered by legislatures– Some states had Free Banking legislation – Private investors provide assets– Made loans in form of bank notes

• National Bank– First National Bank 1791

• Set up Alexander Hamilton• 20 year charter, not renewed in 1811

– Second National Bank 1816

How do banks create money?

• Reserves are deposits that banks have received but have not loaned out.

• In a fractional-reserve banking system, banks hold a fraction of the money deposited as reserves and lend out the rest.

Banks and Money Supply

• Bank A receives a $100 gold as deposit

• Recorded as an asset and liability in T account

LiabilitiesAssets

D $100gold $100

Banks and Money supply

• Banks make money by loaning some of this deposit to others

• The fraction of total deposits that a bank keeps as reserves is called the reserve ratio.

• Banks decides how much to keep as reserves

• What happens when bank makes a loan?

Banks and Money Supply

• Assume RR=10%• Bank A makes a

90$ loan• Bank makes no

money on deposit• Created $90 in

Bank notes, Money supply has increased by $90

LiabilitiesAssets

deposit $100gold $100

Loan $90 Bank notes $90

Banks and Money Supply

• What happens when person receiving the loan spends it and it is deposited in another bank?

• gold and notes go down in bank A

LiabilitiesAssets

deposit $100

gold $100

Loan $90

Bank notes $90

- $90=$10

-90=0

• Bank notes are used and deposited in another bank which may redeem notes and then make more loans

• What limits the amount of notes created?– No Fed, no reserve requirement– Bank may go under– More notes issued, value of notes decrease

Problems with Fractional Reserve Banking

• If reserves are less the deposits, banks could not have enough cash to pay all depositors even if bank is solvent.

• Banks the issue too many notes are even more vulnerable.

• Rumors can lead to runs on banks and banking panics

• Bank of US

What was the role of 1st Bank of US?

• Modeled after Bank of England– Public and Private

• Accepted Deposits, printed notes that were redeemed for specie, made loans

• Served as a fiscal agent for Federal Gov– Held tax receipts, tariffs, made loans to gov,

paid gov bills– Allowed to have branches in all states

Advantages over State Banks

• Large Gov deposits• Lots of Branches• Notes were more useful than state bank notes• Held more state bank notes than state banks

held BUS notes– Could redeem them faster

• Demand for state bank notes reduced• Charter was not renewed in 1811 due to political

pressure

What happened?

• The BUS acted as lender of last resort– probably reduced state banks note issue

• After 1811, number of state banks increased, note issue increased, reserves decreased

• Panic in 1814

• 2nd BUS chartered in 1816

2nd Bank of US

• Unpopular as the 1st for same reason

• Andrew Jackson elected in 1828 is an enemy of the bank

• Attempt to recharter bank early in 1832 passes in Congress, Jackson veto bill and there are not enough votes to over ride veto

What happens

• Number of Banks increases at first, price increase

• Bank panic in 37, moderate recovery in 38

• Panic in 1939, prices fall

date # banks

1819 274

1830 300

1834 506

1840 901

1841 784

1844 696

1850 824

1860 1562

What was cause?

• Soundness school– Increase in banks and reduction in reserves

increased money supply– Over issued notes which caused panic

• Not clear this is true. While there was an increase in notes and price , ratio of bank reserves to liabilities did not decrease

What caused changes in M ?

• Inflow of silver from Mexico due to political instability

• Capital inflow from abroad for canal etc

• Chinese trade deficit, meant silver would flow to China

• but China exchanged US silver for Bills of exchange on London Banks held in US, so China could by opium from British

What caused Panic?

• Specie Circular of 1836– Land payments had to made in specie– No evidence of reserves going west

• More likely increase in interest rates in Britain and fall in US commodity prices

• Not clear that the panic had large real effects GDP continues to grow even with large fall in prices

Banks and inflation

• Did the Bank of US restrain growth in state banks and note issue?– Some evidence that it did – At same time there was an increase in Bank

of US notes

• What was the effect on price level?

18381811 Prices rise after the first Bank of US loses its charter , but not after the second bank loose its charter. Prices rise after gold is discovered in California in 1848.

In spite of inflation and deflation during this period, GDP growth is constant. Changes in money supply and prices do not have long term real effects.