Money and Financial Institutions
Money
An American dollar bill can be used to buy products all across the United States (and even in other parts of the world). Have you ever thought about why people care so much about a scrap of paper? It has no value in itself, and at one time, paper money was considered worthless. In the eighteenth century, the American government printed paper money called continentals. The money was considered so worthless that it spawned an idiom that something of minimal value is "not worth a continental."
But even though the rise of paper money is somewhat recent, the use of money has been prevalent throughout human history. Gold and silver coins were popular in Europe, but many other types of money have been used. When the English came to America in the 1600s, the local Native Americans did not want gold or silver in exchange for their goods. Instead, they wanted wampum—beads made from clamshells and strung together. For the tribes, wampum was their currency. In Virginia, settlers began to use tobacco as money. Settlers bought goods and services, paid taxes, and paid wages all with tobacco.
Defining Money
If so many different things can be used as money, then how do we define money? We've already shown that money doesn't have to be paper or coins. It also doesn't have to be issued by a government—there was no political body that created the wampum and tobacco that was used as money. So our definition of money has to be very broad—it is anything widely accepted as final payment for goods and services. The key component of this definition is widely accepted. A friend might give you pizza in exchange for your helping him move, but that doesn't mean that pizza is money. An exchange like this is called barter—an exchange of goods and services for other goods and services without using money. Pizza isn't money because you couldn't turn around and use that pizza to buy a movie ticket or a cheeseburger or a box of doughnuts. Tobacco only qualified as money because nearly everyone, including the government, accepted tobacco as payment for goods and services. Likewise, the paper bills in your wallet only qualify as money because nearly everyone is willing to sell you goods and services in exchange for that paper.
Functions of Money
Money has three primary functions that work together to make it easier to trade, borrow, save, invest, and compare the value of goods and services.
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Medium of exchange. Because money acts as a medium of exchange, trade is easier. Without money, everyone would have to use barter to exchange goods and services. Barter makes trading much more difficult because I may want to sell you a pizza, and you may want to buy a pizza, but you don't have anything to trade that I'm interested in.
Money also encourages specialization because it decreases the cost of exchange. Imagine you wanted to buy groceries, but you had no idea what goods the grocer was looking to trade for. You'd have to load up your car with lots of different types of goods. Perhaps you knitted some shirts, painted some flower vases, and built some wooden cages. You'd have to split your time between all those pursuits. Because of money, however, you can specialize in just knitting shirts. You can then sell those shirts for money and use the money to buy whatever goods you need. Remember how important the specialization of labor is in market economies. By focusing on just making shirts, you'll become more efficient at it, generating more profit for yourself and improving the standard of living for your community.
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Store of value. Money also acts as a store of value, which makes saving and investing more practical. When you put $100 in a bank, you can expect that it will still be worth roughly the same amount in a year.
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Unit of account. Because money acts as a measure of value, or unit of account, it allows people to compare the value of different goods and services. It's easy to determine that gold is more valuable than silver because people are willing to pay $1,600 for an ounce of gold and only $18 for an ounce of silver.
Characteristics of Money
There are six characteristics of money:
Durability: Money must last a long time.
Portability: Money must be easily transportable.
Divisibility: Money must be easily divisible into smaller or larger units.
Uniformity: Money must maintain the same shape, size, and value (e.g., all $20 bills look the same and are worth the same).
Limited Supply: Money must have a limited supply, or it would become worthless as more and more money was created.
Acceptability: Money must be widely accepted as payment for goods and services.
Fiat vs. Commodity
You may have noticed that several forms of money we've discussed in this lesson have inherent value, beyond their ability to buy goods and services. Gold and silver coins have inherent worth because the gold and silver in the coins have value. Tobacco has a use and thus has inherent value. Money that has value in itself is called commodity money.
In the modern age, commodity money is all but extinct. Instead, the money we use is fiat money—money that only has value because the government has declared it has value. The paper in your $20 bill might have a sliver of value (perhaps a fraction of a cent), but it's essentially worthless. The bill is only worth $20 because the government says it is.
In addition to having no inherent value, most money today has no physical form at all. The money supply in most nations, including the United States, consists not only of paper currency and coins but also of checking account deposits. Money digitally changes hands between individuals, businesses, and governments without the use of any physical currency.
Financial Institutions
Fiat money and digital currency have made managing money both easier and more complicated. It's simpler than ever to buy goods and services; a simple swipe of a card or even a text message can transfer money. At the same time, these changes have necessitated the development of new financial institutions to help manage that money supply.
Checking accounts, savings accounts, and credit cards are staples of the modern economy. Many individuals also take out loans, such as mortgages, car loans, and student loans. To fund their operations, companies take out business loans, sell bonds, or issue stock. All this has greatly increased the size and importance of financial institutions. A financial institution is an organization that provides financial products and services to customers. In this lesson, we'll take a deeper look at the services offered by various types of financial institutions and why they are so important in modern market economies.
Services Offered by Financial Institutions
Review the information in the image below to learn about the main services offered by various financial institutions.
Types of Financial Institutions
There are many different types of financial institutions, each offering different types of services.
Central Banks
Most nations have a central bank that is responsible for managing all the other financial institutions in that nation. These other financial institutions are the "customers" of the central bank. In many countries, financial institutions can take out loans from the nation's central bank. In the United States, the Federal Reserve Bank is the central bank. The Federal Reserve supervises all the financial institutions in the United States and develops economic policies for the nation.
Commercial Banks
These are the institutions that most people bank with. They offer checking and savings accounts as well as debit and credit card services. They usually issue loans to both individuals and businesses. Many also have financial advising services. Major commercial banks in the United States include Wells Fargo, Bank of America, and Chase.
Credit Unions
Credit unions act like commercial banks in many respects, but they restrict membership to a certain set of customers. For example, the Navy Federal Credit Union only accepts deposits from members of the military and their families. Credit unions are collectively owned by their members (those who have money deposited in the credit union), which often results in more favorable interest rates on loans and deposits. On the downside, because credit unions restrict membership, they're usually smaller and don't offer as many services.
Brokerage Firms
Brokerage firms help customers buy and sell stocks and other types of investments. They do the work of bringing together buyers and sellers of different investments and facilitating the exchange of those investments. Major brokerage firms include Morgan Stanley, Fidelity Investments, and Charles Schwab.
Insurance Companies
These companies provide a variety of insurance services, such as health insurance, life insurance, car insurance, and homeowners' insurance. You've likely seen advertisements from many of these companies, such as Geico, Allstate, and State Farm.
Fractional Reserve Banking
The reason that banks and other financial institutions are able to lend out large amounts of money is due to the practice of fractional reserve banking—a system in which only a percentage of deposits are kept in reserve and available for withdrawal. In the United States, federal law requires that banks keep a certain percentage of their deposits in reserve. This reserve requirement fluctuates but usually stays around 10%. Therefore, if you put $100 into your bank account, the bank only has to keep $10 in reserve. It can lend the other $90 out to other customers. The bank can do this because it knows that not everyone will come and ask for their deposits back at the same time.
Connecting Borrowers and Savers
Borrowers
Savers
Financial institutions are a critical component of keeping money flowing through the economy because they connect borrowers and savers. In this way, they act as a financial intermediary—a middleman between two parties that are conducting a financial transaction. Financial institutions attract funds from savers by promising them an interest rate on their savings. The institution then lends out that money to borrowers at a higher rate, which the institution uses to run its operations and make a profit. The institution can pool the savings from many individuals in order to provide loans to borrowers.
For example, a bank might have ten customers who have each deposited $10,000 into their savings accounts. Between those ten customers, the bank has access to $100,000. It must keep $10,000 (10%) in reserve, but it can loan out the other $90,000 to a customer who wants to buy a house. The customer will repay that loan over time, but she will have to pay a 5% interest rate every year. At the same time, the bank will be paying out 2% interest to the ten customers with savings accounts. So the bank will make 5% interest from the borrower and pay 2% interest to the savers. In the first year, this means the borrower will pay the bank about $4,500 in interest. The bank will then pay the ten savers $200 each. It will keep the remaining $2,500 to pay for the human and capital resources required to run the bank, in addition to making a profit.
By doing this, the bank has created more wealth for the community. Without the bank, the ten savers could have simply stuffed their $10,000 under their mattress. But that money would have just sat there, useless. Thanks to the bank, the customer who took out the $90,000 mortgage can buy a house that she couldn't have afforded otherwise. Meanwhile, the savers were able to increase their own wealth thanks to the interest they earned. By connecting the borrower with the savers, the bank was able to improve the lives of everyone involved.
Review of Key Terms
money: anything widely accepted as final payment for goods and services
barter: an exchange of goods and services for other goods and services without using money
commodity money: money that has value in itself
fiat money: money that only has value because the government has declared it has value
financial institution: an organization that provides financial products and services to customers
fractional reserve banking: a system in which only a percentage of deposits are kept in reserve and available for withdrawal
financial intermediary: a middleman between two parties that are conducting a financial transaction
Financial institutions are critical components of modern economies. Through checking accounts, debit cards, and credit cards, they create more efficient transactions between buyers and sellers. In addition, they connect borrowers and savers to keep money flowing efficiently through the economy.