U.S. Monetary System Components and History
The U.S. monetary system can be thought of as a vehicle that facilitates both the production and exchange of money. Money is defined as a commonly accepted form of compensation for goods and services. There are three essential functions of money: it is a medium of exchange, a standard of value, and a store of value. A medium of exchange is a mechanism that enables financial transactions. Standard of value is a concept that ensures an equal measure of worth for monetary units. Store of value is the ability of money to continue to represent the same level of worth over time. For example, Jim Smith finds a $100 bill in a jacket he has not worn in years. With this unexpected cash, Jim decides to purchase a new pair of shoes. The shoes at his local shoe retailer cost exactly $100. In this scenario, the $100 bill demonstrates the three functions of money. Its function as a medium of exchange is demonstrated by Jim's ability to offer the retailer the $100 in exchange for the shoes. Its function as a standard of value is demonstrated by the agreed-upon value of the transaction. Its function as a store of value is shown by the $100 bill maintaining its worth over time without depreciating.
The U.S. money supply has two fundamental instruments: deposit money and material money. Deposit money, also called credit money, is a deposit that is payable on demand to the account holder by the financial institution. Material money consists of coins and paper currency.
In 1792 the U.S. government established a monetary supply system centered on the value of precious metals, primarily gold and silver. Gold and silver were used to establish a standard of value for the dollar. The mass of silver or gold in a coin could be expressed as a dollar amount on the coin. Thus, coins made of silver and gold are what is called full-bodied money. Full-bodied money is a form of currency that has a face value equal to the value of the substance from which it is constructed.
Historically, in the U.S. monetary system paper money has come in two forms: representative full-bodied and fiat money. Representative full-bodied money is a note with a face value that originated from a quantity of precious metal. In 1971 the United States moved away from the gold standard and shifted to a fiat money system. Fiat money is a note that a government establishes, and backs the value of, as a valid form of payment by law. As such, fiat money is not backed by precious metals and has no intrinsic value. In the United States, the Federal Reserve is the issuing authority for fiat money, and it distributes, receives, and processes money and distributes and receives coin through depository institutions.U.S. Congress established the first bank of the United States in 1791 to serve as a repository for federal funds. Its charter expired in 1811, but in 1816 Congress created a second bank of the United States with a charter set to expire in 1836. By the 1830’s the bank had become a volatile political issue and the charter for the U.S. central bank was not renewed. However, the Federal Reserve Act of 1913, which established the Federal Reserve as the central bank of the United States, originally chartered the Federal Reserve banks for twenty years. But in the McFadden Act of 1927, Congress re-chartered the Federal Reserve banks into perpetuity, and so there is currently no "expiration date" or repeal date for the Federal Reserve.
Timeline of U.S. Money
Financial Crises and Globalization
The U.S. monetary system was shaped by crises and globalization. In 1907, a bank panic occurred as the result of inadequate regulation of financial institutions. A period of unusually severe illiquidity adversely affected financial institutions. These conditions were largely a result of a seasonal flow of capital to the transportation of harvested crops from the Midwest to the East Coast and Europe as well as abnormal gold flows from domestic and foreign markets. These conditions adversely affected gold and gold certificates, leaving financial institutions in a liquidity crisis. In addition, these institutions had insufficient and, at times, deficient cash deposits to support withdrawals. This resulted in the banks' inability to pay depositors upon demand. Furthermore, because of the unavailability of gold, the government was unable to support banks by producing additional money. Instead, J.P. Morgan, a wealthy American financier, provided banks with the required resources to pay their debts. The 1907 bank panic resulted in the creation of a central bank. A central bank is an institution that manages a country's or state's money supply, interest rates, and currency. The Federal Reserve is the central bank of the United States.
Globalization is the assimilation of cultures, economies, and technologies from across the globe. Economic globalization is the increasing interdependence of the world's economies. For the U.S. consumer, the historical and continuing process of economic globalization has resulted in a reduction in the price of goods. The consumer's preference for cheaper goods results in spending benefits for other economies, sometimes to the detriment of the home economy. A method to curtail this is imposing a tariff, or a tax placed on the imports and exports exchanged between countries. The idea behind tariffs is to make domestic goods more attractive by increasing the cost of foreign goods through additional taxes. However, other nations may impose tariffs of their own. When it faces an unfavorable economic environment, a nation's economy may experience a phenomenon called capital flight. Capital flight is the rapid movement of assets and money out of a nation's economy because of adverse conditions. The adverse conditions that cause capital flight may take the form of higher taxes, harmful regulation, high inflation rates, high interest rates and general uncertainty about the nation's economic future. In the early 2000s Argentina experienced capital flight for years because of increasingly high interest rates.