Types of Money in The United States

The two main components of the money supply in the United States are physical money (coins and currency) and deposit money. A review of the evolution of money in the United States will help us understand the characteristics of money today and assess how well money in the United States performs the three functions of money.

Physical Money (Coin and Paper Currency)

The first function of “successful” money is that it serves as a medium of exchange. Physical money is the coins and paper money used to buy goods and services and to pay debts.

We will first examine how U.S. coins have changed over time in terms of their precious metal content (gold and silver). Then we will examine how U.S. paper currency has changed in terms of its physical characteristics and its “backing” of precious metals.

U.S. Coins 

Although barter undoubtedly played an important role in early American history, the government quickly moved to a monetary system based on precious metals to serve as an efficient medium of exchange. Throughout much of the seventeenth and eighteenth centuries, the American colonies relied primarily on the Spanish dollar for business transactions.

In 1785, the word dollar was adopted by the U.S. Congress as the standard unit of currency or measure of value. The first monetary law of the United States, passed in 1792, provided for a bimetallic standard based on both gold and silver.

The dollar was defined in both grains of pure silver and grains of pure gold. All gold and silver coins were to be full-value money, as their metal content had the same value as their face value. For example, a silver dollar was to contain one dollar’s worth of silver, a ten-dollar gold coin was to contain ten dollars’ worth of gold, and so on.

An 1837 law changed the weight of the silver dollar to 412.5 grains of silver with a fineness of .900, and copper with a fineness of .100 was used to increase the durability of the coins. The result was that each dollar contained 0.77344 ounces of pure silver. Since the value of the silver content was to be $1, the silver was valued at $1.29 per ounce ($1/.77344).

The Peace-type dollar was produced from 1921 to 1935. The Franklin half a dollar, produced from 1948 to 1963, contained 0.36169 ounces of pure silver. As silver prices gradually increased, the Franklin half a dollar was full value money at a silver price of $1.38 ($.50/.36169). Depending on the prevailing market price for silver, a silver coin like the half dollar could be less, more, or exactly full value.

The store of value of full money was reflected in the current value of its precious metal content. As long as the price of precious metals moved in line with the prices of goods and services, the store of value of that money reflected purchasing power.

However, the rapid rise in silver prices in the 1960s meant that silver coins, as melted-down bullion, were worth more than their face value. As a result, the U.S. government “debased” its bullion by replacing the silver content with copper and nickel. Coins whose face value is higher than the value of their metal content are called token coins.

The Eisenhower dollar was minted from 1971 to 1978. The Kennedy half-dollars were full-value coins in 1964, were converted to silver-coated coins (with reduced silver content) from 1965 to 1970, and have been copper-nickel-coated coins since 1971.

Gold coin production began in 1795 with the $5 and $10 coins. The issuance of full-value gold dollars was authorized in 1849, and production continued until 1889. For several decades, the value of a U.S. dollar was expressed in both silver and gold.

Production of gold coins ceased in 1933, and in 1934 U.S. citizens were prohibited from owning gold in the United States. This restriction was extended to gold held by U.S. citizens abroad in 1961. All restrictions on the possession of gold in monetary form were lifted in 1975.

Paper Currency

The development and use of paper money in the United States have been marked by a very checkered history. Although paper money was issued by individual colonies, the first attempt by a government to issue paper money occurred when the Continental Congress authorized the issuance of bank bills, called Continentals, to finance the Revolutionary War.

While these bills were denominated in dollars, they were not backed by silver or gold. Rather, they were backed only by possible future tax revenues that would be collected after the colonies became independent. As you can imagine, the Continentals soon became worthless. This led to a long period of distrust of paper money.

After a brief experience with two national banks, American banking went through a period without federal regulation and with inconsistent operating laws. State-licensed banks issued their own paper currency almost at will, and in many cases, their bills were not backed by gold or silver deposits or were backed only to a limited extent.

Paper money can be either representative full money or fiat money. Representative fiat money is paper money backed by an amount of precious metal equal in value to the face value of the paper money.

The U.S. government has issued two types of representative fiat money. Gold certificates were issued from 1865 to 1928. Because they could be redeemed for gold, whose value was equal to the face value of the paper money, they were “as good as gold.”

However, since most gold certificates were issued in large denominations, they were not intended for general circulation but for the settlement of institutional gold accounts.

The issuance of silver certificates was authorized beginning in 1878. The switch to “small” silver certificates occurred in 1929, and they continued to be issued and used until 1963.

These silver certificates could be exchanged for silver dollars or silver bullion when presented to the U.S. Treasury. Of course, like full-fledged silver coins, these silver certificates became more valuable relative to their face value when the price of silver began to rise in the 1960s.

As a result, the redemption of silver certificates for silver dollars was stopped by the U.S. government in 1964, and redemption for silver bullion was also stopped in 1968.

Today, almost all paper money in circulation is in the form of Federal Reserve Notes, authorized by the Federal Reserve Act of 1913.

These bills, which are not backed by gold or silver, are called fiat money because the government has declared the bills to be “legal tenderfor payments and for settling public and private debts. Of course, today’s copper-nickel coins or tokens are also fiat money because their metal content is less than their face value.

Trust in the use of fiat money can be problematic.

First, fiat money usually becomes worthless if the issuing government fails. For example, Confederate currency was issued during the American Civil War. However, when the Confederacy lost the war, this paper money became worthless.

Second, it is relatively easy to issue more and more fiat money because it does not have to be backed by gold or silver. Issuing too much money, in turn, can lead to rising prices and a lack of confidence in the government. An effective monetary system with a strong central bank and prudent policymakers is required when a financial system relies on fiat money to conduct its transactions.

Over time, there have been several important changes to Federal Reserve Notes. In 1929, the size of the bills was reduced by about 30 percent, from large bills (7.42 inches by 3.13 inches) to small bills (6.14 inches by 2.61 inches).

This change made the paper money less expensive to produce, easier to handle, and less costly to store and transfer. Figure 2.5 shows the old and current designs of the $20 U.S. Federal Reserve note.

When it comes to money, the “behavior” of individuals ranges from high ethical standards to fraud and counterfeiting. How you acquire and handle money affects your reputation.

People who work hard, obey the law and treat others involved in money transactions fairly and honestly are able to succeed, accumulate wealth, and build a good reputation. However, probably since the beginning of money creation, there have been people who are driven by greed and engage in counterfeiting to obtain money illegally instead of working for it.

Most of us find it difficult to understand such extreme unethical behavior, which usually results in them getting caught, going to jail, and destroying the reputations of those involved.

Unfortunately, attempts to counterfeit U.S. currency are a major illegal business for some individuals and organizations. In addition, the ability to counterfeit money has been aided in recent years by the introduction of high-quality color copiers.

To thwart counterfeiting attempts, the U.S. Treasury Department’s Bureau of Engraving and Printing has developed new currency designs in recent years. A new series of banknotes with microprinting and an embedded security strip was introduced in 1990 to improve security and make counterfeiting more difficult.

A more comprehensive design change began in 1996 with the $100 bill with a large portrait. The $50 bill with a large portrait was introduced in 1997, and the $20 bill entered circulation in 1998. New $5 and $10 bills were introduced in 2000 so today only the $1 bill uses the small portrait format.

In 2003, further changes were made to the design of the currency. In the 1998 version, the larger portrait was placed off-center for the first time to allow the inclusion of a watermark that is visible from both sides when held against a light.

The bill contains a vertically embedded security thread that glows red in ultraviolet light, at the far left of the portrait. Color-shifting ink, fine-line printing, and microprinting were added. In the 2003 version, U.S. currency took on additional colors. Peach and light blue hues were added to the previous green and black bills.

Other changes included the removal of the circle around Andrew Jackson’s head and the addition of a faded bald eagle to the left of the portrait and the words “Twenty USA” and “USA Twenty” to the right of the portrait.

These anti-counterfeiting measures, while very costly, are essential to maintain public confidence in paper money. Of course, it is important to remember that even if the appearance of U.S. paper money changes, the government recognizes all previously issued U.S. paper currency at full face value.

There is no requirement or deadline for exchanging old bills for new ones. Old bills remain in circulation until they are returned to the Fed by depository institutions for withdrawal.

Credit Money and Deposit Money

Credit money is money backed by the creditworthiness of the issuer. Recall that paper money issued in the United States is called fiat money because the government has made the currency legal tender to make payments and pay public and private debts. Fiat money is a form of credit money.

Using physical money (coins and cash) to conduct transactions can be costly and inefficient when large amounts and/or long distances are involved.

Because of these limitations on the use of physical money and concerns about over-reliance on the banking system, a special type of credit money called deposit money has gained slight prominence in the U.S. monetary system.

Deposit money is backed by the credit of the depository institution that issued the deposit. While deposit money is a form of credit money, it is not fiat money because it has not been declared by the government to be legal tender for the payment of debt.

Deposit money is held in the form of demand deposits at commercial banks or other verifiable deposits at S&Ls, savings banks, and credit unions. A demand deposit takes its name from the fact that the holder of a deposit account “requires” that all or a portion of the amount in his or her demand deposit account be transferred to another person or organization.

Traditionally, checks or drafts are used to transfer demand deposits or other checkable deposit amounts. Let us return to our example in which the company ABC deposits $1,000 at First Bank to establish a demand deposit account in the amount of $1,000 in the name of ABC.

ABC then writes a check in the amount of $1,000 on the deposit account and sends the check to an equipment manufacturer as payment for the purchase of equipment. The equipment manufacturer deposits the check into its own demand deposit account at a bank (e.g., Last Bank). The check must then be processed and cleared through the banking system, either with or without Fed assistance.

That is, it must be returned to First Bank, which pays the check amount to Last Bank and deducts $1,000 from the company’s demand deposit account at First Bank. To facilitate and expedite the clearing process, copies of the checks can be sent electronically instead of waiting for the paper checks to be delivered.

The use of electronic means to transfer funds to demand deposits and other checking accounts continues to grow, replacing the use of expensive and time-consuming paper checks.

Automatic transfer accounts (ATSs) are used for direct deposits to and payments from checking accounts. Employers often have their employees’ wages deposited directly into their employees’ checking accounts instead of issuing paychecks. Electronic funds transfers for utility bill payments, mortgage loans, credit card balances, etc. are becoming more common.

Debit cards allow for instant direct deposit transfers. For example, when a debit card is used to purchase merchandise at a retailer’s checkout (POS) or on its Internet sites, the cardholder’s bank transfers the specified amount from the shopper’s checking account to the retailer’s account.

Debit cards are also used for cash withdrawals from automated teller machines (ATMs). When cash is withdrawn, the balance of the user’s demand deposit account is immediately reduced by the amount withdrawn.

A number of companies have recently introduced digital and mobile payment systems designed to provide a more efficient online and POS experience. Examples include Apple Pay, PayPal, and Square. This will lead to a continued increase in the use of less physical money and a cashless or cashless money system.

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