ECON120 Study Guide

Site: Saylor Academy
Course: ECON120: Monetary History
Book: ECON120 Study Guide
Printed by: Guest user
Date: Friday, June 14, 2024, 4:29 AM

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Study Guide Structure

In this study guide, the sections in each unit (1a., 1b., etc.) are the learning outcomes of that unit. 

Beneath each learning outcome are:

  • questions for you to answer independently;
  • a brief summary of the learning outcome topic; and
  • and resources related to the learning outcome. 

At the end of each unit, there is also a list of suggested vocabulary words.

 

How to Use this Study Guide

  1. Review the entire course by reading the learning outcome summaries and suggested resources.
  2. Test your understanding of the course information by answering questions related to each unit learning outcome and defining and memorizing the vocabulary words at the end of each unit.

By clicking on the gear button on the top right of the screen, you can print the study guide. Then you can make notes, highlight, and underline as you work.

Through reviewing and completing the study guide, you should gain a deeper understanding of each learning outcome in the course and be better prepared for the final exam!

Unit 1: Introduction to Monetary History

1a. Examine benefits from and risks to a precious metal coin-based monetary system

  • What was used as money before coinage?
  • Why did coinage advance the monetary system?
  • What were the disadvantages of a non-coin system of trade?
  • What is money velocity?
  • How did coinage affect money velocity?
Early coins were made with metals considered precious, durable, and rare. They were fungible, or interchangeable, money. When two things are fungible, they have an equal and undifferentiated value, like how we think of a one-dollar bill as equal to any other one-dollar bill. They were also divisible: they represented a small value and could be used in minor transactions or amassed for larger ones. The best coins were difficult to forge. Counterfeiting could undermine the value of a currency, so mints had to create coins with difficult-to-mimic engravings.
 
Money velocity
measures how quickly money changes hands. It's the speed at which money moves from one owner to the next, and only with sufficient speed can money help human beings trade to their fullest potential. Gold and silver coins accelerated money velocity relative to metal bars and nuggets of non-standardized weights. Thousands of competing coins were used, which meant that an equivalency conversion had to occur alongside practically every transaction between people of different geographies. This presented major challenges to money velocity and international trade because standards for weights and purities varied worldwide.
 
Moneychangers specialized in this requisite conversion and became integral to all trade. They were tasked with trafficking hundreds or even thousands of different coins to facilitate every type of international exchange. This profession exists today in the form of foreign exchange brokers.
 
To review, see The First Coins.
 

1b. Identify some ancient coins and their key characteristics

  • When did coins first appear?
  • What is currency devaluation?
  • What was the significance of the florin?
  • Why did the florin become Europe's reserve currency?
Greek historian Herodotus traced the first signs of gold and silver coins to Lydia, modern-day Turkey, around 700 BC. Evidence of gold and silver jewelry being used as money goes back tens of thousands of years. The coins of Lydia were embossed with an image of a roaring lion and weighed 126 grains, which is about 8 grams. Because all coins had a precise amount of gold, they could then be used as a unit of account. Coins with consistent weights changed money forever. They eliminated the need to weigh and test the purity of every piece of metal before two parties could transact, and this seemingly straightforward adaptation ultimately transformed the world of trade.
 
In the second century, under the rule of Marcus Aurelius, the denarius coin weighed about 3.4 grams. It contained about 80% silver, which was already reduced from its 98% purity when Augustus Caesar declared himself the first Emperor of Rome three centuries prior. When the Roman Empire reduced the precious metal content of the denarius while leaving its name and value unchanged, it caused currency devaluation. This can lead to unstable prices. By the end of the third century, the denarius was 5% silver.
 
The northern Italian cities of Florence, Venice, Genoa, and Pisa established themselves as city-republics after breaking free from their feudal overlords during the eleventh century. The florin earned a reputation of being unchanging, as its denomination did not change for centuries. Historically, precious metal coins were durable, divisible, and portable, but with governments constantly reducing the purity of their coins, no coin existed with multigenerational credibility. For four centuries, the florin maintained an unchanged weight and purity, about 3.5 grams of pure gold. Florins proved to be good collateral and could be pawned to borrow silver coins for smaller transactions.
 
To review, see The First Coins.
 

1c. Explain the advantages and disadvantages of bimetallism

  • Why were gold and silver both used as money?
  • What were the advantages of silver as a medium of exchange?
  • What were the advantages of gold as an international settlement tool?
Bimetallism allowed for two separate metals to be used as money. Silver is a more abundant metal in the Earth's crust than gold is and has historically served as the money of common people and daily transactions. Gold is more desired but didn't suffice for daily use; a single florin was worth more than a week of labor from the average worker. The gold and silver dichotomy complicated the formation of a unified monetary system until the end of the nineteenth century.
 
To review, see The Florin.
 

1d. Compare final settlement and deferred settlement

  • What is deferred settlement?
  • Why would a merchant agree to a deferred settlement?
  • Why would a consumer request a deferred settlement?
  • Why is deferred settlement a form of credit?
Deferred settlement takes place when one party unambiguously promises to pay another later. At that time, final settlement occurs, and the owed party receives ultimate payment, historically gold and silver. These promises, or credits, were made as a way for merchants to reduce the risk of international coin transfer.
 
To review, see The Florin.

 

Unit 1 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.
 
  • bimetallism
  • currency devaluation
  • deferred settlement
  • divisible
  • final settlement
  • fungible
  • money velocity

Unit 2: The Hierarchy of Money

2a. Identify the mathematical works that introduced modern accounting to Europe 

  • What knowledge did Fibonacci bring to Europe from Northern Africa, India, and Islamic Spain?
  • How did accounting affect the monetary system?
  • What was the focus of Pacioli's writings?
  • How did double-entry accounting affect the monetary system?
  • How is credit issued thanks to double-entry accounting?

In 1202, Leonardo da Pisa, popularly known as Fibonacci, published a book called Liber abaci (Book of Calculation) that brought the Hindu-Arabic numeral system to Europe. These accounting techniques were the foundation of double-entry accounting. Fibonacci's work spawned a new type of merchant class: the banker.
 
Mathematician Luca Pacioli published Summa de arithmetica, geometria, proportioni et proportionalita (Summary of arithmetic, geometry, proportions and proportionality) in 1494, which gave Pacioli the nickname "the father of accounting and bookkeeping". He formalized the "Venetian Way" of double-entry accounting, a system still utilized by most business entities today.
 
To review, see Modern Accounting.
 

2b. describe a two-layered monetary hierarchy between the gold florin and bills of exchange 

  • What is monetary hierarchy?
  • How does a layered-money framework compare to a "hierarchy of money" framework?
  • What is the relationship between assets and liabilities?
  • How did the florin contribute to a layered money system?
  • What is a bill of exchange and how was it used as a credit instrument?
  • What are the advantages and disadvantages of first-layer money?
  • What are the advantages and disadvantages of second-layer money?

Bills of exchange were a way to send money from one place to another and simultaneously convert it to the recipient's desired currency. They were letters written by bankers promising payment. By the fourteenth century, bill of exchange issuers denominated at least one side of most transactions in gold florin. Florins were the international business balance sheet denomination of choice and the world's first reserve currency.
 
To review, see Layered Money.
 

2c. Explain the importance of counterparty risk and default risk 

  • What type of risks did bills of exchange carry?
  • How has the word "cash" evolved?
  • What is credit elasticity and how does its extension affect counterparty and default risk?
  • How was money velocity affected by the counterparty risk of bills of exchange?

The gold coin is first-layer money and the form of final settlement. The piece of paper only exists because of the gold it represents; it's second-layer money, created as a liability on somebody's balance sheet. Second-layer money has counterparty risk, or the risk that comes with holding a promise made by a counterpart.
 
Bills carried default risk by the issuer because they were a form of deferred settlement. Default risk is the risk that the actor between money layers cannot or will not fulfill the promise to pay.
 
Cash is defined as anything we use as a form of money that others accept at face value, even if it's paper with counterparty risk and no guarantee of final payment. For something to work as cash, people have to trust the issuer or whoever has made the promise to pay.
 
To review, see Layered Money.
 

2d. Summarize how fractional reserve lending works 

  • How does fractional reserve lending work?
  • Why does the issuance of credit rely on fractional reserve lending?
  • What is the difference between full reserve banking and fractional reserve banking?

Assume a goldsmith's deposits gain credibility and start circulating as cash because people trust that they are redeemable for gold. He then issues gold deposits to himself without reserving the corresponding gold in his vault and spends these deposits as cash into circulation. The goldsmith will then default if ever faced with a full redemption request. This type of activity is called fractional reserve banking, as opposed to full reserve banking, which is when all deposits have corresponding gold in a vault.
 
To review, see Layered Money and Traveling Between Layers of Money.
 

2e. Explain the advantages and disadvantages of a layered money system

  • What are the advantages of fractional reserve lending?
  • What are the disadvantages of fractional reserve lending?
  • How does a layered money system affect economic potential?
  • How does a layered money system affect the risk of financial panic?
  • What were some early advantages to the rise in second-layer monetary instruments?
  • What were their problems?

The hierarchy of money is dynamic. When credit expands, the money pyramid expands as the second layer grows in size. A gold coin and a gold deposit have almost no observable difference when confidence is high. People freely accept gold certificates as money because they trust the issuer's ability to satisfy redemption. Contractions can result in redemption requests, called bank runs, and eventually financial crises.
 
To review, see Traveling Between Layers of Money.
 

2f. Explain cash, clearance, and liquidity in monetary systems 

  • Why were bills of exchange not involved in a clearance process?
  • How is liquidity defined within monetary science?
  • What is the importance of liquidity?

Clearance is the process of settling transactions. Liquidity is the ability to exchange an asset for cash. Early on, cash and coins were synonymous, meaning that the only form of money considered to function as cash were precious metal coins themselves. Bills of exchange didn't readily convert to precious metal unless presented to the appropriate underwriters upon their maturity date.
 
To review, see Traveling Between Layers of Money.
 

Unit 2 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • bank run
  • bill of exchange
  • cash
  • clearance
  • counterparty risk
  • default risk
  • fractional reserve banking
  • full reserve banking
  • liquidity

Unit 3: Money Market History (16th–19th century)

3a. Describe the monetary advance in Antwerp in the 16th century 

  • What were traveling merchant fairs?
  • Why was Antwerp considered the "continuous fair"?
  • Why did bills of exchange not have liquidity before Antwerp?
  • What is the practice of discounting?
  • How did promissory notes affect the monetary landscape?
  • How did the Antwerp Bourse affect monetary history?

During the Antwerp Bourse in 1531, the money market described the market for second-layer monetary instruments such as bills of exchange, gold deposits, and other promises to pay precious metal.
Before the money market, you had to wait a month before presenting the bill to collect cash. If you needed cash faster, you found a banker willing to purchase the bill before it matured. The banker would split the difference between your purchase price ($98) and the face value ($100) and pay you $99. This process of a banker buying the bill for $99, which is "discounted" from the $100 par value upon maturity, is called discounting.
 
To settle any outstanding balances at the end of the day, bankers issued another form of credit, called promissory notes or notes. These notes were promises to pay the bearer, meaning that whoever held the piece of paper was due the promise. These instruments were the direct predecessors to paper cash today.
 
To review, see Time Value of Money.
 

3b. Explain the reasons for the creation of the Bank of Amsterdam, its innovations, and privileged lending

  • How did the formation of the Dutch East India Company affect money?
  • What impact did the Amsterdam Bourse have in forming the Bank of Amsterdam?
  • What were the major innovations of the Bank of Amsterdam?
  • How did the BoA monopolize the second layer of money?
  • How did debt issued to the Dutch East India Company rise to the first layer of money?
  • What is privileged lending from a layered-money perspective?

The Bank of Amsterdam (BoA) was created thanks to the world's first joint-stock company, the Dutch East India Company. It was the first example of equity investors providing capital in exchange for a share of ownership in the form of a paper certificate. The Amsterdam Bourse was founded shortly after the first signs of a market for Dutch East India Company shares. The Dutch East India Company created it to facilitate the exchange of its shares on a secondary market.
 
In 1609, the Bank of Amsterdam was founded to outlaw cashiers and their notes and mandate all gold and silver coins be deposited at the bank. The BoA monopolized the issuance of second-layer money by eliminating public access to first-layer money.
 
The Bank of Amsterdam allowed instant transfers among its depositors. The BoA didn't charge a fee for internal transfers. The Bank of Amsterdam was the first central bank because, by law, the bank was central to all money dealings. It was a regulatory response to stock trading and a way for the government to monitor every transaction taking place amongst its depositors.
 
The BoA eventually eliminated the ability to withdraw precious metal altogether yet managed to maintain the public's trust in its second-layer money. By suspending convertibility to first-layer money, the Bank of Amsterdam proved that precious metal wasn't necessarily required to operate a monetary and financial system.
 
To review, see Bank of Amsterdam.
 

3c. Outline the founding of the Bank of England and identify key differences between BoE and BoA 

  • How did war affect the finances of the English government?
  • Why was the Bank of England formed in 1694?
  • How did the Bank of England purchases of English sovereign debt mirror the Bank of Amsterdam's purchases of debt issued to the Dutch East India Company?
  • How did the Bank of England's actions as a liquidity provider make it different from the Bank of Amsterdam?

In 1694, the Bank of England (BoE) was created to purchase new government bonds. The BoE issued second-layer money and was tasked with taking custody of precious metal, issuing deposits, effecting transfers between depositors, and circulating notes as cash. The BoE discounted bills of exchange and increased liquidity in the London money market. London allowed competing versions of paper money, and the BoE discounted bills when customers needed liquidity. This became the archetype of central banking today.
 
To review, see Bank of England.
 

3d. Describe the origins of the international gold standard and how it functioned 

  • Why did gold and silver both function as money?
  • How did Isaac Newton change the monetary system as Master of the Mint?
  • From a layered-money perspective, what relationship did gold and pound currency have?
  • How did other countries react to the English gold standard?

Shortly after the creation of the Bank of England, English mathematician and physicist Sir Isaac Newton set a new exchange rate between gold guineas and silver shillings in 1717. Newton studied the flow of gold and silver throughout Europe and the exchange rates outlined in other countries' bimetallic standards, specifically France, the Netherlands, and Germany. He created an exchange rate that made it profitable for arbitrageurs to export silver and import gold, and before long, silver stopped being used as money in England. This brought the world under one money pyramid with gold at the top. Eventually a gold standard, where the English pound became valued only in gold, became law.
 
To review, see Bank of England.
 

3e. Summarize the three-layer monetary system in England during the 19th century 

  • What monetary instrument exists on the third layer of money, and why?
  • What instrument do deposits promise to pay?
  • What instrument does currency promise to pay?
  • What are the advantages of holding second-layer money versus first-layer money?
  • What are the risks to holding second-layer money versus first-layer money?
  • What are the advantages of holding third-layer money versus second-layer money?
  • What are the risks to holding third-layer money versus second-layer money?

During the Bank of England era, bills were promises not to pay gold but to pay pounds and therefore existed on the third layer of money. The private sector issued promises to pay second-layer money. Liabilities of the private sector exist on the third layer of money.
 
To review, see Bank of England.
 

3f. Explain the origins of the "lender of last resort" function of central banking 

  • Why is the central bank positioned to be the lender of last resort?
  • How does the lender of last resort affect the second layer of money during a financial crisis?
  • How does the lender of last resort affect the third layer of money during a financial crisis?
  • What happens to a layered money system in a financial crisis?
  • Is a higher or lower layer of money more demanded during a financial crisis?
  • What effect does the discounting of bills by the central bank have during a financial crisis?

Financial crises correspond with sudden surges in demand for cash. Those issuing or holding third-layer money required liquidity in second-layer notes. When the demand for cash swells, the central bank must create second-layer money to satisfy that demand. It should flex its power of elasticity while still maintaining the discipline to not encourage moral hazard, which occurs when a financial institution takes on excessive risk because it anticipates being rescued by the government or central bank if its financial position worsens.
 
To review, see Bank of England.
 

Unit 3 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • discounting
  • gold standard
  • money market
  • notes
  • promissory notes

Unit 4: Federal Reserve System (1913–1944)

4a. Summarize the American monetary system up until the creation of the Federal Reserve System 

  • What were some forms of money used during the colonial era?
  • How was the dollar picked as a unit of account for the United States?
  • How was the American monetary system linked to precious metals?
  • What were some of the credit instruments on the second and third layers of money used in the United States from the late 18th century until the formation of the Federal Reserve system in 1913?
  • How did the Panic of 1907 contribute to the formation of the Federal Reserve system?

In New York in the American colonies, sea-shell beads called wampum circulated as legal tender during the seventeenth century. In Virginia, tobacco became a first-layer monetary asset and the pound-of-tobacco unit became an accounting standard. Virginia issued notes promising the delivery of pounds of tobacco as second-layer money circulated among the public as cash. Shells and tobacco sufficed as regional money because they each demonstrated some, but not all, of the monetary characteristics of coinage.
 
As time elapsed, gold and silver coins circulated as currency throughout the colonies. The most popular coin amongst the people was the Spanish silver dollar. In 1784, Thomas Jefferson argued for the dollar as the new American currency unit.
 
Two central banks were created in 1791 and 1812, but each ended after its twenty-year charter. Many early Americans didn't trust central banks to administer their currency. Notes issued by private sector banks functioned as cash throughout the nineteenth century. These notes were secured by United States Treasuries, the name for US government bonds. US government-issued gold certificates also circulated as cash. During the Civil War, paper money called the greenback, which couldn't be redeemed for precious metal, circulated as cash.
 
The gold standard that began in England influenced gold usage in the United States. The Gold Standard Act of 1900 eliminated silver from its monetary role and fixed one dollar at 1.5 grams of gold. This gave the United States the chance to create a central bank.
 
In the Panic of 1907, depositors withdrew bank deposits for gold coins or US Treasuries. These withdrawals caused regional banks to run on New York banks. The next year, United States Senator Nelson Aldrich set up the National Monetary Commission to study Europe's monetary system and recommend overhauling and modernizing the dollar system without a central bank. Congress created the Federal Reserve System on December 23, 1913.
 
To review, see Early American Money.
 

4b. Differentiate between the Federal Reserve's wholesale money and retail money 

  • What are the two types of money issued by the Federal Reserve?
  • Why does the Federal Reserve need retail-facing money and wholesale-facing money to conduct central banking?
  • How are Fed notes used in the financial system?
  • How are Fed reserves used in the financial system?

The word reserve implies a safety mechanism to help in a crisis. The Federal Reserve System (the Fed) was founded to combat financial crises. Fed reserves are deposits issued by the Federal Reserve to private sector banks. Fed notes (or "dollars") are available to people. Fed notes are issued as a reliable paper currency that can be easily used as a medium of exchange.
 
Wholesale money (Fed reserves) is money banks use, and retail money (Fed notes) is money that people use. The Federal Reserve's mandate was to provide wholesale money, or money for the banking system when credit instability stoked financial unrest. The Federal Reserve System is a wholesale rescue mechanism of reserves.
 
To review, see The Federal Reserve System.
 

4c. Describe some purposes of the Federal Reserve and how they affect the monetary hierarchy in the United States 

  • According to the Federal Reserve Act, what are the purposes of the Federal Reserve Act?
  • How does the Federal Reserve Act allow for a fractional reserve monetary system?
  • How did the Federal Reserve Act link the US monetary system to gold?

The Federal Reserve Act's first purpose is "to provide for the establishment of Federal reserve banks", and immediately establishes a federally unified and accepted second-layer money, "reserves", underlying all banking activity in the United States.
The second stated purpose of the Act is "to furnish an elastic currency", which confirmed that the Federal Reserve would have the ability to issue money in a fractionally reserved way and allow banks within its system to do the same.
 
The third purpose of the Act was the Walter Bagehot provision, giving the Federal Reserve the "means of rediscounting commercial paper". Commercial paper refers to short-term debt issued by banks and corporations. This allowed the Federal Reserve to act as a lender of last resort for the financial system by creating second-layer reserve balances to purchase distressed financial assets.
 
The last major purpose of the Act was "to establish a more effective supervision of banking in the United States", which allows the Federal Reserve to issue bank charters.
 
Finally, the Act decreed that 35% of the Federal Reserve's assets must be held in gold. Gold was 84% of the Federal Reserve's assets upon its founding, which decreased over time. Today, gold represents less than 1% of assets.
 
To review, see The Federal Reserve System.
 

4d. Describe the relationship between gold, US Treasuries, Fed reserves and notes, and commercial bank deposits by 1918

  • How do private sector banks contribute to the elasticity of the US dollar system?
  • Why was the Federal Reserve Act amended to allow for the ownership of US Treasuries?
  • On which layer of money did gold, US Treasuries, Fed reserves, and private sector bank deposits exist by 1918?
  • How did the Federal Reserve's gold-coverage ratio evolve?
  • How has war finance contributed to the layered-money system?

During World War I in 1916, the Federal Reserve Act was amended to effectively help the United States government finance its war effort. The Federal Reserve created reserves to purchase US Treasuries. US Treasuries joined gold on the first layer of money because by the end of World War I in 1918, the Federal Reserve's gold-coverage ratio went from 84% to less than 40% since the Federal Reserve held most assets in US government bonds. US Treasuries eventually replaced gold as the dollar pyramid's first-layer asset.
 
To review, see The Federal Reserve System.
 

4e. Explain why and how the United States government reduced its reliance on gold during the Great Depression 

  • How did the Federal Reserve respond to the financial crisis of 1929?
  • How did the Federal Reserve's gold-coverage ratio affect the crisis in 1929?
  • What did Executive Order 6102 mandate?
  • How was gold's role in the layered-money system affected by Executive Order 6102?
  • How did the Gold Reserve Act of 1934 affect gold's role in the monetary system?
  • How did the formation of the FDIC change the banking system and bank deposits?
  • How did the FDIC affect the three-layered monetary system in the US?

In October 1929, the Federal Reserve responded to a major financial crisis. With a fixed amount of gold reserves and a legally binding 35% gold-coverage ratio, the Federal Reserve could not create the necessary second-layer money to stave off economic depression. The Federal Reserve attempted to be a lender of last resort to the best of its ability, but it wasn't enough to overcome the effects of third-layer money contraction. These events led to gold being removed from the monetary landscape.
 
President Franklin Roosevelt issued Executive Order 6102 on April 5, 1933, which instructed all "gold coin, gold bullion, and certificates to be delivered to the government". The order eliminated access to first-layer money. The following year, the United States passed the Gold Reserve Act of 1934, which devalued the dollar against gold by increasing the gold price from $20.67 to $35 per ounce. The Act also legally transferred the ownership of all Federal Reserve gold to the United States Treasury and preceded the physical movement of gold bullion from New York to the United States Army's installation at Fort Knox in Kentucky.
 
The Banking Act of 1935 established the Federal Deposit Insurance Corporation (FDIC), which provided bank deposit insurance for the average American family. In the context of layered money, FDIC insurance is a federally guaranteed insurance policy on all third-layer bank deposits. The FDIC guarantee alleviated the public's fear of third-layer money. At this point, the monetary system existed between the second and third layers of money. The US dollar became independent of gold.
 
To review, see The Evolution of the Federal Reserve.
 

Unit 4 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • commercial paper
  • Fed notes
  • Fed reserves
  • reserves
  • retail money
  • wholesale money

Unit 5: Eurodollar System (1944–Present)

5a. Describe the Bretton Woods agreement of 1944, its ramifications, and its ultimate collapse

  • How did the US dollar become the world's reserve currency by 1944?
  • How did the Bretton Woods agreement affect the global hierarchy of money?
  • After the Bretton Woods agreement, how was gold linked to the global monetary system?
  • Why was a gold pool formed in the 1960s?
  • Hpe did gold's role in the global monetary system formally end?

In 1944, world leaders met in Bretton Woods, New Hampshire, and formalized that all currencies besides the dollar were forms of third-layer money within the dollar pyramid. The Bretton Woods agreement was when the dollar became the world reserve currency. Federal Reserve notes still promised the bearer gold coins on demand at $35 per ounce, but currencies now had fixed exchange rates with the dollar and wouldn't be redeemable for gold. The dollar kept a link between itself and gold.
 
Foreign currencies were on the third layer of money because of their price relationship to dollars. Other currencies are below the dollar in the layers of money because their price is measured in dollars. While United States citizens were banned from owning gold, other nations were still allowed to convert their accumulated dollar reserves to metal. To prevent the dollar value of gold from changing, the United States, United Kingdom, and others formed the Gold Pool, whereby central banks sold precious metal into the market to keep a lid on its price at $35 per ounce. Nations accumulated dollars due to their world reserve currency status and began converting these dollars into gold. The Gold Pool collapsed when the price exceeded $35 in European markets.
 
Over the next few years, gold lost its official monetary status. In 1971, the United States suspended gold convertibility for the dollar. In 1973, the modern era of free-floating currencies began, which ended the Bretton Woods agreement.
 
To review, see Offshore Dollars.
 

5b. Explain the origins of the eurodollar (offshore dollar) system 

  • How did demand for a dollar issued outside of the United States emerge?
  • How are Eurodollars characterized?
  • What were some of the primary sources of demand for Eurodollar deposits in the 1950s?
  • How were Eurodollars related to the Federal Reserve system during this era?

During the Bretton Woods era, the dollar denominated most international commerce. Demand for dollars outside of the United States skyrocketed, and European banks offered more attractive deposit rates than their US counterparts because of regulatory differences. This steered people into European-domiciled dollar deposits. These offshore dollar deposits issued by banks of European origin came to be called Eurodollars.
 
Dollars were needed outside of the United States to participate in an increasingly dollarized global economy. European banks were responding to the emergent international demand for dollars by issuing Eurodollars. Due to the advent of the Eurodollar, the dollar money pyramid changed. The Eurodollar system has an unclear first layer of money because of the monetary ambiguity of international banks issuing USD.
 
To review, see Offshore Dollars.
 

5c. Illustrate how Money Market Funds (MMFs) work within the monetary hierarchy

  • Why does demand exist for money market funds?
  • What are the assets of MMFs?
  • How did a US Treasury-collateralized lending market called "repo" evolve?
  • Why is repo considered a core dollar-type within the layered-money system?
  • How do MMF shares fit into the layered-money system?
  • How are LIBOR and Eurodollars related?
  • How are LIBOR and the Federal Reserve Funds rates related?

In a Treasury Repo transaction, a bank that owns a Treasury bond can pledge it as collateral and borrow money against it, just like in a pawn shop. Treasury Repo dollar creation occurred via bookkeepers. Banks could use the money they borrowed in the Treasury Repo market in interbank dollar settlement, and thus their Treasury holdings were a new source of money. By 1979, the Federal Reserve concluded that Treasury Repo transactions were causing an increase in the supply of dollars. By 1982, the Federal Reserve shifted to a monetary policy regime focused on managing short-term interest rates.
 
The Federal Reserve targets a short-term interest rate as a part of its monetary policy called the Federal Funds Rate (Fed Funds), an interbank lending rate for second-layer reserve deposits held at the Fed. Fed Funds is an essential reference rate because it is the Federal Reserve's desired price for short-term lending within the U.S. domestic banking system.
 
In 1986, interest rates on Eurodollar deposits in London were formalized in a rate called LIBOR, which would express the average rate at which banks in London lent Eurodollars to each other. These dollars didn't connect to the Federal Reserve's second-layer reserves or third-layer dollar deposits insured by the FDIC.
 
Money Market Fund (MMF shares) are a cash instrument that services demand for safe money. Money Market Funds became popular during the 1970s alongside the boom in Treasury Repo supply. MMF shares held a par value relative to other high-quality second- and third-layer money types. This means that a dollar invested in MMF shares could always be redeemed for a dollar. Depending on the exact composition of monetary instruments, Money Market Fund shares became second- and third-layer money types.
 
To review, see Money Market Funds.


5d. Describe the financial crisis in the money market in 2007-2009, and explain the Federal Reserve's FX swap lines 

  • What happened on August 9, 2007, in the money markets?
  • How did the Federal Reserve respond to the breakdown of the Eurodollar system, evidenced by the LIBOR market?
  • How did the layered-money system evolve after the Federal Reserve's foreign exchange swap lines were extended to the ECB and SNB?
  • How did the collapse of Lehman Brothers contribute to the financial crisis?
  • Why did the Federal Reserve intervene in financial markets after the collapse of Lehman Brothers?
  • What type of guarantees did financial markets and institutions receive during the financial crisis of late 2008?

On August 9, 2007, banks stopped lending money to each other because they weren't sure which banks might not open back up the next day. On December 12, 2007, the Federal Reserve addressed the European interbank trust and that the Eurodollar funding mechanisms had broken down. The Federal Reserve instituted foreign exchange swap lines to the European Central Bank and Swiss National Bank to provide liquidity to the offshore banking system. These foreign exchange swaps created another type of second-layer money made available by the Federal Reserve to other select central banks.
 
When Brothers failed on September 15, 2008, a money market fund called Reserve Primary Fund posted a share price of $0.97 because it owned a fair amount of newly defaulted Lehman Brothers commercial paper. This drop of three cents triggered financial panic from central banks and governments. This happened because of a fear that if Lehman Brothers' commercial paper could fail and Reserve Primary Fund's shares weren't worth a whole dollar, nothing could be trusted. Bank liabilities lost liquidity.
 
The insurance giant American International Group (AIG) received a Federal Reserve lifeline on September 16 because it had underwritten insurance on risky mortgage securities that were suddenly defaulting. The Money Market Fund complex received a guarantee from the Federal Reserve on September 19 that its share prices would be supported to prevent withdrawal panic. Goldman Sachs and Morgan Stanley received their lifeline on September 22 after being allowed to convert from investment banks into bank holding companies which gave them direct access to Fed lending. Concurrently, the Federal Reserve increased liquidity capacity for major central banks worldwide daily. This allowed the Federal Reserve to avoid systemic collapse.
 
To review, see Financial Crises.
 

5e. Define Quantitative Easing (QE) and other Federal Reserve asset purchase programs 

  • How does Quantitative Easing provide liquidity to the financial markets?
  • How does QE reinforce that US Treasuries exist on the first layer of money?
  • How does QE give the Federal Reserve a monetary policy tool to use in a financial crisis?

On November 25th, the Federal Reserve purchased US Treasuries, many of which had been newly issued, to finance deficits resulting from economic recession, tax shortfalls, and corporate bailouts. This expansion of second-layer money responded to contraction elsewhere in the system; it met the collapse in interbank trust and liquidity with reliable liquidity. The Federal Reserve called it Quantitative Easing (QE).
 
To review, see Financial Crises.
 

5f. Describe the liquidity crises of 2019 and 2020 and the Federal Reserve's response 

  • What happened to the Treasury repo market during September 2019?
  • How has the Federal Reserve's treatment of the Treasury repo market evolved?
  • How is the Treasury repo considered in the layered-money system after the Federal Reserve's guarantees?
  • How did the pandemic reinforce the Federal Reserve's role as lender of only resort?

During the pandemic-induced global financial panic of March 2020, the Federal Reserve announced several additional lending facilities to backstop the Treasury Repo market, Money Market Funds, and fifteen additional central banks. To protect the system against foreign liquidation of US Treasuries, the Federal Reserve instituted a facility to lend money in the Treasury Repo market to approved foreign entities so that these governments and central banks didn't disrupt the Treasury market if they ever needed cash. They could post their Treasuries as collateral directly at the Federal Reserve's pawn shop. Treasury prices soared in the first few days of pandemic panic as demand emerged for safe assets while prices of stocks and corporate bonds fell. US Treasuries with longer maturities (ten to thirty years) lost a bid despite their typical safe-haven status because of all the chaos in the markets. US Treasury purchases and reserve creation were implemented to allow the Federal Reserve to prevent sustained disturbances to the security market.
 
To review, see Financial Crises.
 

Unit 5 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • Eurodollars
  • Federal Funds Rate (Fed Funds)
  • LIBOR
  • Money Market Fund (MMF)
  • Treasury Repo

Unit 6: Bitcoin (2009–Present)

6a. Summarize the goals of the Bitcoin software 

  • What did Satoshi Nakamoto intend to create, according to the Bitcoin whitepaper?
  • How were financial institutions eliminated in their role within the Bitcoin network?
  • How does Bitcoin draw some inspiration from gold though its network characteristics?

Satoshi Nakamoto's worte "Bitcoin: A Peer-to-Peer Electronic Cash System" was an attempt to describe a "peer-to-peer" electronic cash that would allow online payments to be sent directly from one party to another without going through a financial institution. Bitcoin was intended to mimic gold as a first-layer, counterparty-free money.
 
To review, see Bitcoin.
 

6b. Summarize proof-of-work, Bitcoin mining, and Bitcoin's difficulty adjustment 

  • What is the difference between the Bitcoin protocol and the monetary unit, also known as Bitcoin or BTC?
  • What type of encryption does Bitcoin use?
  • What does the Bitcoin blockchain describe?
  • How does a block get mined?
  • How does proof-of-work contribute to the process of mining bitcoin?
  • Why does Bitcoin require a difficulty adjustment, and what does the difficulty adjustment help to accomplish?
  • How is Bitcoin mining comparable in some ways to gold mining?
  • Why did Satoshi Nakamoto link Bitcoin mining and gold mining by metaphor?
  • How do private keys and addresses contribute to the functioning of the Bitcoin network?
  • What are some of the ways one can store private keys, or numbers, that control balances of BTC?

The word "Bitcoin" refers to two things, the Bitcoin software protocol and the monetary unit within that software. It uses a Secure Hash Algorithm 2 (SHA2) as an attempt to create a secure system with gold's monetary properties but in the digital world. Its rules built a mechanism called a "chain of blocks", or blockchain, which is a distributed database of transactions in the network.
 
This database is maintained by Bitcoin nodes, which are computers running the Bitcoin software. These operate in a trustless way, meaning they rely on their software to verify settlement of BTC transactions. However, most people rely on some form of provider to interact with Bitcoin, such as smartphone applications for wallets and exchanges for trading and custody. Using the Bitcoin software should only be done by people with a high degree of proficiency, as it is impractical for most everyday users.
 
A block is a set of data that includes the details of unsettled Bitcoin transactions that people are trying to complete. Blocks become chained together, and unsettled transactions get confirmed when a block is mined. Bitcoin miners compete over the new supply of BTC and expend energy that awards them the currency within the Bitcoin software. Bitcoin miners are awarded BTC when they find a random number; consider it a lottery. They expend energy to perform trillions of computations every second to find that number. That makes Bitcoin mining virtually one giant random-numbers game, and only the fastest and most powerful computers can compete. Today, supercomputers called ASICs (application-specific integrated circuits) are required to mine BTC successfully.
 
Miners are financially motivated and dedicate energy and computing power toward adding blocks to the chain. This is commonly referred to as hashpower, with the word "hash" coming from SHA2. Bitcoin mining is also called performing proof-of-work, which is expending resources to add BTC to circulation.
 
The Bitcoin protocol mandates that blocks occur on average ten minutes apart, but the actual time between blocks can take seconds or hours depending on how long it takes a miner to win each BTC lottery. The algorithm that adjusts the computational lottery every two weeks to make sure blocks occur ten minutes apart is called the difficulty adjustment. No single peer has control over the entirely automated difficulty adjustment. A miner can win an outsized proportion of block rewards with superior mining ASICs, but Bitcoin regularly increases in mining difficulty as a security mechanism. This attempts to prevent fast computers from running away with block rewards.
 
Addresses used to receive BTC are generated from numbers called private keys. Private keys are 256-character strings. The private keys generate an address used to receive BTC, but the address cannot be reverse-engineered to reveal the private key behind it.
 
To review, see Bitcoin.
 

6c. Summarize Bitcoin's legal precedent and standing in the US 

  • How did the IRS rule on Bitcoin ownership, and when did it issue that ruling?
  • How does the US commodities regulator view Bitcoin?

Bitcoin officially gained recognition in the United States government in 2014, when the IRS determined that ownership of BTC was to be treated as property and that gains realized in USD terms were subject to capital gain taxes. The US commodity futures regulator ruled that Bitcoin was a commodity and not a currency. It compared Bitcoin to gold in its research process and concluded that ownership of BTC is possession of a numerical commodity due to the software's reliance on private keys. Despite being difficult to define in the traditional context, Bitcoin was starting to morph into its own asset class.
 
To review, see Bitcoin's Denomination.
 

6d. Describe the evolution of Bitcoin as an asset class, including the introduction of Lightning Network 

  • How have Bitcoin futures traded on the CME changed Bitcoin as an asset class?
  • How has investment demand for Bitcoin evolved since the start of the pandemic?
  • What does the Lightning Network allow users to do?

CME Bitcoin futures help financial market participants translate between BTC and USD, which has contributed to Bitcoin adoption. Bitcoin futures offer a second-layer BTC to participants that operate within the dollar pyramid and want exposure to changes in BTC price, not possession of Bitcoin private keys. In 2020, several hedge fund investors acknowledged ownership of BTC. Investment management companies and payment processors started to give customers the ability to purchase BTC on their platforms.
 
The Lightning Network allows Bitcoin transactions to happen more quickly through smart contracts, which are agreements written in code. Smart contracts attempt to provide escrow and multiple-party coordination. The smart contracts in Lightning Network, Hashed TimeLock Contracts (HTLCs), allow the Bitcoin network to process more transactions per second via Bitcoin Improvement Proposals (BIPs) that did not change any of Bitcoin's fundamental rules.
 
To review, see Layered Bitcoin.
 

Unit 6 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • Bitcoin
  • block
  • difficulty adjustment
  • hashpower
  • Lightning Network
  • node
  • private keys
  • proof-of-work
  • smart contracts
  • trustless

Unit 7: Cryptocurrencies, Stablecoins, and Central Bank Digital Currencies (2013–Present)

7a. Outline the goals and functions of stablecoins and alternative cryptocurrencies

  • Why did alternative cryptocurrencies emerge in the years after Bitcoin's formation?
  • How are alternative cryptocurrencies treated in their price relationship with Bitcoin on cryptocurrency exchanges?
  • What does a stablecoin attempt to accomplish?
  • Why were stablecoins originally demanded?
  • How does a stablecoin fall into the layers of money?
  • How are stablecoins and cryptocurrencies evolving in the regulatory landscape in the US?

Many alternative versions of cryptocurrency to Bitcoin have emerged. They exist on a lower layer within the BTC money pyramid due to a price relationship, much like national currencies existed on a layer below the dollar after the Bretton Woods agreement of 1944. Like the USD acts as the base price for currencies from around the world, BTC acts as a base price for many digital currencies.
 
Stablecoins are liabilities issued as digital tokens by private sector companies. They are supposed to trade at a "stable" value relative to dollars. However, they rarely possess enduring stability. Stablecoins were invented because exchanges needed an easier and quicker way for customers to convert between BTC and USD. In essence, exchanges create cryptocurrencies representing USD in a bank account but transacted with private keys and addresses like Bitcoin. In January 2021, the US Treasury approved stablecoins for banks to digitally transact value as long as banking laws are followed.
 
To review, see Alternative Cryptocurrencies, Stablecoins, and CBDCs.
 

7b. Identify the origin of central bank digital currencies (CBDCs)

  • How does a central bank's digital currency differ from traditional currency?
  • What are the motivations behind CBDCs?
  • How do CBDCs differ from Bitcoin?
  • How might governments use CBDCs to enact fiscal policy?

In 2016 a senior Bank of England official argued that central banks could use token-based digital cash like Bitcoin to their benefit by widening access to who could hold central bank liabilities, or second-layer money.
 
With a CBDC, the Federal Reserve can issue second-layer money directly to people. The Federal Reserve wouldn't necessarily be able to provide this type of economic stimulus without political debate; a CBDC blurs the line between the central bank's independent monetary policy and government-controlled fiscal policy.
 
To review, see Alternative Cryptocurrencies, Stablecoins, and CBDCs.
 

7c. Distinguish between retail and wholesale CBDCs

  • How do retail-facing CBDCs compare to paper cash issued by central banks?
  • How would a wholesale-facing CBDC compare to Fed reserves?
  • What is the difference between a retail CBDC and a wholesale CBDC?

So far, CBDCs are unchartered. From a layered-money perspective however, CBDCs are more defined. When issued by a central bank, digital currency will be second-layer money (a liability on the central bank's balance sheet alongside cash notes and reserves). Central banks first have to decide which liability they want their digital currencies to emulate more: wholesale reserves or retail cash.
 
When people use cash, they use second-layer money and avoid the banking layer altogether. But most people use bank deposits and payment platforms linked to bank accounts for their daily interaction with money, which occurs in the third and lower layers. With CBDCs, governments might reduce the role of banks in the issuance of money. Alternatively, central banks could issue a digital currency as wholesale reserves, which would only be accessible to banks.
 
To review, see Alternative Cryptocurrencies, Stablecoins, and CBDCs.
 

7d. Predict how Bitcoin, cryptocurrencies, stablecoins, and CBDCs may change the international monetary system

  • How could Bitcoin evolve in its monetary role?
  • How could distributed ledger technology affect the international monetary system?
  • How could stablecoins function in the future?
  • How could the relationship between central banking and private sector banking evolve after the introduction of CBDCs?

​​An atomic swap is a smart contract that allows for the trade between digital currencies without using a third-party exchange. They are programmed to execute the trade for both parties or neither, which attempts to eliminate counterparty, exchange, and default risk. Atomic swaps will only work on central bank digital currencies. However, this doesn't necessarily mean that a central bank issuing a CBDC on a distributed ledger would cede any control over the underlying currency.
 
To review, see The Potential Future of the Monetary System.
 

Unit 7 Vocabulary

This vocabulary list includes terms you will need to know to successfully complete the final exam.

  • atomic swap
  • stablecoins