Financial Institutions, Markets, & Money Chapter 2 Questions and Answers Study Guide
CHAPTER 2 ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS
1. What were the objectives of the National Banking Acts and what problems existed in the U.S. banking system before those acts were passed in the 1860s?
Solution: For much of the 19th century there was no systematic regulation of banking or the money supply. Banks, state-chartered but otherwise largely unsupervised, were free not only to engage in unsound lending practices but to issue banknotes—IOUs against themselves—without restraint. Consequent and frequent bank failures weakened public faith in banks and the money supply, and exacerbated downturns in the normal business cycle. The National Banking and Currency Acts (1862-64) created a new class of federally chartered banks, “National Banks”. These banks could issue banknotes, but they had to have them printed at the U.S. Treasury in standard form and denominations to reduce counterfeits. National bank notes also had to be backed above face value with U.S. government bonds, thus “enlisting” national banks to help finance the Civil War and assuring redemption of any national bank note at face value, even if the bank failed. To encourage circulation of national bank notes, the federal government also taxed state banknotes practically out of existence. Beyond this first systematic effort at a standard national currency, the Acts also represented the first systematic federal regulation of banking: They required that national banks have adequate capital to absorb losses, hold adequate reserves, be examined regularly by the Office of the Comptroller of the Currency, and avoid unsound lending practices.
2. What were the problems posed by the National Banking Acts?
Solution: The currency was inelastic after bond issuance to finance the war ended, but before there was political consensus for an alternate way of backing it (gold, silver, etc). The tax on state banknotes increased the popularity of demand deposits which, despite the
1. What were the objectives of the National Banking Acts and what problems existed in the U.S. banking system before those acts were passed in the 1860s?
Solution: For much of the 19th century there was no systematic regulation of banking or the money supply. Banks, state-chartered but otherwise largely unsupervised, were free not only to engage in unsound lending practices but to issue banknotes—IOUs against themselves—without restraint. Consequent and frequent bank failures weakened public faith in banks and the money supply, and exacerbated downturns in the normal business cycle. The National Banking and Currency Acts (1862-64) created a new class of federally chartered banks, “National Banks”. These banks could issue banknotes, but they had to have them printed at the U.S. Treasury in standard form and denominations to reduce counterfeits. National bank notes also had to be backed above face value with U.S. government bonds, thus “enlisting” national banks to help finance the Civil War and assuring redemption of any national bank note at face value, even if the bank failed. To encourage circulation of national bank notes, the federal government also taxed state banknotes practically out of existence. Beyond this first systematic effort at a standard national currency, the Acts also represented the first systematic federal regulation of banking: They required that national banks have adequate capital to absorb losses, hold adequate reserves, be examined regularly by the Office of the Comptroller of the Currency, and avoid unsound lending practices.
2. What were the problems posed by the National Banking Acts?
Solution: The currency was inelastic after bond issuance to finance the war ended, but before there was political consensus for an alternate way of backing it (gold, silver, etc). The tax on state banknotes increased the popularity of demand deposits which, despite the