Almost everybody has heard about the Y2K problem. It has raised fears about everything from the security of our water supply to the threat of missile attacks triggered by computer glitches. Some of these threats seem pretty far-fetched. But what about threats to the security of our money? Could the Y2K problem wreak havoc with our bank accounts and other financial holdings? What can be done to prevent trouble of this sort from occuring? And whose job is it to ensure that the necessary steps are taken? This lesson addresses these questions.

KEY CONCEPTS

Currency, Federal Reserve, Federal Reserve Structure, Money Supply

STUDENTS WILL

  • Describe the patterns of currency holding by U.S. households.
  • Describe recent trends in currency demand.
  • Explain how banks and the money creation process are affected by a currency drain.
  • Identify the role of the Federal Reserve, the nation's central bank and monetary authority, in controlling the money supply.

INTRODUCTION

Almost everybody has heard about the Y2K problem. It has raised fears about everything from the security of our water supply to the threat of missile attacks triggered by computer glitches. Some of these threats seem pretty far-fetched. But what about threats to the security of our money? Could the Y2K problem wreak havoc with our bank accounts and other financial holdings? What can be done to prevent trouble of this sort from occurring? And whose job is it to ensure that the necessary steps are taken? This lesson addresses these questions.

RESOURCES

PROCESS

Defining the Problem

First, what exactly is the Y2K problem? It arises because dates on many older computer systems are recorded only by reference to the last two digits of a given year--e.g., "99" for "1999." As computer users begin to date documents with the year 2000, some computers will not know how to read the "00" endings, and the confusion that follows from that might have important ripple effects. Some people fear it could cause computer systems around the world to crash. This possibility is at the heart of the Y2K problem.

What might this have to do with your money? Our nation's central bank and monetary authority, the Federal Reserve (also known as the Fed), relies on the interaction of depositors and banks in order to control the nation's money supply. Most of the time, this interaction is quite predictable: banks attempt to maximize profits and thus economize on their holdings of reserves (because reserves don't earn interest), and households satisfy their needs for liquidity and security by maintaining sizable deposit balances in banks. Y2K threatens to upset all of this. Because of uncertainty arising from the Y2K problem, banks may decide to hold a substantially larger share of reserves than normal and households and businesses may significantly increase their holdings of currency.

In anticipation of possible problems, federal regulators and the financial services industry have been preparing for the date change for more than two years. As a result, the Fed is confident that the transition to a new millennium will create nothing other than minor, temporary glitches. Cathy Minehan, president of the Federal Reserve Bank of Boston, has this advice for the public about the possibility of such glitches: "Keep cool--an overreaction will only create new problems."

Read the article "Shared Responsibility ."

What appears to be the Federal Reserve's primary concern regarding the century date change? [To ensure that consumers and businesses do not overreact to Y2K concerns in the financial system.]

Why has the Fed ordered an additional $50 billion in currency? [In case there is an excess demand for currency. This excess demand for currency could arise if bank customers desire to hold a larger-than-usual amount of currency as January 1, 2000 approaches.]

How might monetary policy be used if the century date change causes economic disruptions? [The extra currency mentioned above will be available. The Fed will be prepared to lend to financial institutions. In the unlikely event that a recession arises from Y2K shocks, monetary policy could be used to offset any decline in aggregate demand.]

Understanding U.S. Currency

So what could happen if U.S. households decide to increase their holdings of currency prior to the century date change? Increased currency demand can drain reserves from the banking system. Banks hold reserves as vault cash as well as deposits maintained at regional Federal Reserve banks. A Federal Reserve note (those pieces of paper, denominated in amounts of $1, $2, $5, $10, $20, $50, and $100) is not classified as currency when it is held in a bank vault because it is not circulating. When a depositor decides to withdraw funds from a bank account (such as a checking or savings account), currency in circulation increases. This happens because Federal Reserve notes have been transferred from bank vaults to the depositor and as a consequence are circulating in the hands of the non-bank public. By itself, this is not likely to cause a direct change in the money supply since money includes both deposits and currency (although it might alter the money multiplier). It does, of course, change the composition of the money supply.

See the Components of M1

What was the amount of currency in circulation in March 1999? [$472.0 billion.]

What was the amount of currency in circulation in March 1959? [$28.6 billion.]

By what percentage has the amount of currency in circulation increased over the 40-year period ending in March 1999? [1550 percent; [{(472.0 - 28.6)/28.6} x 100]; note that this is a huge increase]

What was the amount of currency in circulation in November 1998? [$456.5 billion.]

November 1998 is the most recent month for which U.S. population estimates are available from the Census Bureau. The U.S. population is estimated to be about 270 million for that month.

Suppose that all of the U.S. currency in circulation is held only by the U.S. population. Given this assumption, calculate the average holdings of currency per capita in November 1998. [$1690.74 per person; {$456.5 billion/0.270 billion}; note that 270 million equals 0.270 billion.]

Activity 1

Determine how much currency you are carrying.

[Note to teacher: Ask for a few student volunteers to report their currency holdings. You can get things started by reporting how much cash you are carrying. Students should have a lot of fun with this one. Not only do they like to talk about money, they will also laugh at how little currency they are carrying. Note that this activity does not give an entirely accurate portrait of each student's currency holdings, because it does not include the value of the currency in piggy banks that are kept at home. But the point is still made. None of the students are likely to have actual currency holdings that are even close to the average

The currency-per-capita calculation does not include the value of deposits held in the banking system. Deposits are treated as a separate category of money. Currency includes only paper money and coin.]

For more information about U.S. currency, see "Dollars and Cents ."

How can the relatively large amount of currency in circulation be reconciled with your observation that members of your class were not even close to holding the average amount of currency? [Some currency is stored at home; businesses also keep and use currency; a great deal of currency is held by a small percentage of the population, typically those who are involved in illegal underground economic activities such as gambling, prostitution, and drug trafficking; a great deal of U.S. currency is held by persons who are not in the U.S. population.]

The Federal Reserve estimates that approximately 65 percent of our cash is circulating outside of the U.S. The tendency for U.S. currency to circulate outside of the U.S. has probably risen over the past 10 years. The factor cited most frequently to explain this phenomenon is the dissolution of the Soviet Union. When the former Soviet countries received independence, their people were free to hold the currency of their choosing. Throughout the last half of the 20th century, the U.S. dollar has been the world's most popular currency because of its global acceptability in exchange. During times of economic uncertainty, citizens of other countries have routinely used dollars as a means to store purchasing power and reduce financial risk.

  • Using the estimate reported in the above paragraph, calculate the amount of currency held outside the U.S. in November 1998. [The amount of currency held outside the U.S. in November 1998 was $296.7 billion; {$456.5 billion x 0.65}.]
     
  • Now calculate the amount of currency the Federal Reserve estimates is held within the U.S. for November 1998. [The amount of currency the Federal Reserve estimates is held within the U.S. for November 1998 is $159.8 billion; $456.5 billion - $296.7 billion.]
     
  • Use this estimate of currency held within the U.S. to make a new calculation of average per capita currency holdings in the U.S. in November 1998. [The new calculation of average per capita currency holdings in the U.S. in November 1998 is $591.85; {$159.8 billion/0.270 billion}.]
     

This number is certainly more realistic than $1690.74, although it still may seem a little high to you. But remember that cash is not evenly distributed throughout the population. Persons in the 0 to 18 age bracket are probably less likely to maintain these average currency holdings than people in any other population cohort.

The Fed, Banks, and the Potential of Rising Currency Demands

The U.S. government typically maintains an inventory of extra cash equal to about $150 billion. During normal times, this is more than enough for the Fed to meet any unexpected increases in currency demand. This year, however, may not be an ordinary year. Bank depositors worried about the availability of funds and the reliability of electronic payments could significantly increase holdings of currency. For this reason, the Fed has ordered an additional $50 billion of cash to hold in inventory. This means that the currency inventory will be more than 42 percent (calculated by dividing $200 billion by $472 billion) of actual currency in circulation! Yet, some observers question whether this will be enough!

Read "Should We Fear the Y2K Bug? ."

  • What are some of the bank-related concerns about the Y2K phenomenon expressed in the article? [A bank could run out of cash and cause a panic; crime could increase because of all the additional cash that is expected to be in circulation; ATMs could fail for non-Y2K reasons, but still cause a panic; there may not be enough armored trucks to distribute all of the extra cash demanded by banks.]
     
  • According to statements made in the article, what percentage of deposits do banks typically keep on hand as cash? [Banks typically keep one-half percent of deposits on hand as cash. Note that your students will probably think that this is a surprisingly low number.]
     
  • By what amount might banks increase currency holdings this year in order to meet greater currency demands? [Banks might increase currency holdings this year in order to meet greater currency demands by as much as 20 times their current holdings: a huge increase!]
     

Monetary Policy and Cash Withdrawals

The article points out several concerns about cash shortages, but it does not touch upon the adverse effects Y2K cash withdrawals could have on the conduct of monetary policy. In attempting to control the nation's money supply, the Federal Reserve relies on the lending of banks. Bank lending is usually quite predictable. Banks keep a small fraction of total deposits on hand as reserves and use any funds in excess of what they are legally required to hold to make loans and/or purchase securities. When all banks do this, they end up creating deposits. Since deposits are classified by the Fed as money, the banks are literally involved in money creation.

[NOTE: To order a free curriculum resource titled "How Banks Create Money: The Deposit Multiplier Module" (this is part of the Money and the Economy Modular Series), go to the WWW site of the Federal Reserve Bank of San Francisco's Economics Teaching Resources ]

The process of money creation breaks down when depositors are expected to make unusually large cash withdrawals. Instead of lending out all idle funds, banks will hold additional reserves in anticipation of increased currency demands. Reserves that are held by banks are not used to create money. You can therefore understand why it might be difficult for the Fed to control the money supply toward the end of the year. The models that are normally used to predict the creation of money by the banking system are likely to be inaccurate during this time of uncertain bank reserve holdings and rising currency demands.

Suggested extension activity: Ask each student to conduct brief interviews in three separate households. Note: it is important that the interview represent the household decision and not simply an individual decision. The following questions should be asked in the interview (it should be made clear to the party being interviewed that all responses are confidential and are to be used for a class project): Does the household (again, this has to be the entire household) plan to hold any additional cash because of Y2K? If yes, how much additional cash does your household expect to hold? If yes, when do you plan to increase cash holdings? If so, are you concerned that holding cash is not as safe as keeping funds at your bank? Give your students a day or two to conduct the interviews; then collect the data. Calculate what the average increase in cash holdings is for the surveyed households. If you have 25 students, then you will receive 75 responses. Total up all responses and divide by 75 (this assumes that each student has collected exactly three responses). Once you have determined the increase in currency holdings for the average household in your sample, inform your class that, according to the most recently reported figures, there are 102,528,000 households in the U.S. Multiply the average increase in currency holdings from your classroom sample by 102,528,000 and you will have a simple projection of the increased currency demand by U.S. households. Discuss this in the context of the numbers used in the lesson. Note also that this number does not account for additional U.S. currency holding in other countries or by U.S. businesses.

Example:

Average increase in currency holdings from the classroom sample: $550.00

102,528,000 x $550.00 = $56,390,400,000.00 or $5.63904 x 1010

Thus the total projected increase in currency demand for all U.S. households is more than $56 billion.

While most observers agree that the Y2K problem should not be taken lightly, most feel that any glitches are likely to be temporary and minor. This is particularly true of the financial services industry, where firms are probably better prepared for the century date change than any other industry. Is your money safe? What do you think?

EDUCATOR REVIEWS