Chapter 20 Outline – Money, Financial Institutions, and the Federal Reserve
I.WHY MONEY IS IMPORTANT
A.Economic growth and creation of jobs depends on money—its availability and its value relative to other currencies.
1.The recent banking crisis has focused attention on the Federal Reserve.
2.Money is so important that many institutions have evolved to manage money and to make it available to you when you need it.
3.The flow of money from country to country is as free as the flow FROM STATE TO STATE.
4.Each day about $4 trillion is exchanged in world markets.
5.What happens to any major country’s economy has an effect on the U.S. economy, and vice versa.
B.WHAT IS MONEY?
1.MONEY is anything that people generally accept as payment for goods and services.
2.BARTER is the direct trading of goods and services for other goods and services.
a.Many people have discovered the benefits of bartering online.
b.Others today still barter goods and services, but transactions are difficult.
c.Today barter exchanges let people put goods and services into the system and get credits for other goods and services.
d.People need some form of currency that is portable, divisible, durable, and stable so that they can trade without having to carry the actual goods.
3.Coins and paper bills meet all the standards for a more useful money:
a.PORTABILITY: Coins are easier to take to market than goods.
b.DIVISIBILITY: Different-sized coins can be made to represent different values.
c.STABILITY: When everybody agrees on the value of coins, the value of money is relatively stable.
d.DURABILITY: Coins last for thousands of years.
e.UNIQUENESS:
i.The government has had to go to extra lengths to make real dollars readily identifiable.
ii.The new paper money has many security enhancements, including blue, peach, and green color inks.
4.Coins and paper money thus became UNITS OF VALUE, simplifying exchanges.
a.Most countries have their own coins and paper that they use as money.
b.However, they are not always equally stable.
5.Electronic money (e-money) is a newer form of money.
a.You can make online payments.
b. Cryptocurrencies, like Bitcoin, are a new form of electronic money – though not yet generally accepted.
C.WHAT IS THE MONEY SUPPLY?
1.Control of the money supply involves two questions:
a.What is the money supply?
b.Why does it need to be controlled?
2.The MONEY SUPPLY is the amount of money the Federal Reserve Bank makes available for people to buy goods and services.
3.There are several CLASSIFICATIONS OF THE MONEY SUPPLY (M-1, M-2, and so on).
a.M-1 is money that can be accessed quickly and easily (coins and paper bills, checks, traveler’s checks, etc.).
b.M-2 is money included in M-1 plus money that may take a little more time to obtain (savings accounts, money market accounts, mutual funds, certificates of deposit, and the like).
c.M-2 is the most commonly used definition of money.
d.M-3 is M-2 plus big deposits like institutional money market funds.
D.Managing Inflation and the Money Supply
1.If TOO MUCH MONEY is available, prices go up: INFLATION (too much money chasing too few goods).
2.If TOO LITTLE MONEY is available, prices would go down: deflation.
3.The prices of goods and services can be managed somewhat by controlling the amount of money available in the economy.
E.THE GLOBAL EXCHANGE OF MONEY
1.FALLING DOLLAR means that the amount of goods and services you can buy with a dollar goes down.
2.RISING DOLLAR means that the amount of goods and services you can buy with a dollar goes up.
3.For example, a strong euro would drive up the cost of cars from Germany.
4.What makes the dollar weak or strong is the position of the U.S. economy relative to other economies.
a.In a strong ECONOMY, the demand for dollars is high and the value of the dollar rises.
b.When the country’s economy is perceived as weakening, the demand for the dollar declines and the value of the dollar falls.
II.CONTROL OF THE MONEY SUPPLY
A.An organization is needed that controls the money supply to try to keep the U.S. economy from growing too fast or too slowly.
1.The organization in charge of monetary policy is the FEDERAL RESERVE SYSTEM (THE FED).
B.BASICS ABOUT THE FEDERAL RESERVE
1.The Federal Reserve System consists of five major parts:
a.The BOARD OF GOVERNORS administers and supervises the 12 Federal Reserve System banks.
i.Seven members are appointed by the president and confirmed by the senate.
ii.The primary function is to set monetary policy.
b.The FEDERAL OPEN MARKET COMMITTEE has 12 voting members and is the policy-making body.
c.The 12 FEDERAL RESERVE BANKS
d.THREE ADVISORY COUNCILS
e.The MEMBER BANKS of the system
2.The Federal Reserve:
a.Buys and sells foreign currencies
b.Regulates various types of credit
c.Supervises banks
d.Collects data on the money supply and other economic activities
3.The tools used to regulate the money supply include reserve requirements, open-market operations, and the discount rate.
C.THE RESERVE REQUIREMENT
1.The RESERVE REQUIREMENT is a percentage of commercial bank’s checking and savings accounts that must be physically kept in the bank (for example, as cash in the vault) or a non-interest-bearing deposit at the local Federal Reserve district bank.
2.Changing the reserve requirement is one of the Fed’s most powerful tools.
3.When the Fed INCREASES THE RESERVE REQUIREMENT:
a.Banks have LESS MONEY FOR LOANS and make fewer loans, which reduces inflation.
b.The money supply would be reduced and prices would likely fall.
4.When the Fed DECREASES THE RESERVE REQUIREMENT:
a.Banks have MORE MONEY AVAILABLE FOR LOANS and make more loans.
b.An increase in the money supply stimulates the economy for higher growth, but it can also create inflationary pressures.
D.OPEN-MARKET OPERATIONS
1.The most commonly used tool is OPEN-MARKET OPERATIONS, the buying and selling of U.S. government bonds by the Fed with the goal of regulating the money supply.
2.When the Fed wants to DECREASE THE MONEY SUPPLY, it SELLS GOVERNMENT SECURITIES to the public.
3.When the Fed wants to INCREASE THE MONEY SUPPLY, it BUYS GOVERNMENT SECURITIES from individuals, corporations, or organizations willing to sell.
E.THE DISCOUNT RATE
1.The Fed is called the BANKER’S BANK.
2.Member banks can borrow money from the Fed and then pass it on to their customers.
3.The DISCOUNT RATE is the interest rate that Fed charges for loans to member banks.
4.INCREASING THE DISCOUNT RATE discourages banks from borrowing and consequently reduces the number of available loans, resulting in a DECREASE IN THE MONEY SUPPLY.
5.LOWERING THE DISCOUNT RATE encourages bank borrowing and increases the amount of funds available for loans, resulting in an INCREASE IN THE MONEY SUPPLY.
6.The Fed also sets the federal funds rate, the rate that banks charge each other.
F.THE FEDERAL RESERVE’S CHECK-CLEARING ROLE
1.One of the functions of the Federal Reserve System is to help process your checks.
2.When a check is presented at another bank, a complicated process (shown in Figure 20.3) transfers funds from one’s home bank.
3.This process is costly, so banks try to lessen the use of checks through use of credit cards, debit cards, and electronic transfer of money.
G.The whole economy is affected by actions taken by the Federal Reserve System.
III.THE HISTORY OF BANKING AND THE NEED FOR THE FED
A.EARLY BANKING HISTORY
1.There were NO BANKS IN EARLY COLONIAL AMERICA.
a.Strict laws limited the number of coins that could be brought to the colonies.
b.Colonists were forced to barter for goods.
2.MASSACHUSETTS issued its own PAPER MONEY in 1690, and soon other colonies did as well.
a.But continental money, the first paper money printed in the U.S., became worthless because people didn’t trust its value.
b.LAND BANKS were established to make loans to farmers, but England stopped these practices by 1741.
c.Colonies rebelled against these restrictions, and a new bank was formed during the American Revolution.
3.ALEXANDER HAMILTON convinced Congress to form a CENTRAL BANK in 1791.
a.The bank had so much opposition that it closed in 1811.
b.An attempt to replace the bank in 1816 caused conflict between the Second (Central) Bank and state banks.
c.The bank was closed in 1836.
4.By the time of the civil war, banking was a mess.
a.Different banks issued different currencies.
b.Often the coins were worth more as gold or silver than as coins.
c.Many people became nervous about their money and caused runs on banks; trust in banking declined.
5.The cash shortage problems of 1907 led to the formation of the FEDERAL RESERVE SYSTEM, designated as a “lender of last resort.”
a.All federally chartered banks must join; state-chartered banks may join.
b.The Federal Reserve became the BANKERS’ BANK.
B.BANKING AND THE GREAT DEPRESSION
1.The STOCK MARKET CRASH OF 1929 led to bank failures in the early 1930s.
2.People rushed to take money out of banks; banks ran out of money and closed.
3.Franklin D. Roosevelt extended these bank closings in 1933 to gain time for a solution.
4.In 1933 and 1935, the federal government passed LAWS to strengthen the banking system.
5.The government also started an insurance program to protect depositors from bank failures.
- THE U.S. BANKING SYSTEM
A.The U.S. BANKING SYSTEM consists of commercial banks, savings and loan associations, credit unions, mutual savings banks, and nonbanks.
B.COMMERCIAL BANKS
1.A COMMERCIAL BANK is a profit-making organization that receives deposits from individuals and businesses in the form of checking and savings accounts and then uses some of these funds to make loans.
2.Commercial banks have two types of customers: DEPOSITORS and BORROWERS.
3.Commercial banks make a profit if the revenue generated by loans exceeds the interest paid to depositors.
C.SERVICES PROVIDED BY COMMERCIAL BANKS
1.Individuals and businesses that deposit money in a checking account can write personal checks to pay for almost any transaction.
2.A DEMAND DEPOSIT is the technical name for a checking account; the money in a demand deposit can be withdrawn anytime on demand from the depositor.
a.Banks impose a service charge for check writing, and may charge a handling fee.
b.In the past, checking accounts paid no interest, but interest-bearing checking accounts have grown in recent years.
3.A TIME DEPOSIT is the technical name for a savings account; the bank can require prior notice before the owner withdraws money from a time deposit.
a.A CERTIFICATE OF DEPOSIT (CD) is a time-deposit (savings) account that earns interest to be delivered at the end of the certificate’s maturity date.
b.The CD cannot be withdrawn without penalty until the maturity date.
c.The interest rate depends on the length of the period, the economic conditions, and the prime rate at the time of deposit.
4.Commercial banks may also offer other services, such as credit cards, brokerage services, financial counseling, automatic payment of bills, safe deposit boxes, tax-deferred IRAs, travelers’ checks, and overdraft privileges.
5.AUTOMATED TELLER MACHINES (ATMs) give customers the convenience of 24-hour banking.
D.SERVICES TO BORROWERS
1.Banks are supposed to screen loan applicants carefully to make sure that the loan plus interest will be paid back on time.
2.Loans are generally given on the basis of the recipient’s creditworthiness.
E.SAVINGS AND LOAN ASSOCIATIONS (S&Ls)
1.A SAVINGS AND LOAN ASSOCIATION (S&L) is a financial institution that accepts both savings and checking deposits and provides home mortgage loans.
a.S&Ls are often known as thrift institutions since their original purpose was to promote consumer thrift and home ownership.
b.Thrifts were permitted to offer slightly higher interest rates to attract funds.
c.These funds were then used to offer long-term fixed rate mortgages.
d.S&Ls no longer offer better rates than banks.
2.In the early 1980s, S&Ls ran into trouble; 20% of the nation’s S&Ls failed.
a.The biggest reason was that capital gains taxes were raised, making investments in real estate less attractive.
b.S&Ls were left with property that was worth less than the money they had lent to investors.
c.In the 1980s, the federal government has stepped in to strengthen S&Ls, allowing them to:
i.Offer higher interest rates
ii.Allocate up to 10% of their funds to COMMERCIAL LOANS
iii.Offer mortgage loans with ADJUSTABLE INTEREST RATES
d.Savings and loans have become very similar to commercial banks.
F.CREDIT UNIONS
1.CREDIT UNIONS are nonprofit, member-owned financial cooperatives that offer the full variety of banking services to their members, including:
a.Interest-bearing checking accounts at relatively high rates
b.Short-term loans at relatively low rates
c.Financial counseling
d.Life insurance
e. Home mortgage loans
2.As not-for-profit institutions, credit unions enjoy an exemption from federal income taxes.
G.OTHER FINANCIAL INSTITUTIONS (NONBANKS)
1.NONBANKS are financial organizations that accept no deposits but offer many of the services provided by regular banks.
a.NONBANKS include life insurance companies, pension funds, brokerage firms, commercial finance companies, and corporate financial services.
b.Nonbanks cut back their lending during the recent banking crisis.
c.Competition between banks and nonbanks has increased making the difference between them less apparent.
d.In response to the diverse investment alternatives offered by nonbanks, banks expanded their services.
e.Some banks have merged with brokerage firms.
2.LIFE INSURANCE COMPANIES provide financial protection for policyholders who periodically pay premiums.
3.PENSION FUNDS are amounts of money put aside by corporations, nonprofit organizations, or unions to cover part of the financial needs of members when they retire.
a.Contributions to pensions are made by employees, employers, or both.
b.Pension funds typically invest in low-return, but safe, corporate stocks or government securities.
c.Many large pension funds are becoming forces in U.S. financial markets.
4.BROKERAGE FIRMS traditionally offered investments in stock exchanges, but now offer services such as high-yield checking/savings accounts and loans.
5.COMMERCIAL AND CONSUMER FINANCE COMPANIES are institutions that offer short-term loans to businesses and individuals with higher credit risks.
a.Interest rates are higher than regular banks.
b.Use caution when borrowing from such institutions because the interest rates can be quite high.
V.THE BANKING CRISIS AND HOW THE GOVERNMENT PROTECTS YOUR MONEY
A.The RECENT Banking Crisis
1.Who is responsible? Some have blamed:
a.The Federal Reserve, for keeping costs of borrowing low.
b.Congress, for pressuring banks to make risky loans.
c.The Community Reinvestment Act, for encouraging loans with families with questionable ability to repay
2.Banks made risky loans and then divided their portfolios of mortgages up into mortgage-backed securities (MBSs) and sold to other organizations.
a.Banks sold more and more MBSs to consumers.
b.The Fed and the SEC were accused of failing their regulatory duties by not issuing sufficient warnings.
c.House values plummeted and people lost their homes.
3Bank profits dropped; this led to the banking crisis.
B.Protecting Your Funds
1.As a result of the depression of the 1930s, several organizations evolved to protect your money.
2.Three organizations protect your money: the Federal Deposit Insurance Company (FDIC), the Savings Association Insurance Fund (SAIF), and the National Credit Union Administration (NCUA).
C.The FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC) is an independent agency of the U.S. government that insures bank accounts.
1.If a bank were to be in serious danger, the FDIC would arrange to have its accounts transferred to another bank or pay off depositors up to $250,000 per account.
2.The goal is to maintain confidence in banks so that if one falls others don’t.
3.The FDIC covers many institutions, mostly commercial banks.
D.The SAVINGS ASSOCIATION INSURANCE FUND (SAIF) insures holders of accounts in savings and loan associations.
1.It was originally called the Federal Savings and Loan Insurance Corporation).
2.During the Great Depression, some 1,700 bank and thrift institutions failed, and people lost confidence in them.
3.The FDIC and FSLIC were designed to create more confidence in banking institutions.
4.Recently, the FSLIC was placed under the FDIC (and renamed) to better control banking.
E.The NATIONAL CREDIT UNION ADMINISTRATION (NCUA)
1.The NCUA provides up to $250,000 coverage per depositor.
2.Additional protection can be obtained by holding accounts jointly or in trust.
VI.USING TECHNOLOGY TO MAKE BANKING MORE EFFICIENT
A.Banks have long looked for ways to make the system more efficient.
1.Credit cards reduce the flow of checks but have their own costs.
a.There will be more electronic rather than physical exchange of money in the future.
b.If you must use a credit card, look for one that offers the best deal for you.
2.ELECTRONIC FUNDS TRANSFER (EFT) SYSTEM is a computerized system that electronically performs financial transactions such as making purchases, paying bills, and receiving paychecks.
a.EFT tools include electronic check conversion, debit cards, smart cards, direct deposits, and direct payments.
3.Debit cards eliminate the paper-handling costs of using checks.
a.A DEBIT CARD is an electronic funds transfer tool that serves the same function as checks; it withdraws funds from a checking account.
b.Your spending is limited to the amount that is in your account.
c.A debit card is swiped at a point-of-sale terminal signaling the bank to immediately transfer funds.
d.Some companies use payroll debit cards to reduce paper processing.
4.A SMART CARD is an electronic funds transfer tool that is a combination credit card, debit card, phone card, driver’s license card, and more.
a.The magnetic strip on a credit card is replaced with a microprocessor.
b.The card can store a variety of information, including the bank balance.
c.Some smart cards have embedded radio-frequency chips.
5.Automatic transfers
a.A DIRECT DEPOSIT is a credit made directly to a checking or savings account, such as automatically deposited paychecks.
b.A DIRECT PAYMENT is a preauthorized electronic payment.
B.ONLINE BANKING
1.Using online banking, you can complete all your financial transactions from home on your computer:
a.Transfer funds from one account to another.
b.Pay bills.
c.Check account balances.
d.Apply for a car loan or mortgage.
e.Buy and sell stocks and bonds.
2.Online banks such as E*Trade Bank offer online banking only, not physical branches.
a.They can offer slightly higher interest rates and lower fees.
b.Some people are nervous about online security and fear putting their money into online banks.
c.Others want to talk to a banking professional in person.
VII.INTERNATIONAL BANKING AND BANKING SERVICES
A.Banks help businesses conduct business in other countries by providing three services.
1.A LETTER OF CREDIT is a promise by the bank to pay the seller a given amount if certain conditions are met.
2.A BANKER’S ACCEPTANCE is a promise that the bank will pay some specified amount at a particular time.
3CURRENCY EXCHANGE is the exchange of one country’s currency for another country’s currency.
4.ATMs now may provide foreign currency.
B.LEADERS IN INTERNATIONAL BANKING
1.In the future, many crucial financial issues will be international in scope.
2.Today’s money markets form a GLOBAL MARKET system.
a.Large international banks make investments in any country where they can earn maximum return.
b.World economies are linked into one interrelated system with no regulatory control.
c.American firms must compete for funds with firms all over the world.
3.Banking is no longer a domestic issue—it is an international issue.
4.The world economy has evolved, financed by international banks.
C.THE WORLD BANK AND THE INTERNATIONAL MONETARY FUND (IMF)
1.The World Bank and the IMF are twin intergovernmental pillars that support the structure of the world’s banking community.
2.The WORLD BANK is the bank primarily responsible for financing economic development; it is also known as the International Bank for Reconstruction and Development.
a.Today, most of the money is lent to developing nations to raise productivity and raise the standard of living.
b.Recently, the World Bank has received considerable criticism regarding human rights, AIDS, and the environment.
c.Some want the bank to forgive the debts of less developed countries or stop making loans until the country makes economic reforms.
3.The INTERNATIONAL MONETARY FUND (IMF) is an organization that assists the smooth flow of money among nations.
a.About 185 countries are voluntary members of the IMF.
b.It requires members to allow their own money to be exchanged for foreign currencies freely and keep the IMF informed about changes in monetary policy.
c.The IMF is not primarily a lending institution, rather an overseer of member countries monetary and exchange rate policies.
d.The IMF has allowed some countries like Brazil, South Korea, and Turkey to put up barriers to protect their currencies from inflation.
