Economics Unit 6 – Money, Banking, and the Fed

Unit 6 – Money, Banking, and the Fed

Chapter 14.1 – The evolution, functions, and characteristics of money

• Federal Reserve System (Fed) – private owned, publicly controlled central bank of the united states
• Federal reserve note – paper currency issued by the Fed in use today

The evolution of money

• Barter economy – moneyless economy that relies on trade or barter
• Exchange of goods and services would be more difficult because the products some people have to offer are not always acceptable or easy to divide for payment.
• Commodity money – money that has an alternative use as an economic good, usually referring to actual goods (can be consumed)
• Fiat money – money by government decree, such as metallic coins
• A commonly accepted commodity money was tobacco
• Continental dollars, a form of fiat paper currency with no gold nor silver backing; along with the large volume, it virtually worthless by the end of revolution
• Specie – money in the form of gold or silver coins
• Coins were the most desirable form of money, because they were limited supply
• Monetary unit – standard unit of currency in a country’s money supply

Characteristics and functions of money

• Money must be portable, or easily transferred from one person to another, to make the exchange of money for products easier
• Money must be reasonably durable so it does not deteriorate when it is handled
• Money should be easily divisible into smaller units so that people can use only as much as they need for a transaction
• If something is to serve as money, it must available, but only in limited supply
• Moneys roles in the economy
  • Medium of exchange – money or other substance generally accepted as payment for goods and services
  • Measure of value – a function of money that allows it to serve as a common way to express value
  • Store of value – a function of money that allows people to preserve value for future use
• Money can be in forms of Federal Reserve notes, metallic coins issued by US Bureau, or
• Demand deposit account (DDA) – account from which funds can be removed by writing a check and without having to gain prior approval from the depository institution
• Definitions of money supply
  • M1 – component of the money supply relating to money’s role as a medium of exchange
  • M2 – component of the money supply relating to money’s role as a store of value

Chapter 11.1 – savings and the financial system

• Saving – absence of spending that frees resources for use in other activities or investments
• Savings – the dollars that become available for investors to use when others save

Saving and economic growth

• The saved money was borrowed by businesses to produce new goods and services, etc.
• Money can be saved through savings account, buy a bond, or …
• Certificate of deposit – document showing that an investor has made an interest bearing loan to a financial institution
• Financial assets – a stock or other document that represents a claim on the income and property of a borrower, such as a CD, bond, treasury bill, or mortgage
• Stocks, or ownership claims on a corporation, are another type of financial asset
• Financial system – network of savers, investors, and financial institutions working together to transfer savings for investment uses
• System consist of funds that a saver transfers to a borrower, financial assets that certify conditions of the loan, organizations that bring the surplus funds and financial assets together
• Financial intermediary – institution that channels savings to investors

Households, businesses                             financial intermediaries*                        governments, businesses

*examples: commercial banks, savings and loan associations, saving banks, mutual savings banks, credit unions, life insurance companies, mutual funds, pension funds, finance companies

• Government and businesses are the biggest borrowers

Chapter 14.2 – the development of modern banking

The development of banking in America

• Unregulated banking led to abuses, and problems with the money supply
• During the civil war, supply of money were left to private banks
• State bank – bank that receives its charter from the state in which it operates
• Problems with currency
  • Each bank issued its own currency
  • Banks were tempted to issue too many notes because they can print more money
  • Counterfeiting became a major problem
• 1861, congress authorized the printing of $60 million with no gold nor silver backing
• Legal tender – fiat currency that must be accepted for payment by decree of the government
• 1863, congress enacted the national currency act, creating the national banking system consist of national banks
• National bank – commercial bank chartered by the national banking system, they issued their own notes called…
• National currency – currency backed by government bonds and issued by commercial banks in the national banking system
• Gold certificate – paper currency backed by gold and issued between 1863 and 1934
• Silver certificate – paper currency backed by, and redeemable for, silver from 1878 to 1968

Chapter 14.1 – the evolution, functions, and characteristics of money

• Federal Reserve System (Fed) – privately owned, publicly controlled central bank of the united states
• Federal Reserve notes – paper currency issued by the Fed in use today

Chapter 14.2 – the creation of the Fed

• National banking system used to financial the civil war
• Checking accounts grew popular
• Minor recession had caused major problems for banks and other lending institutions
• Central bank – bank that can lend money to other banks in times of need
• All banks required to be a part of Fed, and shares stocks of the system
• Bank run – sudden rush by depositors to withdraw all deposited funds, generally in anticipation of bank failure or closure
• Bank holiday – brief period during which all banks or depository institutions are closed to prevent bank runs
• 1933, congress passed legislation to strengthen the banking industry
• Banking act of 1933, also created federal deposit insurance corporation (FDIC)
• Fractional reserve system – system requiring financial institutions to set aside a fraction of their deposits in the form of reserves
• Legal reserves – currency and deposits used to meet the reserve requirement
• Reserve requirement – formula used to compute the amount of a depository institution’s required reserves
• Member bank reserve (MBR) – reserves kept by member banks at the fed to satisfy reserve requirements
• Excess reserves – financial institution’s cash, currency, and reserves not needed for reserve requirements

Structure of the Fed

• Fed components had not changed since the Great Depression
• Member bank – bank belonging to the federal reserve system
• Fed directed by seven members board of governors

Advisory councils

Federal, consumer, thrift institution

Board of governors

Composition: 7 members appointed by the president to 14 years terms

Function: supervises and regulates the Fed

Federal open market committee (FOMC)

Composition: 7 members of the Board of governors, and 5 presidents of district banks

Function: decides monetary policy

Other Fed Responsibilities

• Maintaining the money supply and the payment system, regulating and supervising banks, preparing consumer legislation, and serving as the federal government’ bank
• Currency – paper component of the money, supply, today consisting of federal reserve notes
• Coins – metallic forms of money such as pennies, nickels, dimes, and quarters
• Payments system involves money supply, electronic transfer of funds, checks, online banking
• Fed is responsible for establishing specific guidelines, monitoring, inspecting, and examining various banking agencies
• Bank holding companies – company that owns and controls one or more banks
• Regulation Z – provision extending truth in lending disclosures to consumers
• Fed maintain accounts and provide financial service to federal government and its agencies

Chapter 14.1 – Modern Money

• Demand deposit account (DDA) – account from which funds can be removed by writing a check and without having to gain prior approval from the depository institution
• M1 – component of the money supply relating to money’s role as a medium of exchange
• M2 – component of the money supply relating to money’s role as a store of value
• Modern money is portable, durable, divisible, and limited availability and stable in value

Chapter 14.2 – fractional reserves and deposit expansion

• Fractional reserve system – system requiring financial institutions to set aside a fraction of their deposits in the form of reserves
• Legal reserves – currency and deposits used to meet the reserve requirement
• Reserve requirement – formula used to compute the amount of a depository institution’s required reserves
• Member bank reserve (MBR) – reserves kept by member banks at the Fed to satisfy reserve requirements
• Excess reserves – financial institution’s cash, currency, and reserves not needed for reserve requirements

Chapter 11.1 – Basic investment considerations

• Investors invest consistently over long periods of time
• Ignore any investment that seems too complicated, investment that seems too good to be true probably is
• Risk – situation in which the outcome is not certain, but the probabilities can be estimated
• Increase risk equal to increase return
• Objective for investing also contribute in the consideration

Chapter 11.2 – Financial assets and their markets

Bonds as financial assets

• Bond – contract to repay borrowed money and interest on the borrowed money at regular future intervals
• Increasingly bonds are taking on international flavor, with companies in one country issuing bond in another
• Coupon rate – stated interest on a corporate, municipal, or government bond
• Maturity – life of a bond or length of time funds are borrowed
• Par value – principal of a bond or total amount borrowed
• Bonds as a financial asset
• Current yield – bond’s annual coupon interest divided by purchase price; measure of a bond’s return

Financial assets and their characteristics

• Certificates of deposit (CDs) are one of the one of the most common forms of investments available
• Corporate bonds are an important source of corporate funds
• Junk bonds – bond that carries an exceptionally high risk of nonpayment and a low rating
• Municipal bonds – bond, often tax exempt, issued by state and local government
• Tax exempt – not subject to tax by federal or state governments
• Savings bond – low denomination, non-transferable bond issued by the federal government
• Paper bonds are available in denominations.
• Paperless bonds are purchased directly from the treasury
• Beneficiary – person designated to take ownership of an asset if the owner of the asset dies
• Treasury note – US government obligation with a maturity of 2 to 10 years
• Treasury bond – US government bond with a maturity of 10 to 30 years
• Treasury bills – short term united states government obligation with a maturity of one year or less in denominations of $1,000
• Individual retirement accounts (IRAs) – retirement account in the form of a long-term time deposit, with annual contributions not taxed until withdrawn during retirement

Markets for financial assets

• Capital market – market in which financial capital is loaned and/or borrowed for more than one year
• Money market – market in which financial capital is loaned and/or borrowed for one year or less
• Primary market – market in which only the original issuer can sell or repurchase a financial asset
• Secondary market – market in which financial assets can be sold to someone other than the original issuer

Stocks and efficient markets

• Equities – stocks that represent ownership shares in corporations
• Stockbroker – person who buys or sells securities for investors
• Value of the stock depends on the number of outstanding shares to be traded and a company’s profitability influence the price
• Efficient market hypothesis (EMH) – argument that stocks are always priced about right because they are closely watched
• Portfolio diversification – strategy of holding different investments to protect against risk
• Mutual fund – company that sells stock in itself and uses the proceeds to buy stocks and bonds issued by other companies
• Net asset value (NAV) – the market value of a mutual fund share found by dividing the net value of the fund by the number of shares issued
• 401k plan – tax deferred investment and savings plan that acts as a personal pension fund for employees
• This plan is popular because it provides a simple, consistent, and relatively safe way for employees to save

Stock markets and their performance

• Stock or securities exchange – physical place where buyers and sellers meet to exchange securities
• Oldest, largest, and most prestigious of the organized stock exchanges is the NY stock exchange
• Over the counter market – electronic marketplace for securities not listed on organized exchanges such as NYSE
• Most important OTC market is the national association of securities dealers automated quotation, world’s largest electronic stock market
• Dow jones industrial average (DJIA) – measure of stock market performance based on 30 representative stocks
• Standard & poor’s 500 – measure of stock market performance based on 500 stocks traded on the NYSE, AMEX, and OTC market
• Bull market – period during which stock market prices move up for several months or year in a row
• Bear market – period during which stock market prices move down for several months or years in a row