Money, Banking, and Financial Institutions 14 McGraw-Hill/IrwinCopyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Functions of Money Medium of exchange Used to buy/sell goods Unit of account Goods valued in dollars Store of value Hold some wealth in money form Money is liquid LO1

Liquidity Refers to ability to use an asset as a medium of exchange. The easier it is to convert to a medium of exchange, the more liquid. LO1

Money Definition M1 M1 Currency & coins Checkable deposits Only the most liquid assets are included. Coins are token money Excludes money held by government and banks. LO1

Money Definition M2 M2 = M1 + near-monies (easily converted to be used as medium of exchange). Savings deposits including money market deposit accounts (MMDA) Small-denominated time deposits Money market mutual funds (MMMF) LO1

Money Definitions LO1

What “Backs” the Money Supply Money as debt Stable value of money Acceptability Legal tender Relative scarcity LO2

What “Backs” the Money Supply Prices affect purchasing power of money – inverse relationship Hyperinflation renders money unacceptable Stabilizing money’s purchasing power Intelligent management of the money supply – monetary policy Appropriate fiscal policy LO2

Federal Reserve - Banking System Historical background Board of Governors Basic policy making body of U.S. banking system. 7 members appointed by president 14 year terms, staggered Chair/Vice Chair 4 year terms. LO3

Federal Reserve - Banking System 12 Federal Reserve Banks Serve as the central bank Quasi-public banks Public control, private ownership Banker’s bank LO3

Federal Reserve – Banking System Commercial Banks Thrift Institutions (Savings and Loan Associations, Mutual Savings Banks, Credit Unions) The Public (Households and Businesses) 12 Federal Reserve Banks Board of Governors Federal Open Market Committee LO3

Federal Reserve – Banking System The 12 Federal Reserve Banks Source: Federal Reserve Bulletin LO3

Federal Reserve – Banking System Federal Open Market Committee Conducts open market operations Includes Board of Governors and 5 presidents of Federal Reserve Banks LO3

Federal Reserve Functions Issue currency Set reserve requirements Lend money to banks Check collection Fiscal agent for U.S. government Supervise banks Control the money supply LO4

Federal Reserve Independence Established by Congress as independent agency Protects the Fed from political pressures Enables Fed to take actions to increase interest rates to stem inflation as needed LO4

The Financial Crisis of 2007 and 2008 Mortgage Default Crisis Many causes Government programs encouraged home ownership Declining real estate values Bad incentives provided by mortgage-backed bonds LO5

The Financial Crisis of 2007 and 2008 Securitization- the process of slicing up and bundling groups of loans into new securities As loans defaulted the system collapsed AIG sold collateralized default swaps to insure bad loans “Underwater” homeowners abandoned homes and mortgages LO5

The Financial Crisis of 2007 and 2008 Failures and Near-Failures of Financial Firms Countrywide-second largest lender Washington Mutual-largest lender Wachovia Other firms came close LO5

The Financial Crisis of 2007 and 2008 Troubled Asset Relief Program (TARP) Allocated $700 billion to make emergency loans Saved several institutions from failure Created moral hazard LO6

Post-crisis U.S. Financial Services Wall Street Reform and Consumer Protection Act Passed to help prevent many of the practices that led to the crisis Critics say it adds heavy regulatory costs LO7