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 Supply Refers to the money actually in circulation LO1

Money Definition M1 M1 Currency in the hands of the public Checkable deposits Currency = Coins + Paper Money Currency is token money LO1

Money Definition M1 Institutions offering checkable deposits Commercial banks Savings and loan associations Mutual savings banks Credit unions LO1 LO2

Money Definition M1 - Exclusions 1. Currency held by U.S.Treasury, the Federal Reserve banks, commercial banks, and thrift institutions 2. Checkable deposits of the government (U.S. Treasury) or the Federal Reserve that are held by commercial banks or thrift institutions LO2

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 Definition Currency Demand Deposits = Total M1 + Time Deposits & Money Market Accts. Total M2 + =

Money Definitions LO1

What “Backs” the Money Supply? Guaranteed by government’s ability to keep value stable Money as debt Why is money valuable? Acceptability Designated as Legal tender Relative scarcity (supply and demand) LO2 LO3

What “Backs” the Money Supply Prices affect purchasing power of money – inverse relationship Purchasing power: amount of goods and services a unit of money will buy Hyperinflation renders money unacceptable Stabilizing money’s purchasing power Intelligent management of the money supply – monetary policy Appropriate fiscal policy LO2

The Federal Reserve The Central Bank of the United States The Banker’s Bank – – Holds the deposits of commercial banks and makes loans to banks that need additional funds

Buys/Sells Foreign Currency Regulates Credit Supervises Banks

Processes Checks Collects Data on Money Supply/Economic Activities Regulates Money Supply

Federal Reserve - Banking System Historical Background 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 Board of Governors – central authority 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 Serves as the central bank Quasi-public banks Public control, private ownership Banker’s bank LO3

Federal Reserve – Banking System Source: Federal Reserve Bulletin

Federal Reserve – Banking System Federal Open Market Committee Aids Board of Governors in setting monetary policy Conducts open market operations Includes Board of Governors and 5 presidents of Federal Reserve Banks LO3 LO4

Federal Reserve – Banking System Commercial banks and thrifts 6,000 commercial banks 8,500 thrifts Monetary control by Fed Subject to regulation by other agencies, e.g., FDIC, NCUA LO3 LO4

Federal Reserve Functions Issues currency Sets discount rate Sets reserve requirements Lends money to banks Check collection Fiscal agent for U.S. government Supervises banks Controls 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 LO5

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 loans “Underwater” homeowners abandoned homes and mortgages LO5

The Financial Crisis of 2007 and LO5

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

Post-crisis U.S. Financial Services Industry consolidation More than 200 banks shut down by FDIC Assets transferred Major investment banks opted to become commercial banks LO7

The Financial Crisis of 2007 and 2008 Troubled Asset Relief Program-2008 (TARP) Allocated $700 billion to U.S. Treasury 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 – 2010 Passed to help prevent many of the practices that led to the crisis Critics say it adds heavy regulatory costs LO7

InstitutionDescriptionExamples Commercial Banks State and national banks that provide checking and savings accounts and make loans JP Morgan Chase, Bank of America, Citibank, Wells Fargo Thrifts Savings and loan associations, mutual savings banks, credit unions that offer checking and savings accounts and make loans Charter One, New York Community Bank Insurance Companies Firms that offer policies through which individuals pay premiums to insure against lose Prudential, New York Life, Northwestern Mutual, Hartford Mutual Fund Companies Firms that pool customer deposits to purchase stocks or bonds Fidelity, Vanguard, Putnam, Janus, T Rowe Price Pension Funds Institutions that collect savings from workers throughout their working years and then invest the funds to pay retirement benefits TIAA-CREF, Teamsters’ Union, CalPERs Securities Firms Firms that offer security advice and buy and sell stocks and bonds for clients Merrill Lynch, Smith Barney, Charles Schwab Investment Banks Firms that help corporations and governments raise money by selling stocks and bonds Goldman Sachs, Morgan Stanley, Deutsche Bank, Nomura Securities Major Categories of Financial Institutions LO7 LO8