Chapter 14

Understanding Money and Banking

Chapter Overview

Money can be defined as any item that is portable, divisible, durable, and stable.  Money serves three functions:  a medium of exchange, a store of value, and a unit of account.  The nation’s money supply is often determined by two measures.  M-1 includes liquid, or spendable, forms of money such as currency and various types of demand deposits.  M-2 includes M-1 plus easily convertible forms of money such as time deposits, money market funds, and savings deposits.  Credit also plays a role in the money supply.

The U.S. financial system includes commercial banks, savings and loan associations, mutual savings banks, credit unions, and non-deposit institutions.  These financial establishments offer a variety of services, including pension, trust, and international services, financial advice and brokerage services, and a range of electronic funds transfer services (including ATMs).

Banks expand the money supply by taking in deposits and making loans.  The overall supply of money is governed by several federal agencies that are responsible for ensuring a sound, competitive financial system.

The Federal Reserve System (or the Fed) is the nation’s central bank.  The Fed serves as the key bank for both the government and for other banks.  In addition, the Fed sets U.S. monetary policy by controlling the nation’s money supply.  To control the money supply, the Fed specifies reserve requirements, it sets the discount rate at which it lends money to member banks, it conducts open-market operations to buy and sell securities, and it occasionally exerts influence through selective credit controls.

Several key changes have affected the financial system in recent years.  Deregulation and the rise of interstate banking have increased competition.  Furthermore, electronic technology has offered a variety of convenient financial innovations – debit cards, smart cards, and e-cash, etc. – that have dramatically changed banking for consumers and businesses alike.

Electronic technologies now permit speedy global financial transactions to support the growing importance of international finance.  An international payment process moves money among buyers and sellers in different nations.  The World Bank and the International Monetary Fund help to finance international trade and promote global fiscal stability.

 

Chapter Objectives

 

1. Define money and identify the different forms that it takes in the nation’s money supply.
2. Describe the different kinds of financial institutions that comprise the U.S. financial system and explain the services they offer.
3. Explain how banks create money and describe the means by which they are regulated.
4. Discuss the functions of the Federal Reserve System and describe the tools that it uses to control the money supply.
5. Identify three important ways in which the financial industry is changing.
6. Understand some of the key concepts and activities in international banking and finance.

REFERENCE OUTLINE

Opening Case:  Argentines No Longer Bank on the Peso

• What Is Money?
• The Characteristics of Money
• Portability
• Divisibility
• Durability
• Stability
• The Functions of Money
• Medium of Exchange
• Store of Value
• Unit of Account
• The Spendable Money Supply:  M-1
• M-1 Plus the Convertible Money Supply:  M-2
• Credit Cards:  Plastic Money?

 

• The U.S. Financial System
• Financial Institutions
• Commercial Banks
• Diversification and Mergers
• Commercial Interest Rates
• Savings and Loan Associations
• Mutual Savings Banks and Credit Unions
• Nondeposit Institutions
• Special Financial Services
• Pension and Trust Services
• International Services
• Financial Advice and Brokerage Services
• Automated Teller Machines
• Electronic Funds Transfer
• Banks as Creators of Money
• Regulation of Commercial Banking—Federal Deposit Insurance Corporation (FDIC)

• The Federal Reserve System
• The Structure of the Fed
• The Boards of Governors
• Reserve Banks
• Member Banks
• The Functions of the Fed
• The Government’s Bank
• The Bankers’ Bank
• Controlling the Money Supply

 

• The Tools of the Fed
• Reserve Requirements
• Discount Rate Controls
• Open-Market Operations
• Selective Credit Controls

• The Changing Money and Banking System
• Deregulation
• Interstate Banking
• E-Cash

 

• International Banking and Finance
• The International Payments Process
• International Bank Structure—The World Bank and the IMF

LECTURE OUTLINE

• What Is Money?  (Use PowerPoint 14.3.)

 

• The Characteristics of Money

• Portable

 

• Divisible

• Durable

 

• Stable

• The Functions of Money  (Use PowerPoint 14.4.)

 

Money serves three functions.

• Medium of Exchange.  We use money to buy and sell things.

• Store of Value.  Money can be saved and used for future purchases.

 

• Unit of Account.  All products can be valued in terms of money.

• The Spendable Money Supply:  M-1  (Use PowerPoint 14.5.)

 

The value of money decreases when its supply is high; when the money supply is low, its value increases.  A common measurement of the money supply is M-1, which counts only the most liquid forms of money, including cash, demand deposits, and other checkable deposits.

• M-1 + Convertible Money Supply:  M-2

 

M-2 includes M-1 and items that can be converted to spendable forms; M-2 accounts for almost all of the country’s money supply. 

• Credit Cards:  Plastic Money?  (Use PowerPoint 14.6.)

 

Convenient and reliable, credit cards have become important in the purchase of consumer goods.  Profits to credit card issuers come from annual fees to holders, interest on unpaid balances, and fees paid to issuers from merchants who accept credit cards.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

• The U.S. Financial System 

 

• Financial Institutions  (Use PowerPoint 14.7, 14.8.)

Financial institutions ease the flow of money from sectors with surpluses to those with deficits.

• Commercial Banks.  More than 10,000 commercial banks exist in the U.S.; all banks must be chartered.  Seventy percent of all commercial banks are state banks; most large banks are national banks, chartered by the federal government.
• Diversification and Mergers.  These result from numerous other investment options that attract investors.

 

• Commercial Interest Rates.  Banks can set their own interest rates; the lowest rate allowed is the prime rate.

• Savings and Loan Associations.  These institutions accept deposits and make loans primarily for home mortgages.

 

• Mutual Savings Banks and Credit Unions.  Depositors in these banks are considered owners of the bank with all profits divided among depositors; these banks attract most of their funds from savings deposits and loan them in the form of mortgages.  Credit unions accept deposits only from qualified members, usually working for a certain employer.

• Nondeposit Institutions.  This category includes other organizations that accept deposits, provide interest, and make loans.  They include pension funds, insurance companies, finance companies, and securities dealers.

 

• Special Financial Services  (Use PowerPoint 14.9.)

• Pension Services and Trust Services.  IRAs are pension funds that wage earners and their spouses can set up to supplement other retirement funds.  Banks receive funds and invest them as directed by customers and provide information on IRA investment alternatives.  Banks also provide assistance in establishing Keogh plans, which can be opened by self-employed people.  In addition, commercial banks offer trust services for a fee.

 

• International Services.  Banks offer services including currency exchange; letters of credit, which are promises by the bank to pay a firm a certain amount of money if certain conditions are met; and banker’s acceptances, which are promises that the bank will pay some specified amount at a future date.

• Financial Advice and Brokerage Services.  Serving as financial advisors, banks help customers manage their money by recommending different investment opportunities and serving as a securities intermediary.

 

• Automated Teller Machines.  With these machines customers can withdraw money, make deposits, transfer funds, and check on account status.

• Electronic Funds Transfer.  These systems transfer many types of financial information over wire, cable, or microwave.

 

• Banks as Creators of Money  (Use PowerPoint 14.10.)

Financial institutions create money by taking in deposits and making loans, which expands the money supply.

• Regulation of Commercial Banking

 

Banks create money; therefore, the government regulates them via the Federal Reserve System and the Federal Deposit Insurance Corporation to ensure a sound financial system.

• Federal Deposit Insurance Corporation (FDIC).  The FDIC insures deposits in member banks up to $100,000.

 

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

• The Federal Reserve System  (Use PowerPoint 14.11.)

 

• The Structure of the Fed

The Federal Reserve System is comprised of a Board of Governors, a group of Reserve Banks, and member banks.

• The Board of Governors.  This group is comprised of seven members appointed by the President for 14-year terms; the board plays a major role in controlling the money supply through reserve requirements, discounts rates, and open-market operations.

 

• Reserve Banks.  There are 12 banks in the Fed that hold deposits from and set the discount rate for commercial banks in their respective regions; reserve banks also largely contribute to the country’s check-clearing process.

• Member Banks.  National banks and some state banks are members of the Fed; depositor accounts in member banks are protected by FDIC.

 

• The Functions of the Fed  (Use PowerPoint 14.12.)

The Fed functions as the government’s bank and the banker’s bank and control the money supply.

• The Government’s Bank.  The Fed produces the nation’s currency and lends money to the government to finance the national deficit.

 

• The Banker’s Bank.  Individual banks borrow from the Fed and pay interest on the loans.  The Fed clears checks for commercial banks.  Check clearing involves the transfer of funds that occurs when one uses a check.

• Controlling the Money Supply.  Managing the money supply through commercial banks and interest rates allows the Fed to manage the nation’s economic growth.

 

• The Tools of the Fed

In controlling the money supply, the Fed uses four main tools:  reserve requirements, discount-rate controls, open-market operations, and selective credit controls.

• Reserve Requirements.  These are the percentage of deposits that banks must hold with a Federal Reserve Bank.  High reserve requirements reduce the money available to lend; low requirements allow the money supply to expand.

 

• Discount-Rate Controls.  The discount rate is the interest rate that the Fed charges on loans made to member banks.  An increased discount rate reduces the money supply; a low rate encourages borrowing and lending.

• Open-Market Operations.  This tool refers to the sale and purchase of securities in the open market.

 

• Selective Credit Controls.  The Fed designed rules for consumer stock purchases and credit rules for other purchases, such as down-payment percentages and repayment periods on loans.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

• The Changing Money and Banking System  (Use PowerPoint 14.13.)

 

• Deregulation

The Depository Institutions and Deregulation and Money Control Act (DIDMCA) of 1980 promoted competition by eliminating many restrictions on banks; the deregulation of interest rates was a crucial part of DIDMCA.

• Interstate Banking

 

The Interstate Banking Efficiency Act (1994) allows banks to enter into interstate banking; however, key provisions in the act limit the extent to which banks can engage in interstate banking.

• E-Cash  (Use PowerPoint 13.14.)

 

Investing in new technologies allows banks to improve their efficiency and customer service levels.  Debit cards allow the transfer of money between accounts and can be used to make retail purchases.  Smart cards are credit card-sized computers that can be programmed with “electronic money.”  Electronic money is money that moves along multiple channels of consumers and businesses via digital electronic transmissions.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

• International Banking and Finance

 

• The International Payments Process  (Use PowerPoint 14.15.)

International payments are simplified through the services provided by their local banks.  When money inflows and outflows as a result of international transactions remain equal for both countries, money does not have to flow between the two countries.  Within each bank, dollars spent by local importers affect dollars received by local exporters.

• International Bank Structure  (Use PowerPoint 14.16.)

 

Worldwide banking stability relies on a loose structure of agreements among individual countries.  The World Bank and the IMF.  Both of these United Nations agencies help to finance global trade.

Notes:  ______________________________________________________________________________________________________________________________________________________________________________________________________

Answers to Questions and Exercises

Questions for Review

1. What are the components of M-1?  Of M-2?

 

M-1 includes currency, demand deposits, and other checkable deposits.  M-2 includes M-1 plus time deposits, money market mutual funds, savings deposits, and overnight transactions.

2. Explain the roles of commercial banks, savings and loan associations, and non-deposit institutions in the U.S. financial system.

 

• Commercial banks:  Accept deposits and make loans to earn profits.
• Savings and loan associations:  Accept deposits and make loans primarily for home mortgages.
• Non-deposit institutions:  Collect money, provide interest or other benefits, and/or make loans.  This category includes pension funds, insurance companies, finance companies, and securities investment dealers.

3. Explain the types of pension services that commercial banks provide for their customers.

 

• Establishing savings plans such as IRAs
• Serving as financial intermediaries by receiving and investing funds as directed by customers, providing information about investment vehicles
• Offering trust services that can pay bills, manage investment portfolios, or manage the estates of the deceased.

4. Describe the structure of the Federal Reserve System.

 

The Federal Reserve System is comprised of a board of seven governors, 12 reserve banks, and member banks.  Its key functions are to control the money supply by establishing and managing monetary policies and to serve as both the government’s bank and as the bankers’ bank.

5. Show how the Fed uses the discount rate to manage inflation in the U.S. economy.

 

The Fed regulates the supply of money, decreasing the discount rate to keep the economy from slowing down too much and/or increasing it to stimulate the economy.

Questions for Analysis

6. Do you think credit cards should be counted in the money supply?  Why or why not?  Support your arguments by using the definition of money.

 

Answers may vary.  In terms of the characteristics of money, credit cards are portable, divisible, durable, and stable.  In terms of the functions of money, credit cards serve as a medium of exchange, a store of value, and a unit of account.  However, credit cards represent borrow funds, which students may believe prevents them from fitting the definition of money.

7. Should commercial banks be regulated, or should market forces be allowed to determine the money supply?  Why?

 

Answers will vary.  However, students should understand that the U.S. banking system has remained strong primarily because of strict controls that allow the government to adjust the money supply.

8. Identify a purchase made by you or a family member in which payment was made by check.  Draw a diagram to trace the steps in the clearing process followed by that check.

 

Answers will vary, but diagrams should identify the following steps:

• Payee deposits the check in its bank.
• The bank deposits the check in the payee’s regional district reserve bank.
• The payee’s regional district reserve bank sends the check to your regional district reserve bank.
• Your regional district reserve bank sends the check to your local bank for payment.
• Your local bank deducts the amount of the check from your account, and transfers the amount to its account at your regional district reserve bank.
• Your regional district reserve bank transfers the amount to the payee’s regional district reserve bank.
• The payee’s regional district reserve bank sends the amount to the payee’s local bank.
• The payee’s local bank credits the payee’s account.

Application Exercises

9. Start with a $1,000 deposit and assume a reserve requirement of 15%.  Now trace the money created by the banking system after five lending cycles.

 

Cycle 1:  $1,000 X .85   =      $850.00
Cycle 2:       850X.85     =        722.50
Cycle 3:       722.50X.85=       614.12
Cycle 4:       614.12X.85=       522.00
Cycle 5:        522X.85    =        443.70
$4,152.32  (+315%)

10. Interview the manager of a local commercial bank.  Identify several ways in which the Fed either helps the bank or restricts its operations.

 

Students’ answers will vary.

Answers to Building Your Business Skills

1. What are the most important factors in the Fed’s interest rate decision?

 

The Fed uses the discount rate to enhance or inhibit the economy to control inflation and resulting interest rates.  It also determines a reserve requirement that reduces or expands the money supply.  The Fed may also stipulate selective credit controls.

2. Consider the old joke about economies that goes like this:  When there are four economists in a room analyzing current economic conditions, there are at least eight different opinions.  Based on your research and analysis, why do you think economists have such varying opinions?

 

Answers will vary, but students should recognize that economics is part art and part science, and unforeseen events can disrupt the most careful analysis and predictions.

Answers to Exercising Your Ethics

1. From the standpoint of a commercial bank, can you find any economic justification for ATM access fees?

 

From an economic standpoint, the fees can be justified since the bank is offering a service to non-customers, and should be compensated for the cost of that service plus a fair profit margin.

2. Based on the scenario described for our bank, do you find any ethical issues in this situation?  Or do you find the main issues legal and economic rather than ethical?

 

Answers will vary, but potential ethical issues revolve around the bank’s responsibility to the communities in which it operates.  Questions might include:  Is it right to charge people exorbitant fees to access their own money?  What if no other ATMs were available in certain communities?

3. As an officer for this bank, how would you handle this situation?

 

Answers will vary.

Classroom Activities

1. Divide the class into appropriately-sized discussion groups.  Ask the groups to discuss among themselves the creation of a worldwide currency.  They should consider whether such an arrangement would be feasible and what factors might prevent it from becoming a reality.  In their discussions, also ask the groups to ponder whether a single world market could possibly one day emerge.  Finally, ask each group to share their input with the rest of the groups.

 

2. The Federal Reserve System is comprised of a Board of Governors, 12 district banks, and many member banks.  From time to time, controversy arises over whether the chair of the Board of Governors holds too much power in determining interest rates.  Ask students to discuss their opinions regarding this topic.  In terms of the structure of the Federal Reserve System, what other options can students present?