Money, Banking, and Financial Institutions

1. 9 Money, Banking, and Financial Institutions

2. Functionsof 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 Liquid LO1

3. Money Definition M1 M1 Currency Checkable deposits Institutions offering checkable deposits Commercial banks Savings and loan associations Mutual savings banks Credit unions LO1

4. Money Definition M2 M2 M1 plus near-monies Savings deposits including money market deposit accounts (MMDA) Small-denominated time deposits Money market mutual funds (MMMF) LO1

5. Money Definitions Money supply, M2 $9001 billion Savings deposits, including money market deposit accounts 61% Currency 50% M1 22% Checkable deposits 50% Money market mutual funds 8% Small time deposits 9% Money supply, M1 $1935 billion Source: Federal Reserve System LO1

6. What “Backs” the Money Supply? Guaranteed by government’s ability to keep value stable Money as debt Why is money valuable? Acceptability Legal tender Relative scarcity LO2

7. What “Backs” the Money Supply? Prices affect purchasing power of money Hyperinflation renders money unacceptable Stabilizing money’s purchasing power Intelligent management of the money supply—monetary policy Appropriate fiscal policy LO2

8. Federal Reserve — Banking System Historical background Board of Governors 12 Federal Reserve Banks Serve as the central bank Quasi-public banks Banker’s bank LO3

9. Federal Reserve — Banking System Board of Governors Federal Open Market Committee 12 Federal Reserve Banks Commercial banks Thrift institutions (savings and loan associations, mutual savings banks, credit unions) The public (households and businesses) LO3

10. Federal Reserve — Banking System The 12 Federal Reserve Banks LO3

11. Federal Reserve — Banking System Federal Open Market Committee Aids Board of Governors in setting monetary policy Conducts open market operations Commercial banks and thrifts 6,800 commercial banks 8,700 thrifts LO3

12. Federal Reserve Functions Issue currency Set reserve requirements Lend money to banks Collect checks Act as a fiscal agent for U.S. government Supervise banks Control the money supply LO4

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

14. Global Snapshot World’s 12 Largest Financial Institutions, 2011 Source: Forbes Global 2000, www.forbes.com LO4

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

16. 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 “Underwater” homeowners abandoned homes and mortgages LO5

17. 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

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

19. Postcrisis U.S. Financial Services Major categories of financial institutions Commercial banks Thrifts Insurance companies Mutual Fund companies Pension funds Securities firms Investment banks LO7

20. Major Categories of Financial Institutions LO7

21. Postcrisis 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

22. Fractional Reserve System The goldsmiths Stored gold and gave a receipt Receipts used as money by public Made loans by issuing receipts Characteristics: Banks create money through lending Banks are subject to “panics” LO8

23. Fractional Reserve System Balance sheet Assets = Liabilities + Net worth Both sides balance Necessary transactions Create a bank Accept deposits Lend excess reserves LO8

24. A Single Commercial Bank Transaction #1 Vault cash: cash held by the bank Assets Liabilities and Net Worth Creating a Bank Balance Sheet 1: Wahoo Bank Cash $250,000 Stock shares $250,000 LO8

25. A Single Commercial Bank Transaction #2 Acquiring property and equipment Assets Liabilities and Net Worth Acquiring Property and Equipment Balance Sheet 2: Wahoo Bank Cash $ 10,000 Stock shares $250,000 Property 240,000 LO8

26. A Single Commercial Bank Transaction #3 Commercial bank functions Accepting deposits Making loans Assets Liabilities and Net Worth Accepting Deposits Balance Sheet 3: Wahoo Bank Checkable deposits Cash $110,000 $100,000 Property 240,000 Stock shares 250,000 LO8

27. A Single Commercial Bank Transaction #4 Depositing reserves in a Federal Reserve Bank Required reserves Reserve ratio Commercial bank’s required reserves Reserve ratio = Commercial bank’s checkable-deposit liabilities LO8

28. A Single Commercial Bank Assets Liabilities and Net Worth Transaction #4 Assume the bank deposits all cash on reserve at the Fed Depositing Reserves at the Fed Balance Sheet 4: Wahoo Bank Cash $ 0 Checkable Deposits Reserves 110,000 $100,000 Property 240,000 Stock Shares 250,000 LO8

29. A Single Commercial Bank Excess reserves Actual reserves - Required reserves Required reserves Checkable deposits × Reserve ratio Example: Checkable deposits: $100,000 Reserve ratio: 20 percent LO8

30. A Single Commercial Bank Transaction #5 Clearing a check $50,000 check reduces reserves and checkable deposits Assets Liabilities and Net Worth Clearing a Check Balance Sheet 5: Wahoo Bank Checkable deposits Reserves $ 60,000 $ 50,000 Property 240,000 Stock shares 250,000 LO8

31. Money-Creating Transactions Transaction #6a Granting a loan $50,000 loan deposited to checking Assets Liabilities and Net Worth When a Loan Is Negotiated Balance Sheet 6a: Wahoo Bank Reserves $ 60,000 Checkable deposits $100,000 Loans 50,000 Property 240,000 Stock shares 250,000 LO8

32. Money-Creating Transactions Transaction #6b Using the loan $50,000 loan cashed Assets Liabilities and Net Worth After a Check Is Drawn on the Loan Balance Sheet 6b: Wahoo Bank $ 10,000 Reserves Checkable deposits $ 50,000 Loans 50,000 Property 240,000 Stock shares 250,000 A single bank can only lend an amount equal to its preloan excess reserves LO8

33. The Banking System Multiple-deposit expansion Assumptions: 20 percent required reserves All banks “loaned up” Banks lend all of their excess reserves A $100 bill is found and deposited Multiple deposits can be created LO8

34. The Banking System The Banking System’s Lending Potential Assets Liabilities and Net Worth Multiple-Deposit Expansion Process Balance Sheet: Commercial Bank A Reserves $+100 (a1) Checkable deposits $+100 (a1) -80 (a3) Loans +80 (a2) +80 (a2) -80 (a3) LO8

35. The Banking System The Banking System’s Lending Potential Assets Liabilities and Net Worth Multiple-Deposit Expansion Process Balance Sheet: Commercial Bank B Reserves $+80 (b1) Checkable Deposits $ +80 (b1) -64 (b3) +64 (b2) Loans +64 (b2) -64 (b3) LO8

36. The Banking System (2) Required Reserves (Reserve Ratio = .2) (3) Excess Reserves (1)-(2) (4) Amount Bank Can Lend; New Money Created = (3) (1) Acquired Reserves and Deposits Bank Bank A Bank B Bank C Bank D Bank E Bank F Bank G Bank H Bank I Bank J Bank K Bank L Bank M Bank N Other Banks $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $100.00 80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 21.99 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00 LO8

37. The Monetary Multiplier 1 Monetary multiplier = Required reserve ratio 1 = R LO8

38. The Monetary Multiplier Maximum amount of new money created by a single dollar of excess reserves Higher R, lower m Reversibility Making loans creates money Loan repayment destroys money LO8

39. Bank Panics of 1930–1933 Before deposit insurance Bank failure led to mass withdrawals Forced loan reduction 25-33 percent decline in money supply 1933 national bank holiday to evaluate all banks Contributed to the Great Depression Regulation protects the system today LO8