Chapter 16 Banking and other Tidbits

1. Chapter 16 Banking and other Tidbits Other tidbits

2. BANKING, MONEY AND THE FED What is money? Why do we need it? How can we get it? Is there ever enough? Is there ever too much???? What backs the dollar?

3. Early Banking continued • GOLD STANDARD- 1900 Congress passed the Gold Standard Act- tied to the basic unit of currency and equal to it. Currency could be traded in for gold- people felt secure. • Advantage: confidence of people- prevented government from printing too much currency. • Disadvantage- economic growth is tied to the money supply – no flexibility for productive growth. • Most countries between 1871 and 1914 were on Gold Standard. U.S was last to get on.

4. Early Banking • 1933- U.S. government went off the gold standard • Britain went of two years earlier. • 1934 Gold Reserve Act passed- required citizens to turn in their gold and gold certificates- people were given Federal Reserve Notes in exchange- those who refused to turn in gold had their gold confiscated • 1971- President Nixon declared no gold backing whatever for dollar- placed the exchange equivalent with other currencies (dollar v pound v yen v mark) (now in 2008… dollar v pound v Euro) Gold window was closed! • And as we know, the dollar will fluctuate with currency market. .Referred to as Exchange rate.

5. What Gives Money Its Value? • Our money today has value because of its general acceptability.

6. Money vs. Barter • Money - Any good that is widely accepted for purposes of exchange and in the repayment of debt. • Barter - Exchanging goods and services for other goods and services without the use of money.

7. Barter is inefficient and expensive • Deteriorates after few trades • Requires a double co-incidence of wants. • Too costly to travel long distances(trading a cow for a fuzzy fleece from L.L. Bean in Maine.)

8. MONEY SUPPLY Key to money is…………do people have faith in it? If not, they rush out and spend it….. No savings! SO… what do we have today in our economy- high/low savings rate What has the federal government done lately to increase our spending? Money supply means- all the money available for spending at any one time. Fed used to use M1 as barometer. Today, they use M2.

9. History of Why American Banks were created

10. The warm(Revolutionary) left us in debt. Some states were bankrupt. We needed one unified currency ... Hamilton suggested a central bank. The First Bank's charter was drafted in 1791 by the Congress and signed by George Washington. In 1811, Congress voted to abandon

11. Progression to FED • 1812 War with Britain- no money to finance- almost lost- scraped enough at last moment to win – British distracted with Napoleonic Wars. • 1815 Second Bank of U.S. • 1836 – Andrew Jackson took it down- only wanted State Banks Free-for-all began….

12. EARLY PROBLEMS OF U.S. BANKING SYSTEM. • Before the Fed was established 1913- U.S. could not adjust supplies of money to business activity • Banks were often short of cash- if people deposited their money- wanted it on the spot, had legal right to withdraw it. • Banks often kept some $ in their reserve accts, and deposited money in other banks. • Sometimes demand for currency was >than the amount of money on hand. • Banks would draw on deposits from other banks and sell other assets such as government securities.

13. banking system problems • Pressure from depositors often caused a chain reaction of money shortage in a number of banks. • People panicked. If bank could not meet its demand for currency- it “failed” • Bank closings brought on periods of economic depression called “money panics” (people lost confidence in their bank and wanted their money out) • Panic of 1907- Congress decided the U.S. needed acentral banking system where money supply could expand and contract.- Federal Reserve System- 1913

14. Previous cyclical depressions prior to Federal Reserve being created 1819 – Several years of inflation engineered by the 2nd Bank of the U.S. 1836 – 2nd Bank of U.S. went down after Andrew Jackson did away with central banking. He felt central banking was inherently inflationary. 1857 – depression in northern states and not southern states.. Reflected by state chartered banks requiring state banks to buy state bonds by state govts. • 1893 – happened as a result of silver legislation- caused inflated currency- lasted 4 years. 1907 – Panic… set the stage for Federal Reserve System.

15. EARLY BANKING • Under what authority can the U.S. Treasury print dollars? (Article I, Section 8, clause 5) • In early days: most banks were state banks – issued their own currency backed by their own supply of either gold or silver • Bank of the U.S. – only national bank- acted much like the U.S. Treasury by collecting and paying debts owed to the federal government • No regulation of state banks-no limit on amount of currency they could print. • Early years- many banks went bankrupt.

16. So… what’s the bottom line? • Beginning government – attempt at national banking… that failed • States wanted to control banking and that failed. • Chaos evident with no confidence and market crashes/ depression- banks failed… attempt to re-build national stability • For a period of years, banking stability seemed assured. • Today,(2010) we have seen that banking took • a turn of strong instability.

17. Additional info on Banking….legalities Has Congress the power to incorporate a bank? (Yes, “necessary and proper clause” “to make all laws which shall be necessary and proper for carrying into execution” the expressed powers in the Constitution.” May a state tax a U.S. Bank? (No, the power to taxinvolves the power to destroy. Such a tax could be used to destroy an institution vitally necessary to carry out the operations of the federal government, and therefore is unconstitutional and void. McCulloch vs.Maryland (1819)

18. Banks Today! • Community Reinvestment Act (Carter Administration)- required banks to provide loans to low-income families. • Continued with no-income families. • Banks bundled the risky loans- sold paper- good investment for other banks, financials, global players entered here also. • Continued for about 10 years, with banks continuing the risky loans. • Hedge fund investors played their cards, and entered the scene. • Off to the races!

19. Bailout Begins!@ U.S. Government.gov Federal Reserve/Treasury Department have orchestrated the biggest bailout of banks, financials, Fannie and Freddie, AIG, etc. etc. The automobile industry is also in on the act. • Fed has pumped billions into system • Treasury has trillions extra and • 200 billion for Fannie and Freddie

20. Crisis of Banking Part 1 and 2 Part I K:\videos for class\HornK8 sent you a video The Crisis of Credit Visualized - Part 1.htm Part 2http://www.youtube.com/watch?v=iYhDkZjKBEw&feature=relmfu

21. M1= Currency coins, demand deposits, travelers checks M2=M1+Savings deposits, small time deposits (under $100,000), money market mutual funds. M3=M1+M2+large denomination time deposits (over $100,000) LM3 + liquid assets (T-bills, U.S.Savings bonds, commercial paper) Near Monies: Credit cards Stocks and Bonds IRA’s Keogh Accounts COMPONENTS OF MONEY

22. Four functions of money • Medium of exchange • Basis for quoting prices • Store of value (can accumulate wealth by saving) • Standard of deferred payment (buy now, pay later… no payments until 2020) Money will be good to pay in 2020 as is today.

23. Are Credit and Debit Cards Money?Yes! • Credit card use represents loans which must be repaid. They represent the use of someone else's money. • Debit cards give access to checkable deposits which are already part of the money supply.

24. Value of Money • How much money do you have: in your pocket in your checking account in your savings account • Money has value- too much in circulation, decreases its value……. inflation is BAD • What backs our currency? • Our money is called what? • What will a dollar buy today?

25. MONEY SUPPLY Key to money is…………do people have faith in it? If not, they rush out and spend it….. No savings! SO… what do we have today in our economy- high/low savings rate What has the federal government done lately to increase our spending? Money supply means- all the money available for spending at any one time. Fed used to use M1 as barometer. Today, they use M2.

26. Supply and Demand for Credit • Banks and other lending institutions lend money- expect to be paid for its use. • Amount they lend (subject to some legal restrictions) is determined by how much they have to lend and how much the borrower is willing to pay. • This charge or price for use of money = interest

27. Demand for Money • Represents the inverse relationship between the quantity demanded of money balances and the price of holding money balances. • Interest rate is the price (opportunity cost) of holding money balances.

28. Equilibrium in the Money Market • At an interest rate of i1, the money market is in equilibrium: There is neither an excess supply of money nor an excess demand for money

29. Interest rates fluctuate with changes in demand for money in relationship to changes in supply of money available. • Money becomes valuable just like other value created for other commodities (demand relative to supply) • So when the FED began lowering the FF Rate, and money was almost “free,” did this affect our financial crisis today????

30. HOW DID WE GET FRACTIONAL BANKING SYSTEM? • Goldsmiths: Knights brought back gold when making conquests…what to do with it? – measured it for purity of value • Gold treasure more than King could use • Receipt was given for deposits- based on purity value • People who had gold began to deposit with Goldsmiths- receipts given - receipts exchanged rather than gold and used for purchase. • Church entered and said it was fraudulent for Goldsmiths to do this.

31. Easier to exchange receipts than pick up actual gold and exchange for g/s • Goldsmiths began to make loans on deposits not claimed… kept a fraction on reserve…loaned out rest

32. Federal Reserve

33. FEDERAL RESERVE STRUCTURE One of 7 is Chairman Board of Governors 7 Members 12 District Banks Member Banks

34. FED Can Issue Federal Reserve Notes………………. Have you ever seen a Federal Reserve Note? Do any of you have any Federal Reserve Notes? A=Boston B= New York C= Philadelphia D= Cleveland E= Richmond, VA F= Atlanta G= Chicago H= St. Louis I= Minneapolis J= Kansas City K= Dallas L= San Francisco

35. 12 Regional Banks 1. A.Boston 2. B. NY 3.C. Philadelphia 4.D. Cleveland 5.E. Richmond,VA 6.F. Atlanta 7. G. Chicago 8.H. St. Louis 9. I. Minneapolis 10. J. Kansas City 11. K. Dallas* 12.L. San Francisco

36. 12 District Banks. Dallas is the 11th District… K http://www.dallasfed.org/ 25 Regional Banks. Dallas has region banks in El Paso, San Antonio, Houston.

37. Is the Fed effective???--------- What is the Discount Rate today 11/26/12 4/18/12 .75 8/8/11 .75 11/2/10 .75 4/22/10 .75 4/20/09 .50 11/17/08 1.25% 4/15/08 2.50 4/16/07 6.25% 6/29/06 6.00% 4/17/06 5.75% 11/21/05 5.00% Spring, 2005 3.75% Dec. 2004, 3.00%

38. What is the Federal Funds Rate –Today 11/26/12 4/18.12 .25 8/8/11 .25 11/2/10 .25 422/10 .25 4/20/09 .25 11/17/08 1.00% 4/15/08 2.25 % 4/16/07 5.25% 6/29/06 5.18% 4/17/06, 5.00% 11/21/05, 4.15% Was 2.875%(spring, 2005) (was 2% 12/2004) (2003, FFR was 1.0%)

39. Prime Rate? – Today –11/26/12 3.25 4/18/12 3.25 8/8/11 3.25 11/2/10 3.25 4/22/10 3.25% 4/20/09 3.25% 11/17/08 4.00% 5/15/08 5.25% 4/16/07 8.25% 6/29/06, 8.00% 4/17/06, 7.75%, 11/21, 7.00% (was 5.75% in spring 2005) (was 5.00 12/2004)? Where does fiscal policy enter in here? What would constitute a counter cyclical move by either the Federal government or the Federal Reserve?

40. 3 Monetary Tools for the FED • Reserve Requirement • Discount Rate • FOMC

41. One Tool to Control Money Supply Reserve Requirement • The Fed requires banking institutions, including S&Ls, Credit Unions, Loan Assns, to maintain reserves against the demand deposits of their customers. Required and excess are important concepts • Required Reserves are: vault cash and deposits held for them at the Fed. • This RR can alter the loans that members can make by: • Lowering RR = creating more money to loan • Raising the RR= decreasing money creation. RR’s do not change very often. Changes in RR can be disruptive of banking operations. RR change could force banks to sell securities quickly or call in loans to meet the Fed requirement. Current: 3% 0-$46.5 Mil 10% $46.5 +

42. How Fractional Banking WorksFed RR is 20%(bank required to hold a percentage of its deposits on RR Deposit made = $100,000 -20,000 (bank holds in reserve $ 80,000 (bank can loan this amount) This $80,000 is considered new money Whoever receives the $80,000 as a loan then deposits it into an account and can write checks immediately, but the bank views it as “never seen before.”

43. CONTINUED RR/FRACTIONAL BANKING EXAMPLE $80,000 -16,000 (20% reserve required) $64,000 (potential new loan which can be created and loaned out to another customer $64,000 new deposit in mind of bank - 12,800 (20 % must be kept in reserve) $51,200 considered new money available for loan

44. CONTINUED RR/FRACTIONAL EXAMPLE This cycle keeps going on and on- The money multiplier factor for 20% RR is 5 to 1 Using the above example- banks could create 5 times the $100,000 at 20% reserve required or in other words, it can create $500,00 “NEW MONEY” At 25% required as opposed to say 10%- higher requirement would lower the multiplier effect from 10 to 4 which in turn would not allow banks to have as much money to loan- or would be taking money out of circulation.

45. Summary/RR/Fractional Banking/Multiplier • The higher the required reserve- the lower the multiplier. • The potential deposit expansion multiplier is merely the reciprocal of the required reserve ratio (r ) In case of 20% example or l/5 of total deposits to be held- deposit expansion multiplier is 5 • If 10% was to be held- deposit expansion multiplier is 10.

46. DOES MULTIPLIER ALWAYS WORK? no • Creating New Money with the deposit expansion multiplier effect will not work if: • All excess reserves are tied up. (purchase securities, loans, etc.) • Ifperson receiving the loan decides to hold currency rather than deposit it into the bank • If banks decide not to extend loans even though they have excess reserves available (referred in the early 90’s as “credit crunch.” And… is happening today!

47. Banking Change 1993Sweet Accounts Banks are in business to make money!!!When they get greedy- they often fail as we have seen To get around the RR requirement- Banks got creative Transfer from savings to deposit accounts if accounts were negative Transfer out of deposit to savings if too much not “earning interest” Reducing the amount in deposit accounts can lower % required for RR.

48. SECOND TOOL TO CONTROL MONEY SUPPLY- DISCOUNT RATE • There are two types of interest: Simple and discount. • Simple- paid each time a payment is made on the loan. • Discount- entire amount of interest owed is deducted from loan before it is issued

49. Discount Rate Continued -Member banks “lent out” (have no money to loan and a good corporate customer wants a loan) - Or, perhaps they can’t cover their required reserve requirement. - Need to pay out customer request for deposited funds and poor management of prior loans left bank short of cash

50. DISCOUNT RATE CONTINUED • District Bank is not a charity bank… charges interest on money loaned to member banks. • If Member Bank borrows $100,000 at 10% • The interest is discounted up-front- Member has $90,000 to take back to loan. • Member bank is not going to loan at 10% • Adds 2 to 3 points to constitute prime rate. In this example is 13%