CHAPTER 21

I. THE IMPORTANCE OF MONEY.

LEARNING GOAL 1. Explain what money is and the importance of the money supply to domestic and international exchange.

A. THE AMERICAN ECONOMY DEPENDS UPON MONEY: its availability, its value relative to other currencies, and its cost.

1. Money is so important that MANY INSTITUTIONS HAVE EVOLVED TO MANAGE MONEY and to make it available to you when you need it.

2. The banking system is so complex because the flow of money FROM COUNTRY TO COUNTRY is as free as the flow FROM STATE TO STATE.

3. What happens to any major country's economy has an effect on the U.S. economy and vice versa.

B. WHAT IS MONEY?

1. MONEY is anything that people generally accept as payment for goods and services.

2. BARTER is the trading of goods and services for other goods and services directly.

a. Many people today still barter goods and services, but transactions are difficult.

b. People need some object that's more portable, divisible, durable, and stable so that they can trade without having to carry the actual goods.

c. Coins meet all the standards for a more useful money.

3. The STANDARDS FOR USEFUL MONEY:

a. PORTABILITY. Coins were easier to take to market than goods.

b. DIVISIBILITY. Different-sized coins could be made to represent different values.

c. STABILITY. Everybody agreed on the value of coins so the value of money became relatively stable.

d. DURABILITY. Coins last for years.

e. DIFFICULT TO COUNTERFEIT. The government has had to go to extra lengths to make real dollars readily identifiable.

4. Coins and paper money thus became UNITS OF VALUE and a means of making exchanges easier.

a. Most countries have their own coins and paper that they use as money.

b. However, they are not always equally stable-the text uses the example of Russian money.

C. WHAT IS THE MONEY SUPPLY?

1. The value of money depends on the MONEY SUPPLY, how much money there is to buy available goods and services.

2. There are several DEFINITIONS OF MONEY SUPPLY (M-1, M-2, and so on)

a. M-1 includes CURRENCY (coins and paper bills), money that's available by writing checks, and money held in traveler's checks; that is MONEY THAT IS QUICKLY AND EASILY RAISED.

b. M-2 includes everything in M-1 PLUS MONEY IN SAVINGS ACCOUNTS (time deposits), and money in money market accounts, mutual funds, certificates of deposit, and the like; that is MONEY THAT MAY TAKE A LITTLE MORE TIME TO OBTAIN THAN CURRENCY.

c. M-2 is the most commonly used definition of money.

D. WHY DOES THE MONEY SUPPLY NEED TO BE CONTROLLED?

1. The money supply needs to be controlled because the prices of goods and services can be somewhat managed by controlling the amount of money available in the economy.

2. If TOO MUCH MONEY is available, prices go up-INFLATION.

3. If TOO LITTLE MONEY is available, prices would go down resulting in RECESSION.

4. The money supply tools have an effect on employment and economic growth and decline.

E. THE GLOBAL EXCHANGE OF MONEY.

1. FALLING DOLLAR means that the amount of goods and services you can buy with a dollar goes down.

2. RISING DOLLAR means that the amount of goods and services you can buy with a dollar goes up.

3. What makes the dollar weak or strong is the position of the U.S. economy relative to other economies.

a. When the economy is strong, people want to buy dollars and the value relative to other economies rises.

b. When a country's economy is perceived as weakening, people no longer desire its currency and the currency's value falls.

II. CONTROL OF THE MONEY SUPPLY.

LEARNING GOAL 2. Describe how the Federal Reserve controls the money supply.

A. It is important to have an organization that controls the money supply to try to keep the U.S. economy from growing too fast or too slowly.

1. The FEDERAL RESERVE SYSTEM (THE FED) is the organization in charge of monetary policy.

2. The head of the Federal Reserve Alan Greenspan, is one of the most influential people in the world.

B. BASICS ABOUT THE FEDERAL RESERVE.

1. The Federal Reserve System consists of five major parts:

a. The BOARD OF GOVERNORS administers and supervises the 12 Federal Reserve System banks.

(i) There are seven members who are appointed by the President.

(ii) The primary function is to set monetary policy.

b. The FEDERAL OPEN MARKET COMMITTEE has 12 voting members and is the policy-making body.

c. The 12 FEDERAL RESERVE BANKS.

d. THREE ADVISORY COUNCILS.

(i) The advisory councils offer suggestions to the board and the FOMC.

(ii) The councils represent the various banking districts, consumers, and member institutions.

e. The MEMBER BANKS of the system.

2. The Federal Reserve:

a. Buys and sells foreign currencies.

b. Regulates various types of credit.

c. Supervises banks.

d. Collects data on the money supply and other economic activities.

3. The tools used to regulate the money supply include: reserve requirements, open-market operations, and the discount rate.

C. THE RESERVE REQUIREMENT.

1. The RESERVE REQUIREMENT is a percentage of commercial bank's checking and savings accounts that must be physically kept in this bank (for example, as cash in the vault) or a non-interest-bearing deposit at the local Federal Reserve district bank.

2. Changing the reserve requirement is the Fed's most powerful tool.

3. When the Fed INCREASES THE RESERVE REQUIREMENT, banks have LESS MONEY FOR LOANS and make fewer loans, which tends to reduce inflation.

4. When the Fed DECREASES THE RESERVE REQUIREMENT, banks have MORE MONEY AVAILABLE FOR LOANS and make more loans, which tends to stimulate the economy RISKING INFLATION.

5. Because this tool is so potent, and can cause such major changes in the U.S. economy, it is rarely used.

D. OPEN-MARKET OPERATIONS.

1. OPEN-MARKET OPERATIONS (the most commonly used tool) involves the buying and selling of U.S. government securities by the Fed with the goal of regulating the money supply.

2. When the fed wants to DECREASE THE MONEY SUPPLY, it SELLS GOVERNMENT SECURITIES.

3. When the fed wants to INCREASE THE MONEY SUPPLY, it BUYS GOVERNMENT SECURITIES from individuals, corporations, or organizations willing to sell.

E. THE DISCOUNT RATE.

1. The Fed is called the BANKER'S BANK.

2. Member banks can borrow money from the Fed and then pass it on to their customers.

3. The DISCOUNT RATE is the interest rate that Fed charges for loans to member banks.

4. INCREASING THE DISCOUNT RATE discourages banks from borrowing and consequently reduces the number of available loans, resulting in a DECREASE IN THE MONEY SUPPLY.

5. DECREASING THE DISCOUNT RATE encourages banks borrowing and increases the amount of funds available for loans, resulting in an INCREASE IN THE MONEY SUPPLY.

F. The whole banking industry is affected by actions taken by the Federal Reserve System.

III. THE DEVELOPMENT OF THE FEDERAL RESERVE SYSTEM.

LEARNING GOAL 3. Trace the history of banking and the Federal Reserve System.

A. EARLY BANKING HISTORY.

1. There were NO BANKS IN EARLY COLONIAL AMERICA.

a. Strict laws limited the number of coins that could be brought to the colonies.

b. Colonists were forced to barter.

2. MASSACHUSETTS issued its OWN PAPER MONEY in 1690 and soon other colonies did as well.

a. LAND BANKS made loans to farmers.

b. England stopped these practices by 1741.

3. ALEXANDER HAMILTON convinced Congress to form a CENTRAL BANK in 1781.

a. The bank had so much OPPOSITION that it CLOSED in 1811.

b. An attempt to replace the bank in 1816 failed again by 1836.

4. By the time of the CIVIL WAR, BANKING WAS A MESS.

a. Different banks issued different currency.

b. Often the coins were worth more as gold or silver than as coins.

5. The chaos reached a climax in 1907 when many BANKS FAILED.

6. People withdrew their funds from the bank until there was no cash left and money could no longer be given to depositors.

7. To avoid another cash shortage, the FEDERAL RESERVE SYSTEM was formed.

a. All Federally chartered banks must join; state chartered banks may join.

b. The Federal Reserve became the BANKERS' BANK.

B. THE GREAT DEPRESSION.

1. The STOCK MARKET CRASH OF 1929 led to bank failures in the early 1930s.

2. In 1933 and 1935, the federal government passed LAWS to strengthen the banking system.

3. One move established FEDERAL DEPOSIT INSURANCE (discussed later in the chapter).

C. THE FEDERAL RESERVE AND THE BANKING INDUSTRY.

1. During the 1990s, there has been much debate about the Fed's actions.

a. In the early 1990s the Fed pumped up the money supply and lowered interest rates to get the economy moving.

b. The Fed increased short-term interest rates in 1994, threatening the stock market.

c. Some applauded hiking the interest rates saying it would cut inflation and let the economy grow slowly.

d. Others said there was no threat of inflation and higher interest rates would slow the economy to the point of recession.

2. Businesses are concerned because higher bank rates mean a higher cost of borrowing.

3. STAGFLATION, the combination of slow growth and inflation, is possible.

IV. THE AMERICAN BANKING SYSTEM.

LEARNING GOAL 4. Classify the various institutions in the U.S. banking system.

A. The AMERICAN BANKING SYSTEM consists of commercial banks, savings and loan associations, credit unions, mutual savings banks, and NONBANKS (nondeposit institutions that perform several banking functions.)

B. COMMERCIAL BANKS.

1. A COMMERCIAL BANK is a profit-making organization that receives deposits from individuals and corporations in the form of checking and savings accounts and uses some of these funds to make loans.

2. Commercial banks have two types of customers: DEPOSITORS and BORROWERS.

3. Commercial banks make a profit if the revenue generated by loans exceeds the interest paid to depositors.

C. SERVICES PROVIDED BY COMMERCIAL BANKS.

1. A DEMAND DEPOSIT is the technical name for a checking account; the money can be withdrawn on demand at any time by the owner.

2. In the past, checking accounts paid no interest, but interest-bearing checking accounts (NOW and SUPER NOW accounts) have grown in recent years.

3. A NOW (NEGOTIABLE ORDER OF WITHDRAWAL) ACCOUNT pays an annual interest rate, but imposes a minimum balance.

4. A SUPER NOW account pays higher interest and requires a large minimum balance.

5. A TIME DEPOSIT is the technical name for a SAVINGS ACCOUNT for which the bank requires prior notice before withdrawal.

a. A CERTIFICATE OF DEPOSIT is a note issued by a bank that earns a guaranteed interest rate for a fixed period of time.

b. The CD cannot be withdrawn without penalty until the maturity date.

6. Some other services include CREDIT CARDS and ATMs.

a. AUTOMATED TELLER MACHINES (ATMs) give customers the convenience of 24-hour banking.

b. Commercial banks may also offer credit cards, brokerage services, financial counseling, automatic payment of bills, safe deposit boxes, tax-deferred IRAs, travelers' checks, and overdraft privileges.

7. SERVICES TO BORROWERS.

a. Banks screen loan applicants carefully to ensure that the loan plus interest will be paid back on time.

b. Small businesses and minority businesses often search out banks that cater to their needs.

8. BUSINESS LOANS.

a. SHORT-TERM LOANS are those that have to be paid in one year or less.

b. Businesses can establish a line of credit before they actually need money.

c. LONG-TERM LOANS are those payable in a period that exceeds one year.

d. The interest charged for most long-term loans to large corporations is negotiated.

e. Most loans require COLLATERAL, some object of value.

D. SAVINGS AND LOAN ASSOCIATIONS.

1. SAVINGS AND LOAN ASSOCIATIONS are financial institutions that accept both savings and checking deposits and provide home mortgage loans.

a. Samp;Ls are often known as thrift institutions since their original purpose was to promote consumer thrift and home ownership.

b. Thrifts were permitted to offer slightly higher interest rates to attract funds.

c. These funds were then used to offer long-term fixed rate mortgages.

2. In the early 1980s Samp;Ls ran into trouble.

a. To help relieve the pressure, the federal government permitted Samp;LS to offer NOW and SUPER NOW ACCOUNTS, to allocate up to 10% of their funds to COMMERCIAL LOANS, and to offer mortgage loans with ADJUSTABLE INTEREST RATES.

b. Samp;Ls became similar to commercial banks.

3. Congress decided to guarantee Samp;L savings up to $100,000 per account.

a. Banks and Samp;Ls made risky loans in the 1980s, with the thought that such loans were guaranteed by the government.

b. Banks and Samp;Ls made many loans that failed, costing the government about $500 billion.

c. Many Samp;L directors were sentenced to prison for defrauding investors and mismanaging funds.

E. CREDIT UNIONS.

1. CREDIT UNIONS are nonprofit, member- owned financial cooperatives that offer basic banking service.

2. Credit unions offer members interest-bearing checking accounts at relatively high rates, short-term loans at relatively low rates, financial counseling, life insurance, and home mortgage loans.

3. As not-for-profit institutions, credit unions enjoy an exemption from federal income taxes.

F. OTHER FINANCIAL INSTITUTIONS.

1. NONBANKS are financial organizations that accept no deposits, but offer many of the services provided by other banks.

a. NONBANKS INCLUDE life insurance companies, pension funds, brokerage firms, and commercial finance companies.

b. The diversity of financial services offered by nonbanks has caused banks to expand their services.

2. LIFE INSURANCE COMPANIES provide financial protection for policyholders who periodically pay premiums.

3. PENSION FUNDS are amounts of money designated by corporations, nonprofit organizations, or unions to cover part of the financial needs of members when they retire.

a. Pension funds typically invest in low-return but safe corporate stocks or government securities.

b. Many large pension funds are becoming a force in U.S. financial markets.

4. BROKERAGE FIRMS are organizations that buy and sell securities for their clients and provide other financial services.

5. COMMERCIAL AND CONSUMER FINANCE COMPANIES are institutions that offer short-term loans to individuals at higher interest rates than commercial banks.

a. The primary customers are new businesses and individuals with no credit history.

b. One should be careful when borrowing from such institutions because the interest rates can be quite high.

6. CORPORATE FINANCIAL SYSTEMS are financial services offered to customers of major corporations such as GE, Sears, and GM.

V. HOW THE GOVERNMENT PROTECTS YOUR FUNDS.

LEARNING GOAL 5. Explain the importance of the Federal Deposit Insurance Corporation and other organizations that guarantee funds.

A. As a result of the depression of the 1930s, several organizations evolved to protect your money.

1. The three major sources of financial protection are the FDIC, the SAIF, and the NCUA.

2. All three insure deposits in individual accounts up to $100,000.

B. THE FEDERAL DEPOSIT INSURANCE CORPORATION (FDIC) is an independent government agency that insures accounts in banks against bank failures (up to a limit of $100,000 per account).

1. If a bank were to fail, the FDIC would arrange to have its accounts transferred to another bank.

2. The idea is to maintain confidence in banks so that others don't fail if one falls.

C. THE SAVINGS ASSOCIATION INSURANCE FUND (SAIF) (Formerly Federal Savings and Loan Insurance Corporation)

1. SAIF insures holders of accounts in savings and loan associations.

2. For 50 years the FSLIC was successful in covering losses from Samp;Ls.

3. In the 1980s, as more Samp;Ls failed, the FSLIC became INSOLVENT as well.

4. In 1989 the government created the Resolution Trust Corporation to sell the Samp;L's assets.

D. NATIONAL CREDIT UNION ADMINISTRATION (NCUA).

1. The NCUA provides up to $100,000 cover age per depositor.

2. Additional protection can be obtained by holding accounts jointly or in trust.

VI. THE FUTURE OF BANKING.

LEARNING GOAL 6. Weigh the future of the U.S. banking system.

A. The U.S. economy appears to be in the best shape in years.

1. However, federal debt and personal debt keep rising.

a. Over a million people are declaring bankruptcy each year.

b. The banking system may not be as strong as it appears.

2. Banks as we've traditionally known them will change.

B. INTERSTATE BANKING.

1. Businesses, including banks, are reorganizing to become more efficient and effective through a series of mergers and acquisitions.

2. However, there is a counter trend toward the opening of community banks that are more user-friendly and convenient.

C. EXPANDING WHAT BANKS DO.

1. State banks are taking the lead in giving banks freedom to go into other businesses.

2. Today banks are taking on new roles in insurance, securities (stocks and bonds), and real estate.

D. ELECTRONIC BANKING TAKES ON TRADI TIONAL BANKING.

1. The whole banking system is on the brink of a major revolution.

a. The way things were done was expensive.

b. One step in the past was to issue credit cards.

c. The next step was to create the electronic exchange of money.

2. ELECTRONIC FUNDS TRANSFER SYSTEM (EFTS) is a computerized system that electronically performs financial transactions such as making purchases, paying bills, and receiving paychecks.

3. EFTS frees banks from processing checks and managing credit card fraud and bad checks.

4. Some workers receive no paycheck-their employers transfer funds from the employer's account to the worker's account.

5. Smart cards are an advanced version of the cards used in EFTS, more prevalent overseas than in America.

E. ELECTRONIC BANKING ON THE INTERNET.

1. Soon all of the top 200 banks in America will have some kind of online banking.

2. The latest in technology makes it safer than giving your credit card to a retailer.

VII. INTERNATIONAL BANKING AND BANK ING SERVICES.

LEARNING GOAL 7. Evaluate the role and importance of international banking and the role of the World Bank and the International Monetary Fund.

A. Banks help businesses conduct business in other countries by providing three services.

1. A LETTER OF CREDIT is a promise by the bank to pay the seller a given amount if certain conditions are met.

2. A BANKER' ACCEPTANCE promises that the bank will pay some specified amount at a particular time.

3. CURRENCY EXCHANGE is the exchange of one country's currency for another country's currency.

B. LEADERS IN INTERNATIONAL BANKING.

1. In the future, many crucial financial issues will be international in scope.

2. Today's money markets are GLOBAL MARKETS.

a. American firms must compete for funds with firms all over the world.

b. The success of American business is tied to the success of businesses throughout the world.

3. Banking is no longer a domestic issue.

4. What has evolved is a world economy financed by international banks.

C. THE WORLD BANK AND THE INTERNATIONAL MONETARY FUND (IMF).

1. The World Bank and the IMF are twin pillars that support the structure of the world's banking community.

2. The WORLD BANK is responsible for financing economic developing.

a. It is also known as the International Bank for Reconstruction and Development.

b. Today, most of the money is lent to poor nations to raise productivity and raise the standard of living.

3. The INTERNATIONAL MONETARY FUND (IMF) was established to assist the smooth flow of money among nations.

a. It requires members to allow their currency to be exchanged for foreign currencies freely and keep the IMF in formed about changes in monetary policy.

b. The IMF is not primarily a lending institution, rather an overseer of member countries monetary and exchange rate policies.

4. The IMF's goal is to maintain a global monetary system that works best for all nations.

D. BANKS THROUGHOUT THE WORLD ARE FINANCIALLY WEAK.

1. In the 1990 Asian countries experienced currency problems.

a. The IMF bailed them out, but they were not forced to suffer the full consequences.

b. IMF policies are thus being challenged.

2. Asian countries are also eager for U.S. dollars and intend to sell their products to the U.S. at greatly reduced prices.

3. U.S. producers will have trouble selling goods and services in Asia because people have less money to spend.

4. The effects of the 'Asian Crisis' have not been fully realized around the world.

5. A major failure in any one country has an effect on all countries.

E. THE YEAR 2000 PROBLEM.

1. The problem, that computer systems that will read 1900 instead of 2000 on January 1, 2000, will be a major problem for banks.

2. Most large banks are trying to fix the problem before it occurs, but many banks are behind.