14 Money, Banking, and Financial Institutions McGraw-Hill/Irwin Copyright © 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 Definition M1 • M1 • Currency & coins • Checkable deposits • Only the most liquid assets are • • LO1 included Coins are token money Excludes money held by government and banks 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 Definitions LO1 What “Backs” the Money Supply • Money as debt • Stable value of money • Acceptability • Legal tender • Relative scarcity LO2 What “Backs” the Money Supply • Prices affect purchasing power of money – inverse relationship • Hyperinflation renders money unacceptable • Stabilizing money’s purchasing power • Intelligent management of the money supply – monetary policy • Appropriate fiscal policy LO2 Federal Reserve - Banking System • Historical background • Board of Governors • Basic policy making body of U.S banking system • members appointed by president • 14 year terms, staggered • Chair/Vice Chair year terms LO3 Federal Reserve - Banking System • 12 Federal Reserve Banks • Serve as the central bank • Quasi-public banks • Public control, private ownership • Banker’s bank LO3 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 Federal Reserve – Banking System The 12 Federal Reserve Banks Source: Federal Reserve Bulletin LO3 Federal Reserve – Banking System • Federal Open Market Committee • Conducts open market operations • Includes Board of Governors and presidents of Federal Reserve Banks LO3 Federal Reserve Functions • Issue currency • Set reserve requirements • Lend money to banks • Check collection • Fiscal agent for U.S government • Supervise banks • Control the money supply LO4 Federal Reserve Independence • Established by Congress as • • LO4 independent agency Protects the Fed from political pressures Enables Fed to take actions to increase interest rates to stem inflation as needed 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 • • • LO5 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 The Financial Crisis of 2007 and 2008 • Failures and Near-Failures of • LO5 Financial Firms • Countrywide-second largest lender • Washington Mutual-largest lender • Wachovia Other firms came close The Financial Crisis of 2007 and 2008 • Troubled Asset Relief Program (TARP) • Allocated $700 billion to make emergency loans • Saved several institutions from failure • Created moral hazard LO6 Post-crisis U.S Financial Services • Wall Street Reform and Consumer • • LO7 Protection Act Passed to help prevent many of the practices that led to the crisis Critics say it adds heavy regulatory costs ... of Governors • Basic policy making body of U.S banking system • members appointed by president • 14 year terms, staggered • Chair/Vice Chair year terms LO3 Federal Reserve - Banking System • 12