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 nations money supply is often determined by two measures. M-
1 includes liuid, or spendable, forms of money such as currency and various
types of demand deposits. M-! includes M-1 plus easily convertible forms of
money such as time deposits, money mar"et funds, and savings deposits. #redit
also plays a role in the money supply.
The $.%. financial system includes commercial ban"s, savings and loan
associations, mutual savings ban"s, credit unions, and non-deposit institutions.
These financial establishments offer a variety of services, including pension, trust,
and international services, financial advice and bro"erage services, and a range of
electronic funds transfer services &including 'TMs(.
)an"s expand the money supply by ta"ing in deposits and ma"ing loans. The
overall supply of money is governed by several federal agencies that are
responsible for ensuring a sound, competitive financial system.
The *ederal +eserve %ystem &or the *ed( is the nations central ban". The *ed
serves as the "ey ban" for both the government and for other ban"s. ,n addition,
the *ed sets $.%. monetary policy by controlling the nations money supply. To
control the money supply, the *ed specifies reserve reuirements, it sets the
discount rate at which it lends money to member ban"s, it conducts open-mar"et
operations to buy and sell securities, and it occasionally exerts influence through
selective credit controls.
%everal "ey changes have affected the financial system in recent years.
-eregulation and the rise of interstate ban"ing have increased competition.
*urthermore, electronic technology has offered a variety of convenient financial
innovations . debit cards, smart cards, and e-cash, etc. . that have dramatically
changed ban"ing for consumers and businesses ali"e.
/lectronic technologies now permit speedy global financial transactions to
support the growing importance of international finance. 'n international
payment process moves money among buyers and sellers in different nations.
The 0orld )an" and the ,nternational Monetary *und help to finance
international trade and promote global fiscal stability.
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Chapter Objectives
1. -efine money and identify the different forms that it ta"es in the nations
money supply.
!. -escribe the different "inds of financial institutions that comprise the $.%.
financial system and explain the services they offer.
2. /xplain how ban"s create money and describe the means by which they
are regulated.
3. -iscuss the functions of the Federal Reserve System and describe the tools
that it uses to control the money supply.
4. ,dentify three important ways in which the financial industry is changing.
5. $nderstand some of the "ey concepts and activities in international
banking and finance.
REFERENCE OU!"NE
6pening #ase: 'rgentines 7o 8onger )an" on the 9eso
,. 0hat ,s Money:
'. The #haracteristics of Money
1. 9ortability
!. -ivisibility
2. -urability
3. %tability
). The *unctions of Money
1. Medium of /xchange
!. %tore of ;alue
2. $nit of 'ccount
#. The %pendable Money %upply: M-1
-. M-1 9lus the #onvertible Money %upply: M-!
/. #redit #ards: 9lastic Money:
,,. The $.%. *inancial %ystem
'. *inancial ,nstitutions
1. #ommercial )an"s
a. -iversification and Mergers
b. #ommercial ,nterest +ates
!. %avings and 8oan 'ssociations
2. Mutual %avings )an"s and #redit $nions
3. 7ondeposit ,nstitutions
). %pecial *inancial %ervices
1. 9ension and Trust %ervices
!. ,nternational %ervices
2. *inancial 'dvice and )ro"erage %ervices
3. 'utomated Teller Machines
4. /lectronic *unds Transfer
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#. )an"s as #reators of Money
-. +egulation of #ommercial )an"ing<*ederal -eposit ,nsurance
#orporation &*-,#(
,,,. The *ederal +eserve %ystem
'. The %tructure of the *ed
1. The )oards of =overnors
!. +eserve )an"s
2. Member )an"s
). The *unctions of the *ed
1. The =overnments )an"
!. The )an"ers )an"
2. #ontrolling the Money %upply
#. The Tools of the *ed
1. +eserve +euirements
!. -iscount +ate #ontrols
2. 6pen-Mar"et 6perations
3. %elective #redit #ontrols
,;. The #hanging Money and )an"ing %ystem
'. -eregulation
). ,nterstate )an"ing
#. /-#ash
;. ,nternational )an"ing and *inance
'. The ,nternational 9ayments 9rocess
). ,nternational )an" %tructure<The 0orld )an" and the ,M*
!ECURE OU!"NE
"# $hat "s Money% &Use 'ower'oint 14#(#)
*# he Characteristics o+ Money
1# 'ortab,e
-# .ivisib,e
(# ./rab,e
4# 0tab,e
B# he F/nctions o+ Money &Use 'ower'oint 14#4#)
Money serves three functions.
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1. Medi/1 o+ E2change# 0e use money to buy and sell
things.
!. 0tore o+ 3a,/e# Money can be saved and used for future
purchases.
2. Unit o+ *cco/nt# 'll products can be valued in terms of
money#
C# he 0pendab,e Money 0/pp,y4 M51 &Use 'ower'oint 14#6#)
The value of money decreases when its supply is high> when the
money supply is low, its value increases. ' common measurement
of the money supply is M-1, which counts only the most liuid
forms of money, including cash, demand deposits, and other
chec"able deposits.
.# M51 7 Convertib,e Money 0/pp,y4 M5-
M-! includes M-1 and items that can be converted to spendable
forms> M-! accounts for almost all of the countrys money supply.
E# Credit Cards4 ',astic Money% &Use 'ower'oint 14#8#)
#onvenient and reliable, credit cards have become important in the
purchase of consumer goods. 9rofits 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.
Notes4
99999999999999999999999999999999999999999999999999999999999999999
99999999999999999999999999999999999999999999999999999999999999999
99999999999999999999999999999999999999999999999999999999999999999
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""# he U#0# Financia, 0yste1
*# Financia, "nstit/tions &Use 'ower'oint 14#:; 14#<#)
*inancial institutions ease the flow of money from sectors with
surpluses to those with deficits.
1. Co11ercia, Banks# More than 1?,??? commercial
ban"s exist in the $.%.> all ban"s must be chartered.
%eventy percent of all commercial ban"s are state banks>
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most large ban"s are nationa, banks, chartered by the
federal government.
a. .iversi+ication and Mergers# These result
from numerous other investment options
that attract investors.
b. Co11ercia, "nterest Rates# )an"s can set
their own interest rates> the lowest rate
allowed is the pri1e rate.
!. 0avings and !oan *ssociations# These institutions
accept deposits and ma"e loans primarily for home
mortgages.
2. M/t/a, 0avings Banks and Credit Unions# -epositors
in these ban"s are considered owners of the ban" with all
profits divided among depositors> these ban"s attract
most of their funds from savings deposits and loan them
in the form of mortgages. #redit unions accept deposits
only from ualified members, usually wor"ing for a
certain employer.
3. Nondeposit "nstit/tions# This category includes other
organi@ations that accept deposits, provide interest, and
ma"e loans. They include pension funds, insurance
companies, finance companies, and securities dealers.
B# 0pecia, Financia, 0ervices &Use 'ower'oint 14#=#)
1. 'ension 0ervices and r/st 0ervices# ,+'s are pension
funds that wage earners and their spouses can set up to
supplement other retirement funds. )an"s receive funds
and invest them as directed by customers and provide
information on ,+' investment alternatives. )an"s also
provide assistance in establishing >eogh p,ans, which
can be opened by self-employed people. ,n addition,
commercial ban"s offer trust services for a fee.
!. "nternationa, 0ervices# )an"s offer services including
currency exchange> letters of credit, which are promises
by the ban" to pay a firm a certain amount of money if
certain conditions are met> and ban"ers acceptances,
which are promises that the ban" will pay some specified
amount at a future date.
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2. Financia, *dvice and Brokerage 0ervices# %erving as
financial advisors, ban"s help customers manage their
money by recommending different investment
opportunities and serving as a securities intermediary.
3. */to1ated e,,er Machines# 0ith these machines
customers can withdraw money, ma"e deposits, transfer
funds, and chec" on account status.
4. E,ectronic F/nds rans+er# These systems transfer
many types of financial information over wire, cable, or
microwave.
C# Banks as Creators o+ Money &Use 'ower'oint 14#1?#)
*inancial institutions create money by ta"ing in deposits and
ma"ing loans, which expands the money supply.
.# Reg/,ation o+ Co11ercia, Banking
)an"s create money> therefore, the government regulates them via
the *ederal +eserve %ystem and the *ederal -eposit ,nsurance
#orporation to ensure a sound financial system.
1. Federa, .eposit "ns/rance Corporation &F."C)# The
*-,# insures deposits in member ban"s up to A1??,???.
Notes4
99999999999999999999999999999999999999999999999999999999999999999
99999999999999999999999999999999999999999999999999999999999999999
99999999999999999999999999999999999999999999999999999999999999999
999
"""# he Federa, Reserve 0yste1 &Use 'ower'oint 14#11#)
*# he 0tr/ct/re o+ the Fed
The *ederal +eserve %ystem is comprised of a )oard of
=overnors, a group of +eserve )an"s, and member ban"s.
1. he Board o+ @overnors# This group is comprised of
seven members appointed by the 9resident for 13-year
terms> the board plays a maBor role in controlling the
money supply through reserve reuirements, discounts
rates, and open-mar"et operations.
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!. Reserve Banks# There are 1! ban"s in the *ed that hold
deposits from and set the discount rate for commercial
ban"s in their respective regions> reserve ban"s also
largely contribute to the countrys chec"-clearing process.
2. Me1ber Banks# 7ational ban"s and some state ban"s
are members of the *ed> depositor accounts in member
ban"s are protected by *-,#.
B# he F/nctions o+ the Fed &Use 'ower'oint 14#1-#)
The *ed functions as the governments ban" and the ban"ers ban"
and control the money supply.
1. he @overn1entAs Bank# The *ed produces the
nations currency and lends money to the government to
finance the national deficit.
!. he BankerAs Bank# ,ndividual ban"s borrow from the
*ed and pay interest on the loans. The *ed clears chec"s
for commercial ban"s. Check c,earing involves the
transfer of funds that occurs when one uses a chec".
2. Contro,,ing the Money 0/pp,y# Managing the money
supply through commercial ban"s and interest rates
allows the *ed to manage the nations economic growth.
C# he oo,s o+ the Fed
,n controlling the money supply, the *ed uses four main tools:
reserve reuirements, discount-rate controls, open-mar"et
operations, and selective credit controls.
1. Reserve ReB/ire1ents# These are the percentage of
deposits that ban"s must hold with a *ederal +eserve
)an". Digh reserve reuirements reduce the money
available to lend> low reuirements allow the money
supply to expand.
!. .isco/nt5Rate Contro,s# The disco/nt rate is the
interest rate that the *ed charges on loans made to
member ban"s. 'n increased discount rate reduces the
money supply> a low rate encourages borrowing and
lending.
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2. Open5Market Operations# This tool refers to the sale
and purchase of securities in the open mar"et.
3. 0e,ective Credit Contro,s# The *ed designed rules for
consumer stoc" purchases and credit rules for other
purchases, such as down-payment percentages and
repayment periods on loans.
Notes4
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"3# he Changing Money and Banking 0yste1 &Use 'ower'oint
14#1(#)
*# .ereg/,ation
The -epository ,nstitutions and -eregulation and Money #ontrol
'ct &-,-M#'( of 1EC? promoted competition by eliminating
many restrictions on ban"s> the deregulation of interest rates was a
crucial part of -,-M#'.
B# "nterstate Banking
The ,nterstate )an"ing /fficiency 'ct &1EE3( allows ban"s to enter
into interstate ban"ing> however, "ey provisions in the act limit the
extent to which ban"s can engage in interstate ban"ing.
C# E5Cash &Use 'ower'oint 1(#14#)
,nvesting in new technologies allows ban"s to improve their
efficiency and customer service levels. .ebit cards allow the
transfer of money between accounts and can be used to ma"e retail
purchases. 01art cards are credit card-si@ed computers that can
be programmed with Gelectronic money.H E,ectronic 1oney is
money that moves along multiple channels of consumers and
businesses via digital electronic transmissions.
Notes4
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99999999999999999999999999999999999999999999999999999999999999999
99999999999999999999999999999999999999999999999999999999999999999
999
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3# "nternationa, Banking and Finance
*# he "nternationa, 'ay1ents 'rocess &Use 'ower'oint 14#16#)
,nternational payments are simplified through the services
provided by their local ban"s. 0hen money inflows and outflows
as a result of international transactions remain eual for both
countries, money does not have to flow between the two countries.
0ithin each ban", dollars spent by local importers affect dollars
received by local exporters.
B# "nternationa, Bank 0tr/ct/re &Use 'ower'oint 14#18#)
0orldwide ban"ing stability relies on a loose structure of
agreements among individual countries. he $or,d Bank and
the "MF# )oth of these $nited 7ations agencies help to finance
global trade.
Notes4
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99999999999999999999999999999999999999999999999999999999999999999
99999999999999999999999999999999999999999999999999999999999999999
999
*nswers to C/estions and E2ercises
C/estions +or Review
1# $hat are the co1ponents o+ M51% O+ M5-%
M-1 includes currency, demand deposits, and other chec"able deposits.
M-! includes M-1 plus time deposits, money mar"et mutual funds, savings
deposits, and overnight transactions.
-# E2p,ain the ro,es o+ co11ercia, banks; savings and ,oan associations;
and non5deposit instit/tions in the U#0# +inancia, syste1#
#ommercial ban"s: 'ccept deposits and ma"e loans to earn
profits.
%avings and loan associations: 'ccept deposits and ma"e loans
primarily for home mortgages.
7on-deposit institutions: #ollect money, provide interest or other
benefits, andIor ma"e loans. This category includes pension funds,
insurance companies, finance companies, and securities investment
dealers.
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(# E2p,ain the types o+ pension services that co11ercia, banks provide
+or their c/sto1ers#
/stablishing savings plans such as ,+'s
%erving as financial intermediaries by receiving and investing
funds as directed by customers, providing information about
investment vehicles
6ffering trust services that can pay bills, manage investment
portfolios, or manage the estates of the deceased.
4# .escribe the str/ct/re o+ the Federa, Reserve 0yste1#
The *ederal +eserve %ystem is comprised of a board of seven governors,
1! reserve ban"s, and member ban"s. ,ts "ey functions are to control the
money supply by establishing and managing monetary policies and to
serve as both the governments ban" and as the ban"ers ban".
6# 0how how the Fed /ses the disco/nt rate to 1anage in+,ation in the
U#0# econo1y#
The *ed regulates the supply of money, decreasing the discount rate to
"eep the economy from slowing down too much andIor increasing it to
stimulate the economy.
C/estions +or *na,ysis
8# .o yo/ think credit cards sho/,d be co/nted in the 1oney s/pp,y%
$hy or why not% 0/pport yo/r arg/1ents by /sing the de+inition o+
1oney#
'nswers may vary. ,n terms of the characteristics of money, credit cards
are portable, divisible, durable, and stable. ,n terms of the functions of
money, credit cards serve as a medium of exchange, a store of value, and a
unit of account. Dowever, credit cards represent borrow funds, which
students may believe prevents them from fitting the definition of money.
:# 0ho/,d co11ercia, banks be reg/,ated; or sho/,d 1arket +orces be
a,,owed to deter1ine the 1oney s/pp,y% $hy%
'nswers will vary. Dowever, students should understand that the $.%.
ban"ing system has remained strong primarily because of strict controls
that allow the government to adBust the money supply.
<# "denti+y a p/rchase 1ade by yo/ or a +a1i,y 1e1ber in which
pay1ent was 1ade by check# .raw a diagra1 to trace the steps in
the c,earing process +o,,owed by that check#
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'nswers will vary, but diagrams should identify the following steps:
9ayee deposits the chec" in its ban".
The ban" deposits the chec" in the payees regional district reserve
ban".
The payees regional district reserve ban" sends the chec" to your
regional district reserve ban".
Jour regional district reserve ban" sends the chec" to your local
ban" for payment.
Jour local ban" deducts the amount of the chec" from your
account, and transfers the amount to its account at your regional
district reserve ban".
Jour regional district reserve ban" transfers the amount to the
payees regional district reserve ban".
The payees regional district reserve ban" sends the amount to the
payees local ban".
The payees local ban" credits the payees account.
*pp,ication E2ercises
=# 0tart with a D1;??? deposit and ass/1e a reserve reB/ire1ent o+ 16E#
Now trace the 1oney created by the banking syste1 a+ter +ive ,ending
cyc,es#
#ycle 1: A1,??? K .C4 L AC4?.??
#ycle !: C4?K.C4 L 1!!.4?
#ycle 2: 1!!.4?K.C4L 513.1!
#ycle 3: 513.1!K.C4L 4!!.??
#ycle 4: 4!!K.C4 L 332.1?
A3,14!.2! &M214N(
1?# "nterview the 1anager o+ a ,oca, co11ercia, bank# "denti+y severa,
ways in which the Fed either he,ps the bank or restricts its operations#
%tudents answers will vary.
*nswers to B/i,ding Fo/r B/siness 0ki,,s
1# $hat are the 1ost i1portant +actors in the FedAs interest rate
decision%
The *ed uses the discount rate to enhance or inhibit the economy to
control inflation and resulting interest rates. ,t also determines a reserve
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reuirement that reduces or expands the money supply. The *ed may also
stipulate selective credit controls.
-# Consider the o,d joke abo/t econo1ies that goes ,ike this4 $hen
there are +o/r econo1ists in a roo1 ana,yGing c/rrent econo1ic
conditions; there are at ,east eight di++erent opinions# Based on yo/r
research and ana,ysis; why do yo/ think econo1ists have s/ch varying
opinions%
'nswers will vary, but students should recogni@e that economics is part art
and part science, and unforeseen events can disrupt the most careful
analysis and predictions.
*nswers to E2ercising Fo/r Ethics
1# Fro1 the standpoint o+ a co11ercia, bank; can yo/ +ind any
econo1ic j/sti+ication +or *M access +ees%
*rom an economic standpoint, the fees can be Bustified since the ban" is
offering a service to non-customers, and should be compensated for the
cost of that service plus a fair profit margin.
-# Based on the scenario described +or o/r bank; do yo/ +ind any ethica,
iss/es in this sit/ation% Or do yo/ +ind the 1ain iss/es ,ega, and
econo1ic rather than ethica,%
'nswers will vary, but potential ethical issues revolve around the ban"s
responsibility to the communities in which it operates. Ouestions might
include: ,s it right to charge people exorbitant fees to access their own
money: 0hat if no other 'TMs were available in certain communities:
(# *s an o++icer +or this bank; how wo/,d yo/ hand,e this sit/ation%
'nswers will vary.
C,assroo1 *ctivities
1. -ivide the class into appropriately-si@ed discussion groups. 's" 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. ,n their
discussions, also as" the groups to ponder whether a single world mar"et
could possibly one day emerge. *inally, as" each group to share their
input with the rest of the groups.
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!. The *ederal +eserve %ystem is comprised of a )oard of =overnors, 1!
district ban"s, and many member ban"s. *rom time to time, controversy
arises over whether the chair of the )oard of =overnors holds too much
power in determining interest rates. 's" students to discuss their opinions
regarding this topic. ,n terms of the structure of the *ederal +eserve
%ystem, what other options can students present:

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