I. Learning Objectives In this chapter students will learn: A. The functions of money and the components of the U.S. money supply. B. What backs the money supply, making us willing to accept it as payment. C. The makeup of the Federal Reserve and its relationship to banks and thrifts. D. The functions and responsibilities of the Federal Reserve. E. The main factors that contributed to the financial crisis of 2007-2008. F. The actions of the U.S. Treasury and the Federal Reserve that helped keep the banking and financial crisis of 2007-2008 from worsening. G. The main subsets of the financial services industry in the United States and some examples of some firms in each category. II. The Functions of Money A. Medium of exchange Money can be used for buying and selling goods and services. B. Unit of account Money measures the relative worth of goods and services. C. Store of value Money allows us to transfer purchasing power from the present into the future. It is the most liquid (spendable) of all assets and a convenient way to store wealth. III. The Components of the Money Supply A. M1 includes currency and checkable deposits (Figure 31.1a). 1. Currency consists of coins and paper money held by the public (51% of M1 in 2010). a. Currency is token money, which means its intrinsic value is less than its actual value in the ability to buy goods and services. The metal in a dime is worth less than 10. b. All paper currency consists of Federal Reserve Notes issued by the Federal Reserve. 2. Checkable deposits are included in M1 because they can be spent almost as readily as currency and can easily be changed into currency (49% of M1 in 2010). a. Commercial banks are a main source of checkable deposits for households and businesses. b. Thrift institutions (savings and loans, credit unions, mutual savings banks) also have checkable deposits. 3. Qualification: Currency and checkable deposits held by the federal government, Federal Reserve, or other financial institutions are not included in M1.
B. M2 = M1 + some near-monies which include: (Figure 31.1b) 1. Savings deposits and money market deposit accounts. 2. Small-denominated time deposits (certificates of deposit) less than $100,000. 3. Money market mutual funds. C. Consider This Are Credit Cards Money? 1. Credit cards are not money, because their use involves short-term loans. 2. Their convenience allows consumers to keep M1 balances low because they need less for daily purchases. IV. What Backs the Money Supply? A. The federal government backs money with its ability to keep the value stable. 1. If money were backed by something tangible, such as gold, the money supply would vary with the amount of gold available. If more gold mines were discovered, the printing of additional money could lead to inflation; if gold production were decreased for a long period of time, it could cause a recession and unemployment. 2. By not backing currency, the government is able to manage the money supply by increasing or decreasing it to suit the needs of the economy. B Money is debt; paper money is a debt of Federal Reserve Banks and checkable deposits are liabilities of banks and thrifts because depositors own them. C. The value of money arises not from its intrinsic value, but its value in exchange for goods and services. 1. It is acceptable as a medium of exchange. 2. Currency has been declared legal tender by the government (fiat money). In general, it must be accepted in payment of debt, but that doesn t mean that private firms and government are mandated to accept cash; alternative means of payment may be required. (Note that checks are not legal tender but, in fact, are generally acceptable in exchange for goods, services, and resources.) 3. The relative scarcity of money compared to goods and services allows money to retain its purchasing power. D. Purchasing power the amount of goods and services a unit of money will buy. Money s purchasing power determines its value. Higher prices mean less purchasing power, because more dollars are needed to buy the same amount of goods.
E. Excessive inflation may make money worthless and unacceptable. An extreme example was the excessive printing of German marks after World War I, causing hyperinflation which made the mark worth less than 1 billionth of its former value within a four-year period. 1. Worthless money leads to the use of other currencies that are more stable. 2. Worthless money may lead to a barter exchange system. F. Stabilizing Money s Purchasing Power 1. The government tries to keep prices stable with appropriate fiscal policy. 2. The government uses monetary policy to keep money scarce enough to maintain its purchasing power, while expanding the money supply enough to allow the economy to grow. V. The Federal Reserve and the Banking System A. The Federal Reserve System (the Fed ) was established by Congress in 1913 and holds power over the money and banking system (Figure 31.2). 1. Historical Background a. Decentralized, unregulated banking had led to a multitude of private bank notes being used as currency. Because the money supply was not controlled, significant changes in the money supply would cause inflation and recessions. b. Banking crises had caused bank runs and bank failures, crippling confidence in the banking system. 2. Board of Governors a. The Board of Governors is the central authority of the United States money and banking system. b. The seven members are appointed by the president and confirmed by the Senate. c. Members serve 14-year terms that cannot be renewed if fully served. Terms are staggered so that a new member is appointed every two years. d. The chairman of the Board of Governors is appointed by the president and confirmed by the Senate for a four-year renewable term.
3. The 12 Federal Reserve Banks a. The system has twelve districts, each with its own regional bank, which collectively serve as the nation s central bank (Figure 31.3). b. Regional banks help to implement Fed policy and advise the Board of Governors about economic conditions in their region of the country. c. Each regional bank is quasi-public, owned by member banks but controlled by the Board of Governors, and any profits go to the U.S. Treasury. d. Regional banks act as bankers banks by accepting reserve deposits and making loans to banks and other financial institutions. The Federal Reserve is the lender of last resort, meaning that the Fed is available to lend money, should other banks not be available. 4. FOMC a. The Federal Open Market Committee includes the seven members of the Board of Governors, the president of the New York Federal Reserve Bank, and four regional bank presidents whose terms annually rotate. b. The FOMC meets several times each year to direct the buying and selling of government bonds, in order to change the money supply and interest rates. These open market operations are the most frequently used aspect of monetary policy. 5. Commercial Banks and Thrifts a. About 6,800 privately-owned commercial banks are part of the Federal Reserve System. Approximately 3/4 of the banks are chartered by states, while 1/4 are chartered by the federal government. b. The 8,700 thrift institutions are primarily credit unions, but also include savings and loan associations and mutual savings banks. They are subject to monetary controls by the Federal Reserve and are also regulated by other agencies. c. Global Perspective 31.1 shows the world s 12 largest financial institutions. B. Fed Functions and the Money Supply 1. The Fed issues Federal Reserve Notes, the paper currency used in the American monetary system. 2. The Fed sets reserve requirements, the fractions of checking account balances that banks must maintain as currency reserves. The Fed holds the reserves that banks and thrifts choose not to hold as vault cash.
3. The Fed lends money to banks and thrifts, charging them an interest rate called the discount rate. It is also a lender of last resort during a crisis. 4. The Fed provides a check collection service for banks. 5. The Fed acts as the fiscal agent for the federal government. 6. The Fed supervises the operations of member banks. 7. The Fed has the ultimate responsibility for regulating the money supply and influencing interest rates. This is the primary function of the Fed. C. Federal Reserve Independence 1. Congress specifically established the Fed as an independent agency of government to protect the Fed from political pressures so that it could effectively control the money supply and maintain price stability. 2. Advocates of independence fear that more political ties would cause the Fed to follow expansionary policies and create too much inflation, leading to an unstable currency. VI. The Financial Crisis of 2007 and 2008 A. The Mortgage Default Crisis 1. Banks had made a significant number of subprime mortgage loans high interest rate loans to home buyers with higher-than-average credit risk. The banks then sold these mortgagebacked securities (bonds backed by mortgage payments) to investment funds. 2. Because banks thought they were no longer exposed to large portions of their mortgage default risk, they became lax in their lending practices, failing to run credit checks and allowing applicants to claim higher incomes than they really earned, in order to qualify for large home mortgage loans. Government programs subsidized and encouraged home ownership, and many new homeowners assumed mortgages they were unable to pay. A decline in real estate values and rising interest rates on adjustable-rate mortgages combined with these factors to set up a significant failure in the home mortgage industry. 3. In 2007, a major wave of defaults on these loans threatened the banks that made the loans, as well as investment companies that had purchased the loans from the banks. B. Securitization 1. Securitization the process of slicing up and bundling groups of loans, mortgages, corporate bonds, or other financial debts into distinct new securities. 2. These mortgage-backed securities are traded in financial markets just like stocks and bonds, and ended up in the investment portfolios of banks, thrifts, insurance companies, pension funds, and personal accounts around the world. 3. A few large insurance companies, such as AIG, developed collateralized default swaps, insurance policies that were designed to compensate the holders of mortgage-backed securities if the mortgage loans were not repaid. These policies exposed the insurance companies to the risk of mortgage failures, as well. C. Failures and Near-Failures of Financial Firms 1. When the interest rates for adjustable-rate mortgages rose and home values fell, many homeowners found that they owed more on their houses than the properties were worth. As the economy slid into recession, homeowners fell behind in their payments and either walked away from their mortgages or had their homes repossessed by banks that could not resell them to recoup the loans. 2. Three large mortgage lenders (Countrywide, Washington Mutual, and Wachovia) collapsed or nearly collapsed and were taken over by other banks. 3. Securities firms and investment banks (Merrill Lynch, Lehman Brothers, Goldman Sachs, Morgan Stanley, and Citibank) that held large amounts of mortgage-backed securities suffered huge losses. 4. Insurance company AIG had not set aside sufficient reserves to back the insurance policies it had sold to the holders of mortgage-backed securities, and it, too, suffered enormous losses.
D. The Treasury Bailout: TARP 1. In late 2008, Congress passed the Troubled Assets Relief Program (TARP), which allocated $700 billion to the Treasury to make emergency loans to critical financial and other firms. The initial funds were loaned primarily to AIG and financial institutions, but later loans were made to Chrysler and General Motors. 2. Supporters of TARP recognize that the program saved many financial institutions whose failures would have caused serious secondary effects that would have brought down other financial firms and frozen credit throughout the economy. 3. Critics of TARP argue that the program created a moral hazard, because financial investors and financial services firms are likely to take greater risks if they assume they are at least partially insured against losses. The assumption by large firms that they were simply too big for government to let them fail may have given them an incentive to make riskier investments. E. The Fed s Lender-of-Last-Resort-Activities 1. The Federal Reserve designed and implemented several new facilities for the purpose of keeping credit flowing in the economy. 2. The Fed bought the illiquid mortgage-backed securities and Treasury bonds from financial institutions in return for cash, the most liquid financial asset. 3. Many economists credit TARP and the Federal Reserve for averting a second Great Depression, but critics argue that the Fed s activities intensified the moral hazard by preventing significant losses that would have resulted from bad financial assumptions and decisions. VII. The Postcrisis U.S. Financial Services Industry A. Even before the financial crisis, the financial services industry was consolidating into fewer, larger firms, each offering a wider spectrum of services (Table 31.1).
B. In 1999, Congress ended the Depression-era prohibition against banks selling stocks, bonds, and mutual funds, blurring the distinctions between subsets of the financial industry. C. The financial crisis further consolidated the industry, as the FDIC shut down more than 200 banks by 2009, transferring their deposits to other, larger banks. Major investment banks became commercial banks in order to gain access to emergency Federal Reserve loans. D. Politicians and financial regulators tightened lending rules to prevent banks from making loans to those unlikely to repay them. Other legislation helped homeowners who were underwater in their mortgage loans to remain in their homes. E. In 2010, Congress passed the Wall Street Reform and Consumer Protection Act, giving government broader authority to regulate the financial system, establishing a process for the federal government to sell off the assets of failed financial institutions, requiring mortgage backed securities to be sold on public exchanges, requiring companies selling mortgage backed securities to retain part of the securities to share in the risk, and providing stronger consumer financial protection. F. Proponents of the new law argue that it will help to prevent many of the practices that led to the financial crisis, and it sends a strong message that firms and investors will suffer unavoidable and high financial losses if they ever again get into serious financial trouble. G. Skeptics argue the government already had the necessary tools to prevent the crisis, and the new law simply imposes heavy regulatory costs on the financial industry while doing little to prevent future government bailouts. VIII. LAST WORD: Electronic Banking A. Households and businesses increasingly use electronic payments rather than currency and checks to buy products, pay bills, pay income taxes, transfer bank funds, and handle recurring mortgage and utility payments. B. Credit cards, debit cards, Fedwire transfers, and automated clearinghouse transactions have allowed instant transfers of funds without the use of currency or checks. C. Some experts believe the next step is electronic money, similar to PayPal. Consumers would be able to make nearly all payments through the Internet or smart cards. D. Electronic money is poised to make a big impact in developing countries, where people live far from bank branches. Customers are able to use their cell phones to accept and make payments, as if they were using currency.