ECO Ch 14 notes - Summary Macroeconomics PDF

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Professor James D'Angelo...

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ECO 200 Ch 14 – Money, Banking & Financial Institutions 14. 1 – The Functions of Money - Liquidity – the degree to which an asset can be converted quickly into cash with little or no less - Medium of Exchange – any item sellers generally accept & buyers generally use to pay for a good or service; money; a convenient means of exchanging goods & services without engaging in barter - Store of Value – an asset set aside for future use; one of the three functions of money - Unit of Account – a standard unit in which prices can be states & the value of goods & services can be compared; one of the three functions of money - Functions of money: o Medium of exchange o Unit of account o Store of value 14.2 – The Components of the Money Supply - Checkable Deposits - any deposit in a commercial bank or thrift institution against which a check may be written - Commercial Banks – a firm that engages in the business of banking (accepts deposits, offers checking accounts & makes loans) - Federal Reserve Notes – paper money issued by the Federal Reserve Banks - M1 – the most narrowly defined money supply, equal to currency in the hands of the public & the checkable deposits of commercial banks & thrift institutions - M2 – a more broadly defined money supply, equal to M1 plus noncheckable savings accounts (including money market deposit accounts), small time deposits (deposits of less than $100,000) & individual money market mutual fund balances - Money Market Deposit Account (MMDA) – interest-bearing accounts offered by commercial banks & thrift institutions that invest deposited funds into a variety of shortterm securities. Depositors may write checks against their balances, but there are minimum-balance requirements as well as limits on the frequency of check writing & withdrawals - Money Market Mutual Fund (MMMF) – (MMMFs) Mutual funds that invest in shortterm securities. Depositors can write checks in minimum amounts or more against their accounts - Near-Monies – financial assets that aren’t themselves a medium of exchange but that have extremely high liquidity & thus can be readily converted into money. Includes noncheckable savings accounts, time deposits & short-term U.S. government securities plus savings bonds - Savings Account – a deposit in a commercial bank or thrift institution on which interest payments are received; generally used for saving rather than daily transactions; a component of the M2 money supply - Time Deposits – an interest-earning deposit in a commercial bank or thrift institution that the depositor can withdraw without penalty after then end of a specific period - Thrift Institutions – a savings & loan association, mutual savings bank, or credit union - Token Money – bills or coins for which the amount printed on the currency bears no relationship to the value of the paper or metal embodied within it; for currency still circulating, money for which the face value exceeds the commodity value - M1 consists of 2 components: o Currency (coins & paper money) in the hands of the public o All checkable deposits (all deposits in commercial banks & “thrift” or savings institutions on which checks of any size can be drawn) - Money, M1 = currency + checkable deposits - M2 definition of money includes 3 categories of near-monies:

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o Savings deposits, including money market deposit accounts o Small-denominated (less than $100,000) time deposits o Money market mutual funds held by individuals Money, M2 = M1 + savings deposits, including: MMDAs + small denominated (less than $100,000) time deposits + MMMFs held by individuals

14.1 – 14.2 Review - Money serves as a medium of exchange, a unit of account & a store of value - The narrow M1 definition of money includes currency held by the public plus checkable deposits in commercial banks & thrift institutions - Thrift institutions, as well as commercial banks, offer accounts on which checks can be wrriten - The M2 definition of money includes M1 plus savings deposits, including money market deposit accounts, small-denominated (less than $100,000) time deposits & money market mutual fund balances held by individuals 14.3 – What “Backs” the Money Supply? - Legal Tender – any form of currency that by law must be accepted by creditors (lenders) for the settlement of a financial debt; a nation’s official currency is legal tender within its own borders - Purchasing power of the dollar: o $V = 1 / P 14.3 Review - In the US, all money consists of essentially of the debts of government, commercial banks & thrift institutions - These debts efficiently perform the functions of money as long as their value, or purchasing power, is relatively stable - The value of the dollar (its domestic purchasing power) is inversely related to the price level - Government’s responsibility in stabilizing the purchasing power of the monetary units calls for (a) effective control over the supply of money by the monetary authorities & (b) the application of appropriate fiscal policies by the president & Congress 14.4 – The Federal Reserve & the Banking System - Board of Governors – the seven-member group that supervises & controls the money & banking system of the US; the Board of Governors of the Federal Reserve System; the Federal Reserve Board - Federal Open Market Committee (FOMC) – the 12-member group within the Federal Reserve System that decides U.S. monetary policy & how it is executed through openmarket operations (in which the Fed buys & sells U.S. government securities to adjust the money supply - Federal Reserve Banks - the 12 banks chartered by the U.S. government that collectively act as the central bank of the U.S. They set monetary policy & regulate the private banking system under he direction of the Board of Governors & the Federal Open Market Committee. Each of the 12 is a quasi-public bank & acts as a banker’s bank in its designated geographic region - Federal Reserve System – the U.S. central bank, consisting of the Board of Governors of the Federal Reserve & the 12 Federal Reserve Banks, which controls the lending activity of the nation’s banks & thrifts & thus the money supply; commonly referred to as the “Fed” - The FOMC is made up of 12 individuals: o The 7 members of the Board of Governors o The president of the New York Federal Reserve Bank o 4 of the remaining presidents of Federal Reserve Banks of a 1-year rotating basis

14.5 – Fed Functions, Responsibilities & Independence - The Fed performs several functions: o Issuing currency o Setting reserve requirements & holding reserves o Lending to financial institutions & serving as an emergency lender of last resort o Providing for check collection o Acting as fiscal agent o Supervising banks o Controlling the money supply 14.4 – 14.5 Review - The US banking system consists of (a) the Board of Governors of the Federal Reserve System, (b) the 12 Federal Reserve Banks & (c) some 6,000 commercial banks & $8,500 thrift institutions (mainly credit unions) - The 12 Federal Reserve Banks are simultaneously (a) central banks, (b) quasi-public banks & (c) bankers’ banks - The major functions of the Fed are (a) issue Federal Reserve Notes, (b) set reserve requirements & hold reserves deposited by banks & thrifts, (c) lend money to financial institutions & serve as the lender of last resort in national financial emergencies, (d) provide for the rapid collection of checks, (e) act as the fiscal agent for the federal government, (f) supervise the operations of the banks, & (g) regulate the supply of money in the best interest of the economy 14.6 – The Financial Crisis of 2007 & 2008 - Mortgage-Backed Securities – bonds that represent claims to all or part of the monthly mortgage payments from the pools or mortgage loans made by leaders to borrowers to help them purchase residential property - Securitization – the process of aggregating many individual financial debts, such as mortgages or student loans, into a pool & then issuing new securities (typically bonds) backed by the pool. The holders of the new securities are entitled to receive the debt payments made on the individual financial debts in the pool - Subprime Mortgage Loans – high-interest-rate loans to home buyers with aboveaverage credit risk 14.6 Review - The financial crisis of 2007-2008 consisted of an unprecedented rise in mortgage loan defaults, the collapse or near collapse of several major financial institutions & the generalized freezing up of credit availability - The crisis resulted from band mortgage loans together with declining real estate prices - The crisis exposed the underestimation of risk by holders of mortgage-backed securities as well as faulty insurance securities that had been designed to protect holders of mortgage-backed securities from the risk of default 14.7 – The Policy Response to the Financial Crisis - Moral Hazard – the possibility that individuals or institutions will change their behavior as the result of a contract or agreement. Example: a bank whose deposits are insured against losses may make riskier loans & investments - Troubled Asset Relief Program (TARP) – a 2008 federal government program that authorized the U.S. Treasury to loan up to $700 billion to critical financial institutions & other U.S. firms that were in extreme financial trouble & therefore at high risk of failure 14.7 Review - The Troubled Asset Relief Program (TARP) authorized the US Treasury to spend up to $700 billion to make emergency loans & guarantees to failing financial firms

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The Treasury rescue, or bailout, was aided by lender-of-last-resort loans provided by the Federal Reserve to financial institutions through a series of newly established Fed facilities The TARP loans & the Fed’s lender-of-last-resort actions intensified the moral hazard problem in which financial investors & financial firms take on greater risk because they assume that the government will bail them out if they lose money

14.8 – The Post-Crisis U.S. Financial Services Industry - Financial Services Industry – the broad category of firms that provide financial products & services to help households & businesses earn interest, receive dividends, obtain capital gains, insure against losses & plan for retirement. Includes commercial banks, thrift institutions, insurance companies, mutual fund companies, pension funds, investment banks & securities firms - Wall Street Reform & Consumer Protection Act – the law that gave authority to the Federal Reserve System (the Fed) to regulate all large financial institutions, created an oversight council to look for growing risk to the financial system, established a process for the federal government to sell off the assets of large failing financial institutions, provided federal regulatory oversight of asset-backed securities & created a financial consumer protection bureau within the Fed - This sweeping law includes provisions that: o Eliminate the Office of Thrift Supervision & give broader authority to the Federal Reserve to regulate all large financial institutions o Create a Financial Stability Oversight Council to be on the lookout for risks to the financial system o Establish a process for the federal government to liquidate (sell off) the assets of failing nonbank institutions, much like the FDIC does with failing banks o Provide federal regulatory oversight of mortgage-backed securities & other derivatives & require that they be traded on public exchanges o Require companies selling asset-backed securities to retain a portion of those securities so the sellers share part of the risk o Establish a stronger consumer financial protection role for the Fed through creation of the Bureau of Consumer Financial Protection 14.8 Review - The main categories of the U.S. financial services industry are commercial banks, thrifts, insurance companies, mutual fund companies, pension funds, securities firms & investment banks - The reassembly of the wreckage from the financial crisis of 2007-2008 has further consolidated the already-consolidating financial services industry & has further blurred some of the lines between the subsets of the industry - The Wall Street Reform & Consumer Financial Protection Act of 2010 responded to the financial crisis by consolidating financial regulation, providing federal oversight of mortgage-backed securities & creating the Bureau of Consumer Financial Protection...