Chapter 32 - The Functions of Money

unit of account

a standard unit in which prices can be stated and the value of goods and services can be compared

liquidity

an assets liquidity is the ease with which it can be converted quickly into the most widely accepted and easily spent form of money, cash, with little or no loss of purchasing power

time deposits

an interest earning deposit in a commercial bank or thrift institution that the depositor can withdraw without penalty after the end of a specified period

medium of exchange

any item sellers generally accept and buyers generally use to pay for a good or service

Formula for finding the value of a dollar

divide 1 by the price level expressed as an index number (in hundredths) *$value = 1/price level (in hundredths)*

12 Federal Reserve Banks

the 12 banks chartered by the US gov't that collectively act as the central bank of the US; they set monetary policy and regulate the private banking system under the direction of the Board of Governors and the Federal Open Market Committee; each of the 12 is a quasi public bank and acts as a banker's bank in its designated geographic region

What does it mean by the Federal Reserve Banks being "Bankers' Banks"?

they perform essentially the same functions for banks and thrifts as those institutions perform for the public; just as banks and thrifts accept the deposits of and make loans to the public, so the central banks accept the deposits of and make loans to banks and thrifts

moral hazard problem

the possibility that individuals or institutions will change their behavior as the result of a contract or agreement ex) a bank whose deposits are insured against losses may make riskier loans and investments

Are the federal reserve banks publically or privately owned?

they are privately owned but are not motivated by profit; the policies they follow are designed by the Board of Governors to promote the well-being of the economy as a whole

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

What was the purpose of the Wall Street Reform and Consumer Protection Act?

- supporters of the law say that it will prevent the practices that led up to the financial crisis of 2007-2008

Quasi-public bank

A bank that is privately owned but governmentally (publicly) controlled; each of the U.S. Federal Reserve Banks.

M1 money supply

Consists of 2 Components: 1) currency in the hands of the public 2) all checkable deposits (all deposits in commercial banks and thrift or savings institutions on which checks of any size can be drawn)

Most important function of the Federal Reserve:

Controlling the money supply

Federal Reserve System

The U.S. central bank, consisting of the Board of Governors of the Federal Reserve and the 12 Federal Reserve Banks, which controls the lending activity of the nation's banks and thrifts and thus the money supply; commonly referred to as the "Fed."

Purchasing Power of the Dollar

The amount a dollar will buy varies inversely with price level; when the cost of living goes up, the value of the dollar goes down; higher prices lower the value of the dollar b/c more dollars are needed to buy stuff

store of value

an asset set aside for future use

near monies

certain highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted into currency or checkable deposits

subprime mortgage loans

high interest rate loans to home buyers with higher than average credit risk

token money

money whose face value exceeds its cost of production; the face value of any piece of currency is unrelated to the physical material it was made out of

What was the Mortgage Default Crisis of 2007?

- a major wave of defaults (failing to repay a loan) on home mortgage loans threatened the health of not only the original mortgage lenders, but of any financial institution that had made such loans or invested in such loans either directly or indirectly - when loans couldn't be repaid, banks had to declare the loans unrecoverable, but by doing that, banks reduced their reserves and ability to make loans --> economy threatened b/c both consumers and businesses both rely on loans to finance consumption and investment expenditures

Federal Open Market Committee (FOMC)

- aids the Board of Governors in conducting monetary policy Made up of 12 individuals: - the 7 members of the Board of Governors - President of the NY Federal Reserve Bank - 4 of the remaining presidents of the Federal Reserve banks on a 1-year rotating basis - settles the Fed's monetary policy and directs the buying and selling of gov't securities

Troubled Asset Relief Program (TARP)

- allocated $700 B to the US Treasury to make emergency loans to critical financial and other US firms - TARP saved several financial institutions whose bankruptcy would have caused a tsunami of secondary effects that would have brought down other financial firms and frozen credit throughout the country - financial firms never had to pay a single cent in insurance premiums for this massive bailout

What does the M2 category of money include?

M1 + savings deposits including MMDAs + small-denominated (less than $100k) time deposits + MMMFs held by individuals

What did the Fed do in the 2007-2008 financial crisis to keep the flow of money going?

in addition to its use of monetary policy, the Fed increased the amounts of securities (US securities, mortgage backed securities, and others) in order to increase liquidity in the financial system by exchanging illiquid bonds (ones that firms couldn't sell during the crisis) for cash the most liquid of all assets

Money Market Deposit Account (MMDA)

interest bearing accounts offered by commercial banks and thrift institutions that invest deposited funds into a variety of short term securities. Depositors may write checks against their balances, but there are minimum balance requirements as well as limits on the frequency of check writing and withdrawals

money market mutual funds (MMMF)

mutual funds that invest in short term securities; depositors can write checks in minimum amounts or more against their accounts

Thrift Institutions (Thrifts)

savings and loan associates, mutual savings banks, and credit unions which supplement the commercial banks

securities

stocks, bonds, and other financial documents that attest to a financial obligation

Formula for calculating change in purchasing power of money (percentage)

(1/1.__ or 0.__)-1

What gives money its value?

- ACCEPTABILITY) currency and checkable deposits are money b/c people accept them as money; they are acceptable as a medium of exchange b/c we are confident money will be exchangeable for real goods, services, and resources when we spend it - LEGAL TENDER) our confidence in acceptability of paper money is strengthened b/c gov't has designated it as legal tender; money is a valid and legal means of payment of any debt - RELATIVE SCARCITY) value of money depends on its supply and demand; money derives its value from its scarcity relative to its utility (want-satisfying power). Utility of money lies in its capacity to be exchanged for goods and services

What are the institutions that offer checkable deposits?

- Commercial Banks) the primary depository institutions - Thrift Institutions) savings and loan associations and mutual savings banks accept the deposits of households and businesses and then use the funds to finance housing mortgages and to provide other loans; credit unions accept deposits from and lend to members who usually are a group of people who work for the same company

What currency is excluded from the M1 money supply?

- currency held by the US Treasury, the Federal Reserve Banks, commercial banks, and thrift institutions - a paper dollar, if deposited back into the bank, is counted twice - once as physical currency in a bank vault, and once as money available in a checking account - checkable deposits of the gov't (US Treasury) or the Federal Reserve that are held by commercial banks or thrift institutions - exclusion is designed to enable a better assessment of the amount of money available to the PRIVATE SECTOR for potential spending

Wall Street Reform and Consumer Protection Act

- eliminated the Office of Thrift Supervision and gave broader authority to the Federal Reserve to regulate all large financial institutions - created a Financial Stability Oversight Council to be on the lookout for risks to the financial system - established a process for the federal gov't to liquidate (sell off) the assets of failing non-bank institutions, like how the FDIC does with failing banks - provided federal regulatory oversight of mortgage backed securities and other derivatives and required that they be traded on public exchanges - required companies selling asset backed securities to retain a portion of those securities so the sellers share part of the risk - established a stronger consumer financial protection role for the Fed through creation of the Bureau of Consumer Financial Protection

The Fed's 7 Responsibilities:

- ISSUING CURRENCY) Federal Reserve Banks issue currency - SETTING RESERVE REQUIREMENTS AND HOLDING RESERVES) the Fed sets reserve requirements, which are the fractions of checking account balances that banks must maintain as currency reserves; the central banks accept as deposits from the banks and thrifts any portion of their mandated reserves not held as vault cash - LENDING TO FINANCIAL INSTITUTIONS AND SERVING AS AN EMERGENCY LENDER OF LAST RESORT) Fed makes routine short-term loans to banks and thrifts and charges them an interest rate called the discount rate. Occasionally auctions off loans to banks and thrifts through its Term Auction Facility and serves as emergency lender to critical parts of US financial industries - PROVIDING FOR CHECK COLLECTION) Fed provides banking system with a means for collecting on checks. If Sue writes check on her Miami bank or thrift to Joe who deposits it in his Dallas bank or thrift, the Fed handles it by adjusting the reserves (deposits) of the 2 banks - ACTING AS A FISCAL AGENT) the Fed provides financial services for the federal gov't; gov't collects huge sums through taxation, spends equally large amounts, and sells and redeems bonds; must use the Fed's facilities to do this - SUPERVISING BANKS) Fed supervises the operations of banks. Makes periodic examinations to assess bank profitability, to ensure that banks perform in accordance with the many regulations to which they are subject, and to uncover questionable practices or fraud - CONTROLLING THE MONEY SUPPLY) Fed regulates supply of money and this enables it to influence interest rates. Major task of Fed is to manage money supply according to needs of the economy. Involves making an amount of money available that is consistent with high and rising levels of output and employment and a stable price level

What are the functions of money?

- MEDIUM OF EXCHANGE) money is a social invention with which resource suppliers and producers can be paid and that can be used to buy any of the full range of items available in the market - UNIT OF ACCOUNT) society uses money as a yardstick for measuring the relative worth of a wide variety of goods, services, and resources; money aids rational decision making by enabling buyers and sellers to easily compare the prices of various gods, services, and resources - STORE OF VALUE) money enables people to transfer purchasing power from the present to the future; when inflation is mild or nonexistant, money is a safe way to store your wealth for future use

What did the Fed do as the lender-of-last-resort in the 2007-2008 financial crisis?

- PRIMARY DEALER CREDIT FACILITY) provided overnight loans to primary dealers who were willing to post loan-backed securities as collateral. Fed kept collateral on any loan that was not repaid on time. Primary dealers are the 21 major financial institutions that the Fed uses to buy and sell US securities - TERM SECURITIES LENDING FACILITY) lent US securities to primary dealers for 1 month terms to promote liquidity in the markets for these US securities. Financial institutions obtained the securities from the Fed through participating in competitive single-bid auctions - ASSET BACKED COMMERCIAL PAPER MONEY MARKET MUTUAL FUND LIQUIDITY FACILITY) provided loans to US banks and thrifts to finance their purchases of commercial paper from money market mutual funds. Commercial paper consists of asset-backed short term IOU's that are mainly issued by corporations. These short term loans are vital for financing the day to day operations of businesses - COMMERCIAL PAPER FUNDING FACILITY) purchased commercial paper to support the commercial paper market and therefore the short term credit needs of businesses - MONEY MARKET INVESTOR FUNDING FACILITY) provided funding support to private sector initiative designed to ensure the liquidity of US money market mutual funds; many Americans rely on these as low-risk investments - TERM ASSET BACKED SECURITIES LOAN FACILITY) helped households and businesses with their credit needs by providing funding support for asset backed securities collateralized by student loans, auto loans, credit card loans, and loans guaranteed by the SBA - INTEREST PAYMENTS ON RESERVES) strengthened profitability of banks by paying interest on the reserves they hold in their vaults or in the federal reserve banks

The M2 definition of money includes what 3 categories of near monies?

- SAVINGS DEPOSITS, INCLUDING MONEY MARKET DEPOSIT ACCOUNTS) depositor can easily withdraw funds from a savings account at a bank or thrift or simply request that the funds be transferred from a savings account to a checkable account; person can also withdraw funds from a money market deposit account, however, there's a limit on how often a person can withdraw - SMALL DENOMINATED (less than $100k) TIME DEPOSITS) funds from time deposits become available at their maturity; In return for the withdrawal limitation, person gets higher interest rate on deposit (compared to MMDA) but must pay severe penalty if withdrawing early - MONEY MARKET MUTUAL FUNDS HELD BY *INDIVIDUALS*) depositor can redeem shares in an MMMF offered by a mutual fund company; such companies use combined funds of individual shareholders to buy interest bearing short term credit instruments; Then they can offer interest on the MMMF accounts of the shareholders who jointly own those financial assets; MMMF accounts include in M2 include only those accounts held by individuals, not by businesses or other institutions

Board of Governors

- The seven-member group that supervises and controls the money and banking system of the United States; the Board of Governors of the Federal Reserve System; the Federal Reserve Board - members appointed by president and the Senate - terms are 14 years and set up so 1 member is replaced every 2 years - the chairperson and vice chairperson are appointed by the president and serve 4 year terms

Mortgage Back Securities (MBS)

- bonds backed by mortgage payments - created to protect banks from mortgage defaults - to create them, banks first made mortgage loans, but instead of holding all of these loans as assets and collecting the monthly mortgage payments, they bundled hundreds or thousands of them together and sold them off as bonds - they sold the right to collect the future mortgage payments for an up-front cash payment for the bond - seemed like a smart idea on the bank's part as they were off the hook for these mortgages, however, banks lent a large portion of the money they received from selling the bonds to investment funds that invested in mortgage backed bonds. They also purchased large amounts of mortgage backed securities as financial investments to help meet bank capital requirements set by regulators

securitization

- process of slicing up and bundling groups of loans, mortgages, corporate bonds, or other financial debts into distinct new securities. These securities were sold to financial investors who purchased them to obtain the interest payments - American International Group issued billions of dollars of collateralized default swaps (insurance policies) that were designed to compensate the holders of loan-backed securities if the loans of these investments went into default

What happened when the exposure to the growing problem of loan defaults quickly jumped from direct mortgage lenders to other financial institutions?

- securities firms and investment banks that held large amounts of loan backed securities began to suffer huge losses. Financial Firms that had heavy exposures to mortgage backed securities and collateralized default swaps rushed to become bank holding companies so they could qualify for the massive emergency loans that the Federal reserve was making - insurance company AIG suffered b/c it didn't set aside sufficient reserves to pay off the unexpectedly large losses that accrued to the insurance policies that it sold to holders of mortgage backed securities

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

commercial banks

a firm that engages in the business of banking (accepting deposits, offing checking accounts, and making loans)

What is America's central bank?

the 12 federal reserve banks which implement the basic policy of the board of directors

financial services industry

the broad category of firms that provide financial products and services to help households and businesses earn interest, receive dividends, obtain capital gains, insure against losses, and plan for retirement; includes commercial banks, thrift institutions, insurance companies, mutual fund companies, pension funds, investment banks, and securities firms