Chapter One Introduction to Money and Banking Money

Chapter One Introduction to Money and Banking

Money Makes the World Go ‘Round • Money flows through the modern world with astonishing speed. . . with the help of banking institutions and financial markets. • Economic policy determines the rules and regulations by which banks work. • The efficiency of money and banks is very influential, both in individual’s lives and the macroeconomy. • Looking at the interactions between politics and the banking system helps us to understand financial markets and how they work. Copyright © Houghton Mifflin Company. All rights reserved. 1|2

The Value of Money • The amount you pay for your student loan depends in part on the actions of the Federal Reserve. • Your mortgage payment is influenced by inflation, the health of the banking system, and more. • How can you make money in the stock market? Copyright © Houghton Mifflin Company. All rights reserved. 1|3

Government Policy & Money • Government intervention influences how markets perform, and financial markets are no exception. • Because of externalities, the government plays a vital role in the financial system. • Example: Bank runs used to be commonplace, and often led to recession. Safeguards, such as FDIC, today reduce the likelihood of such events. Copyright © Houghton Mifflin Company. All rights reserved. 1|4

The Federal Reserve • The Federal Reserve (a. k. a. the Fed) determines the level of the U. S. money supply, sets rules for currency flows and check clearing, and supervises the banking system. • The Fed also decides on the federal funds rate eight times per year, influencing interest rates on everything from Treasury bills to car loans. Copyright © Houghton Mifflin Company. All rights reserved. 1|5

Ten (Surprising) Facts Concerning Money & Banking 1. Most financial formulas—no matter how complicated they look—are based on the compounding of interest. • • The key feature of interest is that it compounds over time…meaning interest is paid on interest earned in previous periods. Interest compounds both ways. . . the interest you pay (on a loan) compounds, as does the interest you earn on investments. Copyright © Houghton Mifflin Company. All rights reserved. 1|6

Ten (Surprising) Facts Concerning Money & Banking (cont’d) 2. More U. S. currency is held in foreign countries than in the United States. • • • U. S. citizens need American dollars to buy goods domestically. . . and they need foreign currency to buy international goods. Some foreigners hold U. S. dollars to buy American goods and services. Some hold dollars as protection against inflation. Copyright © Houghton Mifflin Company. All rights reserved. 1|7

Ten (Surprising) Facts Concerning Money & Banking (cont’d) 3. Interest rates on long-term loans generally are higher than interest rates on shortterm loans. • • • Though the press often refers to “the” interest rate, there are many. Because long-term loans tend to be riskier and are held longer, their rates need to be higher to incentivize the loan process. The difference between short and long term rates is an indicator of the state of the economy. Copyright © Houghton Mifflin Company. All rights reserved. 1|8

Ten (Surprising) Facts Concerning Money & Banking (cont’d) 4. To understand how interest rates affect economic decisions, you must account for expected inflation. • • • Interest rates tell you only how much you will earn on an investment, not what you can buy with it. Economic decisions must take into consideration that prices change over time. People’s decisions about how much to save or invest depend on interest rates as well as how much they expect prices to rise. Copyright © Houghton Mifflin Company. All rights reserved. 1|9

Ten (Surprising) Facts Concerning Money & Banking (cont’d) 5. Buying stocks is the best way to increase your wealth —and the worst. • • • All investment decisions involve risk. While stock market investing often pays off well, it also carries more risk than many other investments. Buying stocks does give you ownership in corporations, with a say in their operations. Copyright © Houghton Mifflin Company. All rights reserved. 1 | 10

Ten (Surprising) Facts Concerning Money & Banking (cont’d) 6. Banks are so healthy these days that almost none are required to pay premiums for deposit insurance. • • • A strong economy requires the support of the banking system. When depositors start a “run on the bank”, banks become reluctant to lend, stifling economic growth. The U. S. government now manages a deposit insurance program so depositors no longer have to worry about their money. Copyright © Houghton Mifflin Company. All rights reserved. 1 | 11

Ten (Surprising) Facts Concerning Money & Banking (cont’d) 7. Recessions are difficult to predict. • • • Recessions occur when the overall level of business activity in the economy persistently declines. Recessions are harmful, bringing higher unemployment and decreased profits. While sudden “shocks” to the economy may bring on recessions, they are difficult to predict with any accuracy. Copyright © Houghton Mifflin Company. All rights reserved. 1 | 12

Ten (Surprising) Facts Concerning Money & Banking (cont’d) 8. The Fed creates money by changing a number in its computer system. • • • The Fed buys government securities from Wall Street firms, thereby increasing the money supply in the economy. The Fed gives currency to banks in exchange for reducing the amount of funds they must maintain on deposit. This process holds the potential for abuse—if too much money is created, inflation will result. Copyright © Houghton Mifflin Company. All rights reserved. 1 | 13

Ten (Surprising) Facts Concerning Money & Banking (cont’d) 9. In the long run, the only economic variable the Federal Reserve can affect is the rate of inflation-the Fed has no effect on economic activity. • • When the Fed increases the money supply, the economy speeds up…people buy more. But there are limits…In the long run, the economy achieves the same level of economic activity no matter how much money is circulating. Copyright © Houghton Mifflin Company. All rights reserved. 1 | 14

Ten (Surprising) Facts Concerning Money & Banking (cont’d) 10. You can predict how the Federal Reserve will change interest rates using a simple equation. • • • The Fed bases its decisions on two major variablesthe output gap and the inflation rate. The Taylor Rule can predict how the Fed will respond to changes in these variables. While not perfect, the Taylor Rule is quite accurate…You, too, can predict!!! Copyright © Houghton Mifflin Company. All rights reserved. 1 | 15