MONEY AND FINANCIAL INSTITUTIONS Chapter 12 MONEY If

MONEY AND FINANCIAL INSTITUTIONS Chapter 12

MONEY • If you didn’t have money, you would have to trade. This is called? – Barter – trade goods and services for other goods and services • Monetary System – goods and services are indirectly exchanged for money

MONEY • Money – anything that people accept as a standard of payment • Must have three functions – Medium of exchange – Standard of value – Store of value

FUNCTIONS • Medium of Exchange – money is a medium to trade for goods and services – Prevents bartering • Sell tomatoes to get CDs – example • Money is NOT a good or a service – It is a means of exchanging goods and services

FUNCTIONS • Standard of Value – a fixed measure of something – How many tomatoes makes up one CD? – How many gallons of milk for a Big Mac ® – With money, these are not issues – Money has same value to everyone – Can have set values (prices) for goods and services

FUNCTIONS • Store of value – holds value over time and can be saved – Can increase money to make you wealthier – Stores very well, does not mold or fall apart

CHARACTERISTICS • In most of the world, money is paper and coins. • All money has to have the same characteristics • Characteristics: – – – Scarce Accepted Divisible Portable Durable

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BANKING • Financial Institution – organization for managing money in our economy • Banks offer several services – Storing Money – Transferring Money – Lending Money – Other

STORING MONEY • Bank Account – record of how much money a customer has deposited or withdrawn • Deposit – money put into the bank • Withdrawal – money taken out of the bank • Keeping money in bank makes it safer and harder for you to spend.

ACCOUNTS • Checking Account – Demand Deposit because you can demand that money is paid – Store money in short term – Some banks charge fees for checking accts. • Savings Account – Store money for long term – Earn interest

INTEREST • Interest is money you earn on your savings – Rate bank pays you for keeping your money –I=P*R*T • Interest = Principal * Rate * Time – Principal is your money – Rate is the % the bank pays (as a decimal) – Time is given in terms of years

INTEREST EXAMPLE • You have $1, 000, and the bank pays 3% interest, compounded yearly. How much money would you have after two years? • I=P*R*T I = 1, 000 *. 03 * 2 I = $60 Your money is P + I or 1, 000 + 60 = $1, 060

TRANSFERRING MONEY • Every business transaction involves transfer of money • Almost all transfers occur electronically • Electronic Funds Transfer – money is transferred through a network of computers – Used to give you money – Used to pay bills

LENDING MONEY • Banks lend out the money you deposit. Give this money to other people to buy things. • Bank pays you interest on the money you have in bank • Bank charges interest on the money it loans out to people • Difference in interest rates is profit for bank

TYPES OF LOANS • Mortgage Loan – loan used to buy real estate – the real estate is the collateral • Commercial Loan – loan to businesses • Individual Loan – made to people based on other collateral to allow for payment. • Line of Credit – Set aside money for use later (sometimes called a home equity loan)

Business Building Blocks How to Compute Interest Step 2. Use this formula: interest = principal x interest rate x time continued

Business Building Blocks How to Compute Interest Decimal Principal x Interest x Time Rate $1, 000 x . 10 x 3 = Interest = $300 continued

Business Building Blocks How to Compute Interest At the end of 3 years, the cost of the loan would be $300. Since you also must pay back the principal, you owe the lender $1, 300.

Figure 12. 2 HOW BANKS DO BUSINESS Banks are businesses that provide financial services to make a profit. What would happen to a bank’s profits if deposits suddenly decreased?

MORE BANK SERVICES • Safe-Deposit boxes – put valuables in and you have only access • Credit cards – Mastercard, Discover and Visa issued by banks. • Trust and estate – planning for your will • Retirement services – helping you invest for your future

TYPES OF BANKS • Banks are state, national or international • Three main types of banks: – Commercial – Savings and Loans – Credit Unions

COMMERCIAL BANKS • Sometimes called full service banks • Largest type of bank in US • Earn profit by charging higher interest on loans than they pay on savings accounts

SAVINGS AND LOANS • Charged lower interest and paid higher interest to encourage savings and help people be able to afford houses • In 1980’s about 20% of these failed • Government allowed them to charge higher interest rates • Now similar to commercial banks

CREDIT UNIONS • Non-Profit banks set up for members of an organization to use. • Lower risks, so can offer higher interest rates on savings, and lower rates on lending • Offer almost all services a bank does

OTHER FINANCIALS • Mortgage Companies – loans just for houses • Finance Companies – Short term loans with higher interest rates • Insurance Companies – Provide insurance AND loan money • Brokerage Firms – Sell stocks and bonds

THE FED • The Federal Reserve System (FED) is the central banking organization in the US. • Consists of 12 Federal Reserve Banks • 25 Branch Banks • 5, 000 member banks • Run by the Chairman of the Fed – Used to be Alan Greenspan – Now is Ben Bernanke

FED FUNCTIONS • Clearing Checks - Transferring funds from one account to another • Acting as the Federal Government’s Bank – Spends and distributes federal money on behalf of the US Treasury • Supervising Member Banks – regulates banks in the FED – necessary due to bank failures in the early 1900’s.

FUNCTIONS OF FED • Regulating the Money Supply – Determine the amount of money in circulation (Scarcity) • Setting Reserve Requirements – amount of money a bank must have on hand before it can loan money to others • Supplying Paper Currency – making the money that we use

RESERVE REQUIREMENTS • Fed determines how much money a bank must keep. • Current Reserve Requirement is about 8%. • Bank only keeps 8% of deposits, and lends out rest to others. • This lending creates money.

• Reserve Requirements and Money Creation Reserve requirements affect the potential of the banking system to create transaction deposits. If the reserve requirement is 10%, for example, a bank that receives a $100 deposit may lend out $90 of that deposit. If the borrower then writes a check to someone who deposits the $90, the bank receiving that deposit can lend out $81. As the process continues, the banking system can expand the initial deposit of $100 into a maximum of $1, 000 of money ($100+$90+81+$72. 90+. . . =$1, 000). In contrast, with a 20% reserve requirement, the banking system would be able to expand the initial $100 deposit into a maximum of $500 ($100+$80+$64+$51. 20+. . . =$500). Thus, higher reserve requirements should result in reduced money creation and, in turn, in reduced economic activity.