PFL- Elementary Money & Banking

8/6/2019 PFL- Elementary Money & Banking

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Money & Banking

Dr. Katie Sauer

Metropolitan State College of Denver

([email protected])

Presented atJunior Achievement¶s Elementary School Personal Financial Literacy Workshop

in collaboration withthe Colorado Council for Economic Education



Session Overview

I. MoneyII. Money and BankingIII. The Federal Reserve SystemIV. The Fed¶s Tools of Monetary Policy



I. Money

The social custom of using money for transactions is extraordinarilyuseful in a large, complex society.

The existence of money makes trade between people easier.

Imagine, for a moment, that there was no item in the economywidely accepted in exchange for goods and services.

People would have to rely on barter ±the exchange of one good or service for another±to obtain the things they need.





Barter System

3. Certain goods/services are notindivisible.

I want to buy 4 chairs from you.

I only have one cow, which isagreed to be worth more than 4chairs.

It is hard for me to sell you partof a cow.

Monetary System

3. Money is fairly divisible.

Currency:

pennies, nickels, quarters «

$1 $5 $10 $20 «

Electronic transfers:fractions of a penny



Barter System

4. Lack of standards for future payments.

Do I owe you a tank of gas or do

I owe you something of equalvalue to a tank of gas?

5. Difficulty in storing wealth.

Some goods are durable, someare not.

Monetary System

4. Common standard for future payments.

All future payments can be

made in money.

5. By definition, money must be able to store wealth for thefuture.



Money is the set of assets that people generally use to buy goodsand services.

In order to be money, the asset has to fulfill 3 functions:1. medium of excha ng e: an item that buyers give to sellersin exchange for goods and services

ex: paper bills, coins, shells, cigarettes

2. unit of acc ount : the ³yardstick´ that people use to post prices and record debts

ex: your Visa bill is denominated in dollars notchickens

3. st ore of value : the item can be used to transfer purchasing power from the present to the future

ex: diamonds are durable, milk is not



There are 2 kinds of money:

1. C ommodity m oney takes the form of a commodity that has intrinsicvalue.

- the material that the money is made of has uses besidesmoney

ex: gold, silver, cigarettes

2. Fiat m oney has no intrinsic value; it is a material used as money bygovernment decree.

- the general public also has to believe it has value

ex: US paper bills



Don¶t be Afraid of Fiat Money

Money is simply a means to an end.- it is a way to make transactions easier - it is a way to transfer purchasing power to the future

Money itself doesn¶t matter to you « what matters is that you cantrade the m oney for thi ng s you wa nt a nd need , now or in the future.

- money is a ta ng ible symbol of purchasi ng power

Trading money for gold serves no real purpose for you.

If you want to trade money for gold so you can trade gold for goodsand services, the gold is no different than the paper currency.

Money is simply a societal agreement. (but a very important one)



Money in the US economy

The quantity of money in the US economy basically consists of cash and money in checkable bank accounts.

curre ncy: paper bills and coins in the hands of the publicas of 2/21/2010 $930.7 billion (fms.treas.gov)

dema nd dep o sits: money in an account that can be accessed ondemand by writing a check

as of 2/21/2010 $943.1 billion (fms.treas.gov)

f ms.treas. gov



Another way to measure the quantity of money is to add in other types of bank accounts (savings, CDs, money market mutualfunds).

- total amount of money in the US economy is about $8.5trillion including these accounts



II. Money and Banking

The qua ntity of money in the economy is affected by the amount of money dep o sited i n ba nk s and they amount they le nd out.

The US has a f racti onal reserve ba nk ing system . This means banksdo not have to keep all deposits on hand, they can lend out a

portion of them.

The fraction of deposits that a bank must keep on hand is calledthe reserve re quireme nt rati o.

-aka reserve requirement, reserve ratio, required ratio

- For large banks, this ratio is 10%.



Ex: Suppose a bank has $200 million worth of deposits.

That bank has to keep at least

(200m)(0.10) = $20million on hand at all times.

It can lend out the other $180million if it wants to.



Because deposits are counted in the money supply, loans that become deposits will increase the money supply.

The banking system ³creates´ money.



So far, the original deposit of $1000 has become$1000 + $900 + $810 + $729

And the cycle will continue«

The maximum amount of money that can be created from an initialdeposit is equal to

initial deposit x (1/rr)

1/rr is called the money multiplier .



If the required reserve ratio is 10%, the money multiplier equals:1/(0.10)= 10

So, if the initial deposit is $1000, the maximum amount of moneythat can be created in the banking system is

1000 x 10 = $10,000



Banking Institutions

C entral Ba nk = institution which oversees the banking systemand regulates the quantity of money in the economy

- ³banking system¶s bank´

C ommercial Ba nk =1. refers to any bank that is not an investment bank

- performs normal banking functions

2. a bank that mostly deals with deposits and loans fromcorporations or large businesses



C ommercial Ba nk = institution which provides transactional,savings, and money market accounts and that accepts timedeposits

- money mar k et acc ounts = bank invests in governmentand corporate securities and pays the depositor interest

based on current interest rates in those markets- typically have a higher interest rate than savingsaccounts- typically require a higher minimum balance toearn interest or avoid monthly fees

- time dep o sits = deposit cannot be withdrawn for acertain term or period of time, unless a penalty is paid

- typically pay higher interest the longer the term



S aving s Ba nk = institution who¶s primary purpose is acceptingsavings deposits

- can perform other functions

Retail Ba nk = institution which executes transactions directlywith consumers (rather than corporations or other banks).

- savings and transactional accounts, mortgages,

personal loans, debit cards, credit cards, etc



C redit U nion = cooperative financial institution that is owned andcontrolled by its members and operated for the purpose of

promoting savings, providing credit at reasonable rates, and providing other financial services to its members.

S aving s a nd Loan Associati on (aka Thrift)= taking deposits for savings and transaction accounts, make mortgages

- tend to be smaller than other banks and are more focused

on the local communities in which they operate



I nvestme nt Ba nk = financial institution that assists individuals,corporations and governments in raising capital

- underwriting and/or acting as the client's agent in theissuance of securities.

- assist companies involved in mergers and acquisitions

- services such as trading of derivatives, foreign exchange,commodities, and stocks

- they do not take deposits



III. The Federal Reserve System

The Federal Reserve (the Fed) is the Central Bank of the UnitedStates. f ederalreserve. gov

A Central Bank is an institution which oversees the banking systemand regulates the quantity of money in the economy.

The Fed was created in 1913 after a series of bank failures.





2. T he Federal Ope n M ar k et C ommittee (FOMC) makes decisionsregarding the quantity of money in the economy.

The FOMC is most important monetary policymaking body of theFederal Reserve System.

The monetary policy is designed to promoteeconomic growthfull employmentstable pricessustainable pattern of international trade and payments

At meetings they discuss economic conditions and decide how toadjust the money supply.



3. 12 Re g ional District Ba nk s that serve as the operating arms of the nation's central banking system. (the banks¶ bank)

- move currency in and out of circulation- check clearing- supervise/ examine banks- hold banks¶ cash reserves and make loans to banks



IV. The Fed¶s Tools of Monetary Policy

When the econo my is slu gg ish , the Fed may want to try to stimulateit by l oweri ng interest rates .

- firms do more investment when interest rates are low

- economic activity increases

When the econo my is experie ncing inf lati on or is ³heating up´ tooquickly, the Fed may want to try to sl ow it d own by raisi ng interest rates .

- firms do less investment when interest rates are high- economic activity decreases



1. The Fed controls the required reserve rati o.- hugely powerful tool- almost never used

This affects the amount of money that banks can lend out.- more lending means more economic activity

When the reserve re quireme nt is raised :- banks are able to lend out less so the quantity of moneyin the economy falls- sl ows the ec ono my down

When the reserve requirement is l owered :- banks are able to lend out more so the quantity of moneyin the economy rises- speeds the ec ono my up



2. The Fed controls the disc ount rate , which is the interest rate thatthe Fed charges to banks for loans (BoG - every 6 weeks)

This is the only interest rate the Fed can directly control.

This interest rate usually just acts as a si gnal from the Fed to banksabout what the Fed would like banks to do.



A hi g her disc ount rate :- means that it will be more costly for banks to borrow fromthe Fed (should they need to)

- so banks take this as a signal to lend out less (be less risky)

- when banks lend out less, the quantity of money in theeconomy falls

- econo my sl ows d own



A l ower disc ount rate :- means that it will be less costly for banks to borrow fromthe Fed (should they need to)

- so banks take this as a signal to lend out more (okay to be

more risky)

- when banks lend out more, the quantity of money in theeconomy rises

- econo my speeds up



3. Ope n M ar k et Operati on s are the purchase or sale of USgovernment bonds by the Fed. (FOMC ± every 6 weeks)

The Fed uses Open Market Operations to tar g et the Federal Funds

Rate. - can¶t control the Fed Funds Rate directly

The Federal Funds Rate is the rate that banks charge each other onshort term loans. (overnight)



Why would banks borrow from each other overnight?- a bank might not have enough reserves on hand to meettheir requirement (made too many loans)

- books must balance at close of business

- borrow from another bank just overnight



When the Fed buys b onds :- banks receive cash in exchange for the bonds they

were holding

- banks have more cash reserves on hand so they arewilling and able to lend it out to other banks

- this decreases the federal funds rate

- banks know it is cheap to borrow from a bank overnightso they are willing to make more loans

- quantity of money in the economy rises

- econo my speeds up



When the Fed sells b onds :- banks receive bond certificates in exchange for their

cash

- banks have less in cash reserves on hand so they arenot as willing and able to lend it out to other banks

- this increases the federal funds rate

- banks know it is more expensive to borrow from a bank overnight so they want to make fewer loans

- quantity of money in the economy falls

- econo my sl ows d own



Summary of Policy Tools:

To slow down the economy, the Fed will decrease the quantity of money in the economy.

- raise the required reserve ratio- raise the discount rate

- raise the federal funds target and sell bonds

To speed up the economy, the Fed will increase the quantity of money in the economy.

- lower the required reserve ratio- lower the discount rate- lower the federal funds target and buy bonds



The Fed, interest rates, and you:

The Fed directly sets the discount rate.The Fed indirectly controls the federal funds rate.

Banks charge each other the federal funds rate and areinfluenced by the discount rate.

Banks charge their best customers the ³prime rate´, whichis based on the discount rate and federal funds rate.

The interest rate on consumer loans is often ³prime + X´.- credit card- mortgage

Documents

PFL- Elementary Money & Banking