What is Money?

• Store of Value (much better than salt or cattle)

• Medium of Exchange ($45= 1 pair of Dockers)

• Unit of account—can compare the value of goods & services (Lexus RX350 vs. Hyundai Veracruz)

6 Characteristics of Currency (Coins and Paper

Bills)• Durability--Objects used as money must withstand

physical wear and tear.• Portability--People need to be able to take money

with them as they go about their business.• Divisibility--To be useful, money must be easily

divided into smaller denominations, or units of value.

• Uniformity--Any two units of money must be uniform, that is, the same, in terms of what they will buy.

• Limited Supply--Money must be available only in limited quantities.

• Acceptability--Everyone must be able to exchange the money for goods and services.

• Example of all the above: Specie (gold and silver coin)

The Source of Money’s Value

Commodity Money--consists of objects that have value in themselves.

EX: A cow. Representative Money--has value because

the holder can exchange it for something else of value.

EX: Paper exchangeable for silver or goldFiat Money--also called “legal tender,” has

value because the government decreed that is an acceptable means to pay debts.

EX: Federal Reserve Note

Section Review--Money

1. Two units of the same type of money must be the same in terms of what they will buy, that is, they must be(a) divisible.(b) portable.(c) acceptable.(d) uniform.

2. What is the source of fiat money’s value?(a) it represents the value of another item(b) government decree(c) presidential pardon(d) it is equal to the value of the stock market

The Euro ۥ January 1, 2002: 11 EU countries began using the

Euro. Maastricht Treaty had called for EMU in 1991• All currency from member countries became

worthless on July 1, 2002.• Countries had to meet certain economic criteria to

join EMU (Inflation rate, debt ratio, etc).• Will remove the need to keep changing currencies

and will make trade easier between member states• DID NOT adopt Euro: UK, Denmark, Greece,

Sweden, Switzerland (Greece now in)• Why are these countries not in EMU?

American Banking History: 2 Original Views

• Federalists believed the country needed a strong central government to establish economic and social order.

• Alexander Hamilton was in favor of a national bank which could issue a single currency, handle federal funds, and monitor other banks.

• Antifederalists were against a strong central government and favored leaving powers in the hands of the states.

• Thomas Jefferson opposed the creation of a national bank, and instead favored banks created and monitored by individual states.

Shifts in Banking SystemThe First Bank of the United States

– The first Bank of the United States was created in 1791. The Bank held tax revenues, helped collect taxes, issued representative money, and monitored state-chartered banks.

Chaos in American Banking– The first Bank lost support and its charter expired in

1811. Different, state-chartered banks began issuing different currencies.

The Second Bank of the United States– The Second Bank was created in 1816 and was

responsible for restoring stability in banking.The Free Banking Era

– The Second Bank’s charter was not renewed in 1832, and another period dominated by state-chartered banks took hold.

Privately Issued Bank Notes

• Continental currency left a bad taste in people’s mouths.

• By 1811, the nation had 100 state-chartered banks. People could exchange notes for gold or silver. No uniform currency design and counterfeiting was rampant.

• The government first printed fiat money in 1861 to finance the Civil War. Fiat money has value because of government decree.

• People feared the greenbacks had little value, so Congress created the National Banking System of federally chartered, privately owned banks. National bank notes were backed by government bonds.

• In 1863, the Federal government issued gold certificates backed by gold, in large denominations. In 1886, it issued silver certificates.

Banking Stabilizes in the U.S.

• The National Banking Acts of 1863 and 1864 gave the federal government the power to:1. charter banks2. require banks to hold adequate

reserves of silver and gold3. issue a single national currency

.

The Gold Standard• In 1900, the nation shifted to the gold standard, a

monetary system in which paper money and coins are equal to the value of a certain amount of gold.

• The gold standard had advantages:1. It set a definite value on the dollar. People felt

secure. Gold was fixed at $20.67 per ounce.2. The government could only issue currency if it had

gold in its treasury to back its notes.

• The gold standard also had disadvantages. 1. The gold supply may not grow fast enough to

support a growing economy. 2. People may decide to convert their paper money

to gold, draining the government’s gold reserves. 3. The price of gold will respond to the market and

lose value

20th Century American Banking

• A panic in 1907 and the following recession indicated something had to be done.

• The Federal Reserve Act of 1913 created the Federal Reserve System. The Federal Reserve System served as the nation’s first true central bank. Yet, privately owned banks own the “Fed,” not the government.

• Yet even the Fed could not prevent the Great Depression and the multitude of bank failures.

• The Banking Act of 1933 created the Federal Deposit Insurance Corporation (FDIC). Today, the FDIC insures customers deposits up to $100,000. The nation was also taken off of the gold standard. No more gold coins were minted.

The Inconvertible Fiat Money Standard

• Since 1934, the U.S. has been on an inconvertible standard. Paper bills may not be exchanged for gold or silver coin.

• Nixon took the U.S. off the gold standard in the 1970s.

• As a result, the value of the dollar “floats” on exchange markets.

Crisis/Reform Since the 1980s

• Until the 1980s, financial institutions were tightly regulated (even the permissible level of interest!)

• Reagan deregulated the industry, which led to more competition. All depository institutions could borrow from the Fed.

• Savings and Loans went through a fraud crisis, and the FSLIC was left holding the bag. Several Congressmen were tarnished, including John McCain. The FSLIC was dissolved.

• 1990s: Many mergers with stock and security brokerage firms, possible conflict of interest

Banking Section Review1. During the Free Banking Era between 1837 and 1863,

banking in the United States was dominated by which of the following?(a) small, independent banks with no charters (b) the Bank of the United States (c) state-chartered banks(d) savings and loans banks

2. After the Civil War, the National Banking Acts gave the federal government the power to do all of the following EXCEPT:(a) insure banks against failure (b) charter banks (c) require banks to hold adequate gold and silver

reserves(d) issue a single national currency

The Money Supply: M1 and M2

M1• M1 consists of assets

that have liquidity, or the ability to be used as, or easily converted into, cash.

• Components of M1 include all currency, traveler’s checks, and demand deposits--the money in checking accounts.

• Debit cards are M1 too—since they usually link to a checking account

M2• M2 consists of all of

the assets in M1, plus deposits in savings accounts and money market mutual funds.

• A money market mutual fund is a fund that pools money from small investors to purchase government or corporate bonds.

Services Offered by Banks

• Storing Money--Banks provide a safe, convenient place for people to store their money.

• Credit Cards--Banks issue cards entitling their holder to buy goods and services based on each holder's promise to pay.

• Saving Money--Four of the most common options banks offer for saving money are: Savings Accounts, Checking Accounts, Money Market Accounts, and Certificates of Deposit (CDs)

• Loans--By making loans, banks help new businesses get started, and they help established businesses grow.

• Mortgages--a specific type of loan that is used to purchase real estate.

BANK

How Banks Make a Profit

How Banks Make a Profit• The largest source of income for banks is the interest they

receive from customers who have taken loans.• Interest is the price paid for the use of borrowed money.

Deposits from customers

Interest from borrowers

Fees for services

Money enters bankMoney leaves bank

Interest and withdrawals to

customers

Money loaned to borrowers:• business loans•  mortgages• personal loans

Bank’s cost of doing business:• salaries• taxes• other costs

Bank retains required reserves

Types of Financial Institutions

Commercial Banks– Commercial banks offer checking services, accept

deposits, and make loans. Savings and Loan Associations

– Savings and Loan Associations were originally chartered to lend money for home-building in the mid-1800s.

Savings Banks– Savings banks traditionally served people who made

smaller deposits and transactions than commercial banks wished to handle. First to develop NOW accounts (checking accounts that pay interest)

Credit Unions– Credit unions are cooperative lending associations for

particular groups, usually employees of a specific firm or government agency.

Finance Companies– Finance companies make installment loans to

consumers.

Electronic Banking

• Automated Teller Machines (ATMs)--Customers can use ATMs to deposit money, withdraw cash, and obtain account information. Very convenient, but often have extravagant fees. ATMs link to savings accounts.

• Debit Cards--are used to withdraw money directly from a checking account.

• Automatic Clearing Houses (ACH)--An ACH transfers funds automatically from customers' accounts to creditors' accounts.

• Home Banking--Many banks allow customers to check account balances and make transfers and payments via computer.

• Stored Value Cards--Stored value cards are embedded with magnetic strips or computer chips with account balance information.

Section Review1. The money supply of the United States is made up of

which of the following?(a) M1.(b) M1 and parts of M2.(c) All the money available in the economy.(d) All the money available in the economy plus money

that the country could borrow.

2. Why are funds in checking accounts called demand deposits?(a) They are available whenever the depositor

demands them by writing a check.(b) They are not liquid.(c) They are usually in great demand.(d) They are held without interest by the bank.

Banking: Need-to-Know: Checking Accounts

• Cash deposited into your account is immediately available. Checks, however, are NOT. Depends on bank. Be very careful about writing checks if the deposit you put in was in the form of non-directly deposited checks. Direct deposit—no problem.

• Don’t let yourself fall below the minimum balance, and find free checking—don’t ever pay for checking

• Checks are normally returned to you, so try to reconcile you statement with the checks you have written. Report errors immediately. Keep cancelled checks (at least 3-5 yrs)

• Float—number of days between when you write a check and when it clears. DO NOT count on this.

• Get Overdraft protection. Many banks offer this for free.• Safety procedures: 1) Write “For deposit only” if you are

putting money into your account when cashing a check. 2) Spell out the dollar amount using “Exactly” and write the check amount so it can’t be modified.

Special Checks

• Certified Checks—Your bank holds funds from your checking account and verifies that the money is there to cover the amount. You cannot stop payment on a certified check though.

• Cashier’s Checks—drawn against the bank’s account, very secure. Operates like a money order.

• Traveler’s Checks—issued by companies, can be rejected but are usually preferred overseas, and can be replaced if lost or stolen.

Credit

• When you borrow money to pay for something or use a card to charge a purchase, you’re using credit.

• You borrow principal.• You pay back principal + a finance charge (a.k.a.

interest)• Interest rates are usually pegged to the prime

rate, the benchmark rate lenders loan money at to their best customers with high credit ratings.

• Credit is good for the economy, but can be disastrous for the individual.

• Types of credit include: Credit cards, mortgages, personal loans, automobile loans,

Credit Cards

• Usually have a spending limit. When you pay back the loan, your spending limit goes back up.

• Shop for the lowest APR and don’t ever accept a card with an annual fee—there’s too many cards out there that are free. Try to find one that figures interest by adjusted balance.

• Try to pay the balance in full each month. If you can’t, pay at least the minimum.

• Department stores, etc. have charge cards. They’re usually a bad deal. Ditto for travel and entertainment cards—and you usually have to pay off the balance in full each month.

• It costs business money to access credit card accounts, but they usually accept cards because they bring in business.

• Credit card lines of credit can hurt you when applying for a loan, even if you never keep balances on them.

• Cards are useful in emergencies and in verifying obligations.• Best benefit: Usually includes car-rental insurance.• Most you’ll ever owe if your card is used fraudulantly: $50.

Building Solid Credit: FICO Scores

Loans• 3 Things concern you when looking for a loan.• How much can you borrow?• How much will I cost?• When do you have to repay?• What if you don’t pay on time?• Difference between APR and APY• Truth-in-Lending Disclosure requires clearly

stated total of payments and finance charges.• Most lenders front-load their loans—more

interest is paid in the beginning than in the end.• Lender can repossess your property and/or

collateral if you default.• There are many types of loans: Auto loans,

Mortgages, personal loans, home equity loans

Mortgage Qualifications• Generally, a prime borrower has a credit score over 700.• Alt-A and “subprime” mortgages may be on their way out.

Some loans were just dumb—no need to prove income, teaser rates

• Most lenders employ a 2 part test to determine how much home you qualify for:

• #1: Monthly payment (including taxes, PMI, insurance) cannot exceed 28% of your gross income

• #2: Your TOTAL debt cannot exceed 36% of your gross income

• California, Massachusetts, and other high cost states may have slightly higher ratios

• Better credit scores can allow the lender to permit higher ratios as well

• Jumbo Mortgages (>$417,000) have higher interest rates—bigger risk

Mortgage Example in the Real World• Suppose you relatively well: $60,000/year (could be 1 or 2

inc.)• Test #1: 28% of gross income/mth: $1400• Test #2: 36% of gross income/mth: $1800• ALL your debts (credit cards, student loans, car loans, etc)

CANNOT exceed $400 to max out the 28% figure. • Budget $50/mth for insurance and $150/mth for taxes (and

that’s low) • $1400 @ 7% interest WITH 20% DOWN ($36,000) only buys

a $180,000 home (3x salary)• Nat’l home median value: $212,000 (MI $115,600)• San Francisco: $607,000. Manhattan condo/apart: $1.2M• At $40,000 you can only afford ~ $100,000• Homes are drastically overvalued in some areas—supply

exceeds demand* (Michigan not as much as the coasts)• Demand= the desire to buy AND ABILITY to pay

Credit Scores

• Every time you use a credit card or get some kind of a loan, your credit report is affected.

• In fact, just applying for a loan can impact your credit score.

• Every mistake you make with credit will probably be reported.

• The higher your score, the better your chance of gaining a loan approval.

• Good credit score= 700 or better.

Bankruptcy• Try to avoid if at all possible, since it ruins your

credit for at least 7 years. • Basically you file a petition in court saying you’re

insolvent, then you discharge your debts for less than you really owe, guaranteeing your creditors at least some money.

• It can prevent the loss of you home and gives you a chance to start again, but it also involves courts, los of assts, and loss of privacy.

• Chapter 7—You sell all assets except your home and ask to be released after paying creditors. Can only file once every 6 years.

• Chapter 12—You pay off creditors over 3-5 years using your wages. Payment is usually not in full.

Section Review

• 1. To qualify for a mortgage, what are the two debt limitation rules that lenders generally abide by?

• 2. What is the difference between Chapter 7 and Chapter 13 bankruptcy?