Chapter 15

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					Chapter 15 Money and the Financial System

OBJECTIVES

1. Define money, its functions, and its characteristics.
2. Describe various types of money.
3. Specify how the Federal Reserve Board manages the money supply and regulates the American
   banking system.
4. Compare and contrast commercial banks, savings and loan associations, credit unions, and mutual
   savings banks.
5. Distinguish among nonbanking institutions such as insurance companies, pension funds, mutual funds,
   and finance companies.
6. Investigate the challenges ahead for the banking industry.
7. Recommend the most appropriate financial institution for a hypothetical small business.


KEY TERMS AND DEFINITIONS

automated clearing-         A system that permits payments such as deposits or withdrawals to be made to
houses (ACHs)               and from a bank account by magnetic computer tape.

automated teller            The most familiar form of electronic banking, which dispenses cash, accepts
machine (ATM)               deposits, and allows balance inquiries and cash transfers from one account to
                            another.

brokerage firms             Firms that buy and sell stocks, bonds, and other securities for their customers
                            and provide other financial services.

certificates of deposit     Savings accounts that guarantee a depositor a set interest rate over a specified
(CDs)                       interval as long as the funds are not withdrawn before the end of the period.

checking account            Money stored in an account at a bank or other financial institution that can be
                            withdrawn without advance notice; also called a demand deposit.

commercial banks            The largest and oldest of all financial institutions, which perform a variety of
                            financial services but rely mainly on checking and savings accounts as sources
                            of funds for loans to businesses and individuals.

credit cards                Means of access to preapproved lines of credit granted by a bank or a finance
                            company; they allow cardholders to promise to pay for products at a later date.

credit controls             The Fed’s authority to establish and enforce credit rules for financial
                            institutions and some private investors.

credit union                A financial institution owned and controlled by its depositors, who usually have
                            a common employer, profession, trade group, or religion.




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debit card              A card that looks like a credit card but works like a check; using it results in a
                        direct, immediate, electronic payment from the cardholder’s checking account
                        to a merchant or third party.

discount rate           The interest rate the Fed charges to loan money to any banking institution to
                        meet reserve requirements.

electronic funds        Any movement of funds by means of an electronic terminal, telephone,
transfer (EFT)          computer, or magnetic tape.

Federal Deposit         An insurance fund established in 1933 to insure individual bank accounts.
Insurance
Corporation (FDIC)

Federal Reserve         The guardian of the U.S. financial system; an independent agency of the federal
Board                   government established in 1913 to regulate the nation’s banking and financial
                        industry.

finance                 The study of money: how it’s made, how it’s lost, and how it’s managed.

finance companies       Businesses that offer short-term loans at higher rates of interest than banks.

insurance companies     Businesses that protect their clients against financial losses from certain
                        specified risks (death, accident, and theft, for example) in exchange for a fee,
                        called a premium.

monetary policy         Means by which the Fed controls the amount of money available in the
                        economy.

money                   Anything generally accepted in exchange for goods and services.

money market            Accounts that are similar to interest-bearing checking accounts, but which offer
accounts                higher interest rates and have greater restrictions.

mutual fund             An investment company that pools individual investor dollars and invests them
                        in large numbers of well-diversified securities.

mutual savings banks    Financial institutions that are similar to savings and loan associations but, like
                        credit unions, are owned by their depositors.

National Credit Union   An agency that regulates and charters credit unions and insures their deposits
Association (NCUA)      through its National Credit Union Insurance Fund.




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open market                 Decisions by the Fed to buy or sell U.S. Treasury bills and other investments in
operations                  the open market.
pension funds               Managed investment pools set aside by individuals, corporations, unions, and
                            some nonprofit organizations to provide retirement income for members.

reserve requirements        The percentage of deposits that banking institutions must hold in reserve.

savings accounts            Accounts with funds that usually cannot be withdrawn without advance notice;
                            also known as time deposits.

savings and loan            Financial institutions that primarily offer savings accounts and make long-term
associations (S&Ls)         loans for residential mortgages; also called thrifts.




LECTURE OUTLINE AND NOTES
(PPT notations below refer to the Premium Content slides.)

                 I.   Introduction
                      A. Money is the one tool used to measure personal and business income and wealth.
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                      B. Finance is the study of money: how it’s made, how it’s lost, and why.

                 II. Money in the Financial System
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                      A. Money is anything generally accepted in exchange for goods and services.
                         1. Many things have served as money: salt, cattle, and precious metals.
                         2. Later came the development of “IOUs,” slips of paper that could be
                            exchanged for a specified supply of the underlying commodity.
                         3. Finally, fiat money is a paper money not readily convertible to a precious
                            metal, such as gold; it did not gain full acceptance until the 1930s.

                      B. Functions of Money
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                          1. Money serves as a medium of exchange, making it easier for people to buy
                             and sell goods and services and eliminating the need for barter—the trading
                             of one product or service for another of similar value.
                          2. Money serves as a measure of value, or a common standard for the value of
                             all goods and services.
                          3. Money acts as a store of value, or as a way to maintain the value of
                             accumulated wealth until it is needed to purchase goods or services.

                      C. Characteristics of Money



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                1. Acceptability
                   a. To be effective, money must be readily acceptable as a way to pay for
                       goods and services and settle debts.
                   b. Acceptability is probably the most important characteristic of money:
                       People must believe in and trust the value of what they use as money.
                2. Divisibility. To facilitate exchanges, money must be easily divided into
                   smaller units of value.
                3. Portability
                   a. For money to function as a medium of exchange, it must be easily moved
                       and carried.
                   b. For most societies, paper money and metal coins satisfy this need.
                4. Stability
                   a. Money must be stable and maintain its declared face value.
                   b. Stability allows people who wish to postpone purchases and save their
                       money to do so without fear that it will decline in value, as during
                       periods of inflation.
                   c. Instability destroys confidence in a nation’s money, and it will ultimately
                       lose acceptability.
                5. Durability. Because it is in continuous use, money must be durable in order to
                   maintain stability and acceptability.
                6. Difficulty to Counterfeit
                   a. Money must be difficult to duplicate illegally in order to maintain
                       stability and acceptability.
                   b. Because modern technology makes it easier to counterfeit paper money,
                       most nations employ special papers and other techniques to thwart
                       counterfeiting.

             D. Types of Money
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                1. Paper money and coins are the most visible types of money, but there are
                   many others.
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                2. A checking account (also called a demand deposit) is money stored in an
                   account that can be withdrawn without advance notice.
                   a. One way to withdraw funds is by writing a check, a written order to a
                       financial institution to pay the indicated individual or business the
                       amount specified from funds on deposit. As legal instruments, checks
                       serve as a substitute for currency and coins and are preferred due to their
                       low risk.
                   b. A NOW (Negotiable Order of Withdrawal) account is an interest-
                       bearing checking account.
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                3. Savings accounts, also called time deposits, are funds in an interest-earning
                   account that usually cannot be withdrawn without advance notice and/or have



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                              limits on the number of withdrawals per period.
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                          4. Money market accounts are similar to interest-bearing checking accounts
                             but with more restrictions.
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                          5. Certificates of deposit are savings accounts that guarantee a depositor a
                             set interest rate but require the funds to be left in the financial institution
                             for a specified period.
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                          6. Credit cards allow you to promise to pay at a later date by using
                             preapproved lines of credit granted by a bank or finance company.
                             a. They are a popular substitute for cash because of their convenience, easy
                                 access, and acceptance around the world.
                             b. Credit cards allow cardholders great flexibility in paying off their
                                 purchases.
                             c. Credit cards may be issued by banks, travel and entertainment
                                 companies, and retail store chains.
                             d. Identity theft associated with credit cards and the amount of credit card
                                 debt consumers owe have become concerns.
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                          7. A debit card looks like a credit card but works like a check; use of a debit
                             card results in a direct, immediate, electronic payment from the cardholder’s
                             checking account to a merchant or third party.
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                          8. Traveler’s checks, money orders, and cashier’s checks are other common
                             forms of “near money” that can be exchanged for cash or products.

                 III. The American Financial System

                     A. The Federal Reserve System
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                          1. The guardian of the American financial system is the Federal Reserve
                             Board, established by Congress in 1913 as an independent government
                             agency responsible for regulating the banking and financial industry.
                             a. The Federal Reserve System is organized into 12 geographical regions.
                             b. The Federal Reserve Board is the chief economic policy arm of the
                                 United States.
                          2. The Federal Reserve Board has four major responsibilities:
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                              a.To control the money supply with monetary policy.
                              b.To regulate financial institutions.
                              c.To manage regional and national check-clearing procedures.
                              d.To supervise the federal deposit insurance of commercial banks
                                belonging to the Federal Reserve System.
                          3. Monetary Policy


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                    a. Monetary policy refers to the Fed’s methods of controlling the amount
                       of money available in the economy.
                    b. Monetary policy is necessary to balance the supply of and demand for
                       money to minimize economic fluctuations.
                    c. The Fed fine-tunes the money supply with four basic tools.
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                        1) Open market operations are the buying and selling of U.S.
                           Treasury bills and other investments in the open market by the
                           Federal Reserve Board.
                           a) This tool is the most commonly employed.
                           b) To expand the supply of money, the Fed buys securities.
                           c) To decrease the supply of money, the Fed sells securities.
                        2) The second major tool is the reserve requirement, the percentage of
                           deposits that the Fed requires banks to hold in reserve; these cannot
                           be loaned to businesses or individuals.
                        3) The third tool is the discount rate, the interest rate the Federal
                           Reserve charges for money it lends to any banking institution to meet
                           reserve requirements.
                           a) The Fed is the “lender of last resort” to these institutions.
                           b) When the Fed wants to expand the money supply, it lowers the
                                discount rate; when it wants to decrease the money supply; it
                                raises the discount rate.
                        4) The final tool in the Fed’s arsenal of weapons is credit controls—
                           the authority to establish and enforce credit rules for financial
                           institutions and some private investors.
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                4. Regulatory Functions
                   a. The second responsibility of the Fed is to regulate banking institutions
                       that are members of the system.
                   b. The Fed establishes and enforces banking rules that affect monetary
                       policy and competition between banks.
                   c. Surprise bank examinations are conducted annually to ensure that
                       correct accounting practices are followed.
                5. Check Clearing. The Fed provides national check clearing for almost all
                   checks drawn on a bank in one city and presented for deposit at a bank in a
                   second city. The Fed also clears local checks.
                6. Depository Insurance. The Fed is responsible for supervising the federal
                   insurance funds that protect the deposits of member institutions.

             B. Banking Institutions
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                1. Commercial banks are the largest and oldest of all financial institutions and
                   rely mainly on checking and savings accounts as their major source of funds
                   for loans to businesses and individuals.
                   a. Banks today offer a number of services: consumer loans, credit cards,



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                                 safe-deposit boxes, trusts, and securities.
                              b. Legislation permits commercial banks to offer insurance and investment
                                 banking products as well.
                              c. Banks are increasingly merging, even across international borders.
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                          2. Savings and loan associations (S&Ls) are financial institutions that
                             primarily offer savings accounts and make long-term loans for residential
                             mortgages.
                             a. S&Ls, also called “thrifts,” have undergone a metamorphosis in recent
                                 years after having almost collapsed during the 1980s.
                             b. Many S&Ls failed and had to be bailed out by the Federal Savings and
                                 Loan Insurance Corporation and later the Resolution Trust Corporation.
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                          3. Credit unions are financial institutions owned and controlled by their
                             depositors, who usually have a common employer, profession, trade group, or
                             religion.
                             a. At a credit union, a savings account is usually called a share account,
                                  while a checking account is usually called a share draft account.
                             b. Credit unions offer a wide variety of financial services comparable to
                                  commercial banks.
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                          4. Mutual savings banks are financial institutions similar to savings and loan
                             associations except that they are owned by the depositors.
                          5. Going green—produces a bioplastic that is biodegradable.
                             a. Financing has been a serious issue.

                     C. Insurance for Banking Institutions
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                          1. The Federal Deposit Insurance Corporation (FDIC) was created in 1933
                             to provide an insurance fund that insures individual bank accounts.
                          2. Savings and loan associations accounts were insured by the Federal Savings
                             and Loan Insurance Corporation (FSLIC) until it became insolvent with the
                             large-scale thrift failures in the 1980s, it has since merged with the FDIC.
                          3. The National Credit Union Association (NCUA) is an agency that
                             regulates and charters credit unions and insures their deposits.
                          4. These funds are intended to make people feel more secure about their savings
                             so that they won’t panic and withdraw them during a crisis; their
                             effectiveness seems to have been proven during the many bank failures
                             during the 1980s and 1990s.

                     D. Nonbanking Institutions
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                          1. Insurance companies are businesses that protect their clients against
                             financial losses from certain specified risks in exchange for a fee.
                          2. Pension funds are managed investments set aside by individuals,



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                     corporations, unions, and some nonprofit organizations to provide retirement
                     income for members.
                     a. Individual Retirement Accounts (IRAs) are a type of private pension fund
                           set up by individuals to provide for their retirement needs; taxes on the
                           interest earned are deferred until withdrawal upon retirement.
                     b. The Roth IRA is similar to a traditional IRA, but the interest is tax-free
                           upon retirement because investors do not deduct their contributions at the
                           time they are made.
                     c. Most corporations provide some kind of pension plan for their
                           employees.
                     d. Social Security, the largest pension plan, is a public fund. The federal
                           government collects Social Security funds from payroll taxes from
                           employers and deducts them from employees’ paychecks.
                3.   Mutual funds pool investors’ funds and invest them in securities.
                     a. Mutual funds provide professional financial management for people who
                           lack the time and/or expertise to invest in particular securities.
                     b. Money market funds invest in short-term debt securities.
                4.   Brokerage firms buy and sell stocks and bonds for their customers and
                     provide other financial services.
                5.   A growing number of traditionally nonfinancial services have begun offering
                     more financial services to their customers, such as financing the products they
                     sell.
                6.   Finance companies are businesses that offer short-term loans at substantially
                     higher rates of interest than banks; they are often a lender of last resort for
                     individuals and businesses with less than sterling credit.

             E. Electronic Banking
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                1. Electronic funds transfer (EFT) is the transfer of funds by means of an
                   electronic terminal, telephone, computer, or magnetic tape.
                2. Automated teller machines (ATMs) are the most familiar form of electronic
                   banking and dispense cash, accept deposits, transfer funds from one account
                   to another, and display a customer’s account balance through portable
                   machines accessed through ATM networks worldwide.
                3. Automated clearinghouses (ACHs) permit payments such as direct
                   deposits or withdrawals to be made to and from a bank account by
                   magnetic computer tape.
                   a. ACHs permit direct deposits, now used by many companies and the
                       federal government.
                   b. The advantages of direct deposits for individuals include convenience,
                       safety, and potential interest earnings.
                   c. The advantages for businesses include decreased check-processing
                       expenses and increased employee productivity.
                4. Online banking gives customers access to a variety of financial services
                   through personal computers or other devices.




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                 IV. Challenge and Change in the Commercial Banking Industry
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                     A. Some commercial banks made poor managerial decisions in the early 1980s,
                        resulting in several failures.
                        1. Vibrant economic growth in the mid 1990s improved the picture for many
                            financial institutions.
                        2. Better management, combined with better regulation and a robust economy,
                            rescued commercial banks from the fate of the S&Ls.


BOXED TEXT DISCUSSION QUESTIONS

Business Challenges: Wells Fargo Uses Family History to Gain New Clients

    1.       Why is Wells Fargo’s genealogy program less expensive than the competition’s plans
             to attract high-end customers?

    The internet makes it fairly quick and easy to obtain genealogy information, if you know where to
    look. While other banks use fancy parties and expensive guests of honor to woo potential
    customers, a quick search on the internet is all Wells Fargo needs.

    2.       The genealogy approach is working for Wells Fargo—why do you think it has been
             so popular?

    While many people find celebrities interesting, Wells Fargo has hit customers and potential
    customers on a more personal note. Many people are interested in learning more about their family
    history, but they may not know how to go about searching. Other customers may be interested but
    do not have the time to devote to tracking down their family lineage. Many people hope to find
    interesting stories or characters buried in their family’s past and Wells Fargo promises to unearth
    these tales with this program.

    3.       Why are incentives necessary for attracting and keeping customers?

    With competition high among banks, especially for high-end clientele, institutions must devise
    ways to make themselves noticed. Incentives programs indicate to clients that they are willing to go
    the extra mile for customers, and are willing to invest time and attention into making customers
    satisfied.

Going Green Box: A small firm with big plans to reduce waste

    1.       In spite of huge financing obstacles, why is Oliver Peoples not concerned about his
             company’s ultimate success?

    Peoples is not concerned because he knows the world is about to reach a crisis point with the
    availability and price of oil, as well as the disposal of refuse. With increasingly expensive



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      petroleum-based inputs, People’s product is already close to becoming cost competitive. As
      landfills reach capacity and land and water pollution worsen, Peoples knows that consumers will
      start to demand biodegradable packaging more than ever before.

      2.      What are different ways that Peoples has raised capital to finance his company?

      Financing has been a formidable obstacle for Metabolix, but it has begun to experience success in
      this arena. It recently negotiated a joint venture with Archer Daniels Midland, which will supply
      feedstocks and a $200 million plant in Iowa for plastics production. The hope is that in the future
      Metabolix will develop new ways of producing Mirel that will not require food crops like corn, so
      that the product will neither pollute nor cut into an already dwindling food supply.

      3.      Even though Mirel appears to be a superior product, what kinds of competition will
              be a problem for Metabolix?

      Larger multi-national companies are working on their own versions of non-petroleum-based
      plastics. With more influence, capital, and better networks of distribution, companies like Dupont
      and Cargill, carry a lot more international clout than Metabolix and the small company stands the
      risk of being pushed out of the industry if perceived as a threat. As long as traditional plastics
      remain cheaper than bioplastics, customers will probably gravitate toward them. Many customers
      want to do more to save the environment, but as long as it is a more expensive alternative they
      simply cannot afford to do so.

Solve the Dilemma

1. List the various types of U.S. financial institutions and the primary function of each.

      The various types of U.S. financial institutions include commercial banks, savings and loan
      associations, credit unions, and mutual savings banks. Commercial banks are financial institutions that
      hold deposits for individuals and businesses and loan most of the deposited funds to businesses,
      individuals, and government agencies. Savings and loan associations (S&Ls) are financial institutions
      that primarily offer savings accounts and make long-term loans for residential mortgages. Credit unions
      are financial institutions owned and controlled by their depositors. Finally, mutual savings banks are
      financial institutions similar to savings and loan associations except that they are owned by their
      depositors.

2. What services of each financial institution is Hill’s new company likely to need?

      From commercial banks, Hill would need short- and long-term financing, checking accounts, and short-
      term investment capabilities. From savings and loan associations or mutual savings banks, Hill would
      need savings account services and perhaps mortgage services if he chooses to use his personal home to
      finance his business operation. Finally, from a credit union Hill would need checking and savings
      account services, access to financing (probably through mortgage), and short-term investment
      opportunities.

3. Which single financial institution is likely to be best able to meet Hill’s small company’s needs



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    now? Why?

    Hill’s new company is likely to need the services of a commercial bank. Specifically, it will need
    services such as short- and long-term financing, corporate (and/or personal) checking accounts, and the
    availability of short-term investments (money market accounts, certificates of deposit, and so forth). In
    addition, many commercial banks also offer financial consultation to small business owners, a service
    Hill may find desirable. Credit unions represent another possibility if one is available in his area that
    provides services for small businesses. These needs may go unmet at savings and loan or mutual
    savings financial institutions.


SUPPLEMENTAL LECTURE

The Federal Reserve System

The Federal Reserve System monitors the nation’s money supply and tries to exert some influence over it.
The exact nature of the relationship between the money supply and inflation is best treated by a panel of
learned economists and will be explored in depth in your economics classes. Our mission in this lecture is
to discuss three ways in which the Federal Reserve (often called the Fed) tries to alter the money supply.

RESERVE REQUIREMENT

One of several roles of the Federal Reserve System is to regulate commercial banks that have elected to
affiliate themselves with the system. One facet of this control is setting the reserve requirement. As you
know, banks maintain accounts for depositors and also lend funds to borrowers. This arrangement works
well for commercial banks as long as loaned funds earn more interest for the bank than the bank pays out in
interest to the savings and checking customers. The difference is called the spread. A bank earns revenues
by lending money. However, the bank’s eagerness to earn might drive it to lend so generously that there
might be little cash on hand to allow the bank to perform the services expected by savings and checking
customers. The Fed has stepped in to control this eagerness by requiring a commercial bank to keep a
percentage of its funds in ready reserve for cash emergencies that might arise.

This reserve requirement can be changed by the Fed as it wishes. Raising the reserve requirement means
that commercial banks will be forced to hold larger reserves and thus will be less able to release funds into
the economy. Lowering the requirement means that banks have more money and can thus release more
funds into the economy. Turning the reserve “spigot” on or off affects the amount of money in circulation.

DISCOUNT RATE

Our Federal Reserve System is often called the banks’ bank. This means that when a commercial bank has
banking needs, it can turn to the Fed. If a commercial bank needs to borrow funds beyond an overnight
period, it may borrow from the Fed. The interest rate the Fed will charge such a commercial bank is called
the discount rate. If a commercial bank seeks to help a customer with a financing problem and borrows
funds for that purpose from the Fed, the interest rate the bank charges its customer will reflect the discount
rate the Fed has charged the commercial banks. If the Fed raises the discount rate, that increase will be
passed on to the commercial bank’s customer. Such an increase can discourage borrowing, and limiting
borrowing can cut down on funds going into the nation’s money supply. On the other hand, lowering the


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discount rate will make banks more capable of lending “cheap” money, thus adding to the money supply.

In other nations, commercial banks at various times have had to lean very heavily on the lending generosity
of their central bank. (Our central bank is the Fed.) However, in the United States, commercial banks have
many other sources from which to borrow. Altering the discount rate in the United States may not have the
impact on lending that other nations would experience, but altering the discount rate has a major impact in
an unofficial way. When the Fed raises the discount rate, it is a signal to the financial community and to the
securities markets that higher interest rates are coming. We use the term unofficial because it is often not
the discount rate that leads or initiates movements of interest rates.

OPEN MARKET OPERATIONS

Many economists believe that open market actions are the Fed’s most significant and effective tactic. The
Federal Open Market Committee of the Federal Reserve System (known as the FOMC) meets on a regular
basis and decides what moves to make in securities issued by the United States Treasury Department.

If it is decided, for example, that the Fed should sell millions (or even billions) of dollars of Treasury bonds
on a given day, this action will draw millions of dollars out of the economy, thus reducing the money
supply. On the other hand, if it is decided that the Fed should buy millions of dollars of Treasury bonds on a
given day, this action will draw bonds out of the hands of individuals and institutions and put dollars back
into the economy. If the Fed bought millions of dollars of bonds twelve market days in a row, a
considerable sum of dollars would be put into the economy.

Although the Fed’s methods discussed in this lecture can have an effect on the size of the money supply,
changes in the money supply cannot be considered a foolproof method for controlling inflation. Just how
much it helps is a matter for discussion by economists.

Questions
1. How does the Federal Reserve System control the money supply?
2. Why is the Fed sometimes called the “banks’ bank”?


CONTROVERSIAL ISSUE

Does Insurance for Banking Institutions Reward Reckless Decisions of Institutions and Depositors?

The Federal Deposit Insurance Corporation (FDIC) was established in 1933 to help protect deposits. In the
early 1930s, nearly 4,000 banks failed. Many banks failed because of depositor “runs” on banks, when huge
numbers of depositors demanded their money at the same time. Many financially sound and prudently run
banks experienced runs when rumors of a bank failure caused people to panic and withdraw their deposits.

Congress established the Federal Deposit Insurance Corporation (FDIC) to protect individual depositors but
also to restore confidence in the banking system. All federal banks must be insured by the FDIC. Banks,
such as state banks, that are not members of the Federal Reserve System may be covered under FDIC.
Today, the FDIC insures depositors up to $100,000 for each account. The Federal Savings and Loan
Insurance Corporation (FSLIC) was established soon the after the FDIC to extend the same protection to
depositors in savings and loan associations.



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The news media widely reported the savings and loan failures of the 1980s, many of which were caused by
the collapse of the real estate and construction industries, particularly in Texas and California. As
developers and managers of real estate and construction companies were unable to repay their loans, many
savings and loans or banks had financial difficulties or failed. Most of their depositors, protected by the
FDIC or FSLIC, were repaid up to $100,000 per account. The FSLIC did not have enough money to pay all
depositors of failed S&Ls, and thus the FSLIC was combined with the FDIC, the insurer of bank deposits.
In 1989 Congress created the Resolution Trust Corporation (RTC) to oversee the bailout and disposition of
failed savings and loans institutions. At a cost of hundreds of billions of dollars, the RTC cleaned up the
industry and then was dissolved in 1998.

Because of the crisis in the 1980s, especially with savings and loan associations, and because of continued
financial difficulties of some banking institutions, critics have suggested that the insurance plans themselves
may have contributed to some of these problems.

How can insurance designed to protect depositors be a problem? Currently, depositors can have separate
accounts insured up to $100,000. With confidence that an account insured by the FDIC will be paid in case
of institution failure, many individuals have placed money in risky or shaky financial institutions. Evidence
suggests that weak savings and loans often offered higher rates of interest to attract depositors. Even with
rumors of S&Ls’ financial difficulties, depositors were attracted by the higher interest rates. When the weak
savings and loan institutions collapsed, the depositors were repaid.

In some cases, financially strong banks are protesting that the system rewards inept or imprudent banks.
Those institutions that charted a more conservative course by paying lower interest rates or by being more
selective in granting loans feel that bailing out some institutions is rewarding poor management decisions.
Likewise, the argument can be made that depositors who stayed with more conservative banks are actually
paying for the depositors who opted for higher returns with risky banks.

Should depositors have some responsibility? Some in the banking industry have suggested two ways to deal
with depositor responsibility that might enhance wiser consumer choices of banking institutions: (1)
insuring individuals up to a total of $100,000 per person—not each account held by an individual, or (2)
requiring some type of deductible feature whereby the first $10,000 or $20,000 would not be covered in
case of a bank failure. With depositors realizing that deposits would not be covered 100 percent, perhaps
they would be more selective in choosing a bank.

As the banking industry deals with the failures of the past decade, the issue of insurance and protection for
depositors will continue to be debated. At issue is not just depositor protection but confidence in the
banking system.

Questions
1. Should all depositor accounts be protected up to $100,000? Or should depositors be protected only for
   $100,000 per individual?
2. Why is it wise to provide insurance for bank deposits?




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Chapter 15 Money and the Financial System

REVISIT THE WORLD OF BUSINESS

      1.      What are the risks associated with peer-to-peer lending?

      As with any loan, there is the risk that the lender will default. This risk becomes even greater in an
      informal lending situation where the lender may not have the collateral or good credit to back up
      the loan that lenders using traditional banks have..

      2.      What are the advantages and disadvantages of not using a bank?

      One of the greatest advantages to using peer-to-peer lending is that even those people who have
      been turned down by traditional banks can obtain a loan. Loans, often, can provide the capital
      necessary for success, and when they are difficult to obtain people are left trapped in poverty. One
      of the advantages for investors using Prosper is that they can obtain a high return on their money—
      anywhere from 7.76% and 22.67%, which is much higher than most other investments.

      3.      Could the peer-to-peer lending model have other applications in the business world?

      Students’ answers will vary.


CHECK YOUR PROGRESS

1. What are the six characteristics of money? Explain how the U.S. dollar has those six
   characteristics.

      a. Acceptability—the dollar is acceptable as payment for goods and services and settlement of debts.
      b. Divisibility—money must be divisible into small units to facilitate exchanges. The dollar is
         divisible into pennies, nickels, dimes, and quarters.
      c. Portability—money must be easily transported. The dollar is lightweight and folds easily.
      d. Durability—dollars last an average of eighteen months and can be folded thousands of times.
      e. Stability—the dollar is reasonably stable. A dollar will buy a dollar’s worth of goods and services
         today or next week.
      f. Difficulty of counterfeiting—the dollar is extremely difficult to counterfeit because of the paper
         and ink used in printing.

2. What is the difference between a credit card and a debit card? Why are credit cards
   considerably more popular with U.S. consumers?

      A credit card allows consumers to make purchases and pay for them over time, at a specified interest
      rate. With a debit card, the amount of a purchase is immediately deducted from the consumer’s
      account, if enough funds are available. Credit cards are considerably more popular with U.S.
      consumers because they allow instant financing of purchases and are generally accepted around the
      world. Debit cards, however, are beginning to grow in popularity because of their convenience.

3. Discuss the four economic goals the Federal Reserve must try to achieve with its monetary



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Chapter 15 Money and the Financial System

    policy.

    The Fed must promote stable, long-term economic growth; high levels of employment; stable prices;
    and a balance of international payments. It does this by controlling the money supply, regulating
    financial institutions, managing regional and national check clearing procedures, and supervising
    federal deposit insurance of commercial banks belonging to the Federal Reserve System.

4. Explain how the Federal Reserve uses open market operations to expand and contract the money
   supply.

    The open market activities used to expand the money supply involve the Fed buying government
    securities. More money is placed in circulation because the Fed pays cash for the securities. The Fed
    contracts the money supply by selling government securities. Money is transferred from the buyers’
    accounts into the Federal Reserve account, thus reducing the supply of money.

5. What are the basic differences between commercial banks and savings and loans?

    Although both institutions offer checking accounts, savings accounts, and make loans, commercial
    banks loan mainly to individuals and businesses, and savings and loans mainly make mortgage loans.

6. Why do credit unions charge lower rates than commercial banks?

    Credit unions charge lower rates because they are owned by their members and operated for them.
    Commercial banks must return a significant return on investment for their shareholders, whereas credit
    union members, who are the owners, prefer to get their returns in the form of higher interest rates on
    accounts and lower rates on loans.

7. Why do finance companies charge higher interest rates than commercial banks?

    Finance companies charge higher rates because they are usually a lender of last resort for customers
    whose other options have been exhausted. They assume a higher risk level and compensate by charging
    a higher interest rate.

8. How are mutual funds, money market funds, and pension funds similar? How are they
   different?

    Mutual funds, money market funds, and pension funds are similar in that each type of fund pays
    interest based on the performance of a portfolio of securities. In addition, individual investors do not
    select the specific securities in which the investment is made. The portfolio is managed for the investor
    and may include a wide variety of securities. Money market funds, however, focus on investment in
    short-term securities and function more like specialized checking accounts. Finally, unlike mutual
    funds and money market funds, pension funds are generally not accessible (without penalty) until the
    investor retires.

9. What are some of the advantages of electronic funds transfer systems?



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Chapter 15 Money and the Financial System

      Advantages of electronic funds transfer include greater security, greater efficiency and convenience,
      and lower costs in completing financial transactions.


GET INVOLVED

1. Survey the banks, savings and loans, and credit unions in your area, and put together a list of interest
   rates paid on the various types of checking accounts. Find out what, if any, restrictions are in effect for
   NOW accounts and regular checking accounts. In which type of account and in what institution would
   you deposit your money? Why?

2. Survey the same institutions as above, this time inquiring as to the rates asked for each of their various
   loans. Where would you prefer to obtain a car loan? A home loan? Why?


BUILD YOUR SKILLS

Author’s Note: This exercise is designed to have students research (through the Yellow Pages, Chamber of
Commerce, Internet, etc.) available financial services in the local area. This chapter provides the professor
with a good opportunity to ask someone from the local financial community to speak to the class about the
issues posed in this question. The answers for questions 1 and 2 are based on chapter material. The answer
to question 3 is not covered in the text but is designed to help students understand that it is never too early
to start financial planning for retirement.

1. There are a wide variety of banking and nonbanking institutions that can help individuals manage
   money. Banking institutions include commercial banks, savings and loans, and mutual savings banks.
   Nonbank institutions include insurance companies, pension funds, mutual funds, brokerage firms, and
   finance companies. While non-financial firms such as General Electric Capital exist, they specialize in
   financing large businesses rather than individuals.

2. Each of the institutions mentioned in the answer to the first question has traditionally specialized in
   limited products. For example, savings and loans primarily made housing loans, brokerage firms
   primarily sold securities to the public, and insurance companies sold life, property, and casualty
   insurance. However, in the last decade, a consolidation of financial services has been taking place.
   Nations Bank and Bank America merged to create Nationwide Banking. Citibank and Travelers
   merged to create Citigroup, a financial conglomerate that can participate in almost any financial
   transaction. Merrill Lynch, known only as a brokerage firm by many, can not only buy and sell
   securities, but also sells insurance and provides credit cards, check writing privileges against money
   market accounts, pension fund services, and retirement planning. Answers to the question of whether to
   have many specialized providers or one provider of financial services will vary, of course.
   Considerations in making such a decision should include cost (which may be lower with the one-stop
   approach), privacy, time, and knowledge base of the individual. As evidenced by recent mergers, the
   trend is to provide full-service, one-stop financial shopping to consumers.

3. Student research should include information of Social Security. Discussion could center on whether
   students feel Social Security alone will provide for their retirement and if not, alternative strategies they
   may use for retirement planning. Research should also include information about Individual Retirement


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Chapter 15 Money and the Financial System

    Accounts and comparisons of traditional versus Roth IRAs. Traditional IRAs allow up to $3,000 in
    annual contributions (depending on income) with the contribution deductible from taxable income.
    When the income is withdrawn, it is taxed at ordinary tax rates. Roth IRAs allow investors to contribute
    after-tax dollars into the retirement account. Funds invested in a Roth IRA grow tax-free, and income
    withdrawn at retirement is not taxable. Clearly, the Roth IRA is more advantageous to young people.
    Students may also find information about 401K retirement plans. To provide a real-life example,
    professors may wish to explain the retirement plan utilized by their university.


SO YOU’RE INTERESTED IN FINANCIAL SYSTEMS OR BANKING

Why are internships a good way to try out an industry before going into it as a career?

Just because classes in a certain field are interesting does not mean that you will enjoy working in that
industry. Internships provide hands-on, real-world experience with jobs you are interested in applying for
after graduation. They are a low-stakes way to try on different fields until you find one that fits. Internships
also are a great way to network and build up valuable connections before you get out into the working
world. They also signal to future employers that you are interested in learning and working hard, and are
willing to take extra steps to be successful.


BUILD YOUR BUSINESS PLAN
Have students estimate the revenues for the first three months of operation of the Thai Restaurant. This will
force them to think of what the average bill will be for lunch and/or dinner, and how many times the tables
will turn over for each meal. Students should look for competitor information to help them answer these
questions. Review Figure 15.4 with them and make sure they understand all that is involved in putting
together an income statement.

At this point, students should be in the final stages of their written business plan and are beginning to plan
and organize their oral presentations. Tell the students they should look at the judges as possible investors
for their business. Remind them that they need to capture and hold the audience’s attention in the oral
presentation.


SEE FOR YOURSELF VIDEOCASE: Bank One: Keeping Up with Global Trends

Case Overview

In addition to providing many different kinds of insurance, State Farm has recently started a banking
division. This case profiles the start of this division and how successful it has been. The case also discusses
how banking dovetails with State Farm’s other divisions in order to make the banking venture a success.
Finally, the case discusses State Farm’s banking competitive advantages and what makes its banking
division different than other banks.


Questions for Discussion




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Chapter 15 Money and the Financial System

      1.      Given their other lines of business, did it make sense for State Farm to branch out
              into banking?

      Students’ answers will vary. They must defend their answers.

      2.      What are the advantages to customers of being able to obtain insurance, loans, and
              do banking all with the same institution?

      There is the time-saving advantage of being able to take care of numerous different tasks at one
      location. Customers may be more inclined to bank with State Farm if they already have insurance
      through the company because it is easier. The convenience of doing all banking online and at
      ATMs means that customers will never have to stand in long bank lines—a feature that likely is
      attractive to some customers. Also, doing a lot of business with one organization helps to establish
      trust between the customer and that organization. This benefits both parties.

      3.      Are there drawbacks of diversifying the company into other branches of finance?

      State Farm may find that it is spreading the company too thin trying to be a leader in multiple
      industries. The areas where it is strongest could suffer as State Farm tries to add to its portfolio.
      Competition might also be a problem for the company, as State Farm enters into banking—where
      many large establish competitors exist. State Farm will have to emphasize the convenience of
      having insurance, loans, mortgages, and banking all located within the same company. The online
      banking feature may be appealing to some customers.


TERM PAPER OR PROJECT TOPICS

1.    History of Banking in the United States
2.    Electronic Fund Transfer Systems
3.    Security Concerns with Automated Teller Machines (ATMs)
4.    A Study of Major Credit Card Companies
5.    Social Security: The United States’ Largest Pension Plan


GUEST SPEAKER SUGGESTIONS

1. A representative from any one of the following institutions: commercial bank, savings and loan
   association, credit union, or mutual savings bank. The representative can speak about the activities of
   that particular institution.
2. An official from the local Social Security Administration office to speak about funding and benefits of
   Social Security.
3. A representative of a firm providing private pension plans.
4. A representative of a financial network to talk about financial services offered by these firms.
5. A professor specializing in banking and finance to speak about topics pertinent to the chapter.




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Chapter 15 Money and the Financial System

TEACHING SUGGESTIONS

1. For a change of pace, start this class session with the Chapter 15 Quiz.

2. Use the “Lecture Outline and Notes” to review chapter content. The slides are indicated in the left
   margin.

3. The “Supplemental Lecture” provides additional material about the Federal Reserve System, and the
   “Controversial Issue” focuses on some issues involved in the banking crisis.

4. Cover “Get Involved” in class. Also, Exercise 1 would be appropriate for class discussion. “Additional
   Discussion Questions and Exercises” are given in this Instructor’s Manual.

5. Exercise 2, a survey of banks, savings and loans, and credit unions in your area, could be used as a
   group project. Different members could survey different institutions and then pool information for a
   group report.


DESTINATION CEO VIDEO NOTES
(The Destination CEO Videos can be found on the OLC at www.mhhe.com/ferrell7e.)

Clarence Otis – Darden Restaurants

Summary:
About 30 years ago, Clarence Otis changed the name of his restaurant from the Green Frog to the Red
Lobster. Today, it is the #1 seafood chain in the country. The same parent corporation, Darden
Restaurants, owns the Olive Garden chain. Darden has over 150,000 employees and 15,000 restaurants.

At an early age, Clarence Otis had excellent guidance as his mother had very high expectations for him.
His first job was a server in a full service restaurant where he learned the pressures associated with high
expectations of customers. He attended Williams College as an undergraduate. From there, he returned to
northern California to attend law school at Stanford. Otis returned to the east coast where practiced
corporate law in NYC with a focus in mergers and acquisitions. He found that he liked the financial
aspects of the business better than the legal side. Clarence Otis changed his career to that of an investment
banker. He moved to Darden in 1995 as Treasurer. Eventually Otis became the CFO and advanced to the
role of CEO.

Today, he sees a tremendous amount of growth potential for both Red Lobster and Olive Garden chains.
To remain relevant is the key. Both restaurants continue to evolve in concert with the guests’ expectations.
 People who work for the Darden chains must be inspired and understand the corporate philosophy and its
goals.

Discussion Questions:
    1. What prepared Clarence Otis for his position as CEO of Darden?
Answer: His experience with mergers and acquisitions, finance (as an investment banker), his role as
treasurer and then later as CFO all combined to provide him the experience necessary for effectiveness.



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Chapter 15 Money and the Financial System

    2. How extensive is Darden Restaurants in the U.S.?
Answer: Darden owns both the Red Lobster and Olive Garden Chains. The Red Lobster is the #1 seafood
chain in the U.S. The parent company has over 150,000 employees and 15,000 restaurants and continues to
employ a growth strategy.

    3. According to Otis, what is the key area for success for employees at the Darden company?
Answer: His strategy is that the restaurants remain relevant. To that end, employees must be inspired and
understand the corporation’s culture and goals. He sees the success of the restaurants tied to meeting the
evolving needs and expectations of customers.


Multiple Choice Questions for Students on the OLC:
   1. Who is the parent firm for both Red Lobster and Olive Garden?
   a. Dayton Industries
   b. Darden Restaurants
   c. Wendy’s
   d. MacDonald’s
   e. None of the above
Answer: b. Darden Restaurants

   2. Which of the following law schools did Clarence Otis attend?
   a. Stanford
   b. Williams
   c. Amherst
   d. Harvard
   e. Yale
Answer: a. Stanford

   3. Approximately, how many employees are employed by both the Red Lobster and Olive Garden
       chains?
   a. 150,000
   b. 200,000
   c. 10,000
   d. 500,000
   e. None of the above
Answer: a. 150,000

   4. What was the original name of the Red Lobster restaurant?
   a. Sign of the Times
   b. Red Parrott
   c. Green Frog
   d. Golden Olive
   e. Lobster Man
Answer: c. Green Frog

      5. In what area of corporate law did Clarence Otis specialize?


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Chapter 15 Money and the Financial System


   a. Mergers and acquisitions
   b. Finance banking
   c. Investment banking
   d. Portfolio analysis
   e. Arbitration
Answer: a. Mergers and acquisitions




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