Money and Banking

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					          What is Money?
• Store of Value (much better than salt or
• Medium of Exchange ($45= 1 pair of
• 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
EX: Paper exchangeable for silver or gold
Fiat 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           €
• 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     • Antifederalists were
  the country needed a       against a strong central
  strong central             government and favored
  government to              leaving powers in the
  establish economic and     hands of the states.
  social order.            • Thomas Jefferson
• Alexander Hamilton         opposed the creation of a
  was in favor of a          national bank, and
  national bank which        instead favored banks
  could issue a single       created and monitored by
  currency, handle           individual states.
  federal funds, and
  monitor other banks.
         Shifts in Banking System
The 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
• By 1811, the nation had 100 state-chartered banks.
  People could exchange notes for gold or silver. No
  uniform currency design and counterfeiting was
• 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 banks
   2. require banks to hold adequate reserves of
     silver and gold
   3. 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
             20th Century American
                        Banking recession indicated
    A panic in 1907 and the following
    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
        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
• 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 Review
1. 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
    (a) insure banks against failure
    (b) charter banks
    (c) require banks to hold adequate gold and silver
    (d) issue a single national currency
       The Money Supply: M1 and
• M1 consists of assets that   • M2 consists of all of the
  have liquidity, or the         assets in M1, plus
  ability to be used as, or
  easily converted into,         deposits in savings
  cash.                          accounts and money
• Components of M1               market mutual funds.
  include all currency,        • A money market
  traveler’s checks, and         mutual fund is a fund
  demand deposits--the           that pools money from
  money in checking              small investors to
  accounts.                      purchase government
• Debit cards are M1 too—        or corporate bonds.
  since they usually link to
  a checking account
        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.
             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.

       How Banks Make a Profit
                                                     Money leaves bank
       Money enters bank
                                                        Interest and
                                                       withdrawals to
         Deposits from
                                                      Money loaned
         Interest from
                                  BANK                to borrowers:
                                                      • business loans
                                                      • mortgages
           Fees for                                   • personal loans

                                                      Bank’s cost of
                                                      doing business:
                                                      • salaries
                                   Bank retains       • taxes
                                 required reserves    • other costs
     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
             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
• Stored Value Cards--Stored value cards are embedded
  with magnetic strips or computer chips with account
  balance information.
                Section Review
1. 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
   (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
• 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
• Cashier’s Checks—drawn against the bank’s
  account, very secure. Operates like a money
• Traveler’s Checks—issued by companies, can
  be rejected but are usually preferred
  overseas, and can be replaced if lost or
• 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 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
• 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
• 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)
              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.
• 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?