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Chapter 14 – Money, Banking, and Financial Institutions

CHAPTER FOURTEEN

MONEY, BANKING, AND FINANCIAL INSTITUTIONS

CHAPTER OVERVIEW

Chapters 14, 15, 16, and 17 form part four of the text, a conventional unit on money and banking. These

chapters provide the foundation for the discussion of modern monetary theory and for the discussion and

analysis of the monetarist and competing theories that follow.

Chapter 13 introduces the student to the U.S. financial system. The chapter first covers the nature and

functions of money and then discusses the Federal Reserve System’s definition of the money supply. Next,

the chapter addresses the question of what “backs” money by looking at the value of money, money and

prices, and the management of the money supply. Finally, there is a rather comprehensive description of

the U.S. financial system, which focuses on the features and functions of the Federal Reserve System and

the financial crisis of 2007 and 2008 and how the financial crisis has changed the financial system.

WHAT’S NEW

There are four new Quick Reviews to help students retain information.

There are minor changes to some of the Learning Objectives.

There is a new Last Word on too big to fail and how it has affected banking regulation and the prosecution

of financial crimes.

All of the relevant tables and data have been updated.

INSTRUCTIONAL OBJECTIVES

After completing this chapter, students should be able to:

1. List and explain the three functions of money.

2. Define the money supply M1 and near-monies M2.

3. State three reasons why currency and checkable deposits are money and why they have value.

4. Explain the relationship between the purchasing power of money and the amount of money in

circulation.

5. Describe the structure of the U.S. banking system.

6. Explain why Federal Reserve Banks are central, quasi-public, and bankers’ banks.

7. Describe seven functions of the Federal Reserve System and point out which role is the most

important.

8. Summarize and evaluate the arguments for and against the Federal Reserve System remaining an

independent institution.

9. Describe the conditions that have caused the financial crisis of 2007 and 2008.

10. Explain the changes in the financial services industry since the financial crisis.

11. Define and identify terms and concepts listed at the end of the chapter.

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COMMENTS AND TEACHING SUGGESTIONS

1. Definitions of the money supply are arbitrary, and this should be stressed. The definition of M1

changes over time as different instruments become acceptable as money.

2. Most students are fascinated by money and will find trivia on the subject interesting. If you would

like to share some of that, consider using the following “Concept Illustration” that appeared on the

website of the previous edition.

Concept Illustration … U.S. paper currency

Trivia can be interesting! Did you know these facts about U.S. currency (Federal Reserve Notes)?1

The Bureau of Engraving and Printing, a Division of the United States Treasury, prints Federal

Reserve Notes in denominations of $1, $2, $5, $10, $20, $50, and $100. Since 1946, no $500,

$1,000, $5,000, and $10,000 denominations have been printed.

Regional Federal Reserve Banks issue the currency and are identified by coding on the face of

each bill: A1 = Boston; B2 = New York; C3 = Philadelphia; D4 = Cleveland; E5 = Richmond; F6

= Atlanta; G7 = Chicago; H8 = St. Louis; I9 = Minneapolis; J10 = Kansas City; K11 = Dallas;

L12 = San Francisco.

The newly designed bills have several security features, some of which are readily visible.

Examples: (1) A watermark depicts the same person as the portrait and is visible from both sides

when held up to a light. (2) The same technique reveals a vertical security thread containing

“USA” in the strip. (3) The numeral in the lower right corner looks bright green when examined

head on, but shifts to dark green when the bill is held at an angle.

The circle on the right side of the back of the $1 bill contains symbolism representing the 13

original states. The burst of light above the eagle’s head contains 13 stars. The right claws hold

an olive branch with 13 leaves and the left claws hold 13 arrows. (The eagle’s head is turned

toward the olive branch.) The shield has 13 stripes. The ribbon held in the eagle’s beak contains

the Latin motto: E Pluribus Unum, which has 13 letters and means “out of many, one.”

The unfinished pyramid in the left circle on the back of the $1 bill symbolizes striving toward

growth and perfection. The eye inside the triangle represents the eternal eye of God. The Roman

numerals at the base of the pyramid are “1776,” the founding year of the United States.

The average life of the $1 bill is 18 months. The $50 and $100 bills—handled less often—have

average lives of 5 and 8 years, respectively.

Beginning in 1934 all U.S. paper currency was inscribed with “The United States of America Will

Pay to the Bearer on Demand One [Five, Ten, etc.] Dollar [s] in Lawful Money.” In 1964 the

inscription was replaced with “This Note is Legal Tender for Debts, Public and Private.”

 The Federal Reserve estimates that only 3/100ths of 1 percent of total currency in circulation is

counterfeited. Authorities seize about 75 percent of all counterfeited money before it is

circulated.

If you accept a counterfeit bill, you are stuck with the loss. Don’t try to pass a known counterfeit

bill to someone else, or you can be fined up to $5,000.

As long as you present what is clearly more than one-half a bill, a bank will accept it for deposit

or replace it. The bank then sends the bill to a Federal Reserve Bank, which destroys it and issues

another bill in its place.

1 Source: Federal Reserve System, “Fundamental Facts about U. S. Money,” 1998.

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3. The Federal Reserve Banks publish a number of excellent low-cost or free educational materials. A

comprehensive guide to these, along with ordering information, is found in Public Information

Materials, available from the Federal Reserve Bank in your district. It could be ordered from any

district, or from the New York Federal Reserve Bank, 33 Liberty Street, New York, NY 10045.

Address your requests to the Public Information Department of the district bank that you write.

The Federal Reserve Bulletin contains a wealth of financial and economic statistics. Write The

Board of Governors, Federal Reserve System, Washington, D.C. 20551 for subscription

information or check their website given in the first web-based question.

4. As an in-class exercise, have the students collectively identify some or all of the Federal Reserve

districts by finding the bank of issue on bills they have in their possession. On older currency notes

the issuing bank is shown in the circle on the left side of the face of the bill. On the newer style of

notes the name of the issuing Federal Reserve Bank does not appear on the bill, but the district

number and corresponding letter of the alphabet do appear toward the upper left-hand corner (e.g.

L12 denotes the San Francisco district). See if all twelve are represented among the bills present in

your classroom. See if the proportion of notes from the different districts is consistent with the

geographical location of the school.

5. Students may be curious why the name of the issuing bank no longer appears on the bill; it is one

of the many anti-counterfeiting measures appearing on the new style bills. The newest generation

of bills, introduced with the $20 in late 2003, adds more color variety and additional anti-

counterfeiting features.

6. There is a lot of ignorance amongst the general population as to what gives money its value. An

interesting experiment is to have students create their own money and attempt to spend it in the

community. When their currency is refused in transactions, have students ask the vendors why it is

refused and record the responses for later classroom discussion. This would, of course, have to be

monitored closely. It is not illegal to create your own currency so long as you are not attempting to

recreate or pass it off as legal tender. Student currency would have to look sufficiently different

from genuine U.S. currency.

7. Ask students to give examples of each one of the functions of money and point out that in some

contemporary countries, inflation has undermined these functions. In these countries, people often

prefer U.S. dollars (or Euros) instead of their own currencies because their currencies don’t store

value or work for long as a unit of account since prices change rapidly.

8. Discuss the use of barter as an alternative means of exchange in places like Russia and Ukraine.

Ask students to relate examples of barter exchanges they have made. Note the conditions required

for barter. Give students an opportunity to explain why barter exchanges are inconvenient.

9. The Federal Reserve banks, including their branches, offer guided tours of their facilities, and

many of the district banks also have exhibits in their public lobby areas. It is definitely a good

“field trip” if you have the opportunity to take your students. If not, the bank’s public information

department may be willing to schedule a presentation at your institution.

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STUDENT STUMBLING BLOCKS

1. It is hard for students to believe that nothing intrinsic backs the money supply. Make sure they

realize that the gold in Fort Knox (or elsewhere) has no function in terms of the value of our

money. Returning to the gold standard continues to be advocated by some. It is a good topic for

debate. If you look at the debate historically, you may want to include the “free silver debate,”

including its allegorical portrayal in The Wizard of Oz.

2. Point out to the students that the phrase “central bank” refers to the Federal Reserve System and the

Board of Governors. It acts as our Central Bank, whereas other countries have a single institution

as their central bank.

3. Another common error that students make is to equate money with income. Focus on the

distinction between the amount of money in one’s possession and one’s income. This helps

students to understand that money and income are not synonyms. For example, you could ask

them to estimate how much M1 money they have at the moment in currency and checking. If they

are typical, this will be much less than their annual income. In other words, the student’s average

money supply is less than the student’s income. The concept of velocity is introduced later, but it

could be mentioned at this point as a way of helping students to contrast the money supply with

income concepts.

LECTURE NOTES

I. Learning objectives – After reading this chapter students should be able to:

A. Identify and explain the functions of money.

B. List and describe the components of the U.S. money supply.

C. Describe what “backs” the money supply, making us willing to accept it as payment.

D. Discuss the makeup of the Federal Reserve and its relationship to banks and thrifts.

E. Identify the functions and responsibilities of the Federal Reserve and explain why Fed

independence is important.

F. Identify and explain the main factors that contributed to the financial crisis of 2007-2008.

G. Discuss the actions of the U.S. Treasury and the Federal Reserve that helped to keep the

banking and financial crisis of 2007-2008 from worsening.

H. Identify the main subsets of the financial services industry in the United States and provide

examples of some firms in each category.

II. Functions of Money

A. Medium of exchange: Money can be used for buying and selling goods and services.

B. Unit of account: Prices are quoted in dollars and cents.

C. Store of value: Money allows us to transfer purchasing power from present to future. It is the

most liquid (spendable) of all assets, a convenient way to store wealth.

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III. Components of the Money Supply

A. Narrow definition of money: M1 includes currency and checkable deposits (see Figure

14.1a).

1. Currency (coins + paper money) held by public. (45% of M1)

a. Is “token” money, which means its intrinsic value is less than actual value. The metal

in a dime is worth less than 10¢.

b. All paper currency consists of Federal Reserve Notes issued by the Federal Reserve.

2. Checkable deposits are included in M1, since they can be spent almost as readily as

currency and can easily be changed into currency. (55% of M1)

a. Commercial banks are a main source of checkable deposits for households and

businesses.

b. Thrift institutions (savings & loans, credit unions, mutual savings banks) also have

checkable deposits.

3. Qualification: Currency and checkable deposits held by the federal government, Federal

Reserve, or other financial institutions are not included in M1.

B. Money Definition: M2 = M1 + some near-monies which include: (See Figure 14.1b)

1. Savings deposits and money market deposit accounts.

2. Small-denominated time deposits (certificates of deposit) less than $100,000.

3. Money market mutual fund balances, which can be redeemed by phone calls, checks, or

through the Internet.

C. Consider This … Are Credit Cards Money?

Credit cards are not money, but their use involves short-term loans; their convenience allows

you to keep M1 balances low because you need less for daily purchases.

IV. What “backs” the money supply?

A. The government’s ability to keep its value stable provides the backing.

B. Money is debt; paper money is a debt of Federal Reserve Banks and checkable deposits are

liabilities of banks and thrifts because depositors own them.

C. Value of money arises not from its intrinsic value, but its value in exchange for goods and

services.

1. It is acceptable as a medium of exchange.

2. Currency is legal tender or fiat money. In general, it must be accepted in repayment of

debt, but that doesn’t mean that private firms and government are mandated to accept

cash; alternative means of payment may be required. (Note that checks are not legal

tender but, in fact, are generally acceptable in exchange for goods, services, and

resources. Legal cases have essentially determined that pennies are not legal tender.)

3. The relative scarcity of money compared to goods and services will allow money to

retain its purchasing power.

D. Money’s purchasing power determines its value. Higher prices mean less purchasing power.

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E. Excessive inflation may make money worthless and unacceptable. An extreme example of

this was German hyperinflation after World War I, which made the mark worth less than 1

billionth of its former value within a four-year period.

1. Worthless money leads to use of other currencies that are more stable.

2. Worthless money may lead to barter exchange system.

F. Maintaining the value of money

1. The government tries to keep supply stable with appropriate fiscal policy.

2. Monetary policy tries to keep money relatively scarce to maintain its purchasing power,

while expanding enough to allow the economy to grow.

V. The Federal Reserve and the Banking System

A. The Federal Reserve System (the “Fed”) was established by Congress in 1913 and holds

power over the money and banking system.

1. Figure 14.2 gives framework of Fed and its relationship to the public.

2. The central controlling authority for the system is the Board of Governors and has seven

members appointed by the President for staggered 14-year terms. Its power means the

system operates like a central bank.

3. The Federal Open Market Committee (FOMC) includes the seven governors plus five

regional Federal Reserve Bank presidents whose terms alternate. They set policy on

buying and selling of government bonds, the most important type of monetary policy, and

meet several times each year.

4. The system has twelve districts, each with its own district bank and two or three branch

banks. They help implement Fed policy and are advisory. (See Figure 14.3)

a. Each is quasi-public: It is owned by member banks but controlled by the

government’s Federal Reserve Board, and any profits go to the U.S. Treasury.

b. They act as bankers’ banks by accepting reserve deposits and making loans to banks

and other financial institutions. In making loans, the Federal Reserve is the “lender

of last resort,” meaning that the Fed is available to lend money should other avenues

(e.g. other commercial banks) not be available.

5. About 6,000 commercial banks are in operation. They are privately owned and consist of

state banks (three-fourths of total) and large national banks (chartered by the Federal

government).

6. Thrift institutions consist of savings and loan associations, credit unions, and mutual

savings banks. They are regulated by the Treasury Dept. Office of Thrift Supervision, but

they may use services of the Fed and keep reserves on deposit at the Fed. Of the

approximately 8,500 thrift institutions, most are credit unions.

7. Global Perspective 14.1 gives the world’s twelve largest financial institutions.

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B. Functions of the Fed and money supply:

1. The Fed issues “Federal Reserve Notes,” the paper currency used in the U.S. monetary

system.

2. The Fed sets reserve requirements and holds the reserves of banks and thrifts not held as

vault cash.

3. The Fed may lend money to banks and thrifts, charging them an interest rate called the

discount rate and serve as an emergency lender of last resort for banks.

4. The Fed provides a check collection service for banks (checks are also cleared locally or

by private clearing firms).

5. Federal Reserve System acts as the fiscal agent for the Federal government.

6. The Federal Reserve System supervises member banks.

7. Monetary policy and control of the money supply is the “major function” of the Fed.

C. Federal Reserve independence is important but is also controversial from time to time.

Advocates of independence fear that more political ties would cause the Fed to follow

expansionary policies and create too much inflation, leading to an unstable currency such as

that in other countries.

VI. The Financial Crisis of 2007 and 2008

A. In 2007 and 2008 the malfunctioning U.S. financial system experienced the worst financial

crisis since the Great Depression which led to problems in the credits markets and spread to

the rest of the economy resulting in a recession.

B. The Mortgage Default Crisis

1. In 2007 there were a huge number of defaults on home mortgages, mostly subprime loans

which previously the Federal government had encouraged banks to make.

2. When banks wrote-off these loans it reduced their reserves and their ability to loan out

other funds.

3. Banks and mortgage lenders packaged hundreds or thousands of mortgages together and

sold them as bonds, believing that this would protect them from defaults on the

mortgages.

a. Buyers of the mortgage-backed securities collected the mortgage payments as returns

on their investment.

b. The banks received a single up-front payment for the mortgage-backed securities.

4. Banks lent a substantial amount of money to investment firms so that they could buy the

mortgage-backed securities.

5. The banks also bought mortgage-backed securities as investment.

6. With the defaults the banks lost money on the loans that they still held, on the money

they had loaned to investment funds for the purchase of mortgage-backed securities and

on the mortgage-backed securities that they had purchased themselves.

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7. Causes of the substantial number of defaults:

a. Government programs that encouraged and subsidized home ownership for previous

renters.

b. Declining home prices.

c. Lax standards by banks because they felt protected from defaults with the mortgage-

backed securities.

C. Securitization

1. The process of slicing up and bundling groups of loans, mortgages, corporate bonds, or

other financial debt into new securities.

2. Encouraged by bank regulators because they felt that this shed much of the bank’s risk

and because they were bought and sold like stocks and bonds, the debt is spread all over

the world.

3. The securities were attractive for buyers because they offered very high rates of return.

4. Collateralized default swaps were insurance policies meant to compensate the holders of

loan-backed securities in case the investment went into default. This was done by many

insurance companies, AIG in particular.

5. The buying and selling of securities backed by loans was crucial in the U.S. to keep credit

flowing for businesses and consumers to buy goods and services.

6. Interest rates on adjustable home loans rose and home prices fell.

7. Many borrowers found that their loans were “underwater” – they owed more on their

loans than their home was worth.

8. Lenders foreclosed on homes and many homeowners simply walked away from their

home and their loan.

D. Failures and Near-Failures of Financial Firms

1. When mortgages began to fail, the big mortgage lenders either failed or nearly failed

because they still owned a large part of the bad debt.

2. Indirect mortgage lenders like securities and investment firms also began to face large

losses because they held large amounts of loan backed securities.

3. Goldman Sachs, Morgan Stanley and others holding loan backed securities or

collateralized default swaps quickly became bank holding companies to take advantage

of emergency loans the Federal Reserve was providing.

4. Citibank survived because of significant Federal government loans and AIG suffered

large losses because it had not set enough aside in case of defaults.

E. The Treasury Bail-out: TARP

1. Federal government passed the Troubled Asset Relief Program (TARP) in 2008 which

allocated $700 billion for the U.S. Treasury to make emergency loans to those U.S.

financial firms that were deemed too big to fail.

2. $170 billion was spent just on AIG. Other recipients were Citibank, Bank of America,

J.P. Morgan Chase and Goldman Sachs along with General Motors and Chrysler.

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3. When government provides these loans it creates a moral hazard.

a. If financial firms feel that they are protected from losses, there is an incentive to take

on riskier financial behavior.

b. With TARP several firms didn’t go bankrupt, and stockholders, bondholders, and

executives didn’t suffer huge losses giving them incentive to continue with risky

behavior because government will bail them out.

F. The Fed’s Lender of Last Resort Activities

1. In addition to TARP, the Federal Reserve also acted as a lender of last resort to help keep

credit flowing.

2. Fed bought securities from financial institutions in an effort to increase liquidity in the

financial system giving the institutions cash. Fed’s assets increased from $885,097 in

February 2008 to $1,902,789 in March 2009.

3. Fed’s lender of last resort activities included:

a. Primary Dealer Credit Facility (PDCF)

b. Term Securities Lending Facility (TSLF)

c. Asset-backed Commercial Paper Money Market Mutual Fund Liquidity Facility

d. Commercial Paper Funding Facility (CPFF)

e. Money Market Investor Funding Facility (MMIFF)

f. Term Asset-Backed Securities Loan Facility (TALF)

g. Interest Payments on Reserves

4. Many economists feel that TARP and the Fed’s actions prevented serious problems in the

economy including the possibility of a second Great Depression, but again it also created

a moral hazard.

VII. The Post-Crisis U.S. Financial Services Industry

A. There has been a greater consolidation of banks and thrifts because of failures and mergers

even before the financial crisis.

B. In 1999 Congress ended the Depression-era law that prevented banks from selling stocks,

bonds, and mutual funds blurring the line between the financial institutions.

C. The financial crisis further blurred the lines.

D. In September 2009, the FDIC shut-down more than 200 banks. The three largest banks (J.P.

Morgan Chase, Bank of America, and Wells Fargo) have $3 of every $10 deposit.

E. Table 14.1 provides a good summary of the financial services industry today.

F. Politicians and financial regulators have tightened regulations to prevent the “pass the buck”

incentives of loan-backed securities and prevent loans to recipients who cannot pay it.

G. Passed legislation to help homeowners remain in their homes and prevent further defaults and

reductions in home prices.

H. There have been proposals to reduce moral hazard in an effort to send a strong message that

government will not bail out large institutions again.

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VIII. Last Word: Too Big to Fail. Too big for Jail?

A. In 2010, Congress passed the Wall Street Reform and Consumer Protection Act in an attempt

to better regulate big financial firms. But their enormous size has now, apparently, placed

them above the law.

B. HSBC bank was fined $1.9 billion (about five weeks of profit) as punishment for laundering

money for the Sinaloa drug cartel, Al Qaeda, and Russian mobsters. The bank also helped

Iran, the Sudan, and North Korea evade sanctions.

C. The U.S. Attorney General chose not to criminally prosecute the bank because:

1. HSBC would most likely have lost its banking license in the U.S.

2. The future of the institution would have been under threat and the entire banking system

would have been destabilized.

D. In other words HSBC was too big to fail and too big for jail.

E. Many economists believe that this problem was the result of the deregulation of the financial

system during the 1990’s. The objective was to allow banks to offer ‘one-stop shopping’ for

different financial services.

QUIZ

1. The principal advantage money has over barter is its function as:

A. A store of value

B. A medium of exchange

C. Unit of account

D. Debt

2. Securitization refers to:

A. Buying and selling securities.

B. Insurance against potential losses due to defaults.

C. Bundling loans, mortgages, and corporate bonds into new securities.

D. All of the above.

3. If you write a check on a bank to purchase a used Honda Civic, you are using money primarily as:

A. a medium of exchange.

B. a store of value.

C. a unit of account.

D. an economic investment.

4. To say that coins are “token money” means that:

A. their face value is less than their intrinsic value.

B. their face value is greater than their intrinsic value.

C. their face value is equal to their intrinsic value.

D. they are not legal tender.

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5. The purchasing power of money and the price level vary:

A. inversely.

B. directly during recessions, but inversely during inflations.

C. directly, but not proportionately.

D. directly and proportionately.

6. Stabilizing a nation’s price level and the purchasing power of its money can be achieved:

A. only with fiscal policy.

B. only with monetary policy.

C. with both fiscal and monetary policy.

D. with neither fiscal nor monetary policy.

7. The basic policy-making body in the U.S. banking system is the:

A. Federal Open Market Committee (FOMC).

B. Board of Governors of the Federal Reserve.

C. Federal Monetary Authority.

D. Council of Economic Advisers.

8. The Federal Open Market Committee (FOMC) is made up of:

A. the chair of the Board of Governors along with the 12 presidents of the Federal Reserve

Banks.

B. the seven members of the Board of Governors along with the president of the New York

Federal Reserve Bank.

C. the seven members of the Board of Governors of the Federal Reserve System along with the

three members of the Council of Economic Advisers.

D. the seven members of the Board of Governors of the Federal Reserve System along with the

president of the New York Federal Reserve Bank and four other Federal Reserve Banks

presidents on a rotating basis.

9. Currency in circulation is part of:

A. M1 only.

B. M2 only.

C. neither M1 nor M2.

D. both M1 and M2.

10. Moral hazard created during the financial crisis occurred because:

A. Federal government bailed out large firms.

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B. Federal Reserve took a variety of actions as a lender of last resort.

C. A and B

D. Companies created collateralized default swaps.

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