Chapter 16: Understanding Money and the Role of Banking
Chapter Overview
Do you remember your first summer job? Whether it was babysitting, delivering papers, or
mowing lawns, think of how long it took to save just a few dollars. And most of us learned just
how valuable those few dollars were once they were spent on something. Money is discussed in
every introductory business class, and it is the one topic with which we are all familiar.
This chapter presents the different forms that money takes in the nation’s money supply and
discusses the different types of financial institutions that compose the U.S. financial system. It
also looks at how financial institutions create money and describes the means by which they are
regulated. The functions of the Federal Reserve System are discussed, as are the tools that it uses
to control the money supply. Finally, the chapter identifies three important ways in which the
money and banking system is changing and touches on some of the institutions and activities in
international banking and finance.
Learning Objectives
16-1. Define money and identify the different forms that it takes in the nation’s money
supply.
16-3. Explain how financial institutions create money and describe the means by which they
are regulated.
16-5. Identify three important ways in which the money and banking system is changing.
LIST OF IN-CLASS ACTIVITIES: INSTRUCTOR’S CHOICE
Activity
Description
Time Limit
1. Ice-Breaker: How
Much Would That Be
in, Say, Chocolate
Bars?
Students consider the characteristics of money
when making purchases using something other
than ―money.‖
30 min.
2. Up for Debate:
Your Check Is Not in
the Mail
Students analyze the pros and cons of
traditional check writing versus electronic
payments.
20 min.
CHAPTER OUTLINE
Learning Objective 16-1:
Define money and identify the different forms that it takes in the nation’s money supply.
What Is Money?
A. The Characteristics of Money
Money has four main characteristics:
1. Portability—light and easy to handle
B. The Functions of Money
Money serves three functions:
1. It is a medium of exchange. We use money to buy and sell things.
Money adds convenience and simplicity to our lives, for consumers and businesses alike.
C. M-1: The Spendable Money Supply
The value of money decreases when its supply is high; when the money supply is low, its
value increases. A common measurement of the money supply is M-1, which counts only the
most liquid forms of money, including currency (cash), checks, and checking accounts
(demand deposits).
D. M-2: M-1 Plus the Convertible Money Supply
M-2 includes everything in M-1 plus other forms of money that are not quite as liquid—
items that are invested for the short term, but are easily converted to spendable forms. The
major components of M-2 are M-1, time deposits, money market mutual funds, and
savings accounts. M-2 now is viewed as a more reliable measure of the money supply than
M-1.
E. Credit Cards and Debit Cards: Plastic Money?
Credit cards, however, are not money and, accordingly, are not included in M-1 or M-2 when
KEY TEACHING TIPS
Point out that just about any object that can serve as money is portable, divisible, durable,
and stable.
Explain each of the following characteristics of money: portability, divisibility,
durability, and stability.
Students often confuse the characteristics of money with the functions of money. At this
point, a quick review of both may be helpful.
Prior to the discussion of the M-1 and M-2, it may be helpful to point out that the value of
QUICK QUESTIONS
How is it that checking accounts can be counted as part of M-1?
Different cultures ―put different spins‖ on monetary transactions. For example, money is
exchanged with a good deal of respect, even down to the way it is handled, in Japan.
What are some other ways different cultures ―put different spins‖ on money?
Why are credit cards not included in M-1 or M-2?
Use In-Class Activity 1: Ice-Breaker: How Much Would That Be in, Say, Chocolate Bars?
Time Limit: 30 minutes
Learning Objective 16-2:
Describe the different kinds of financial institutions that compose the U.S. financial system
and explain the services they offer.
The U.S. Financial System
A. Financial Institutions
Financial institutions ease the flow of money from users with surpluses to those with deficits
by attracting funds into checking and savings accounts.
1. Commercial Banks. Commercial banks are companies that accept deposits that they use
to make loans, earn profits, pay interest to depositors, and pay dividends to owners.
a. Commercial Interest Rates. Every bank receives a major portion of its income
from interest paid on loans by borrowers. Banks can set their own interest rates.
2. Savings Institutions. Savings institutions include mutual savings banks and savings and
loan institutions. They are often called thrift institutions.
3. Credit Unions. A credit union is a nonprofit, cooperative financial institution owned and
4. Nondeposit Institutions. A variety of other organizations take in money, provide interest
or other services, and make loans. They are called nondeposit institutions because, unlike
commercial banks, inflowing funds are intended for purposes other than earning interest
a. A pension fund is a pool of funds that is managed to provide retirement income for
its members. Public pension funds include Social Security and retirement programs
for state and local government employees. Employers, unions, and other private
groups operate private pension funds.
b. Insurance companies accumulate money from premiums and invest in stocks, real
estate, and other assets. Earnings pay insurance claims.
c. Finance companies specialize in making loans to businesses (needing capital or
long-term funds) and consumers (small loans to individuals such as mortgages,
personal loans).
d. Securities investment dealers (brokers) buy and sell stocks and bonds for client
investors and for their own accounts in hopes of reselling them later at a profit.
B. The Growth of Financial Services
No longer is it enough for commercial banks to accept deposits and make loans. Most, for
example, also offer bank-issued credit and debit cards, safe-deposit boxes, ATMs, electronic
money transfer, online banking, and foreign currency exchange. In addition, many offer pension,
trust, international, and brokerage services and financial advice.
1. Pension and Trust Services. Individual retirement accounts (IRAs) are tax-deferred
pension funds that wage earners and their spouses can set up to supplement other
2. International Services. The three main international services offered by banks are
currency exchange, letters of credit, and banker’s acceptances. Currency exchange
3. Financial Advice and Brokerage Services. Serving as financial advisors, banks help
4. Electronic Funds Transfer. Electronic funds transfer (EFT) systems transfer many
types of financial information electronically. EFT systems provide automatic payroll
deposit, ATM transactions, bill payment, and automatic funds transfer.
a. Automated Teller Machines. Automated teller machines (ATMs) allow customers
to withdraw money, make deposits, transfer funds, and check on account status.
KEY TEACHING TIPS
Remind students that financial institutions include commercial banks, savings and loan
associations, mutual savings banks, and credit unions.
Make sure students understand the distinction between EFT services and ATM services.
Reinforce that financial institutions of all kinds have had to modify their services to
maintain and attract customers.
QUICK QUESTIONS
What are ways in which financial institutions have diversified in recent years?
What was the traditional purpose of a savings and loan association?
Who are considered the owners of mutual savings banks and credit unions?
How are nondeposit institutions different from commercial banks?
When might a letter of credit be used? When might a banker’s acceptance be used?
How do consumers benefit from EFT?
Learning Objective 16–3:
Explain how financial institutions create money and describe the means by which they are
regulated.
How Financial Institutions Create Money and Are Regulated
A. How Money Is Created
Financial institutions create money by taking in deposits and making loans, which expands
the money supply.
B. How Banks Are Regulated
Banks create money, therefore, the government regulates them via the Federal Reserve
System and the Federal Deposit Insurance Corporation to ensure a sound financial system.
KEY TEACHING TIPS
Ensure students understand the purpose of the FDIC.
Review how banks create money by taking in deposits and making loans.
Learning Objective 16-4:
Discuss the functions of the Federal Reserve System and describe the tools that it uses to
control the money supply.
The Federal Reserve System
The Federal Reserve System (the Fed) is the nation’s central bank.
A. The Structure of the Fed
The Fed is comprised of a board of governors, a group of reserve banks, and member banks.
1. The Board of Governors. This group is comprised of seven members appointed by the
2. Reserve Banks. There are 12 banks in the Fed that hold deposits from and set the
3. Open Market Committee. The Federal Open Market Committee is responsible for
4. Member Banks. All nationally-chartered commercial banks and some state-chartered
5. Other Depository Institutions. Although many state-chartered banks, credit unions, and
S&Ls do not belong to the Fed, they are subject to its regulations, pay deposit insurance
premiums, and are covered by the FDIC or NCUA.
B. The Functions of the Fed
The Fed functions as the government’s bank and the banker’s bank and controls the money
supply.
1. The Government’s Bank. The Fed produces the nation’s currency and lends money to
2. The Bankers’ Bank. Individual banks that need money can borrow from the Fed and pay
3. Check Clearing. The Fed also clears checks. With electronic payments, however, the
4. Controlling the Money Supply. The Fed is responsible for the conduct of U.S.
monetary policy—the management of the nation’s economic growth by managing
money supply and interest rates. Controlling these influences the ability and willingness
of banks to loan money.
a. Inflation is a period of widespread price increases throughout an economic
system. It occurs if the money supply grows too large. Demand for goods and
services increases, and the price of everything rises.
b. Deflation occurs when the supply of goods outpaces the supply of money, so
demand for goods and services falls. Decreasing prices lead businesses to cut
output and also lead to rises in unemployment.
C. The Tools of the Fed
In controlling the money supply, the Fed uses these main tools: reserve requirements,
discount rate controls, and open-market operations.
1. Reserve Requirements. The reserve requirement is the percentage of its deposits that a
2. Interest Rate Controls. As the bankers’ bank, the Fed loans money to banks. The
discount rate is the interest rate that the Fed charges on loans made to member banks.
3. Open-Market Operations. Open-market operations refer to the Fed’s sale and purchase
of securities (usually U.S. Treasury notes and bonds) in the open market, as directed by
the open-market committee. The Fed buys government securities from a commercial
dealer, whose bank account is credited for the transaction, thus giving that bank more
money to lend. This action expands the money supply. When the Fed sells securities, the
opposite occurs as it allows the U.S. government to raise money and contract the money
supply.
KEY TEACHING TIPS
Reinforce that monetary policy is the management of the nation’s economic growth by
managing money supply and interest rates; the Fed is responsible for monetary policy.
Remind students that the discount rate is the interest rate charged by the Fed for loans
made to banks.
Make sure students understand that the Federal Reserve System (the Fed) is the central
bank of the United States; it is comprised of a board of governors, 12 reserve banks, and
thousands of member banks.
Point out that some financial institutions don’t belong to the Federal Reserve System;
however, they are still subject to the Fed’s regulations, pay deposit insurance premiums,
and are covered by the FDIC.
QUICK QUESTIONS
How does the Fed serve as the ―government’s bank?‖
How does the Fed serve as the ―bankers’ bank?‖
What typically happens to demand for goods and services, and their prices, during
inflationary times?
How does increasing the reserve requirement help to reduce inflation?
Remind students that the discount rate is the interest rate charged by the Fed for loans
made to banks.
How does the Fed control the nation’s money supply through open-market operations?
Learning Objective 16-5:
Identify two important ways in which the money and banking system is changing.
The Changing Money and Banking System
A. Government Intervention for Stabilizing the U.S. Financial System
Government Emergency Investment. During the recent recession, the Fed invested heavily,
mostly in lending programs to commercial banks, to allow them to get rid of bad investments
and gain cash for lending to bank customers. The Troubled Asset Relief Program (TARP)
was another source of funds to businesses and banks.
B. Anti-Crime and Anti-Terrorism Regulations
The Bank Secrecy Act requires financial institutions to formulate methods, such as
monitoring and keeping records of customer transactions, to deter funding of crimes.
Enforcement includes tracking and reporting on suspicious transactions, such as a sudden
increase in wire transfers or cash transactions exceeding $10,000, to cut off funding of
criminal and terrorist activities.
C. The Impact of Electronic Technologies
Investing in new technologies allows banks to improve their efficiency and customer service
levels.
2. Check 21: Making the Paper Check Go Away. Check 21 allows banks to present a
3. Blink Credit Cards. This ―contactless‖ payment system allows consumers to wave a card
in front of the merchant’s terminal and be on his or her way.
4. Debit Cards. Debit cards allow the transfer of money between accounts and can be used