Money and Financial Institutions

Money and financial institutions are essential to the operation of a modern economy. Money makes exchange easier, while banks and other financial institutions move funds between savers, borrowers, businesses, and governments. This chapter explains what makes money useful, how the Federal Reserve influences the money supply, how the U.S. banking system is organized, how depositors are protected, and how banking supports international business.

What Is Money?

Money is anything people generally accept as payment for goods and services. Without money, people would have to rely more heavily on barter, the direct exchange of goods or services for other goods or services.

For money to work effectively, the chapter identifies several useful characteristics:

• Portability — it should be easy to carry and transfer.
• Divisibility — it should be available in units that make purchases of different sizes practical.
• Stability — its value should be reasonably dependable.
• Durability — it should withstand repeated use.
• Uniqueness — it should be difficult to counterfeit.

The Money Supply

The money supply is the amount of money the Federal Reserve makes available for use in the economy. The chapter groups money into categories according to how readily the funds can be accessed.

• M1 includes money that can be accessed quickly, such as coins and paper currency.
• M2 includes M1 plus additional funds that may take somewhat longer to access, such as savings-type accounts and other near-money assets identified in the chapter materials.
• M3 is presented in the chapter materials as M2 plus large deposits such as institutional money-market funds.

These categories illustrate an important idea: some forms of money are immediately spendable, while others are less liquid but can still be converted into spendable funds.

The Dollar in the Global Economy

The purchasing power and exchange value of the dollar can rise or fall. A falling dollar means the dollar buys less relative to other currencies, while a rising dollar increases its relative purchasing power.

The chapter notes that a falling dollar can increase overseas demand for U.S. products, improve the value of foreign earnings for some U.S. companies, and encourage international tourism to the United States. At the same time, changes in currency values can affect import prices, inflation, interest rates, and the cost of doing business internationally.

The Federal Reserve System

The Federal Reserve System, commonly called the Fed, plays a central role in the U.S. monetary system. The chapter identifies five major parts of the system:

• The Board of Governors
• The Federal Open Market Committee
• 12 Federal Reserve Banks
• Advisory councils
• Member banks

The Federal Reserve was established after recurring banking and cash-shortage problems demonstrated the need for a more coordinated banking system. Under the Federal Reserve Act of 1913, federally chartered banks became part of the Federal Reserve System.

Monetary Policy and the Money Supply

Monetary policy involves actions affecting the money supply and credit conditions. This differs from fiscal policy, which involves government taxing and spending decisions.

The chapter emphasizes three traditional tools used by the Federal Reserve to influence the money supply:

• Reserve requirement — the percentage of certain bank deposits that must be held rather than loaned.
• Open-market operations — the buying and selling of government securities.
• Discount rate — the interest rate charged on certain loans to member banks.

By influencing the amount and cost of funds available to banks, Federal Reserve actions can affect lending, borrowing, spending, and economic activity.

The Federal Reserve and Check Clearing

The Federal Reserve has historically played an important role in moving funds among financial institutions and clearing checks. When a customer deposits a check drawn on another bank, the banking system must transfer funds from the payer's institution to the receiving institution. Modern electronic systems have made this process much faster, but the underlying need to settle transactions among financial institutions remains important.

The U.S. Banking System

The chapter groups financial institutions into several broad categories:

• Commercial banks
• Savings and loan associations
• Credit unions
• Nonbank financial institutions

Commercial Banks

A commercial bank is a profit-seeking organization that accepts deposits from individuals and businesses and uses those funds to make loans. Commercial banks therefore serve two major groups: depositors, who place funds with the bank, and borrowers, who obtain funds from the bank.

Important bank deposit terms include:

• Demand deposit — the traditional technical term for a checking account, with funds available on demand.
• Time deposit — a savings-type deposit for which withdrawal may be subject to conditions or notice.
• Certificate of Deposit (CD) — an interest-bearing deposit designed to be held until a stated maturity date.

Commercial banks may also provide credit cards, financial counseling, automatic bill payment, brokerage services, safe-deposit boxes, and retirement-account services.

Savings and Loan Associations

Savings and loan associations (S&Ls) accept savings and checking deposits and traditionally emphasize home mortgage lending. They are sometimes called thrift institutions because of their historical role in encouraging saving and home ownership.

Credit Unions

Credit unions are nonprofit, member-owned financial cooperatives that provide banking services to their members. Their cooperative structure distinguishes them from profit-seeking commercial banks.

Nonbank Financial Institutions

Nonbanks are financial institutions that do not accept deposits but provide services that overlap with services offered by traditional banks. Examples in the chapter include:

• Life insurance companies
• Pension funds
• Brokerage firms
• Commercial finance companies
• Corporate financial-services organizations

Banking Crises and Depositor Confidence

The chapter uses historical bank failures and the financial crisis surrounding 2008 to demonstrate why confidence is so important to the banking system. Falling home values and mortgage defaults contributed to severe problems for financial institutions. When borrowers could not repay loans and collateral values declined, some banks suffered major losses or failed.

Deposit insurance helps prevent a bank failure from automatically becoming a total loss for covered depositors and can help maintain confidence in the financial system.

Protecting Depositors

The chapter identifies government-related programs designed to protect eligible depositors. The Federal Deposit Insurance Corporation (FDIC) insures qualifying bank deposits up to applicable coverage limits. The chapter materials identify coverage of up to $250,000 in the circumstances described there.

The materials also discuss insurance for savings associations and identify the National Credit Union Administration (NCUA) as providing deposit coverage for qualifying credit-union accounts.

Deposit insurance is important because it reduces the risk that covered depositors will lose their insured funds simply because their financial institution fails.

Technology and Modern Banking

Banking increasingly relies on electronic technology. An Electronic Funds Transfer (EFT) system sends transaction information electronically so funds can be transferred quickly and efficiently.

A debit card performs a function similar to a check by withdrawing funds from a checking account. The chapter also discusses smart cards, which can combine multiple types of information or financial functions in a single card.

Online and mobile banking extend these ideas by allowing customers to review accounts, transfer funds, pay bills, and perform other transactions without visiting a physical branch.

International Banking Services

Businesses operating internationally need banking services that help them manage payments, credit, and currency exchange. The chapter introduces several important services:

• Letter of credit — a bank's promise to pay a seller a specified amount when stated conditions are met.
• Banker's acceptance — a promise that a bank will pay a specified amount at a particular time.
• Currency exchange — converting one nation's currency into another so organizations can conduct international transactions.

These services can reduce uncertainty and make transactions between buyers and sellers in different countries easier to complete.

The World Bank and International Monetary Fund

The World Bank lends much of its money to less-developed nations for projects intended to improve productivity and standards of living.

The International Monetary Fund (IMF) promotes international monetary cooperation and greater stability in currency exchange. Together, these institutions illustrate how financial systems extend beyond individual countries and support the broader international economy.

Putting Chapter 20 Together

Money makes modern exchange possible, and financial institutions help move that money throughout the economy. Commercial banks, savings institutions, credit unions, and nonbank organizations each serve different financial needs. The Federal Reserve influences monetary conditions and helps support the banking system, while deposit-insurance programs help maintain confidence when institutions encounter trouble.

Technology has changed how people access and transfer funds, while international banking institutions and services make global business possible. Understanding these institutions provides an important foundation for understanding how businesses obtain funds, make payments, manage financial risk, and participate in the economy.