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From Wall Street to Main Street, both overseas and at home, money is the one tool used to measure personal and business income and wealth. Finance is the study of how money is managed by individuals, companies, and governments.
Strictly defined, money, or currency, is anything generally accepted in exchange for goods and services. Materials as diverse as salt, cattle, fish, rocks, shells, and cloth, as well as precious metals such as gold, silver, and copper, have long been used by various cultures as money. While paper money was first used in North America in 1685 (and even earlier in Europe), the concept of fiat money—a paper money not readily convertible to a precious metal such as gold—did not gain full acceptance until the Great Depression in the 1930s. The United States abandoned its gold-backed currency standard largely in response to the Great Depression and converted to a fiduciary, or fiat, monetary system. In the United States, paper money is really a government “note” or promise, worth the value specified on the note.
No matter what a particular society uses for money, its primary purpose is to enable a person or organization to trade money for a good or a service. Money serves three important functions: as a medium of exchange, a measure of value, and a store of value.
Medium of Exchange. Before fiat money, the trade of goods and services was accomplished through bartering—trading one good or service for another of similar value. There had to be a simpler way, and that was to decide on a single item—money— that can be freely converted to any other good upon agreement between parties.
Measure of Value. As a measure of value, money serves as a common standard or yardstick of the value of goods and services. Money, then, is a common denominator that allows people to compare the different goods and services that can be consumed on a particular income level.
Store of Value. As a store of value, money serves as a way to accumulate wealth (buying power) until it is needed. Unfortunately, the value of stored money is directly dependent on the health of the economy. If, due to rapid inflation, all prices double in one year, then the purchasing power value of the money “stuffed in the mattress” would fall by half. On the other hand, deflation occurs when prices of goods fall. Deflation also tends to be an indicator of problems in the economy. Deflation usually indicates slow economic growth and falling prices.
To be used as a medium of exchange, money must be acceptable, divisible, portable, stable in value, durable, and difficult to counterfeit.
Acceptability. To be effective, money must be readily acceptable for the purchase of goods and services and for the settlement of debts. Acceptability is probably the most important characteristic of money: If people do not trust the value of money, businesses will not accept it as a payment for goods and services, and consumers will have to find some other means of paying for their purchases.
Divisibility. For money to serve effectively as a measure of value, all items must be valued in terms of comparable units—dimes for a piece of bubble gum, quarters for laundry machines, and dollars (or dollars and coins) for everything else.
Portability. Clearly, for money to function as a medium of exchange, it must be easily moved from one location to the next.
Stability. Money must be stable and maintain its declared face value. A $10 bill should purchase the same amount of goods or services from one day to the next. The principle of stability allows people who wish to postpone purchases and save their money to do so without fear that it will decline in value.
Durability. Money must be durable. The crisp new dollar bills you trade for products at the mall will make their way all around town for about six years before being replaced.
Difficulty to Counterfeit. Finally, to remain stable and enjoy universal acceptance, it almost goes without saying that money must be very difficult to counterfeit—that is, to duplicate illegally.
While paper money and coins are the most visible types of money, the combined value of all of the printed bills and all of the minted coins is actually rather insignificant when compared with the value of money kept in checking accounts, savings accounts, and other monetary forms.
You probably have a checking account (also called a demand deposit), money stored in an account at a bank or other financial institution that can be withdrawn without advance notice. One way to withdraw funds from your account is by writing a check, a written order to a bank to pay the indicated individual or business the amount specified on the check from money already on deposit. There are several types of checking accounts, with different features available for different monthly fee levels or specific minimum account balances. Some checking accounts earn interest.
Savings accounts (also known as time deposits) are accounts with funds that usually cannot be withdrawn without advance notice and/or have limits on the number of withdrawals per period. While seldom enforced, the “fine print” governing most savings accounts prohibits withdrawals without two or three days’ notice. Savings accounts are not generally used for transactions or as a medium of exchange, but their funds can be moved to a checking account or turned into cash.
Money market accounts are similar to interest-bearing checking accounts, but with more restrictions. Generally, in exchange for slightly higher interest rates, the owner of a money market account can write only a limited number of checks each month, and there may be a restriction on the minimum amount of each check.
Certificates of deposit (CDs) are savings accounts that guarantee a depositor a set interest rate over a specified interval of time as long as the funds are not withdrawn before the end of the interval—six months, one year, or seven years, for example. Money may be withdrawn from these accounts prematurely only after paying a substantial penalty. In general, the longer the term of the CD, the higher is the interest rate it earns. As with all interest rates, the rate offered and fixed at the time the account is opened fluctuates according to economic conditions.
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. They are a popular substitute for cash payments because of their convenience, easy access to credit, and acceptance by merchants around the world. Reward cards are credit cards that carry a benefit to the user.
The Credit CARD (Card Accountability Responsibility and Disclosure) Act of 2009 was passed to regulate the practices of credit card companies. The law limited the ability of card issuers to raise interest rates, limited credit to young adults, gave people more time to pay bills, and made clearer due dates on billing cycles, along with several other provisions. For college students, the most important part of the law is that young adults under the age of 21 have to have an adult co-signer or show proof that they have enough income to handle the debt limit on the card.
A debit card looks like a credit card but works like a check. The use of a debit card results in a direct, immediate, electronic payment from the cardholder’s checking account to a merchant or other party. While they are convenient to carry and profitable for banks, they lack credit features, offer no purchase “grace period,” and provide no hard “paper trail.” Debit cards are gaining more acceptance with merchants, and consumers like debit cards because of the ease of getting cash from an increasing number of ATM machines.
Traveler’s checks, money orders, and cashier’s checks are other forms of “near money.” Although each is slightly different from the others, they all share a common characteristic: A financial institution, bank, credit company, or neighborhood currency exchange issues them in exchange for cash and guarantees that the purchased note will be honored and exchanged for cash when it is presented to the institution making the guarantee.
A new type of money called cryptocurrency has become popular over the last several years with technology-oriented people. Bitcoin is the most popular, but it has a fluctuating price, which makes it less desirable than fiat money like dollars, yens, and euros that are backed by governments.
More and more computer hackers have managed to steal credit card information and either use the information for Internet purchases or actually make a card exactly the same as the stolen card. Losses on credit card theft run into the billions, but consumers are usually not liable for the losses. However, consumers should be careful with debit cards because once the money is out of the account, the bank and credit card companies cannot get it back. Debit cards do not have the same level of protection as credit cards.
Answer: C. Car loan
This is not a type of money but a type of debt. The other options are all types of money.
The guardian of the American financial system is the Federal Reserve Board, or “the Fed,” as it is commonly called, an independent agency of the federal government established in 1913 to regulate the nation’s banking and financial industry. The Federal Reserve System is organized into 12 regions, each with a Federal Reserve Bank that serves its defined area.
The Federal Reserve Board is the chief economic policy arm of the United States. Working with Congress and the president, the Fed tries to create a positive economic environment capable of sustaining low inflation, high levels of employment, a balance in international payments, and long-term economic growth. To this end, the Federal Reserve Board has four major responsibilities: (1) to control the supply of money, or monetary policy; (2) to regulate banks and other financial institutions; (3) to manage regional and national checking account procedures, or check clearing; and (4) to supervise the federal deposit insurance programs of banks belonging to the Federal Reserve System.
The Fed controls the amount of money available in the economy through monetary policy. Without this intervention, the supply of and demand for money might not balance. This could result in either rapid price increases (inflation) because of too little money or economic recession and a slowdown of price increases (disinflation) because of too little growth in the money supply.
Open market operations refer to decisions to buy or sell U.S. Treasury bills (short-term debt issued by the U.S. government; also called T-bills) and other investments in the open market. The actual purchase or sale of the investments is performed by the New York Federal Reserve Bank. This monetary tool, the most commonly employed of all Fed operations, is performed almost daily in an effort to control the money supply.
The second major monetary policy tool is the reserve requirement, the percentage of deposits that banking institutions must hold in reserve (“in the vault,” as it were). Funds so held are not available for lending to businesses and consumers. Because the reserve requirement has such a powerful effect on the money supply, the Fed does not change it very often, relying instead on open market operations most of the time.
The third monetary policy tool, the discount rate, is the rate of interest the Fed charges to loan money to any banking institution to meet reserve requirements. The Fed is the lender of last resort for these banks.
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. Buying stock with credit—“buying on margin”—is a popular investment strategy among individual speculators. By altering the margin requirement (currently set at 50 percent of the price of the purchased stocks), the Fed can effectively control the total amount of credit borrowing in the stock market.
Regulatory Functions. The second major responsibility of the Fed is to regulate banking institutions that are members of the Federal Reserve System. Accordingly, the Fed establishes and enforces banking rules that affect monetary policy and the overall level of the competition between different banks. It determines which nonbanking activities, such as brokerage services, leasing, and insurance, are appropriate for banks and which should be prohibited. The Fed also has the authority to approve or disapprove mergers between banks and the formation of bank holding companies.
Check Clearing. The Federal Reserve provides national check processing on a huge scale. Divisions of the Fed known as check clearinghouses handle almost all the checks written against a bank in one city and presented for deposit to a bank in a second city.
Depository Insurance. The Fed is also responsible for supervising the federal insurance funds that protect the deposits of member institutions.
Banking institutions accept money deposits from and make loans to individual consumers and businesses. Some of the most important banking institutions include commercial banks, savings and loan associations, credit unions, and mutual savings banks. They are businesses whose objective is to earn money by managing, safeguarding, and lending money to others. Their sales revenues come from the fees and interest that they charge for providing these financial services.
The largest and oldest of all financial institutions are commercial banks, which perform a variety of financial services. They rely mainly on checking and savings accounts as their major source of funds and use only a portion of these deposits to make loans to businesses and individuals.
Savings and loan associations (S&Ls), often called “thrifts,” are financial institutions that primarily offer savings accounts and make long-term loans for residential mortgages. A mortgage is a loan made so that a business or individual can purchase real estate, typically a home; the real estate itself is pledged as a guarantee (called collateral) that the buyer will repay the loan. If the loan is not repaid, the savings and loan has the right to repossess the property.
A credit union is a financial institution owned and controlled by its depositors, who usually have a common employer, profession, trade group, or religion. While credit unions were originally created to provide depositors with a short-term source of funds for low-interest consumer loans for items such as cars, home appliances, vacations, and college, today they offer a wide range of financial services. Generally, the larger the credit union, the more sophisticated its financial service offerings will be.
Mutual savings banks are similar to savings and loan associations, but, like credit unions, they are owned by their depositors. Among the oldest financial institutions in the United States, they were originally established to provide a safe place for savings of the working classes. Found mostly in New England, they are becoming more popular in the rest of the country as some S&Ls have converted to mutual savings banks to escape the stigma created by the widespread S&L failures in the 1980s.
The Federal Deposit Insurance Corporation (FDIC), which insures individual bank accounts, was established in 1933 to help stop bank failures throughout the country during the Great Depression. Today, the FDIC insures personal accounts up to a maximum of $250,000 at nearly 6,000 FDIC member institutions.
The National Credit Union Administration (NCUA) regulates and charters credit unions and insures their deposits through its National Credit Union Insurance Fund.
Student answers will vary. Students should be able to compare and contrast commercial banks, savings and loan associations, credit unions, and mortgage brokers. Students should consider the following points.
A. Commercial Banks
Pros: More widely available; FDIC Insured; Offer other types of banking products – one stop shop
Cons: Interest rates on loans tend to be higher
B. Credit Union
Pros: Affinity relationship; Better interest rates
Cons: Must be a member; Not as widely available
C. Mortgage Broker
Pros: Allow consumer best option from a variety of sources; Competitive interest rates
Cons: Only offer mortgage products; Lending agencies not as well known
D. Savings and Loan
Pros: Locally owned; Competitive interest rates
Cons: May not offer as many other services as a commercial banks
Nonbank financial institutions offer some financial services, such as short-term loans or investment products, but do not accept deposits. These include insurance companies, pension funds, mutual funds, brokerage firms, nonfinancial firms, and finance companies.
Diversified Firms. There are many nonfinancial firms that help finance their customers’ purchases of expensive equipment.
Insurance companies are businesses that protect their clients against financial losses from certain specified risks (death, injury, disability, accident, fire, theft, and natural disasters, for example) in exchange for a fee, called a premium.
Pension funds are managed investment pools set aside by individuals, corporations, unions, and some nonprofit organizations to provide retirement income for members. One type of pension fund is the individual retirement account (IRA), which is established by individuals to provide for their personal retirement needs.
A mutual fund pools individual investor dollars and invests them in large numbers of well-diversified securities. Individual investors buy shares in a mutual fund in the hope of earning a high rate of return and in much the same way as people buy shares of stock. A special type of mutual fund called a money market fund invests specifically in short-term debt securities issued by governments and large corporations.
Brokerage firms buy and sell stocks, bonds, and other securities for their customers and provide other financial services. Larger brokerage firms like Merrill Lynch, Charles Schwab, and Edward Jones offer financial services unavailable at their smaller competitors. Most brokerage firms are really part financial conglomerates that provide many different kinds of services besides buying and selling securities for clients.
The investment banker underwrites new issues of securities for corporations, states, and municipalities needed to raise money in the capital markets. The new issue market is called a primary market because the sale of the securities is for the first time. After the first sale, the securities trade in the secondary markets by brokers.
Finance companies are businesses that offer short-term loans at substantially higher rates of interest than banks. Commercial finance companies make loans to businesses, requiring their borrowers to pledge assets such as equipment, inventories, or unpaid accounts as collateral for the loans.
Answer: C. Pension fund
Companies like TIAA would management accounts such as IRAs, 403 (B), 401 (K).
Since the advent of the computer age, a wide range of technological innovations has made it possible to move money all across the world electronically. Such “paperless” transactions have allowed financial institutions to reduce costs in what has been, and continues to be, a virtual competitive battlefield. Electronic funds transfer (EFT) is any movement of funds by means of an electronic terminal, telephone, computer, or magnetic tape.
Probably the most familiar form of electronic banking is the automated teller machine (ATM), which dispenses cash, accepts deposits, and allows balance inquiries and cash transfers from one account to another. ATMs provide 24-hour banking services—both at home and far away.
Automated clearinghouses (ACHs) permit payments such as deposits or withdrawals to be made to and from a bank account by magnetic computer tape. Most large U.S. employers, and many others worldwide, use ACHs to deposit their employees’ paychecks directly to the employees’ bank accounts. The advantages of direct deposits to consumers include convenience, safety, and potential interest earnings.
Online Banking. Many banking activities are now conducted on a computer at home or at work or through wireless devices such as cell phones and tablets anywhere there is a wireless “hot spot.” Consumers and small businesses can now make a bewildering array of financial transactions at home or on the go 24 hours a day. 62 percent of adults list Internet banking as their preferred banking method, making it the most popular banking method in the United States.
Rapid advances and innovations in technology are challenging the banking industry and requiring it to change.
The premise that banks will get bigger over the next 10 years is uncertain. During 2007–2008, the financial markets collapsed under the weight of declining housing prices, subprime mortgages (mortgages with low-qualifying borrowers), and risky securities backed by these subprime mortgages.
During this period, the Federal Reserve took unprecedented actions that included buying up troubled assets from the banks and lending money at the discount window to nonbanks such as investment banks and brokers. The Fed also entered into the financial markets by making markets in commercial paper and other securities where the markets had ceased to function in an orderly fashion. Additionally, the Fed began to pay interest on reserves banks kept at the Fed, and finally, it kept interest rates low to stimulate the economy and to help the banks regain their health. Additionally, to keep interest rates low and stimulate the economy, the Fed bought billions of dollars of mortgages and other financial assets on a monthly basis.
Lastly, the future of the structure of the banking system is in the hands of the U.S. Congress. In reaction to the financial meltdown and severe recession, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act. The full name implies that the intent of the act is to eliminate the ability of banks to create this type of problem in the future. The question that remains is how much of this legislation will be revised or reversed by the Trump administration
In broad general terms, shadow banking refers to companies performing banking functions of some sort that are not regulated by banking regulators. Shadow banking activities are increasing.
In addition to shadow banks mentioned by Mr. Dimon, there are the peer-to-peer lenders like Prosper, a company that matches investors and borrowers with loans of between $2,000 and $35,000. There are other sources of funding by Internet websites such as GoFundMe, which helps people enhance their life skills, raise money for health care issues, and more. Another similar website is Kickstarter, which funds creative projects in the worlds of art, film, games, music, publishing, and so on.
This Solve the Dilemma is taken from Chapter 15, Learning Objective 15-7.
Dr. Stephen Hill, a successful optometrist in Indianapolis, Indiana, has tinkered with various inventions for years. Having finally developed what he believes is his first saleable product (a truly scratch-resistant and lightweight lens), Hill has decided to invest his life savings and open Hill Optometrics to manufacture and market his invention.
Unfortunately, despite possessing true genius in many areas, Hill is uncertain about the “finance side” of business and the various functions of different types of financial institutions in the economy. He is, however, fully aware that he will need financial services such as checking and savings accounts, various short-term investments that can easily and quickly be converted to cash as needs dictate, and sources of borrowing capacity—should the need for either short- or long-term loans arise.
Despite having read mounds of brochures from various local and national financial institutions, Hill is still somewhat unclear about the merits and capabilities of each type of financial institution. He has turned to you, his 11th patient of the day, for help.
Answers:
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.
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.
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.
