Chapter One
Introduction to
Money and
Banking
Money Makes the World Go ‘Round
• Money flows through the modern world with
astonishing speed . . .with the help of
banking institutions and financial markets.
• Economic policy determines the rules and
regulations by which banks work.
• The efficiency of money and banks is very
influential, both in individual’s lives and the
macroeconomy.
• Looking at the interactions between politics
and the banking system helps us to
understand financial markets and how they
work.
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The Value of Money
• The amount you pay for your student loan
depends in part on the actions of the Federal
Reserve.
• Your mortgage payment is influenced by
inflation, the health of the banking system,
and more.
• How can you make money in the stock
market?
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Government Policy & Money
• Government intervention influences how
markets perform, and financial markets are no
exception.
• Because of externalities, the government plays
a vital role in the financial system.
• Example: Bank runs used to be commonplace,
and often led to recession. Safeguards, such as
FDIC, today reduce the likelihood of such
events.
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The Federal Reserve
• The Federal Reserve
(a.k.a. the Fed)
determines the level of
the U.S. money supply,
sets rules for currency
flows and check clearing,
and supervises the
banking system.
• The Fed also decides on
the federal funds rate
eight times per year,
influencing interest rates
on everything from
Treasury bills to car
loans.
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Ten (Surprising) Facts Concerning
Money & Banking
1. Most financial formulas—no matter how
complicated they look—are based on the
compounding of interest.
•
•
The key feature of interest is that it compounds over
time…meaning interest is paid on interest earned in
previous periods.
Interest compounds both ways . . .the interest you
pay (on a loan) compounds, as does the interest
you earn on investments.
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Ten (Surprising) Facts
Concerning Money & Banking (cont’d)
2. More U.S. currency is held in foreign
countries than in the United States.
•
•
•
U.S. citizens need American dollars to buy goods
domestically . . .and they need foreign currency to
buy international goods.
Some foreigners hold U.S. dollars to buy American
goods and services.
Some hold dollars as protection against inflation.
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Ten (Surprising) Facts
Concerning Money & Banking (cont’d)
3. Interest rates on long-term loans generally
are higher than interest rates on shortterm loans.
•
•
•
Though the press often refers to “the” interest rate,
there are many.
Because long-term loans tend to be riskier and are
held longer, their rates need to be higher to
incentivize the loan process.
The difference between short and long term rates is
an indicator of the state of the economy.
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Ten (Surprising) Facts
Concerning Money & Banking (cont’d)
4. To understand how interest rates affect
economic decisions, you must account for
expected inflation.
•
•
•
Interest rates tell you only how much you will earn
on an investment, not what you can buy with it.
Economic decisions must take into consideration
that prices change over time.
People’s decisions about how much to save or
invest depend on interest rates as well as how
much they expect prices to rise.
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Ten (Surprising) Facts
Concerning Money & Banking (cont’d)
5.
Buying stocks is the best
way to increase your
wealth—and the worst.
•
•
•
All investment decisions
involve risk.
While stock market investing
often pays off well, it also
carries more risk than many
other investments.
Buying stocks does give you
ownership in corporations,
with a say in their operations.
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Ten (Surprising) Facts
Concerning Money & Banking (cont’d)
6. Banks are so healthy these days that
almost none are required to pay
premiums for deposit insurance.
•
•
•
A strong economy requires the support of the
banking system.
When depositors start a “run on the bank”, banks
become reluctant to lend, stifling economic growth.
The U.S. government now manages a deposit
insurance program so depositors no longer have to
worry about their money.
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Ten (Surprising) Facts
Concerning Money & Banking (cont’d)
7. Recessions are difficult to predict.
•
•
•
Recessions occur when the overall level of business
activity in the economy persistently declines.
Recessions are harmful, bringing higher
unemployment and decreased profits.
While sudden “shocks” to the economy may bring
on recessions, they are difficult to predict with any
accuracy.
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Ten (Surprising) Facts
Concerning Money & Banking (cont’d)
8. The Fed creates money by changing a
number in its computer system.
•
•
•
The Fed buys government securities from Wall
Street firms, thereby increasing the money supply in
the economy.
The Fed gives currency to banks in exchange for
reducing the amount of funds they must maintain on
deposit.
This process holds the potential for abuse—if too
much money is created, inflation will result.
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Ten (Surprising) Facts
Concerning Money & Banking (cont’d)
9. In the long run, the only economic
variable the Federal Reserve can affect
is the rate of inflation-the Fed has no
effect on economic activity.
•
•
When the Fed increases the money supply, the
economy speeds up…people buy more.
But there are limits…In the long run, the economy
achieves the same level of economic activity no
matter how much money is circulating.
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Ten (Surprising) Facts
Concerning Money & Banking (cont’d)
10. You can predict how the Federal Reserve will
change interest rates using a simple equation.
•
•
•
The Fed bases its decisions on two major variablesthe output gap and the inflation rate.
The Taylor Rule can predict how the Fed will
respond to changes in these variables.
While not perfect, the Taylor Rule is quite
accurate…You, too, can predict!!!
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