Economics: Chapter 8

Money, Banking, Saving, and Investing

All about Money

• Functions of money• Characteristics of money• Types of Money• US Money supply

Functions of Money

• Medium of Exchange– Can use it in exchange for an item of value

• Unit of Account– Used as a means to measure the value of goods

and services• Store of Value– Maintains its value over time

Characteristics of money

• Generally accepted• Divisibility• Portability• Durability• Uniformity• Scarce

Types of Money

• Commodity Money– An item used as money that has value on its own, but is also

used as money– Example: Cigarettes in prisons

• Commodity Backed Money– Money that has value because it is representative of a

commodity held in a nation’s treasury– Example: Gold Standard

• Fiat Money– Money that has value because the government has decreed

that what is used as money has value as a medium of exchange

US Money System

• US Money Supply is monitored by the Federal Reserve System (our central bank)

• Money supply is divided up into two categories:– M1 – includes currency and checkable deposits

(demand depositis)• Most liquid

– M2 – includes M1 and savings accounts and time deposits• Less liquid• Savings accounts are called “near money”

US Money System

• What about Credit Cards?• What about Debit Cards?• Are they money?

The Banking System

• Important part of our economy.• Why?

Financial Institutions

• Must have a charter from state or federal government

• Why must banks be regulated?• What do you remember about the Causes of

the Great Depression?• What do you know about the reason we

recently had a Great Recession?

Types of Banks

• Commercial Banks– businesses

• Savings and Loans• Mutual Savings Banks• Credit Unions

• They used to be different, but now most have very similar functions

• What are the functions of financial institutions?

Functions of financial institutions

1. Cash Checks2. Issue Credit Cards3. Exchange foreign currency for US money and

vice versa4. Safe-Deposit Boxes5. E-Banking 6. Main function: financial intermediary

Financial Intermediary

• Brings savers and borrowers together in a financial market

• Savers deposit their money• Banks use their depositors money to make

loans to borrowers

Liquidity

• Liquidity – how fast can an assets be converted into cash

• Currency is the most liquid• Banks offer many types of deposit accounts to

savers– Vary in liquidity– Some accounts require a certain period of time to

pass before a saver can access their money

• How do savings accounts benefit us?

• Interest Rates:– Rates are higher for savings accounts than for

checking accounts (checkable deposits)– Rates are higher for time deposits than for a “regular– Interesting link

• Think risk vs. reward– Higher the “risk” the higher the reward– What is the risk of putting your money in the bank?

• FDIC insures deposits of up to $250,000– What is the cause of this law?

• So rather than “risk”, it’s really about the tradeoffs that you make when you make your decision.

Loans• Commercial Loans

– Purpose?• Consumer Loans

– Purpose?• Mortgages

– Purpose?– Includes

• Principal – amount actually borrowed• Interest – amount• Other fees: points, fees• 15 Year or 30 Year?• Fixed or variable?• Example: $220,000 home, 30-Year fixed mortgage with a rate of 5 percent

– Credit Rating: Be careful, Banks will do a credit history

• “A credit report includes information on where you live, how you pay your bills, and whether you’ve been sued or have filed for bankruptcy. “

Banks create money

• How?

• They use fractional reserve banking– They are required to keep a certain percentage of each

deposit in the bank (reserve requirement)• Now 10%

– Then they loan out the rest

– If I deposit $100 in the bank, how much can the bank loan out?

– How much “additional” money did my savings create?

Role of the Federal Reserve• Holding Reserves

– Banks must keep a fraction of all deposits in reserve– “Banker’s Bank”

• Providing Cash and Loans– Fed lends money to banks (discount rate)

• Clearing Checks– Transfers funds from one bank to another when someone writes a check

• Linking Banks electronically• Controls nation’s money supply

– This is called Monetary policy and it plays an important role in stabilizing our economic system• Too much money – inflation• Too little money – deflation

How do savers help the Economy?

• Remember the most important role of a financial institution is acting as a financial intermediary between savers and borrowers.

• Would banks be able to make loans without the funds that savers deposit?

• What would happen to economic growth if people could not borrow money?

Things to think about

• What is the interest that you will earn by depositing your money in the bank

• How is the interest calculated?– Simple interest• Interest earn in principal only

– Compound interest• Interest earned on both principal and interest

previously earned

Things to think about..

• What is the interest that you will have to pay for a loan?

• Are there any other fees associated with obtaining the loan?

• Remember: Banks are a business out to make profit. The largest source of income for banks is the interest charged on loans.

Planning for the future

• Personal Savings Rate– % of our income that we keep in savings.• Had fallen in the last 30 years

– But statistics indicate that it is now rising again• Nov. 2013 rate was 4.9%

Savings Helps our Economy Grow

• Banks loan out a fraction of depositors money• This benefits banks because they earn interest• But these loans also enable new businesses to

start.• New businesses stimulate the economy when

they purchase physical capital and hire new workers

• There is a rippl effect throughout the whole economy. (multiplier effect)

Savings Helps You Reach Your Goals

• What are you saving for?– Car– College– Independent Life

Savings Helps You When You Need Money for Emergencies

• “Poop” Happens, right?• Rule of Thumb – Keep savings in the bank

worth as much as you would need for a six-month period of time

• “Rainy Day” fund

You need to save for your retirement

• What are your retirement goals?– When do you want to retire?– What lifestyle do you want to have?– Where do you want to live?

• Need to plan now for your retirement because if you wait too long, you may not have enough.– I plan to live past the age of 100!

• Need to plan now for your retirement because if you wait too long, you may not have enough.– I plan to live past the age of 100!

• Other events will make demands on your income– College– Wedding– Travel– Car– Home– Kids –

• Day Care cost me $13,000 per year when my boys were young!

– Kids’ college fund

• Social Security will not be much when you retire– It is a pay as you go system. What we contribute

today pays for current retirees.– When I retire you will fund my social security.

So you better get really good jobs!!!!

Retirement – Three Legged Stool

• Social Security– Age 65– FICA (This is your contribution. You will see it as a

category on your paycheck)• Company Retirement Plans– 401(k), Pension Plans

• Personal savings and investment– Savings accounts, IRAs, Stocks and bonds

Company Retirement Plans

• Company Pension Plan– Employer makes a contribution to your pension

plan• 401(k)– Named after the section of the IRS tax code

where it is located– Money is not taxed now so you can adjust your

contribution to get into a lower tax bracket and lower your federal income taxes

Personal Savings and Investments

• Not employer sponsored• Variety of options• Most common – IRA (Individual Retirement Account)

– Sponsored by federal government– Tax benefits are offered– Two types

• Traditional IRA – Money put into account is not taxed until it is withdrawn

• Roth IRA – Money is taxed before it is put into your account. It is not taxed when it is withdrawn.

• Meet with an advisor trained in personal finance to help you make the right decision

Investing Your Savings

• Make money with your money• What can you invest your money in?– Real Estate– Collections (like stamps, antiques, baseball cards, etc…)– Securities

• Stocks• Bonds

• Relationship between risk and reward. – High risk can be highly rewarded

The Power of Compounded Interest

• Rule of 72. how long will it take to double your money when your interested is compounded. Divide 72 by the interest rate.

• Compound Interest calculator

Bonds

• Relatively Low risk• Represents a loan. Owner of the bond is the

lender. Seller of the bond is the borrower.• Bond are bought and sold in a bond market• Types:– Government Bonds– Municipal Bonds– Corporate bonds– Junk Bonds

Stock Market

• Represents the highest risk• Beware the Bear!