Money, Banking, and International Finance ( PDFDrive )

Money, Banking, and International Finance

issues in Chapter 5). The M3 definition contains the amount of U.S. dollars held outside the United States.

Which definition of the money supply is the best? Four monetary aggregates grow at different rates, at different times, and even in different directions. Before 1981, a stable relationship existed between M1 and GDP, but the government had begun deregulating the financial markets during the 1970s and early 1980s, obscuring this relationship. Currently, many economists use the M2 definition of the money supply to explain changes in the GDP, inflation, and employment. Accordingly, the Fed does not formulate M1 targets and concentrates on M2 instead.

Chapter Questions

1.Identify the purpose of financial markets and financial institutions.

2.Which advantages do financial institutions provide when compared to the financial markets?

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2. Overview of the U.S. Financial System

This chapter explains how financial markets link the savers to the borrowers. Savers can use two separate channels to lend to borrowers. First, the savers could deposit their funds into a financial institution that in turn, lends to the borrowers. Second, savers could lend directly to the borrowers by directly investing in financial securities. Thus, these two channels create a variety of financial markets, such as the spot and derivative markets, and primary and secondary markets. Furthermore, we examine the impact of financial innovation and government regulation of the financial markets. Finally, we define the common financial instruments at the end of the chapter that we will use for the rest of the book.

The U.S. banking system evolved into a complex system. As the United States was forming, the public and the government distrusted large, powerful banks. Consequently, the government passed laws that heavily regulated the banking system, enlarging the number of U.S. banks and shrinking the banks’ asset size. Moreover, the United States created two layers of commercial banks: national and state banks. Several government agencies at the federal and/or state level regulate these banks. Consequently, banks have used ingenious methods and innovations to circumvent governments’ regulations.

Financial Intermediation

A financial system transfers funds from savers to borrowers. Savers and borrowers can be anyone. Some households, businesses, and governments are net savers because they spend less than their income, and they become the source of loans while other households, businesses, and governments are net borrowers. They spend more than their incomes. For example, many college students are net borrowers. Students’ incomes are usually lower than their yearly expenses, and they use student loans to pay for the difference. After graduation, the students enter the workforce, and they start repaying their student loans. As their incomes continually rise over time, the former students repay their loans and become net savers, saving funds for retirement. Using another example, many local and state governments have laws, requiring them to balance their budgets. This fiscal responsibility forces many local and state governments in the United States to be net savers while the U.S. federal government has been a net borrower for the last 50 years.

Transfer of funds from savers to borrowers is vital to an economy. If the borrowers invest the funds by purchasing machines and equipment, the borrowers can produce more goods and services. When businesses produce more goods and services, subsequently, the economy grows, and a growing economy creates jobs and rising incomes. As consumers experience rising incomes, they buy more goods and services, increasing the living standards. Beauty in the U.S. financial system is the financial institutions can collect and concentrate the meager savings of many people and then lend to a large company. For instance, 10,000 savers who have $200 in their savings accounts could allow a financial institution to grant a business loan for $2 million.

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Money, Banking, and International Finance

the United States largest corporations. Furthermore, secondary markets are important because these markets increase the liquidity of financial instruments. Investors can easily sell or buy financial securities on secondary markets. Moreover, when government or corporations issue new securities, the prices from the secondary market set the prices for the new securities in the primary market.

Why would savers deposit their money into banks, instead of investing directly into the financial markets? Financial intermediaries provide three functions. First, your bank account has liquidity. If an emergency arises, you can easily withdraw funds from your account. If you purchased stock and bonds from the financial markets, you could experience time delays and pay a transaction cost to withdraw yours money. Second, financial intermediaries have specialists who collect information about borrowers. Financial intermediaries lend to borrowers who are not likely to default on their loans. Finally, the financial intermediaries reduce the risk. They lend to a variety of borrowers through a process called diversification. For example, banks will issue credit cards, grant mortgages, lend to a variety of businesses, and buy U.S. government securities. If several credit card holders default, a couple of households stop paying their mortgages, or a business bankrupts and defaults on a bank loan, overall, the banks could still earn profits because the majority of bank customers are repaying their loans. On the other hand, if you directly invested in a company that bankrupts, then you could lose all of your investment.

Savers could withdraw their money out of the financial intermediaries and invest directly in the financial markets, such as buying U.S. government securities. We call this process – financial disintermediation. Savers have two reasons to invest directly in government. First, a government may pay a higher interest rate than a bank. For example, your savings account earns 2% interest while a U.S. Treasury bill pays 4% interest. Thus, the investors want to earn the greater interest rate. Second, the U.S. government has a low risk of default because the government has the power to tax and “print” money (i.e. seigniorage). If the government experiences financial trouble, it can raise taxes, issue more government securities, or print money. One problem does occur. If a government accumulates a massive debt, it usually gets money for loans first, while businesses come second. If investors have limited funds, then the businesses might not get the money that they need for investing in machines and equipment. Consequently, a large government debt could impact the financial markets and hamper business investment because a large government debt crowds out private investment. For example, the U.S. government debt has exceeded $17 trillion in 2014. If the U.S. government had a debt of zero dollars, then the investors would invest their funds in the private markets.

Financial markets have two methods to complete a transaction. Up to this point, you assumed when a buyer and seller completed a financial transaction, they exchange money for the financial instrument immediately. We call this the cash market or spot market. However, buyers and sellers have another option to complete a transaction. Buyer and seller of a financial instrument can negotiate a price and quantity today, but they exchange money for the financial instrument on a future specific date. These transactions occur in the derivative market. For example, you negotiate a price today to buy 10 Treasury bills from a seller for $9,000 each in six months. You had entered into a contract with the seller for a future transaction. If these

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Money, Banking, and International Finance

Negotiable Bank Certificates of Deposit (CDs) are loans to banks that banks sell directly to depositors. CDs have a fixed time period. If a depositor withdraws a CD early, then the depositor forfeits the interest. Consequently, CDs usually pay a greater interest rate than a savings account.

Repurchase Agreements (repos) are short-term loans. For example, a bank sells T-bills to a customer and promises to buy it back the next day for a higher price. Greater price reflects interest. Banks used repos to circumvent the law, so banks could pay businesses interest on their checking accounts. Before the 1980s, U.S. banks could not pay interest on checking accounts. For example, IBM has excess funds in their checking account. Bank sells IBM T-bills and uses IBM’s funds. Next day, the bank returns IBM’s funds with interest and takes the T-bills back. Consequently, the bank paid interest on a checking account, although the U.S. law prohibited banks to pay interest on checking accounts.

Federal Funds are overnight loans between banks. For example, a bank with excess funds deposited at the Federal Reserve can lend these funds to another bank. Market analysts and the Fed scrutinize the interest rate in this market because monetary policy influences immediately the federal funds interest rate.

Eurodollars are U.S. dollars that people deposit in foreign commercial banks outside the United States and in foreign branches of U.S. banks. Eurodollars are an important source of funds in the international market. Furthermore, the euro has become a popular currency for investors, who have bank accounts denominated in euros that are located outside the Eurozone. The Eurozone comprises of the 17 countries within the European Union that use the euro as its currency. If people and investors have euro denominated accounts outside the Eurozone, then we still call it Eurodollars.

Capital market securities have maturities longer than a year, and we list the common ones:

U.S. Treasury securities are loans to the U.S. government. The U.S. government issues

Treasury Notes or T-notes from one to 10 years, while Treasury Bonds or T-bonds have maturities greater than 10 years. These Treasury securities have a stated interest rate, and government usually pays interest every six months.

State and local governments can issue bonds, called municipal bonds. The U.S. federal government encourages investors to buy these bonds by exempting investors from U.S. income taxes. Furthermore, municipal bonds fall under two categories: General-obligation bonds and revenue bonds. For general-obligation bonds, a state or local government guarantees the bonds payment with its taxing power. For instance, a city government builds a new firehouse. Then the city government guarantees payment of the bonds with its power to tax. For revenue bonds, local or state government secures the bonds’ payment by the revenues that the project generates. For example, a college builds a new dormitory, using

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Money, Banking, and International Finance

If a bank receives a charter from the federal government, then three government agencies can regulate that bank, which are:

Comptroller of the Currency, an office in the U.S. Treasury Department, regulates national banks. This office also grants charters on behalf of the U.S. federal government, and it requires national banks to be members of the Federal Reserve and Federal Deposit Insurance Corporation. As of 2010, the United States had roughly 1,500 national banks and 50 foreign national banks.

Federal Deposit Insurance Corporation (FDIC) insures deposits at member banks. If this agency insures, then it also regulates. As of 2009, the FDIC had 8,195 member banks.

Federal Reserve System (Fed) is the central bank of the United States and the lender of the last resort. When a bank encounters financial difficulties and cannot receive a loan from other financial institutions, then the bank can ask the Fed for a loan. Moreover, the Fed regulates banks.

A state-chartered bank could have fewer regulations. A state government agency regulates its state banks, and many states require their banks to join the Fed and/or FDIC. Therefore, a state bank could have one or more regulatory agencies to deal with.

U.S. government imposed another restriction upon the U.S. banking industry – the McFadden Act. The McFadden Act prohibited a commercial bank from opening a branch in another state. This law put national and state banks on equal footing and helped foster competition. However, this law kept small inefficient banks in business, causing the United States to have the largest number of banks in the world. The United States had 14,217 banks in 1986, which fell to 9,459 banks by 2010.

Some states imposed more restrictions upon their banks than other states. For example, some states had imposed unit banking that restricted a bank to one geographic location. Unit banking restricts a bank to a single geographical location, such as in one city, and the bank cannot branch to other cities. Currently, no states enforce unit banking. Furthermore, branch banking allows a bank to have two or more banking offices owned by a single banking corporation within a geographical area. Geographic area can be a city, county, or statewide. Currently, 45 states allow statewide branch banking.

Different institutions evolved in the United States that differ from commercial banks. They include savings institutions and credit unions, and they are not commercial banks. Thus, they have their own regulatory agencies. These institutions either have a charter from the federal government or a state government. The Federal Home Loan Bank System (FHLBS) is a U.S. government agency similar to the Federal Reserve. The FHLBS regulates nearly 8,000 savings institutions. Moreover, the FDIC insures deposits at savings institutions. Most credit unions have charters from the National Credit Union Administration, which issues charters on the federal government’s behalf. This agency also insures the deposits at credit unions while the FDIC does not.

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