CHAPTER 34 Money, Banking, and Financial Institutions Money is a fascinating aspect


Money, Banking,
and Financial

Money is a fascinating aspect of the economy:

Money bewitches people. They fret for it, and they sweat for it. They devise most ingenious ways to get it, and most ingenuous ways to get rid of it. Money is the only commodity that is good for nothing but to be gotten rid of. It will not feed you, clothe you, shelter you, or amuse you unless you spend it or invest it. It imparts value only in parting. People will do almost anything for money, and money will do almost anything for people. Money is a captivating, circulating, masquerading puzzle.1

In this chapter and the next two chapters, we unmask the critical role of money in the economy. A well-operating monetary system helps the economy achieve both full employment and the efficient use of resources. A malfunctioning monetary system distorts the allocation of resources and creates severe fluctuations in output, employment, and prices.

The Functions of Money

> > LO34.1 Explain the functions of money.

What exactly is money? There is an old saying that “money is what money does.” Generally, anything that performs the functions of money is money. Here are those functions:

Medium of exchange First and foremost, money is a medium of exchange that is used for buying and selling goods and services. A bakery worker does not want to be paid 200 bagels per week. Nor does the bakery owner want to receive, say, halibut in exchange for bagels. Page 668Money is a social invention with which resource suppliers and producers can be paid, and it can be used to buy any item in the marketplace. As a medium of exchange, money allows society to escape the complications of barter. And because it provides a convenient way of exchanging goods, money enables society to gain the advantages of geographic and human specialization.

medium of exchange Any item sellers generally accept and buyers generally use to pay for a good or service; money; a convenient means of exchanging goods and services without engaging in barter.

1Creeping Inflation: The Pickpocket Prosperity. Federal Reserve Bank of Philadelphia, 1957.

Unit of account Money is also a unit of account. Society uses monetary units—dollars, in the United States—to measure the relative worth of a wide variety of goods, services, and resources. Just as we measure distance in miles or kilometers, we gauge the value of goods in dollars.

With money as an acceptable unit of account, the price of each item needs to be stated only in terms of the monetary unit. We need not state the price of cows in terms of corn, crayons, and cranberries. Money aids rational decision making by enabling buyers and sellers to easily compare the relative values of goods, services, and resources by simply examining their respective money prices. It also permits us to define debt obligations, determine taxes owed, and calculate the nation’s GDP.

Store of value Money also serves as a store of value that enables people to transfer purchasing power from the present to the future. People normally do not spend their entire paychecks on the day they receive them. To buy things later, they store some of their wealth as money. The money you place in a safe or a checking account will still be available to you a few weeks or months from now. When inflation is nonexistent or mild, holding money is a relatively risk-free way to store your wealth.

unit of account A standard unit in which prices can be stated and the value of goods and services can be compared; one of the three functions of money.

store of value An asset set aside for future use; one of the three functions of money.

People can choose to hold some or all of their wealth in a wide variety of assets besides money. These assets include real estate, stocks, bonds, precious metals such as gold, and even collectible items like fine art or comic books. But a key advantage that money has over all other assets is its liquidity, or spendability.

An asset’s liquidity is the ease with which it can be converted quickly into cash with little or no loss of purchasing power. The more liquid an asset is, the more quickly it can be converted into cash and used to purchase goods, services, and other assets.

liquidity The degree to which an asset can be converted quickly into cash with little or no loss of purchasing power. Money is said to be perfectly liquid, whereas other assets have lesser degrees of liquidity.

Levels of liquidity vary greatly. By definition, cash is perfectly liquid. By contrast, a house is highly illiquid for two reasons. First, it may take several months before a willing buyer is found and a sale negotiated. Second, there is a loss of purchasing power when the house is sold because numerous fees must be paid to real estate agents and other individuals to complete the sale.

As we are about to discuss, our economy uses several different types of money including cash, coins, checking account deposits, savings account deposits, and even more exotic things like deposits in money market mutual funds. As we describe the various forms of money in detail, take the time to compare their relative levels of liquidity—both with each other and as compared to other assets like stocks, bonds, and real estate. Cash is perfectly liquid. Other forms of money are highly liquid, but less liquid than cash.

The Components of the Money Supply

> > LO34.2 Describe the components of the U.S. money supply.

Money is a “stock” of some item or group of items (unlike income, which is a “flow”) that is used as a medium of exchange, unit of account, and store of value. Societies have used many items as money, including whales’ teeth, circular stones, elephant-tail bristles, gold coins, furs, and pieces of paper. Anything that is widely accepted as a medium of exchange can serve as money. In the United States, currency is not the only form of money. For example, certain debts of government and financial institutions also are used as money.

Money Definition M 1

The narrowest definition of the U.S. money supply is called M1. It consists of two components:

M1 The most narrowly defined money supply, equal to currency in the hands of the public and the checkable deposits of commercial banks and thrift institutions.

Currency (coins and paper money) in the hands of the public.

Checkable deposits in commercial banks and “thrift” or savings institutions on which checks of any size can be drawn, at any time and as often as desired.2

2In the ensuing discussion, we do not discuss several of the quantitatively less significant components of the money supply, such as traveler’s checks, which are included in the M1 money supply. The statistical appendix of any recent Federal Reserve Bulletin provides more comprehensive definitions.

Page 669

Currency: Coins + Paper Money U.S. currency consists of metal coins and paper money. The coins are issued by the U.S. Treasury while the paper money consists of Federal Reserve Notes issued by the Federal Reserve System (the U.S. central bank). The coins are minted by the U.S. Mint, while the paper money is printed by the Bureau of Engraving and Printing. Both the U.S. Mint and the Bureau of Engraving and Printing are part of the U.S. Department of the Treasury.

Federal Reserve Notes Paper money issued by the Federal Reserve Banks.

As with the currencies of other countries, the currency of the United States is token money. That is, the face value of any piece of currency is unrelated to its intrinsic value—the value of the physical material (metal or paper and ink) from which that piece of currency is constructed. Governments make sure that face values exceed intrinsic values to discourage people from deconstructing coins and bills in order to resell the material that they are made out of as scrap metal or scrap paper. For instance, if 50-cent pieces each contained 75 cents’ worth of metal, then it would be profitable to melt them down and sell the metal. Fifty-cent pieces would disappear from circulation very quickly!

token money Bills or coins for which the amount printed on the currency bears no relationship to the value of the paper or metal embodied within it; for currency still circulating, money for which the face value exceeds the commodity value.

Figure 34.1a shows that currency (coins and paper money) constitutes 43 percent of the M1 money supply in the United States.

Checkable Deposits The safety and convenience of checks has made checkable deposits a large component of the M1 money supply. You would not think of stuffing $4,896 in bills in an envelope and dropping it in a mailbox to pay a debt. But writing and mailing a check for a large sum is commonplace. The person cashing a check must endorse it (sign it on the reverse side); the writer of the check subsequently receives a record of the cashed check as a receipt. Similarly, because you must sign your checks, the theft or loss of your checkbook is not nearly as calamitous as losing a large amount of currency. Finally, it is more convenient to write a check than to transport and count out large sums of currency. For all these reasons, checkable deposits are a large component of the money stock in the United States. About 57 percent of M1 is in the form of checkable deposits, on which checks can be drawn.

checkable deposits Any deposit in a commercial bank or thrift institution against which a check may be written.

Page 670

It might seem strange that checking account balances are regarded as part of the money supply. But the reason is clear: Checks are simply a way to transfer the ownership of bank deposits, and they are generally acceptable as a medium of exchange. Although checks are less generally accepted than currency for small purchases, most sellers willingly accept checks as payment for major purposes. Moreover, people can convert checkable deposits into paper money and coins on demand; checks drawn on those deposits are thus the equivalent of currency.

To summarize:

Money, M1 = currency+ checkable deposits

Institutions That Offer Checkable Deposits In the United States, a variety of financial institutions allow customers to write checks on the funds they have deposited. Commercial banks are the primary depository institutions. They accept the deposits of households and businesses, keep the money safe until it is withdrawn via checks, and in the meantime use it to make a wide variety of loans. Commercial bank loans provide short-term financial capital to businesses, and they finance consumer purchases of automobiles and other durable goods.

commercial bank A firm that engages in the business of banking (accepts deposits, offers checking accounts, and makes loans).

Savings and loan associations (S&Ls), mutual savings banks, and credit unions supplement the commercial banks. Collectively, these institutions are called thrift institutions, or simply “thrifts.” Savings and loan associations and mutual savings banks accept the deposits of households and businesses and then use the funds to finance home mortgages and to provide other loans. Credit unions accept deposits from and lend to “members,” who usually are a group of people who work for the same company.

thrift institution A savings and loan association, mutual savings bank, or credit union.

The checkable deposits of banks and thrifts are known variously as demand deposits, NOW (negotiable order of withdrawal) accounts, ATS (automatic transfer service) accounts, and share draft accounts. Depositors can write checks on all of these accounts whenever, and in whatever amount, they choose.

Two Qualifications We must qualify our discussion in two important ways. First, currency held by the U.S. Treasury, the Federal Reserve banks, commercial banks, and thrift institutions is excluded from M1 and other measures of the money supply. A paper dollar or four quarters in the wallet of, say, Emma Buck obviously constitutes just $1 of the money supply. But if we counted currency held by banks as part of the money supply, the same $1 would count for $2 of money supply if Emma deposited the currency into her checking account. By excluding currency held by banks when determining the total money supply, we avoid this problem of double counting.

Also excluded from the money supply are any checkable deposits of the government (specifically, the U.S. Treasury) or the Federal Reserve that are held by commercial banks or thrift institutions. This exclusion enables a better assessment of the amount of money available to the private sector for potential spending. The amount of money available to households and businesses is of keen interest to the Federal Reserve in conducting its monetary policy (which we discuss in Chapter 36).

Government and government agencies supply coins and paper money. Commercial banks (“banks”) and savings institutions (“thrifts”) provide checkable deposits. Figure 34.1a shows that M1 is about equally divided between the two components.

Money Definition M2

A second and broader definition of money includes M1 plus several near-monies. Near-monies are certain highly liquid financial assets that do not function directly or fully as a medium of exchange but can be readily converted into currency or checkable deposits. The M2 definition of money includes three categories of near-monies.

near-money Financial assets that are not themselves a medium of exchange but that have extremely high liquidity and thus can be readily converted into money. Includes noncheckable savings accounts, time deposits, and short-term U.S. government securities plus savings bonds.

M2 A more broadly defined money supply, equal to M1 plus noncheckable savings accounts (including money market deposit accounts), small time deposits (deposits of less than $100,000), and individual money market mutual fund balances.

savings account A deposit in a commercial bank or thrift institution on which interest payments are received; generally used for saving rather than daily transactions; a component of the M2 money supply.

money market deposit account (MMDA) Interestbearing accounts offered by commercial banks and thrift institutions that invest deposited funds into a variety of short-term securities.

Depositors may write checks against their balances, but there are minimum-balance requirements as well as limits on the frequency of check writing and withdrawls.

time deposits An interestearning deposit in a commercial bank or thrift institution that the depositor can withdraw without penalty after the end of a specified period.

Savings deposits, including money market deposit accounts A depositor can easily withdraw funds from a savings account at a bank or thrift or simply transfer the funds from a savings account to a checkable account. A person can also withdraw funds from a money market deposit account (MMDA), which is an interest-bearing account containing a variety of interest-bearing short-term securities. MMDAs, however, have a minimum-balance requirement and a limit on how often a person can withdraw funds (which is why they are not included in M1).

Small-denominated (less than $100,000) time deposits Funds from time deposits become available at their maturity. For example, a person can convert a 6-month time deposit (certificate of deposit or CD) to currency without penalty 6 months or more after depositing it. In return for this withdrawal limitation, the financial institution pays a higher interest rate on such Page 671deposits than it does on its MMDAs. Also, a person can “cash in” a CD at any time but must pay a severe penalty.

Money market mutual funds held by individuals By making a telephone call, using the Internet, or writing a check for $500 or more, a depositor can redeem shares in a money market mutual fund (MMMF) offered by a mutual fund company. Such companies use the combined funds of individual shareholders to buy interest-bearing short-term credit instruments such as CDs and U.S. government securities. Then they can offer interest on the MMMF accounts of the shareholders (depositors) who jointly own those financial assets. The MMMFs in M2 include only the MMMF accounts held by individuals; those held by businesses and other institutions are excluded. That fact that MMMF checks must be for $500 or more (rather than for any amount) is why MMMFs are not included in M1.

money market mutual fund (MMMF) Mutual funds that invest in short-term securities. Depositors can write checks in minimum amounts or more against their accounts.

All three categories of near-monies possess substantial liquidity. Thus, in equation form,

Note that M2 is defined such that it encompasses the immediate medium-of-exchange items (currency and checkable deposits) that constitute M1 plus certain near-monies that can be easily converted into currency and checkable deposits. M2 is, consequently, a measure of the portion of the money supply that is highly spendable.

In Figure 34.1b, we see that the addition of all these items yields an M2 money supply that is almost four times larger than the narrower M1 money supply. The nearby story explains why credit cards payments are not money.

What “Backs” the Money Supply?

> > LO34.3 Describe what “backs” the money supply.

The money supply in the United States essentially is “backed” (guaranteed) by the government’s ability to keep the value of money relatively stable. Nothing more!

Money as Debt

The major components of the money supply—paper money and checkable deposits—are debts, or promises to pay. In the United States, paper money is the circulating debt of the Federal Reserve Banks. Checkable deposits are the debts of commercial banks and thrift institutions.

Paper currency and checkable deposits have no intrinsic value. A $5 bill is just an inscribed piece of paper. A checkable deposit is merely a bookkeeping entry. And coins, we know, have less intrinsic value than their face value. Nor will government redeem the paper money you hold for anything tangible, such as gold.

To many people, it seems shady that the government does not back its currency with anything tangible. But the decision not to back the currency with anything tangible was made for a very good reason. If the government backed the currency with something tangible like gold, then the money supply would vary with the availability of gold. By not backing the currency, the government grants itself the freedom to provide as much or as little money as may be needed to best suit the country’s economic needs. By choosing not to back the currency, the government gives itself the ability to freely “manage” the nation’s money supply. Its monetary authorities are free to provide whatever amount of money is needed to promote full employment, price-level stability, and economic growth.

Value of Money

So why are currency and checkable deposits money, whereas, say, Monopoly (the game) money is not? What gives a $20 bill or a $100 check its value? The answer to these questions has three parts.

Acceptability Currency and checkable deposits are money because people accept them as money. By virtue of long-standing business practice, currency and checkable deposits perform the basic function of money: They are acceptable as a medium of exchange. We accept paper money because we are confident that we can exchange it for goods, services, and resources.

Legal Tender Our confidence in the acceptability of paper money is strengthened because the government has designated currency as legal tender. Specifically, each bill contains the statement “This note is legal tender for all debts, public and private.” In other words, paper money is a valid and legal means of payment of any debt that was contracted in dollars. (However, private firms and government are not mandated to accept cash. It is not illegal for them to specify payment in noncash forms such as cashier’s checks, debit card transactions, or money orders.)

legal tender Any form of currency that by law must be accepted by creditors (lenders) for the settlement of a financial debt; a nation’s official currency is legal tender within its own borders.

The general acceptance of paper currency by society is more important than the government’s decree that it serve as legal tender. This can be understood by the fact that checks function as money despite never having been designated as legal tender by the government. That being said, the Federal Deposit Insurance Corporation (FDIC) and the National Credit Union Administration (NCUA) enhance our willingness to use checks as a medium of exchange by insuring checking account deposits held at commercial banks and thrifts.

Relative Scarcity The value of money, like the economic value of anything else, depends on its supply and demand. Money derives its value from its scarcity relative to its utility (its want-satisfying power). The utility of money lies in its capacity to be exchanged for goods and services, now or in the future. The economy’s demand for money thus depends on the total dollar volume of transactions in any period plus the amount of money that individuals and businesses want to hold for future transactions. With a reasonably constant demand for money, the supply of money provided by the monetary authorities will determine the domestic value or “purchasing power” of the monetary unit (dollar, yen, euro, and so forth).

Money and Prices

The purchasing power of money is the amount of goods and services a unit of money will buy.

The Purchasing Power of the Dollar The amount a dollar will buy varies inversely with the price level. That is, a reciprocal relationship exists between the general price level and the dollar’s purchasing power. When the consumer price index or “cost-of-living” index goes up, the value of Page 673the dollar goes down, and vice versa. Higher prices decrease the dollar’s value because people need more dollars to buy a particular amount of goods, services, or resources. For example, if the price level doubles, the value of the dollar declines by one-half, or 50 percent.

Conversely, lower prices increase the dollar’s purchasing power because people need fewer dollars to obtain a specific quantity of goods and services. If the price level falls by, say, 50 percent, then the purchasing power of the dollar doubles.

In equation form, the relationship looks like this:

To find the value of the dollar, $V, divide 1 by the price level P expressed as an index number (in hundredths). If the price level is 1, then the value of the dollar is 1. If the price level rises to, say, 1.20, $V falls to 1/1.2 = 0.833; a 20 percent increase in the price level reduces the value of the dollar by 16.67 percent. Check your understanding of this reciprocal relationship by determining the value of $V and its percentage rise when P falls by 20 percent, from $1 to 0.80.

Inflation and Acceptability In Chapter 29 we noted situations in which a nation’s currency became worthless and unacceptable in exchange. Runaway inflation may significantly decrease the value of money between the time it is received and the time it is spent. Rapid declines in a currency’s value may cause people and businesses to reject it as a medium of exchange. They may refuse to accept paper money because they do not want to incur the loss in its value that will occur while it is in their possession.

Without an acceptable domestic medium of exchange, the economy may revert to barter. Alternatively, more stable currencies such as the U.S. dollar or European euro may come into widespread use. At the extreme, a country may adopt a foreign currency as its own official currency as a way to counter hyperinflation.

Similarly, people will use money as a store of value only as long as inflation does not seriously diminish the value of that money. And an economy can effectively employ money as a unit of account only when its purchasing power is relatively stable. A monetary “yardstick” that no longer measures a “yard” (in terms of purchasing power) does not permit buyers and sellers to establish the terms of trade clearly. When the value of the dollar is declining rapidly, sellers do not know what to charge, and buyers do not know what to pay.

Stabilizing Money’s Purchasing Power

Rapidly rising price levels (rapid inflation) and the consequent erosion of money’s purchasing power typically result from imprudent economic policies, especially rapid increases in the money supply. Because money’s purchasing power varies inversely with the price level, stabilizing the purchasing power of a nation’s money requires stabilizing the nation’s price level. Such price-level stability (2 to 3 percent annual inflation) can be achieved through intelligent management of the nation’s money supply and interest rates (monetary policy). It also requires appropriate fiscal policy that supports the efforts of the nation’s monetary authorities to hold down inflation. In the United States, a combination of legislation, government policy, and social practice inhibits imprudent expansion of the money supply that might jeopardize money’s purchasing power. The critical role of U.S. monetary authorities in maintaining the dollar’s purchasing power is the subject of Chapter 36. For now, simply note that they make available a particular quantity of money, such as M2 in Figure 34.1, and can change that amount through their policy tools.

The Federal Reserve and the Banking System

> > LO34.4 Discuss the structure of the Federal Reserve.

In the United States, the “monetary authorities” are the members of the Board of Governors of the Federal Reserve System (the “Fed”). As Figure 34.2 shows, the Board directs the activities of the 12 Federal Reserve Banks, which in turn control the lending activity of the nation’s banks and thrift institutions. The Fed’s major goal is to control the money supply. Because checkable deposits in banks are such a large part of the money supply, its duties also involve ensuring the stability of the banking system.

Federal Reserve System The U.S. central bank, consisting of the Board of Governors of the Federal Reserve and the 12 Federal Reserve Banks, which controls the lending activity of the nation’s banks and thrifts and thus the money supply; commonly referred to as the “Fed.”

Historical Background

Early in the twentieth century, Congress decided that centralization and public control were essential for an efficient banking system. Decentralized, unregulated banking had fostered the inconvenience and confusion of numerous private bank notes being used as currency. It also had resulted in occasional episodes of monetary mismanagement such that the money supply was inappropriate to the economy’s needs. Sometimes “too much” money precipitated rapid inflation; other times “too little money” stunted the economy’s growth by hindering the production and exchange of goods and services.

Furthermore, acute problems in the banking system occasionally erupted when banks either closed down or insisted on immediate repayment of loans to prevent their own failure. At such times, a banking crisis could emerge, with individuals and businesses that had lost confidence in their banks attempting to simultaneously withdraw all of their money—thereby further weakening the banks.

An unusually acute banking crisis in 1907 motivated Congress to create a National Monetary Commission to study the economy’s monetary and banking problems and to propose a course of action for Congress. The result was the Federal Reserve Act of 1913.

Let’s examine the various parts of the Federal Reserve System and their relationship to one another.

Board of Governors

The central authority of the U.S. money and banking system is the Board of Governors of the Federal Reserve System. The U.S. president, with the confirmation of the Senate, appoints the seven Board members. Terms are 14 years and staggered so that one member is replaced every 2 years. In addition, new members are appointed when resignations occur. The president selects the chairperson and vice chairperson of the Board from among the members. Those officers serve 4-year terms and can be reappointed to new 4-year terms by the president. The long-term appointments provide the Board with continuity, experienced membership, and independence from political pressures that could result in inflation.

Board of Governors The seven-member group that supervises and controls the money and banking system of the United States; the Board of Governors of the Federal Reserve System; the Federal Reserve Board.

Page 675

The 12 Federal Reserve Banks

The 12 Federal Reserve Banks, which blend private and public control, collectively serve as the U.S. “central bank.” They also serve as bankers’ banks.

Federal Reserve Banks The 12 banks chartered by the U.S. government that collectively act as the central bank of the United States. They set monetary policy and regulate the private banking system under the direction of the Board of Governors and the Federal Open Market Committee. Each of the 12 is a quasi-public bank and acts as a banker’s bank in its designated geographic region.

Central Bank Most nations have a single central bank—for example, Britain’s Bank of England or Japan’s Bank of Japan. The U.S. central bank consists of 12 banks whose policies are coordinated by the Fed’s Board of Governors. The 12 Federal Reserve Banks accommodate the geographic size and economic diversity of the United States as well as the large number of commercial banks and thrifts that are spread across the country.

Figure 34.3 shows the location of the 12 Federal Reserve Banks and the district that each serves. These banks implement Board of Governors’ basic policies.

Quasi-Public Banks The 12 Federal Reserve Banks are quasi-public banks that blend private ownership and public control. Each Federal Reserve Bank is owned by the private commercial banks in its district. (Federally chartered banks are required to purchase shares of stock in the Federal Reserve Bank in their district.) But the Board of Governors, a government body, sets the basic policies that the Federal Reserve Banks pursue.

Despite their private ownership, the Federal Reserve Banks are in practice public institutions. Unlike private firms, they are not motivated by profit. The policies they follow are designed by the Board of Governors to promote the well-being of the economy as a whole. Thus, the Fed’s activities are frequently at odds with the profit motive. Also, the Federal Reserve Banks do not compete with commercial banks. In general, they do not deal with the public. Rather, they interact with the government on the one hand and commercial banks and thrifts on the other.

Bankers’ Banks The Federal Reserve Banks are “bankers’ banks.” They perform essentially the same functions for banks and thrifts as those institutions perform for the public. Just as banks and thrifts accept the deposits of and make loans to the public, so the central banks accept the deposits of and make loans to banks and thrifts. Normally, these loans average only about $150 million a day. But in emergency circumstances the Federal Reserve Banks become the “lender of last resort” to the banking system and can lend out as much as needed to ensure that banks and thrifts can meet their cash obligations. On the day after terrorists attacked the United States on September 11, 2001, the Fed lent $45 billion to U.S. banks and thrifts. The Fed wanted to make sure that the destruction and disruption in New York City and Washington did not precipitate a nationwide banking crisis.

Page 676

The Federal Reserve Banks also have a third function, which banks and thrifts do not perform: They issue currency. Congress has authorized the Federal Reserve Banks to put into circulation Federal Reserve Notes, which constitute the economy’s paper money supply.


The Federal Open Market Committee (FOMC) aids the Board of Governors in conducting monetary policy. The FOMC is made up of 12 individuals:

Federal Open Market Committee (FOMC) The 12-member group within the Federal Reserve System that decides U.S. monetary policy and how it is executed through open-market operations (in which the Fed buys and sells U.S. government securities to adjust the money supply).

The seven members of the Board of Governors.

The president of the New York Federal Reserve Bank.

Four presidents selected from the remaining Federal Reserve Banks, each serving on a one-year rotating basis.

The FOMC meets regularly to direct the purchase and sale of government securities (bills, notes, bonds) in the open market in which such securities are bought and sold daily. The FOMC also makes decisions about borrowing and lending government securities in the open market. The purpose of these open-market operations is to control the nation’s money supply and influence interest rates. The Federal Reserve Bank in New York City conducts most of the Fed’s open-market operations.

Commercial Banks and Thrifts

There are about 4,600 commercial banks in the United States. Roughly three-fourths are state banks. These private banks are chartered (authorized) by individual states to operate within their respective borders. One-fourth are private banks chartered by the federal government to operate nationally; these are national banks. Some of the U.S. national banks are very large, ranking among the world’s largest financial institutions (see Global Perspective 34.1).

The 7,000 thrift institutions—most of which are credit unions—are regulated by agencies in addition to the Board of Governors and the Federal Reserve Banks. For example, credit unions are regulated and monitored by the National Credit Union Administration (NCUA). The thrifts are subject to monetary control by the Federal Reserve System; like banks, thrifts are required to keep a certain percentage of their checkable deposits as “reserves.” In Figure 34.2, arrows indicate that thrift institutions are subject to the control of the Board of Governors and the central banks. Decisions concerning monetary policy affect the thrifts along with the commercial banks.

Fed Functions, Responsibilities, and Independence

> > LO34.5 Identify the functions and responsibilities of the Federal Reserve.

The Fed performs several functions:

Issuing currency The Federal Reserve Banks issue Federal Reserve Notes, the paper currency used in the United States. (The Federal Reserve Bank that issued a particular bill is identified in black in the upper left of new bills. “A1,” for example, identifies the Boston bank, “B2” the New York bank, and so on.)

Setting reserve requirements and holding reserves The Fed sets reserve requirements, which are the fractions of checking account balances that banks must maintain as currency reserves. The Fed accepts as deposits from the banks and thrifts any portion of their mandated reserves not held as vault cash.

Lending to financial institutions and serving as an emergency lender of last resort The Fed makes routine short-term loans to banks and thrifts and charges them an interest rate called the discount rate. During financial emergencies, the Fed serves as a lender of last resort to critical parts of the U.S. financial industry.

Providing for check collection The Fed provides the banking system with a means for collecting on checks. If Sue writes a check on her Miami bank to Joe, who deposits it in his Dallas bank, how does the Dallas bank collect the money represented by the check drawn against the Miami bank? The Fed clears checks by adjusting the reserves (deposits) that the banks hold at the Fed. In this example, the Miami bank’s reserves are decreased by the amount of Sue’s check while the Dallas bank’s reserves are increased by the amount of Sue’s check. The Dallas bank can then transfer that money into Joe’s account.

Acting as fiscal agent The Fed acts as the fiscal agent (provider of financial services) for the federal government. The government collects huge sums through taxation, spends equally large amounts, and sells and redeems bonds. To carry out these activities, the government uses the Fed.

Supervising banks The Fed supervises the operations of banks. It periodically assesses bank profitability, ensures that banks perform according to the regulations, and seeks to uncover questionable practices or fraud. Following the financial crisis of 2007–2008, Congress expanded the Fed’s supervisory powers over banks.

Controlling the money supply The Fed has ultimate responsibility for regulating the money supply. The Fed’s major task under usual economic circumstances is to manage the money supply (and thus interest rates) according to the economy’s needs. The Fed’s goal is to make an amount of money available that is consistent with high and rising levels of output and employment and a relatively stable price level. While most of the Fed’s other functions are routine, managing the nation’s money supply requires intermittent policy decisions that must be made when and if needed, and tailored as necessary to meet the circumstances. (We discuss those decisions in detail in Chapter 36.)

Federal Reserve Independence

Congress purposely established the Fed as an independent agency of government. The objective was to protect the Fed from political pressures so that it could effectively control the money supply and maintain price stability. Political pressures on Congress and the executive branch may at times result in inflationary fiscal policies, including tax cuts and special-interest spending. If Congress and the executive branch also controlled the nation’s monetary policy, citizens and lobbying groups would undoubtedly pressure elected officials to keep interest rates low even though at times high interest rates are necessary to reduce aggregate demand and thus control inflation. An independent monetary authority (the Fed) can take actions to increase interest rates when higher rates are needed to stem inflation. Studies show that countries that have independent central banks like the Fed have lower rates of inflation, on average, than countries that have little or no central bank independence.

The Financial Crisis of 2007 and 2008

> > LO34.6 Explain the main factors that contributed to the financial crisis of 2007–2008.

A properly functioning monetary system supports the flows of income and expenditures necessary for an economy to grow, produce near potential output, and enjoy low rates of inflation. In contrast, a malfunctioning monetary system causes major problems in credit markets and can cause severe fluctuations in output, employment, and prices.

“Malfunctioning” is too gentle an adjective to describe the monetary system in late 2007 and 2008, when the U.S. financial system faced its most serious crisis since the Great Depression of the 1930s. We discussed the severe recession of 2007–2009 in previous chapters, and we now want to examine the financial crisis that led up to it. What caused it? And how did it alter the U.S. financial services industry?


In 2007, a major wave of defaults on home mortgage loans threatened the financial health of not only mortgage lenders but also the financial institutions that had invested in mortgage loans indirectly.

The majority of mortgage defaults involved subprime mortgage loans. These were mortgage loans extended to home buyers with higher-than-average (subprime) credit risk, meaning loans granted to homebuyers who were probably going to have substantial difficulty making their monthly mortgage payments. Several of the biggest investors in these subprime loans were banks, which had loaned money to investment companies that had purchased the right to collect on those mortgages.

subprime mortgage loans High-interest-rate loans to home buyers with above-average credit risk.

When the mortgages started to go bad, many of those investment companies “blew up” and could not repay the money they had borrowed from the banks. To comply with banking regulations, the banks had to write off (declare unrecoverable) the loans they had made to the investment companies—but the write-offs reduced their reserves and restricted their ability to lend money to households and businesses. Hundreds of banks, insurance companies, and financial firms either went bankrupt or came very close to going bankrupt. The Fed and the Treasury had to intervene to prevent the entire financial system from imploding.


Before the crisis occurred, banks and government regulators had mistakenly believed that an innovation known as the mortgage-backed security had eliminated most of the banks’ exposure to mortgage defaults. Mortgage-backed securities are bonds backed by mortgage payments. To create them, banks and other mortgage lenders first made mortgage loans. But then, instead of holding all of those loans as assets and collecting the monthly mortgage payments, the banks and other mortgage lenders bundled hundreds or thousands of them together and sold them off as bonds—in essence selling the right to collect all the future mortgage payments. As sellers, the banks obtained one-time cash payments for the bonds. In return, the bond buyers received all future mortgage payments.

Mortgage-backed securities Bonds that represent claims to all or part of the monthly mortgage payments from the pools of mortgage loans made by leaders to borrowers to help them purchase residential property.

From the banks’ perspective, the bundling of mortgages seemed like a smart business decision because it transferred any future mortgage-default risk onto the buyers of the mortgage-backed securities. Unfortunately, the banks created a “circular firing squad” by lending a substantial portion of the money they received from selling the mortgage-backed securities to investment funds that invested in . . . mortgage-backed securities! Consequently, the banks were still exposed to mortgage default risk, and they suffered heavy losses when millions of home owners started defaulting on their mortgages in 2006.

Page 679


But what caused the skyrocketing mortgage default rates in the first place? There were many causes, including government programs that subsidized home ownership and the bursting of a large financial bubble in real estate values.

An equally important factor was the bad incentives provided by the mortgage-backed bonds. Because mortgage lenders thought that they were no longer exposed to mortgage default risk, they became lax in their lending practices—so much so that they granted millions of subprime mortgage loans to people who lacked the financial resources to keep current on their monthly mortgage payments.

Some mortgage companies were so eager to sign up new home buyers that they stopped running credit checks and even allowed applicants to claim higher incomes than they were actually earning in order to qualify them for loans. As a result, many people took on “too much mortgage” and were soon failing to make their monthly payments.


When the housing bubble burst and home prices began to decline, borrowers who had made relatively small down payments on houses discovered that they owed more on their mortgages than their properties were worth. As the economy slowed, many borrowers fell behind on their monthly mortgage payments. Lenders began to foreclose on many houses, while other borrowers literally handed in their house keys and walked away from their houses and their mortgages.

The value of mortgage-backed securities plunged, driving several large financial firms either into bankruptcy or right to the edge of bankruptcy. Merrill Lynch lost more in two years than it had made in the prior decade. Lehman Brothers declared bankruptcy. Goldman Sachs and Morgan Stanley rushed to become “bank holding companies” so they could qualify for emergency loans from the Fed (which under the law could only extend emergency loans to banks and bank holding companies). The nightmarish thought of a total collapse of the U.S. financial system suddenly became a realistic possibility.

mmediate Response

The government of the United States responded to the financial crisis with historically unprecedented fiscal policy actions while the Fed acted aggressively as a lender of last resort.

The Treasury Bailout: TARP In late 2008, Congress passed the Troubled Asset Relief Program (TARP), which allocated $700 billion to the U.S. Treasury to make emergency loans to critical financial firms. Most of this “bailout money” was eventually lent out to the likes of Citibank, Bank of America, JPMorgan Chase, and Goldman Sachs. Later, nonfinancial firms such as General Motors and Chrysler also received several billion dollars of TARP loans.

Troubled Asset Relief Program (TARP) A 2008 federal government program that authorized the U.S. Treasury to loan up to $700 billion to critical financial institutions and other U.S. firms that were in extreme financial trouble and therefore at high risk of failure.

TARP saved several financial institutions whose bankruptcy would have caused a tsunami of secondary effects that would have probably brought down other financial firms and frozen credit throughout the economy. TARP and similar government bailouts were essentially government-provided insurance payouts to financial firms that had never paid even a single cent in insurance premiums for the massive bailouts that they received.

The Fed’s Lender-of-Last-Resort Activities As noted earlier, the Fed serves as the lender of last resort to financial institutions during financial emergencies. The Fed performed this vital function admirably following the 9/11 terrorist attacks. The financial crisis of 2007–2008 presented another, broader-based financial emergency. Under Fed Chair Ben Bernanke, the Fed designed and implemented several highly creative new lender-of-last-resort programs to pump liquidity into the financial system to keep credit flowing.

Page 680

Total Fed assets rose from $885 billion in February 2008 to $1,903 billion in March 2009. This increase reflected a huge rise in the amount of securities (U.S. securities, mortgage-backed securities, and others) owned by the Fed. In undertaking its lender-of-last-resort functions, the Fed bought these securities from financial institutions. The purpose was to generate liquidity in the financial system by exchanging illiquid bonds (which the firms could not easily sell during the crisis) for cash, the most liquid of all assets.

Many economists believe that TARP and the Fed’s actions helped to avert a second Great Depression. But their policies also intensified the moral hazard problem discussed in this chapter’s Last Word. By greatly limiting losses, the Treasury and the Fed shielded financial firms from the consequences of their own actions. It was feared that this might prompt financial firms to be even more heedless of risk in the future because they would be anticipating yet another bailout if things went awry as they had in 2007 and 2008.

Post-Crisis Policy Changes

The financial crisis of 2007–2008 generated much discussion about what went wrong and how to prevent anything like it from happening again. Politicians and financial regulators tightened lending rules to offset the “pass the buck” incentives created by mortgage-backed securities. They also passed legislation to help homeowners who ended up “underwater” on their mortgages, owing more than their homes were worth. And they acted to prevent companies from issuing loans to people who were probably not going to be able to pay them off.

The single largest policy response to the crisis was the Wall Street Reform and Consumer Protection Act that:

Wall Street Reform and Consumer Protection Act The law that gave authority to the Federal Reserve System (the Fed) to regulate all large financial institutions, created an oversight council to look for growing risk to the financial system, established a process for the federal government to sell off the assets of large failing financial institutions, provided federal regulatory oversight of asset-backed securities, and created a financial consumer protection bureau within the Fed.

Gave the Federal Reserve broader authority to regulate large financial institutions.

Created a Financial Stability Oversight Council to watch for risks to the financial system.

Established a process for the federal government to liquidate (sell off) the assets of failing nonbank financial institutions, much as the FDIC does with failing banks.

Required mortgage-backed securities and other derivatives to be federally regulated and traded on public exchanges.

Required companies selling asset-backed securities to retain a portion of those securities so that they would always share some of the default risk.

Established a stronger consumer financial protection role for the Fed through the creation of the Bureau of Consumer Financial Protection.

Proponents of the law said that it would help prevent many of the practices that generated the financial crisis of 2007–2008. They also contended that the law would mitigate the moral hazard problem by sending a strong message to stockholders, bondholders, and executives that they would suffer unavoidable and extremely high personal financial losses if they allowed their firms to ever again get into serious financial trouble.

Skeptics of the law said that regulators had already been in possession of all the tools they needed to prevent the 2007–2009 financial crisis before the Wall Street Reform and Consumer Protection Act was passed. They also pointed out that the government’s own efforts to promote home ownership had greatly contributed to the financial crisis. Skeptics contended that the law would impose heavy new regulatory costs on the financial industry while doing little to prevent future government bailouts. This chapter’s Last Word considers those suspicions.

McConnell, C. (2020). Economics (22nd ed.). McGraw-Hill Higher Education (US).