CyberSummary

Money is the one tool used to measure personal and business income and wealth. Finance is the study of money: how it's made, how it's lost, and why.

MONEY IN THE FINANCIAL SYSTEM

Money is anything generally accepted in exchange for goods and services. 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.

Money serves three important functions. As a medium of exchange, money facilitates the buying and selling of goods and services and eliminates the need for bartering. As a measure of value, it serves as a common standard or yardstick of the value of goods and services. As a store of value, it serves as a way to accumulate wealth until needed. The value of stored money is directly dependent on the health of the economy.

To be effective, money must be readily acceptable for the purchase of goods and services and for the settlement of debts. It must be easily divisible into small units of value. For money to function as a medium of exchange, it must be easily moved from one location to another. Money must be stable and maintain its declared face value. It must be durable and retain its original qualities over a long period of time and through much handling. Finally, money must be difficult to counterfeit. Every country takes steps to make counterfeiting difficult.

Many forms of money are accepted for payment or in exchange for products. A checking account (also called a demand deposit) is money stored in an account at a bank or other financial institution that can be withdrawn without advance notice.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 a checking account is by writing a check, a written order to a bank to pay the indicated individual or business the amount specified from money already on deposit. Checks are legal substitutes for currency and coins and are preferred for many transactions due to their lower risk of loss. Some checking accounts earn interest (a small percentage of the amount deposited in the account that the bank pays to the depositor). The NOW (negotiable order of withdrawal) account offered by most financial institutions is one such interest-bearing account.

Some assets are called near money because they are very easily turned into cash, but they cannot be used directly as a medium of exchange like paper money or checks. The most common type of near money account, the savings account (also known as a time deposit), is an account with funds that usually cannot be withdrawn without advance notice (although this is seldom enforced). 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 have more restrictions. 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. Credit cards can access preapproved lines of credit granted by a bank or company. MasterCard and Visa represent the majority of all credit cards, but American Express and cards issued by major department stores and oil company cards are also popular. 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. Other forms of near money include traveler's checks, money orders, and cashier's checks, which the issuing organization guarantees will be honored and exchanged for cash when presented.

THE AMERICAN FINANCIAL SYSTEM

The U.S. financial system fuels the economy by storing money, providing investment opportunities, and making loans.

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 Fed strives 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 money supply; (2) to regulate banks and other financial institutions; (3) to manage regional and national checking account procedures; 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, resulting either in inflation, in the case of too much money, or recession, in the case of too little money. The Fed fine-tunes money growth with four basic tools. Open market operations refer to decisions to buy or sell U.S. Treasury bills (short-term debt issued by the U.S. government) and other investments in the open market. When the Fed buys securities, it writes a check on its own account to the seller of the securities; the seller deposits the check and the Fed transfers the balance from the Federal Reserve account to the seller's account, increasing the supply of money in the banking system. When the Fed sells securities, the amount of money in circulation declines. The second monetary policy tool is the reserve requirement, the percentage of deposits that banking institutions are required to hold in reserve and not lend to businesses and consumers. Because the reserve requirement has such a powerful effect on the money supply, the Fed does not change reserve requirements 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. When the Fed wants to expand the money supply, it lowers the discount rate to encourage borrowing; it raises the discount rate to decrease the money supply. The final monetary policy tool is credit controls--the authority to establish and enforce credit rules for financial institutions and some private investors. By raising and lowering minimum down-payment amounts and payment periods for goods and services bought on credit, the Fed can stimulate or discourage purchases of expensive items. The Fed can also affect the buying and selling of securities by altering the margin requirement--the minimum percentage of a stock price that investors must pay without borrowing.

The second responsibility of the Federal Reserve is to regulate banking institutions that are members of the Federal Reserve System. The Fed establishes and enforces banking rules that affect monetary policy and competition among banks.

A third responsibility of the Fed is national check clearing. The Federal Reserve clearinghouse handles almost all checks drawn on a bank in one city and presented for deposit to a bank in another city. The Federal Reserve also clears local checks.

The final responsibility of the Federal Reserve is to supervise the federal insurance funds that protect

the deposits of member institutions.

Banking institutions accept deposits from and make loans to individual consumers and businesses. The largest and oldest of these 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. Today, banks are quite diversified and offer a number of services, including loans, credit cards and CDs, safe-deposit boxes, and trusts. Savings and loan associations (S&Ls), or 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 a guarantee (collateral) that the buyer will repay the loan. A credit union is a financial institution owned and controlled by its depositors, who usually have a common employer, profession, trade group, or religion. Credit union members vote for directors and share in the credit union's profits in the form of higher interest rates on accounts or lower interest rates on loans. Mutual savings banks are similar to savings and loan associations, but, like credit unions, are owned by their depositors.

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. It insures individual accounts up to a maximum of $100,000. Most major banks are insured by the FDIC; state banks can be insured by the FDIC or by private insurance. The Federal Savings and Loan Insurance Corporation (FSLIC) insured thrift deposits prior to its insolvency and failure during the S&L crisis of the 1980s. Its insurance functions are now handled by the FDIC through its Savings Association Insurance Fund. The National Credit Union Association (NCUA) regulates and charters credit unions and insures their deposits through its National Credit Union Insurance Fund. Congress hoped these funds would make more people feel secure about their savings so they would not panic and withdraw their money when news of a bank failure was announced.

Nonbank financial institutions offer some financial services, such as short-term loans or investment products, but do not accept deposits. Insurance companies, for example, are businesses that protect their clients against financial losses from certain specified risks (death, injury, disability, accident, fire, theft, natural disasters) 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. Examples of pension funds include individual retirement accounts (private pension funds set up by individuals to provide for their retirement needs), corporate plans for employees, and Social Security (a public pension fund that collects funds from employers and employees and pays them to those eligible to receive benefits--the retired, the disabled, and young children of deceased parents). A mutual fund pools individual investor dollars and invests them in large numbers of well-diversified securities. 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. A growing number of nonfinancial firms are entering the financial arena, including manufacturing organizations, such as General Motors, that traditionally confined their financial activities to financing their customers' purchases. Additionally, finance companies are businesses that offer short-term loans to businesses and individuals at substantially higher rates of interest than banks. Because of the high interest rates they charge and other factors, finance companies typically are the lender of last resort for individuals and businesses whose credit limits have been exhausted and/or those with poor credit ratings.

Since the advent of the computer age, a wide range of technological innovations has made it possible to move money around the world electronically. 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 at home and abroad. Automated clearinghouses (ACHs) permit payments such as deposits or withdrawals to be made to and from a bank account by magnetic computer tape.

Several commercial banks have failed in recent years, largely due to poor loan decisions. However, strong economic growth in the 1990s and better management, combined with better regulation, have kept most commercial banks from suffering the fate of the S&Ls. With the passage of the Gramm-Leach-Bliley Bill, banks now are allowed to offer insurance and brokerage and investment banking services. Rapid advances and innovations in technology are challenging the banking industry and requiring it to change.