ECON CH 10-3 BANKING TODAY

LAST: FIRST:

PERIOD:

Study the introduction above. Look at the objectives. Explain what you are expected to learn from this section.
Study the vocabulary words. Look for these words as you study this section. You will be tested on the words later.
Good luck!

Do you have a checking account, credit
card, or ATM card If you don ’t, you
most likely will in the near future. As this
question suggests, people in the United
States today use more than just paper
currency and coins to pay for purchases.

Measuring the Money Supply
You are familiar with paying for the items
you need with currency —the bills and
coins in your pocket. Money consists of
currency. It also consists of traveler’s
checks, checking account deposits, and a
variety of other components. All of these
components make up the United States
money supply —all the money available in
the United States economy. To more easily
keep track of these different kinds of
money, economists divide the money
supply into several categories. The main
categories are called M1 and M2.

M1
M1 represents money that people can gain
access to easily and immediately to pay for
goods and services. In other words, M1
consists of assets that have liquidity, or the
ability to be used as, or directly converted
into, cash.
As you can see from Figure 10.5, about
48 percent of M1 is made up of currency held by the public, that is, all currency held
outside of bank vaults. Another large part
of M1 is deposits in checking accounts.
Funds in checking accounts are also called
demand deposits because checks can be
paid “on demand, ” that is, at any time.

Until the 1980s, checking accounts did not
pay interest, and a new category, called
other checkable deposits, was introduced
to describe checking accounts that did pay
interest. Today this distinction is not as
meaningful as it once was since many
checking accounts pay interest if your
balance is sufficiently high.
Traveler’s checks make up a very small
component of M1. Unlike personal checks,
traveler’s checks can be easily turned into
cash.

M2
M2 consists of all the assets in M1 plus
several additional assets. These additional
M2 funds cannot be used as cash directly,
but can be converted to cash fairly easily.
M2 assets are also called near money.
For example, deposits in savings
accounts are included in M2. They are not
included in M1 because they cannot be
used directly in financial exchanges. You
cannot hand a sales clerk your savings
account passbook to pay for a new
backpack. You can, however, withdraw money from your savings account and then
use that money to buy a backpack.

Deposits in money market mutual funds are
also included as part of M2. These are
funds that pool money from small savers
to purchase short-term government and
corporate securities. They earn interest and
can be used to cover checks written over a
certain minimum amount, such as $250.
You will read more about money market
mutual funds in Chapter 11.

What is M1?

a.	money that get easily to pay for goods and services such as cash	c.	security bonds
b.	money kept in the vaults at Ford Knox	d.	Money 1 dollar bills

Why do economists use categories such as M1 and M2 with regards to the money supply?

a.	to expand the money supply	c.	to decrease the money supply
b.	keep track of the different kinds of money	d.	make money distribution easier

What is liquidity?

a.	gold and silver bars which are melted at a foundry	c.	liquid money such as oil and gas
b.	money kept in a safe place such as Swiss banks	d.	money that is readily available for spending

When you pay your bills with demand deposits, what are you doing?

a.	using cash	c.	obeying the demands of your spouse
b.	making cash deposits into your bill holders bank account	d.	writing checks

What is another name for M2 assets?

a.	near money	c.	Modern Money
b.	funny money	d.	Movable deposits

When you purchase short term money market securities, what kind of money are you getting.

a.	M1 money	c.	government long term bonds
b.	M2 money	d.	government long term securities

The components of M1 can be used as cash or can be easily converted into cash. M2
consists of the assets in M1 plus assets that can be converted to cash fairly easily.
What is the largest component of M1?

a.	Currency	c.	Other checkable deposits
b.	Demand Deposits	d.	Travelers checks

a.	savings deposits	c.	small denomination time deposits
b.	Retail money market funds	d.	M1

10.

You are going to the prom. Before the dance you are going to take your date out to dinner. Which type of currency should you have on hand?

a.	near money	c.	M1
b.	savings deposits	d.	M2

11.

In a fractional reserve system, banks keep only a fraction of funds on hand and lend out the rest. The funds lent out fuel the economy and ensure continued growth. Why does the bank retain a percentage of the money it receives from depositors?

a.	so they can be sure to make at least 20% profit	c.	to prevent 20% of their depositors from withdrawing their money
b.	to have enough money on-hand in case depositors want to withdraw all or part of their money	d.	there is no reason

12.

What does the chart above show?

a.	The safety of money deposits in the banking system	c.	The flow of money through the banking system and how it makes loan money available
b.	The greed of bankers	d.	The danger of lending money while keeping only 20% in deposits

Simple and Compound Interest
As you have read, interest is the price paid for the use of borrowed money. The
amount borrowed is called the principal.
Simple interest is interest paid only on
principal. For example, if you deposit
$100 in a savings account at 5 percent
simple interest, you will make $5 in a year (assuming that interest is paid annually).

Suppose that you leave the $5 in interest
in the bank, so that at the end of the year
you have $105 in your account —$100 in
principal and $5 in interest. Compound
interest is interest paid on both principal
and accumulated interest. That means that in the second year, as long as you leave both the principal and the interest in your account, interest will be paid on $105
Figure 10.7 shows how an account paying compound interest grows over time.

13.

This chart shows the money earned on a $100 deposit when interest is compounded yearly at
5 percent. How many years does it take for the original deposit to double?

a.	1	c.	15
b.	5	d.	20

14.

You deposited $100 in the bank. At 5% interest, how much have you earned at the end of 15 years?

a.	$218.	c.	$207
b.	$118.	d.	$10.39

Functions of Financial Institutions

Banks and other financial institutions are
essential to managing the money supply.
They also perform many functions and
offer a wide range of services to consumers.

Storing Money

Banks provide a safe, convenient place for
people to store money. Banks keep cash in
fireproof vaults and are insured against the
loss of money in the event of a robbery. As
you read in Section 2, FDIC insurance
protects people from losing their money if
the bank is unable to repay funds.

Saving Money

Banks offer a variety of ways for people to
save money. Four of the most common
ways are the following:
• Savings accounts
• Checking accounts
• Money market accounts
• Certificates of deposit (CDs)

Savings accounts and checking accounts
are the most common types of bank accounts. They are especially useful for people who need to make frequent withdrawals. Savings accounts and most checking accounts pay a small amount of interest at an annual rate. Money market accounts and certificates of deposits (CDs) are special kinds of savings accounts that pay a higher rate of interest than do savings and checking accounts. Money market accounts allow you to save and to write a limited number of checks. Interest rates are not fixed, but can move up or down. CDs, on the other hand, offer a guaranteed rate of interest over a certain period of time. Funds placed in a CD, however, cannot be removed until the end of a certain time period, such as one or two years. Customers who remove their money before that time pay a penalty for early withdrawal.

15.

Which statement is true?

a.	The government can manage the money supply without banks and other financial instructions	c.	We do not need banks and other financial institutions to manage the money supply
b.	The stock exchange can easily manage the money supply without interference from banks and other financial institutions	d.	Banks and other financial institutions are needed to manage the money supply

16.

Which statement is true?

a.	Banks are an unsafe place to store money because they are frequently robbed.	c.	Banks are a safe place to store money because they convert cash into bonds before they close each day
b.	Banks are an unsafe place to store money because they sometimes fail	d.	Banks are a safe place to store money because of the FDIC

17.

Which statement is true?

a.	With Money Market Accounts you can write a specific number of checks and interest rates never change	c.	With Money Market Accounts you can write an unlimited number of checks and interest rates may go up or down
b.	With Money Market Accounts you can write a specific number of checks and interest rates may go up or down	d.	With Money Market Accounts you cannot write a checks but interest rates always go up

18.

If you invest your money in CDs, you can be sure that

a.	your interest rate will never change and you will be able to take out your money at any time without a penalty	c.	your interest rate will go up and you will be able to take out your money at any time
b.	you will be able to play your music with a CD, DVD or BlueRay player	d.	your interest rate will stay the same but you cannot take your money out without a penalty until the CD has matured

19.

What are some of the ways that people use banks to save money? (select all that apply)

a.	savings accounts	c.	Money Market Accounts
b.	checking accounts	d.	Certificates of deposit (CDs)

Loans

Banks also perform the important service of providing loans. As you have read, the first banks started doing business when goldsmiths issued paper receipts.
These receipts represented gold coins that the goldsmith held in safe storage for his customers. He would charge
a small fee for this service. In early banks, those receipts were fully backed by
gold —every customer who held a receipt could be sure that the goldsmith kept the equivalent amount of gold in his safe. Gradually, however, goldsmiths realized that their customers seldom, if ever, asked for all of their gold on one day. Goldsmiths could thus lend out half or even three quarters of their gold at any one time and still have enough gold to handle customer demand. Why did goldsmiths want to lend gold

The answer is that they charged interest on their loans. By keeping just enough gold reserves to cover demand, goldsmiths could run a profitable business lending deposits to borrowers and earning interest. The first banks were based on this practice. A banking system that keeps only a fraction of funds on hand and lends out the remainder is called fractional reserve banking. Like the early banks, today ’s banks also operate on this principle. They lend money to homeowners for home improvements,
to families to pay for college tuition,

and to businesses. The more money a bank lends out, and the higher the interest rate it charges borrowers, the more profit a bank is able to make. By making loans, banks help new businesses get started, and they help established businesses grow. When a business gets a loan, that business can create new jobs by
hiring new workers or investing in physical capital in order to increase production.

A business that gets a loan may also help other businesses grow. For example, suppose you and a friend want to start a window-washing business. Your business will need supplies like window cleaner and ladders, so the companies that make your supplies will also benefit. They may even hire workers to expand their businesses.

Bankers must, however, consider the security of the loans they make. Suppose borrowers default, or fail to pay back their loans Then the bank loses money. Bankers therefore always face a trade-off between profits and safety. If they make too many bad loans —loans that are not repaid —they may go out of business altogether. (See pages 510 –511 of the Personal Finance Handbook to learn more about banks and the services they offer.)

20.

Why do banks make loans?

a.	They don’t like to keep too much money in their vaults	c.	They make money by charging interest
b.	Banks do not make loans	d.	The government requires them to

21.

What do the banks do with the money they take in as deposits?

a.	They lend out part of the money as loans	c.	They turn it over to the U.S. Treasury Department
b.	They keep it in a safe place and do not use it for any purpose	d.	They buy gold and keep it in their vaults

22.

What do they call a banking system that keeps only a fraction of funds on hand and lends out the remainder?

a.	return to zero banking	c.	fractional reserve banking.
b.	the Federal Reserve system	d.	zero reserve banking

23.

What is the trade-off that bankers must face when they make loans?

a.	interest on the loans vs the danger that the borrower may default	c.	they may have to make too many loans to handicapped individuals
b.	a lack of deposits and interest they must pay on deposits	d.	being looked down upon by the community

Mortgages
A mortgage is a specific type of loan that is
used to buy real estate. Suppose the Lee
family wants to buy a house for $200,000.
They are unlikely to have the cash on
hand to be able to pay for the house. Like
almost all home-buyers, they will need to
take out a mortgage.

The Lees can afford to make a down
payment of 20 percent of the price of the
house, or $40,000. After investigating the
Lees ’s creditworthiness, their bank agrees
to lend them the remaining $160,000 so
that they can purchase their new house.
Mortgages usually last for 15, 25, or 30
years. According to the terms of their
loan, the Lees are responsible for paying
back the loan plus whatever interest the
bank charges over a period of 25 years.

Credit Cards
If you look at a credit card, somewhere
you will see the name of a bank printed on
it. Another service that banks provide is
issuing credit cards —cards entitling their
holders to buy goods and services based
on the cardholder ’s promise to pay for
these goods and services.

How do credit cards work Suppose you
buy a sleeping bag and tent for $100 on
May 3. You do not actually pay for the
gear until you receive your credit-card bill
and pay it in June. In the meantime,
however, the credit-card issuer (the bank)
will have paid the sporting goods store.
Your payment repays the bank for the
“loan ” of $100.

The person who owns and uses the card pays interest and the companies that accept the cards pay a fee to the bank issuing the card.

24.

What is a mortgage?

a.	money the bank owes to depositors	c.	a bank loan used for funeral expenses
b.	a down payment on a real estate loan	d.	a loan used to purchase real estate

25.

You go to the bank to borrow $20.000 for a new car. The bank gives you the loan. The $20,000 is called the

a.	card charge	c.	interest
b.	principal	d.	mortgage

26.

The bank charges you for your auto loan. What are the bank charges called?

a.	principal	c.	depreciation
b.	interest	d.	excise taxes

Banks and Profit
The largest source of income for banks is the interest they receive from customers who have taken loans. Banks, of course, also pay out interest on customers’ savings and most checking accounts. The amount of interest they pay out, however, is less than the amount of interest they charge on loans. The difference in the amounts is how banks cover their costs and make a profit.

27.

What is the largest source of income for banks?

a.	Insurance from the FDIC	c.	Interest on the loans they make.
b.	Deposits from the Federal Reserve Bank	d.	Deposits from consumers

28.

Which statement is true?

a.	Banks pay out more money in interest to depositors than they take in from loans they make	c.	Fees are the greatest source of income for banks
b.	Banks pay interest to the people who deposit money in their bank but the charge more to people who borrow money from the bank	d.	The Banks costs of doing business is greater than the profits they make by making loans

29.

Which color boxes represent the greatest amount of money?

a.	the green boxes (money entering)	c.	the brown box (reserves)
b.	the purple boxes (money leaving)	d.	all of the boxes represent equal amounts of money otherwise the bank would not be able to stay in business

Types of Financial Institutions

Several kinds of financial institutions
operate in the United States. These include
commercial banks, savings and loan associations, mutual savings banks, and credit unions. During the 1990s, these financial institutions became more similar than dissimilar, although differences still remain.

Commercial Banks
Commercial banks, which traditionally
provided services to businesses, offer a
wide range of services today. Commercial
banks offer checking services, accept
deposits, and make loans. Some commercial
banks are chartered by states and are
regulated by state authorities and by the
Federal Deposit Insurance Corporation
(FDIC). About one third of all commercial
banks are national banks and are part of
the Federal Reserve System. Commercial
banks provide the most services and play
the largest role in the economy of any type
of bank.

Savings and Loan Associations
Savings and Loan Associations (S&Ls),
which you read about in Section 2, were
originally chartered to lend money for
building homes during the mid-1800s. Members of Savings and Loan Associations
deposited funds into a large general fund and then borrowed enough money to buy their own houses. Savings and Loans are also called thrifts because they originally enabled “thrifty ” working class people —that is, people who were careful with their money —to save up and borrow enough to buy their own homes. Over time, Savings and Loan Associations have taken on many of the same functions as commercial banks.

Savings Banks
Mutual savings banks (MSBs) originated
in the early 1800s to serve people who
made smaller deposits and transactions
than commercial banks wished to handle.
Mutual savings banks were owned by the
depositors themselves, who shared in any
profits. Later, many MSBs began to sell
stock to raise additional capital. These
institutions became simply savings banks
because depositors no longer owned them.

Although savings banks were traditionally
concentrated in the Northeast, they
had an important influence on the national
economy. In 1972, the Consumer ’s Savings
Bank of Worcester, Massachusetts, introduced a Negotiable Order of Withdrawal
(NOW) account, a type of checking
account that pays interest. NOW accounts
became available nationwide in 1980.

Credit Unions
Credit unions are cooperative lending
associations for particular groups, usually
employees of a specific firm or government
agency. Credit unions are commonly fairly
small and specialize in home mortgages
and car loans, usually at interest rates
favorable to members. Some credit unions
also provide checking account services.

Finance Companies
Finance companies make installment loans
to consumers. These loans spread the cost
of major purchases like computers, cars,
refrigerators, and recreational vehicles
over a number of months. Because people
who borrow from finance companies more
frequently fail to repay the loans, finance
companies generally charge higher interest
rates than banks do.

30.

How are Commercial banks different from Savings and Loan Associations?

a.	Savings and Loans offer more services	c.	Savings and Loans can only operate in the cities
b.	Commercial banks offer more services	d.	Commercial banks make real estate loans

31.

Which institution charges the highest interest rate on loans to consumers?

a.	savings and loans	c.	credit unions
b.	finance companies	d.	commercial banks

32.

What were NOW accounts offered by Savings Banks?

a.	Banks that go out of their way to help women	c.	accounts that offered interest on checking accounts
b.	interest free loans	d.	banks that cater to the National Organization of Women

33.

What does the North Island Federal, Navy Credit, and Mission Federal have in common

a.	they are all credit unions that cater to special groups of people	c.	they are commercial banks
b.	they are all savings banks	d.	they have nothing in common

Electronic Banking

Banks began to use computers in the early
1970s to keep track of transactions. As
computers have become more common in
the United States, their role in banking has
also increased dramatically. In fact,
computerized banking may revolutionize banking in much the same way that paper
currency changed banking long ago.

Automated Teller Machines
If you use an Automated Teller Machine
(ATM), you are already familiar with one
of the most common types of electronic
banking. ATMs are computers that customers can use to deposit money, withdraw cash, and obtain account information at their convenience. Instead of having to go to the bank during the bank ’s hours of operation to conduct banking business face –to –face with a teller, you can take care of your finances at an ATM.

ATMs are convenient for both banks and for customers, since they are available 24 hours a day and reduce banks ’ labor costs. The overwhelming popularity of ATMs suggests that they are likely to be a permanent feature of modern banking.

Debit Cards
Debit cards are used to withdraw money.
You may use a debit card to withdraw
money at an ATM. You may also use a debit card in stores equipped with special machines. When you “swipe ” your card through one of these machines, your debit
card sends a message to your bank to transfer money from your checking account directly into the store ’s bank account. For security, debit cards require customers to use personal identification numbers, or PINs, to authorize financial transactions.

34.

What one thing is necessary for the function and operation of Electronic Banking?

a.	people to take deposits and disperse money (tellers)	c.	FDIC insurance
b.	commercial banking	d.	computers

Home Banking
More and more people are using the
Internet to conduct their financial
business. Many banks, credit unions, and
other financial institutions allow people to
check account balances, transfer money to
different accounts, pay their bills, and
automatically deposit their paychecks via
computer.

Automatic Clearing Houses
Automatic Clearing Houses (ACHs),
located at Federal Reserve Banks and their
branches, allow customers to pay bills
without writing checks. An ACH transfers
funds automatically from customers ’
accounts to creditors ’ accounts. (A creditor
is a person or institution to whom money
is owed.) People usually use ACHs to pay
regular monthly bills like mortgage
payments, rent, utility bills, and insurance
premiums. They save time, postage costs,
and any worries about forgetting to make
a payment.

Stored Value Cards
Stored value cards, or smart cards, are
similar to debit cards. These cards are
embedded with either magnetic strips or
computer chips with account balance
information. Smart cards include cards
issued to college students living in dormitories
to pay for cafeteria food, computer
time, or photocopying. Phone cards, with
which customers prepay for a specified
amount of long-distance calling, are also
smart cards.

Will stored value smart cards someday
replace cash altogether No one can know
for sure, but private companies and public
facilities have continued to explore new
uses for smart card technology.

35.

Your grandfather gives you a prepaid Visa card for $200. This is an example of

a.	automatic Clearing House card	c.	stored value card
b.	Home Banking	d.	a consumer loan

36.

You need to know how much money you have in your bank account. You go to the computer and check your balance. This is an example of

a.	Home Banking	c.	Stored Value Accounting
b.	Automatic Clearing House	d.	Traditional Banking

a.	liquidity	g.	fractional reserve banking
b.	credit card	h.	principal
c.	money supply	i.	interest
d.	debit card	j.	demand deposit
e.	mortgage	k.	creditor
f.	default	l.	money market mutual fund

37.

a specific type of loan that is used to buy real estate

38.

a banking system that keeps only a fraction of funds on hand and lends out the remainder

39.

a card used to withdraw money

40.

all the money available in the United States economy

41.

failure to pay back a loan

42.

the price paid for the use of borrowed money

43.

the ability to be used as, or directly converted to, cash

44.

person or institution to whom money is owed

45.

a fund that pools money from small savers to purchase short-term government and corporate securities

46.

a card entitling its holder to buy goods and services based on the holder’s promise to pay for
these goods and services

47.

the money in checking accounts

48.

the amount of money borrowed