Chapters 1-6 review
Chapters 1-6 review FINA 30653
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Financial Planning Chapter 1 The Financial Environment What is Finance? Finance: o Study of how individuals, institutions, governments, and businesses acquire, spend, and manage money and other financial assets Financial Environment: o Encompasses the financial system, institutions, markets, and individuals that make the economy operate efficiently Financial Markets Characteristics Money Markets: o Where debt securities with maturities of one year or less are issued/traded Capital Markets: o Where debt securities with maturities longer than one year and corporate equity securities are issued/traded Primary Markets: o Where the initial offering/origination of debt and equity securities takes place Secondary Markets: o Where the transfer of existing bonds, mortgages, and equity securities between investors occurs Major Types of Financial Markets Debt Securities Markets: o Where money market securities, bonds, and mortgages are sold and traded Equity Securities Markets: o Where ownership rights in the form of stocks are initially sold and traded Derivative Securities Markets: o Where financial contracts that derive their values from underlying securities are originated and traded Foreign Exchange Markets: o Electronic markets in which banks and traders buy and sell currencies on behalf of businesses and clients Financial Planning Chapter 2 Money and the Monetary System The 2007-2008 Financial Crisis The results of a number of economic financial trends coming together A rapid decline in housing prices caused a credit crunch and a major decline in economic activity o There is not one cause nor one solution for the financial crisis o In many parts of the country the housing market was going through a big boom and it was good if you were selling not if you were trying to buy o Banks did not have the money to loan to local businesses Many economists trace the start of the crisis to the housing bubble bursting in mid-2006 Mortgage-backed securities (backed by home mortgage loans) declined in value as housing prices declined Many financial institutions had inadequate equity capital due to the loss in value of these debt securities During 2008, the federal government moved to help merge or bail out some troubled institutions o When they were afraid our banks were going to shut down the financial government stepped in Participants in the US Monetary System Central Bank: o Defines and Regulates Money Supply Over the whole system If it was over the bankers bank we would not want to deposit money there o Facilitates and Transferring of Money Banking System: o Creates money Banks are important because they have the ability to do something that other companies cannot, create money, not exactly print it but through their actions they have the power to change the money supply o Transfers money o Provides financial intermediation o Processes/Clears checks The US Monetary System (see slide 5) Central Bank Federal reserve System Board of Governors Federal Reserve Banks o Defines and regulates money supply o Facilitates transfer of money through check processing/clearing Banking System: 1. Creates money 2. Transfers money 3. Provides financial intermediation 4. Processes/clears checks The central bank is the FED Frost bank would be a private bank Importance and Functions of Money Real Assets: o Direct ownership of land, buildings or homes, equipment, inventories, durable goods, and precious metals As a business we want real assets to help create our product and create a profit (as a society this is what gives us wealth, real assets) Financial Assets: o Money, debt instruments, equity securities, and other financial contracts that are backed by real assets and earning abilities of issuers An asset is something you own or something of value Money is a financial asset because it doesn’t help me live somewhere or eat something, it only has value in what it will buy me Economists Meaning of Money Anything that is generally accepted in payment for goods and services Not the same as wealth or income Functions of Money (for money to operate well it has to have these four functions) Money has four key functions that make it the most efficient means of trade: 1. Money acts as a medium of exchange, which is anything that is generally accepted as payment for goods and services or in the settlement of debts Means of payment Eliminates need for barter So that people are able to use their money to get what they need Finalizes payment I want that bowl of soup so I will exchange this for that We can go to Dillard’s and get something using our credit card but that doesn’t mean we have that money, credit cards are not money it is the payment of the bill that is money There are five criteria that a good must meet to be suitable as a medium of exchange: 1. The good must be acceptable to most traders 2. It should be of standardized quality. So that we all know what it is 3. It should be durable 4. It should be valuable relative to its weight 5. It should be divisible 2. Money is a unit of account, which is a way of measuring value in the economy in terms of money Standard of value Like a yardstick Relative prices are what is important For 70,000 products, would have almost 2.5 billion relative prices 3. Money is a store of value, in that it is an asset or a thing of value that can be owned and is, therefore, a component of wealth Must retain its worth The accountant that worked in April needs to sustain his money so that it doesn’t go to waste Not perishable 4. Money offers a standard of deferred payment in credit transactions You do not need to get paid after every item that you make, you get paid in total at the end of the year or the month Types of Money Commodity money o Physical good by which trade is accomplished Such as gold and silver when used to accomplish trade Fiat money o Money authorized by a central bank is the definitive money and doesn’t have to be exchanged for gold or commodity money A system in which the definitive money is money authorized by a central bank or government body as legal trade- that is, the money must be accepted to discharge debts and tax payments must be in cash or checks denominated in that money In the US federal Reserve Notes are fiat money Checks are promises to pay definitive money on demand and are drawn on money deposited with a financial institution Setting and clearing transactions can now be done with computers in electronic funds transfer system. Debit cards and automated teller machines are examples of electronic funds transfer devices 80% of the dollar value of transactions among financial institutions is conducted electronically The efficiency of the payments system reduces the cost of settling transactions Development of Money in the US Historical Types of US Coins: o Full-Bodied Money: Coins that contain the same value in metal as their face value o Token Coins: Coins containing metal of less value than their stated value Historical Types of Paper Currency: o Representative Full-Bodied Money: Paper money fully backed by precious metal o Fiat Money: Legal tender proclaimed to be money by law-not backed by precious metal Today your dollar bill does not equal a certain amount of gold We have fiat money today because the US doesn’t have the amount of gold to back that Deposit Money in the US Credit Money: o Money worth more than what it is made of-backed by the credit-worthiness of issuer Deposit Money: o Special type of credit money backed by the depository institution that issued the deposit Alternatives to “Paper Checks” Automatic Transfer Service (ATS) Accounts: o Provide for direct deposits to, and payments from, checkable deposit accounts Debit Cards: o Provide for immediate direct transfer of deposit amounts and can be used to make cash withdrawals from ATMs Money Market Securities Money Markets: o Markets where debt securities with maturities of one year or less are originated (primary markets) or traded (secondary markets) Money Market Securities: o Debt securities with maturities of one year or less Treasury Bill: o Short-term debt obligation issued by the US federal government Negotiable Certificate of Deposit: o Short-term debt instrument issued by depository institutions that can be traded in the secondary money markets Commercial Paper: o Short-term unsecured note issued by a high credit-quality corporation Banker’s Acceptance: o Promise of future payment issued by an importing firm and guaranteed by a bank Repurchase Agreement: o Short-term debt security where the seller agrees to repurchase the security at a specified price and date Federal Funds: o Very short-term loans between depository institutions with excess funds and those needing funds Components of the M1 Definition of the Money Supply Currency o Things people would use to go buy dinner or milk tonight Traveler’s Checks o Something people use when they would travel and they would state how long they would be there and get a check to able to pay for food and other necessities and it helped keep them from being pick pocketed o This was before there were atm and credit cards Demand Deposits at Banks o This is for when you don’t want to carry a whole lot of cash so you can use your debit card and the money will come straight out of your checking account (readily available money) Other Checkable Deposits at Depository Institutions Components of the M2 Definition of the Money Supply All of M1 Supply Plus: o Saving accounts Money easily used to pay for tuition or a car repair but not for something as simple like dinner o Small-Denomination time deposits Something you saved and didn’t touch for a certain period of time, save to pay for a home or graduate school (this is within households) o Money Market Deposit Accounts (MMDAs) Accounts where you are earning interest o Retail Money market Mutual Funds (MMMFs) The Federal Reserve mostly looks as M2 for their studies Money Supply and Economic Activity Monetarists’ View: o Amount of money in circulation determines the level of economic activity Basic equation: MS x VM= GDP Gross Domestic Product (GDP): measures the output of goods and services in an economy Money Supply (MS): usually defined in terms of M1 or M2 MS is telling us how many dollars we have out there Velocity of Money (VM): the rate of circulation of the money supply VM is telling us how many we are spending Keynesians’ View: o Change in money supply first causes a change in interest rates which then, in turn, alters the demand for goods and services Both Monetarists’ and Keynesians’ views think it is important to look at the money supply but come at it at different sides Another View of GDP Basic Equation: RO x PL= GDP o Gross Domestic Product (GDP): measures the output of goods and services in an economy o Real Output (RO): units of goods and services The number of things you are buying o Price Level (PL): average price of goods and services Price they are being sold at You need to have money supply to be growing in order for output to be growing The money is the fuel for the economy to get it going Two Views of GDP Combined Two basic equations: o MS x VM= GDP o RO x PL= GDP The equations combined: o MS x VM= RO x PL Nominal GDP increases with: o An increase in the money supply and/or velocity of money o An increase in real output and/or price level Financial Planning Chapter 3 Banks and Other Financial Institutions Types of Financial Institutions Financial Institutions Categories: o Depository Institutions Accepts deposits from individuals and then lend pooled deposits to businesses, governments, and individuals First ones people think of They accept deposits and then make big loans to people for long periods of time 1. Commercial Banks Accept deposits, issue check-writing accounts, and make loans With households they tend to give them checking accounts Commercial loan is lending the money to a business to build a new building, lending to a business rather than a family to buy a house or car 2. Thrift Institutions Accumulate individual savings and primarily make consumer and mortgage loans (used for families and their savings) Savings Banks Saving and Loan Associations 3. Credit Unions Cooperative nonprofit organizations that exist primarily to provide member depositors with consumer credit Credit Unions were very small unions that were created to meet the needs of the people in that union It would take the deposits or savings from people who had connections (friends) A credit union does not pay taxes because it is basically a club we are borrowing money within the club They can not make loans to outsiders or offer checking accounts o Contractual Savings Organizations Organizations collect premiums and contributions from participants and provide insurance against major financial losses and retirement Two Types: Insurance Companies Provide financial protection to individuals and businesses for property, liability, and health uncertainties Helps protect me from certain types of risks Property and Casualty Insurance Property and casualty insurance protect me against a loss if some sort of accident causes damage to my property like car insurance Life Insurance (the beneficiary gets the check when you die) Whole Life- insurance that you pay every month or quarter or year as long as you continue to pay it then your life insurance continues Term Life- insurance that you buy for a certain length of time, it only covers you for a certain period of time and doesn’t build up any cash value and tends to be cheap (for most people it is better to use term life) Credit Life- life insurance that pays the lender the amount of money you borrowed and tends to be very expensive Disability Insurance Life insurance only comes into play if you die and have people that need to rely on you not if you are incompasitated then you use disability insurance You are more likely to end up in a situation when you are disabled and in the hospital then health insurance would cover your hospital bills but disability insurance would cover your electricity and food and so on Pension Funds Receive contributions from employees and/or their employers and invest the proceeds on behalf of the employees for use during their retirement years Need for pension funds has increased because people are living longer and being more active in retirement Pension fund gives you a source of income when you retire Two Types: (both depend on how the market is doing) Defined Benefit After you have worked for this employer for 30 years then you will get a check that is 50% of what you use to earn and it can increase based on how long you worked there They are becoming less and less common Defined Contribution You put away 5% of your profit one month and your employer also puts away 5% then you get 10% and son on each month until you retire The money is invested it is not just put in a shoe box and given to you; so if the market is doing well then you get a bigger retirement fund o Securities Firms Accept and invest individual savings and also facilitate the same and transfer of securities between investors Three Types: Investment Companies (Mutual Funds) Sell shares in their firms to individuals and others and invest the pooled proceeds in corporate and government securities Investment companies and brokerage firms are the ones we as consumers are most likely to come in contact with Mutual Funds: open-end investment companies that can issue an unlimited number of their shares to their investors and use the pooled proceeds to purchase corporate and government securities Takes your money and pulls it together with other investors so you can buy shares with a mutual fund Investment Banking Firms Sell or market new securities issued by businesses to individual and institutional investors We may never have any contact with these unless we go into finance An investment bank works with big investors not regular people They do all the legal work and SEC filing for a big business that might want to build a new building or factory Brokerage Firms Assist individuals to purchase new or existing securities issues or to sell previously purchased securities Brings buyers and stocks together o Finance Firms Provide loans directly to consumers and businesses and help borrowers obtain mortgage loans on real property Two Types: Finance Companies Provide loans directly to consumers and businesses or aid individuals in obtaining financing of durable goods and homes Mortgage Banking Firms Originate mortgage loans on homes and other real property by bringing together borrowers and institutional investors Overview of the Banking System Commercial Bank: o Accepts deposits, makes loans, and issues check-writing accounts Investment Bank: o Helps businesses sell their securities to raise financial capital Universal Bank: o Bank that engages in both commercial banking and investment banking activities Glass-Steagall Act of 1933: o Provided for separation of commercial banking and investment banking activities in the US Said no to commercial banking Most important law made is financial history Gramm-Leach-Bliley Act of 1999: o Repealed the separation of commercial banking and investment banking activities provided for in the Glass- Steagall Act Regulation of the Banking System General Banking Legislation (most major acts have been a response to a financial crisis) o National banking Act of 1864 Passed to try and help stable the banking system o Federal Reserve Act of 1913 Passed to help the financial markets not have a panic o Banking Act of 1933 (Glass-Steagall Act) o Depository Institutions Deregulation and Monetary Control Act of 1980 o Garn-St. Germain Depository Institutions Act of 1982 o Gramm-Leach-Bliley Act of 1999 o Dodd-Frank Wall Street Reform and Consumer Protection Act (2010) Savings and Loan Crisis o What Happened? Mid-1980s to Mid-1990s: Over 2,000 savings and loans were closed or merged into other institutions o Why did it Happen? Savings and loans failed due to 1) mismanagement and 2) greed that led to fraudulent activities on the part of some officers and managers Savings and loans was a thrift institution for middle class Americans Texas and California had a lot of savings and loans institutions In the 1980s we were lending money for loans at 8.5% with a 10% inflation rate Nature of Saving and Loans Business Activities o Saving and loans borrow short-term by accepting the deposits of savers and paying interest on the savings o Saving and loans, in turn, provide long-term mortgage loans to help finance homes o The result is loan illiquidity and financing cost risk associated with rising short-term interest rates Changing Saving and Loans Business Activities o Deregulation caused additional saving and loans operating difficulties o In early 1980s, saving and loans were permitted to invest in a range of high-yielding investments including speculative office/commercial buildings and “junk” (low quality) bonds issued by businesses o Saving and loan managements were ill prepared for deregulation resulting in mismanagement o Greed also resulted in fraudulent behavior on the part of some officers and mangers Protection of Depositors’ Funds o The Federal Deposit Insurance Corporation (FDIC) was created in 1933 to protect deposits in banks o The Federal Savings and Loan Insurance Corporation (FSLIC) was created to protect deposits in savings and loans (replaced by SAIF in 1989) o The National Credit Union Share Insurance Fund (NCUSIF) was created to protect deposits in credit unions o Deposit account insurance has been increased over time— it reached $100,000 in 1980 and currently is $250,000 o Bank Insurance Fund: Collects annual insurance premiums from commercial banks to create the pool of funds available to DDIC for covering insured depositors o Federal Deposit Insurance Corporation Improvement Act of 1991: Provides for differences in deposit premiums based on the relative riskiness of banks Structure of Banks: Bank Charters o Dual Banking System: Commercial banks can obtain charters either from the federal government or a state government o Federally Chartered Banks: Must have “national” in their titles and be members of the Federal Reserve System and the Federal Deposit Insurance Corporation Branch Banking o Unit Banking: Exists when a bank can have only one full-service office o Limited Branch Banking: Allows additional banking offices within a defined distance of a bank’s main office o Statewide Branch Banking: Allows banks to operate offices throughout a state The Bank Balance Sheet: Assets Cash and balances due from depository institutions (about 7% of total assets) Securities (about 18% of total assets) Loans (about 59% of total assets) Other assets (about 16% of total assets) Types of Bank Loans Loans Secured by Real Estate Loans to Depository Institutions Commercial and Industrial Loans Loans to Individuals Other Loans The Bank Balance Sheet: Liabilities and Owner’s Capital Deposits (about 68% of total) Other liabilities (about 24% of total) Owners Capital (about 8% of total) Bank Management: Basic Concepts Bank Liquidity: o Reflects ability to meet depositor withdrawals and to pay off other liabilities when due Bank Solvency: o Reflects ability to keep the value of a bank’s assets greater than its liabilities Financial Planning Chapter 4 The Federal Reserve System The US Banking System Prior to the Fed States Rights vs. federal Government National Banking System: o Established when National Banking Acts were passed in 1863 and 1864 Movement to Central Banking Central Bank: o Federal government agency that facilitates operation of the financial system and regulates money supply growth Federal Reserve System (FED): o US central bank that sets monetary policy and regulates banking system Structure of the Federal Reserve The FED System Consists of Five Components: o Member Banks All national banks must be members of the FED State-chartered banks are permitted to join the FED system About one-third of commercial banks are members of the FED Member banks hold about three-fourths of the deposits of all commercial banks Wells Fargo or Frost Bank The banks that we deal with and are part of the FED o Federal Reserve District Banks Hold reserve balances for depository institutions Lend to depository institutions located in their districts at the prevailing discount (interest) rate Issue new currency and withdraw damaged currency from circulation Collect and clear checks and transfer funds for depository institutions 12 FED banks Each FED has their own website o Board of Governors Sets reserve requirements and approves discount rates as part of monetary policy Supervises and regulates member banks and bank holding companies Establishes and administers protective regulations and consumer finance Oversees Federal Reserve Banks Group of individuals in DC appointed by the president called the board of governors 7 members total but right now there are only 5 seats filled They serve 14 year terms and every 2 years the president is allowed to appoint someone new The new president inherits the board of governors and they cannot just decide to replace them all Having 14 year (nonrenewable) terms keeps the board from doing things at the moment to get re-elected because it is such a lot time period o Federal Open Market committee Comprised of the FED Board of Governors and Five Reserve Bank Presidents Directs open market operations (buying and selling of US government securities), which are the primary instruments of monetary policy People who can vote- 7 board of Gov. and 5 reserve banks presidents (12 Federal Reserve Banks) Voting rotates among the presidents but the New York Reserve president always gets a vote because the policy that is implemented is done through that bank FOMP runs the Federal Open market Operations Monetary policy is the intentional change in the money supply to meet macro economic roles Decides how much money we give the economy-monetary systems (job of the FED) Bigger money supply leads to growth in the economy but we to be careful because to much money and the economy will crash but having less money would allow the market to catch up if the problem was that we had to much money o Advisory Committees Chairs of the FED Board of Governors Since Early 1950s 1951-1970: William McChesney Martin Jr. 1970-1978: Arthur Burns 1978-1979: G. William Miller 1979-1987: Paul Volcker 1987- 2006: Alan Greenspan 2006- 2014: Ben Bernanke 2014-present: Janet Yellen Two Recent Past Chairs of the FED Board of Governors Paul Volcker (Chair, 1979-1987) Under his guidance, a restrictive Fed policy was successful in bringing down the double-digit inflation of the 1970s and beginning of the 1980s Monetary Policy Functions and Instruments: Overview Dynamic Actions: o FED actions that stimulate or repress the level of prices or economic activity Defensive Activities: o FED activities that offset unexpected monetary developments and contribute to the smooth functioning of the economy Accommodative Function: o FED efforts to meet credit needs of individuals and institutions, clearing checks, and supporting depository institutions Monetary Policy and Instruments Monetary policy is formulated by the FED to regulate money supply growth (as well as the cost and availability of money) o Monetary system can affect interest rates Banks operate on a fractional reserve system meaning they only keep a fraction of your money and the rest they lend out to earn interest; the more money they can lend out then more people can create businesses and more people can get jobs and then there is more money in the economy Basic Policy Instruments: o Changing Reserve Requirements Lowering the reserve requirements increases the money supply in the economy and if the economy is going to quickly then raising the reserve requirement will decrease the money supply and give everything a chance to catch up The reserve rarely changes the requirements because it is so powerful and sometimes we just need to make small changes o Changing the Discount Rate Type of interest rate When you have an interest rate you have one person borrowing from another With discount rate you have a bank like Frost borrowing from the FED Ex: storm hits in Houston and everyone runs to take their money out of the ATM and the banks sometimes need to make more cash available to their customers; FED will come in and make a loan to the bank in times of trouble Discount rate is the interest rate that the federal reserve changes in the branches It is the only interest rate the FED sets Lowering the discount rate makes banks make more loans and outs more money out there which gets the economy going, fuels it The higher the discount rate is the less likely a bank is to need a loan to same them from a crisis Discount rate has little impact today because banks borrow very little from the federal reserve Original federal reserve banks were able to set their own individual interest rate, borrowing money from the FED is like borrowing money from your parents o Conducting Open-Market Operations Open Market Operations is the primary market that is used today and it was discovered by accident; not something the FED ever meant to use 3 entities US Treasury Accounting division for the US government They buy planes, food for the military or bombs Write checks to people the FED purchases goods from Banks Federal Reserve In charge of the money supply Reserve Requirements: o FED sets reserve requirements for the depository institutions Discount Rate Policy: o Fed sets interest rate at which it will lend to depository institutions Open-Market Operations: o Fed buys/sells government securities to change bank reserves Reserve Requirements: Basic Concepts Fractional Reserve System: o Reserves help with FED that equal a certain percentage of bank deposits Bank Reserves: o Vault cash and deposits help at the Federal Reserve Banks Required Reserves: o Minimum amount of total reserves a depository institution must hold Required Reserve Ratio: o Percentage of deposits that must be held as reserves Excess Reserves: o Amount of the total reserves are greater than required reserves Discount Rate Policy Discount Rate: o Interest rate that a bank must pay to borrow from its regional Federal Reserve bank Forms of Borrowing: o Borrowing institution may receive an “advance” (loan) or may “discount” (sell) to the Reserve Bank its “eligible paper” Open-Market Operations Open-Market Operations: o Buying and selling of securities in the “open market” by the fed to alter bank reserves Fed’s Assets: o Primarily help as US government and government agency securities Quantitative Easing: A New Monetary Policy Tool Quantitative Easing (QE): o Non-traditional monetary policy designed to stimulate economic growth Fed purchases financial assets from banks and other financial institutions with newly created money resulting in larger bank excess reserves and increased money supply and liquidity Implementation of Monetary Policy Monetary policy can focus on either: 1. Trying to control the rate of change or growth in the money supply (M1) 2. Targeting a level for a specific type of interest rate (federal funds rate) Federal Funds Rate: Rate on overnight loans from banks with excess reserves to banks who have deficit reserves Fed Supervisory Responsibilities On-site examination of commercial banks Function shared with: o Office of the Comptroller of the Currency (OCC) o Federal Deposit Insurance Corporation (FDIC) o State regulatory agencies Supervision and Regulation of Non-Commercial Banks Credit Unions: o Regulated by the National Credit Union Administration (NCUA) Saving & Loans and other Saving Institutions: o Regulated by the Office of Thrift Supervision (OTS) Fed Service Functions The Payment Mechanism o Necessary for the monetary system to carry out the financial function of transferring money Involves: Regulating amount of coin and currency Check clearance and collection Check routing Transfer of Credit Electronic Funds Transfers Financial Planning Chapter 5 Policy Makers and the Money Supply National Economic Policy Objectives Economic Growth High Employment o People that are retired are not considered in the unemployment rate o The number of people actively looking for a job divided by the people currently in a job Price Stability Balance in International Transactions National Economic Policy: Important Terms Gross Domestic Product: o GDP is the output of goods and services in an economy GDP is what the FED is watching to make sure we do not have to much inflation GDP is the dollar value of exactly what we produce Inflation: o Increase in process of goods and services not offset by increase in quality o A sustained increase in the general price level of goods and services in an economy over a period of time When the price level rises then each unit of currency buys fewer goods and services Real GDP: o When GDP growth exceeds rate of inflation, the results is higher living standards Increase standard of living is when we have more goods and services then we can consume Four Policy Maker Groups Federal Reserve System o Sets Monetary Policy FED choses what happens to the money supply The President o Helps set the Fiscal Policy The President and Congress decide how much the government is going to spend on the military, education, etc. Congress o Helps Set the Fiscal Policy US Treasury o Conducts Debt Management Policy US Treasury does not set tax policy but they can go to congress and advise them against spending money on certain things The Treasury finds people to lend the money to the government Changing the Money Supply Fractional Reserve System: o Banks only hold a portion of deposits on hand o System which allows banks to keep a fraction or percentage of the deposits actually on hand and the rest can be loaned out When you made a deposit in he bank they lend out a fraction of your money and keep the other half of it in the bank You go to Bank A and deposit $100 the and Bank A puts $10 in the reserve and lends out $90 to another person who takes the $90 to Bank B and deposits it and Bank B keeps $9 in the reserve and lends out $81 to someone who deposits it in Bank C and Bank C puts $8 in the reserve and $72 is loaned out to someone else and so on o Multiple deposit expansion process o Allows FED to alter the money supply Required Reserves o Determined by the Federal Reserve Required Reserves tells the bank that you have to keep a certain amount of money in the reserve if you are going to lend out money If banks choose to they can hold more but they cannot leally choose to hold less Excess Reserves o Determined by the bank o Reserves that are in excess if the reserve requirement The monies that cannot be loaned out Main Tools of the Federal Reserve Discount Rate o Is an interest rate that the FED charges member banks to borrow if they do not have enough reserves on hand Only interest rate set by the FED Higher rates means lower money supply Less loans and more unemployment Lower rates mean larger money supply More loans and less unemployment Required Reserve Ratio o The amount or percentage of deposits that must stay on hand at the bank o Money that cannot be loaned out Open Market Operations o The primary instrument of the monetary policy o Involves buying and selling government securities to control the money supply o Buy bonds to increase the money supply and sell bonds to shrink the money supply Most commonly used tool today Discovered by accident during WWII Financial Planning Chapter 6 International Finance and Trade How the International Monetary System Evolved Before WWI o Prior to 1914 the international monetary system operated mostly under a “gold standard” whereby the currencies of major countries were convertible into gold at fixed exchange rated o After WWI Germany had high inflation because they lost and had to pay back the countries they harmed so it sat as a very high cost for them, everything they made went to other countries to try and make their payments WWI through WWII: 1915-1944 o An attempt was made to go back on the gold standard but financial crises in the early 1930s caused abandonment 1929 we had the Great Depression, things in the US were bad but worse in Germany All the major world currencies today are fiat currencies meaning they are not backed by commodity Add money to speed the economy up and take away money to slow it down Bretton Woods Fixed Exchange Rate System: 1945-1972 o International monetary system in which the US dollar was valued in gold and other exchange rates were pegged to the dollar Flexible Exchange Rate System: 1973-Present o Gold was abandoned as a reserve asset and major currencies were allowed to “float” against one another with currency exchange rates being determined by supply and demand Since 1973 we have had a flexible exchange rate meaning that the US dollar does not represent a certain amount of gold and the peso does not represent a certain amount of the US dollar Exchange Rate Quotations Currency Exchange Rate: o Value of one currency relative to another currency Direct Quotation Method: o Indicates the amount of a home country’s currency needed to purchase one unit of a foreign currency Indirect Quotation Method: o Indicates the amount of a foreign currency needed to purchase one unit of the home country’s currency Factors that Affect Currency Exchange Rates Supply and Demand Relationships Relative Inflations Rates Relative Interest Rates Other Factors (political risk and economic risk o What happens with exchange rates will depend on supply and demand International Currency Arbitrage Arbitrage: o Buying commodities, securities, or bills of exchange in one market and immediately selling them in another market to make a profit from price differences in the two markets Buying and selling securities at the same time to hedge against price changes Way to diversify and hedge against losses and risks In a way like flipping a house; someone comes in a buys an old home then fixes it up and turns around and sells it for way more How many US dollars equal a Euro If you had a US dollar and wanted to convert it to Peso how much would it cost you For each US dollar how many Yen would you receive