Free Practice Test: DSST Money and Banking

Money performs four main functions:
1. a medium of exchange – people use it to pay for goods and services;
2. a unit of account – to compare prices and value of goods and services;
3. a store of value – it will keep its current value (more or less) for a future date;
4. a standard of deferred payment – a current debt can be paid off at a future date or over time.
Money should also have the qualities of:
1. durability – it won’t rust or be easily damaged or destroyed;
2. portability – easy to carry around in your wallet or purse;
3. divisibility – can be divided into smaller denominations; and
4. hard to counterfeit – not easily copied.
Any asset which performs these functions and possesses these qualities can be defined as ‘money’. Over time, money has taken the form of:
1. commodities – as in a barter economy, exchanging goods or services for other goods or services (not common these days);
2. metallic money – gold, silver, copper, etc., either full-bodied (e.g. Kruger Rand) or token;
3. paper money – convertible to gold, or inconvertible/fiat money;
4. bank and credit money – checks, promissory notes, letters of credit, etc.
Some sources distinguish between commodity money (gold, silver), fiat money (paper money), and bank money (checks, credit cards, etc.).
Other sources distinguish three main types of money as (1) currency (sometimes called fiat money because it has no intrinsic value, apart from that decreed by the issuing authority), (2) bank deposits, and (3) central bank reserves.
Although regarded as stores of value or wealth, other assets such as property, art, stamp collections, rare wines, etc. do NOT fall within the definition of money.

Deposit deregulation:
a. The Depository Institutions Deregulation and Monetary Control Act of 1980 (Monetary Control Act) required the Reserve Banks to standardise their practice with regard to the pricing of financial services to depository institutions (banks).
b. In 1999, Bill Clinton signed into law the Gramm-Leach-Bliley Act which repealed the 66-year-old Glass-Steagall Act. This repeal allowed commercial banks to engage in investment banking and insurance activities, previously prohibited. It was a big step forward in recognising banking’s evolved role in managing the financial markets.
Structure of the banking industry: The banking system is regulated by the Federal Reserve Bank (the Fed) which is responsible for controlling the amount of money in the system. All banks must apply for a licence to operate either nationally (federal charter) or locally (state charter). Nearly 40% of the over 8 000 commercial banks in the US are members of the Federal Reserve System, and are required to hold 3% of their capital as stock in their Reserve Banks. Banking regulations ensure that banks do not take excessive risks in their lending practices, and that they maintain a certain level of financial reserves to protect their liquidity. The regulators also promote free competition so that customers are charged a fair price for banking services.

Commercial banks perform a number of functions, but mainly these:
1. To facilitate the flow of funds between lenders and borrowers; this is a savings and wealth storage function, whereby surplus funds are safely stored in risk-free or low-risk financial instruments (government or non-government securities), thereby generating wealth (interest-bearing savings) while making these funds available for interest-bearing loans.
2. Efficient allocation of funds: banks try to allocate surplus funds according to their assessment of the client’s credit-worthiness, so as to reduce the dual risks of adverse selection (lending to clients who may be a bad risk) and moral hazard (borrowers taking risks with the bank’s loan money which were not disclosed in the loan application). The bank’s borrowing and lending pricing policies will reflect the degree of risk involved in the transaction.
3. Assistance in price discovery: commercial banks are the experts in the pricing of financial services and securities, to ensure the equitable and market-related distribution of surplus funds, and also to ensure that they remain competitive in the market.
Apart from the nearly 3000 member banks of the Federal Reserve System, there are another 17 000 deposit and lending institutions including non-member commercial banks, savings banks, savings and loan associations, and credit unions. All are subject to the same banking regulations.

Deposit insurance:
The Federal Deposit Insurance Corporation (FDIC) is there to regulate banks’ lending practices, to make sure that banks do not take excessive risks which could result in bank failure. The FDIC covers defaulting bank’s investor deposits by up to $100 000.

Structure and organization:
The Federal Reserve System comprises:
• the seven-member Board of Governors based in Washington DC;
• 12 Federal Reserve Banks spread regionally throughout the US; and
• 24 branches.
The Fed has three primary functions:
• Formulate monetary policy;
• Oversee and supervise the banks;
• Provide financial services to the banks (“the banker’s bank”).
The Board’s most important function is to participate in the Federal Open Market Committee (FOMC) which determines the country’s monetary policy and money supply. The FOMC is made up of the seven Governors, the President of the Federal Reserve Bank of New York, and four other Reserve Bank presidents who alternate from amongst the twelve Federal Reserve Banks. The committee meets eight times a year in Washington to discuss the US economic outlook and monetary policy.
Historical framework:
The Fed was founded in 1913 to provide a measure of control and stability to the US economy, as well as an oversight over the growing financial sector, and the increasing world trade. The 12 regions were – and still are – based on economic rather than geographic or state-line considerations. Initially, the 12 Reserve Banks were expected to operate quite independently, to the extent of separately-determined discount rates, for example. But as the economy became more integrated and complex, there was a need for greater collaboration, and the sharing of systems and policies. One of the first signs of this collaboration was the formation of the FOMC through changes to the Federal Reserve Act in 1933/35, and later the Monetary Control Act of 1980 which regulated the pricing of financial services.
Current monetary management:
The Fed Board has a number of statutory advisory councils, drawn from the twelve Federal Reserve regions, which meet two to four time a year to advise on current issues:
1. Federal Advisory Council
2. Community/Consumer Advisory Council
3. Thrift Institutions Advisory Council
4. Model Validation Council
The individual Reserve Banks have their own local advisory committees to discuss issues related to agriculture, labour or small business development, for example.

Basic classical and Keynesian economics:
Classical economic theory believes in the supremacy of the market (supply and demand) to determine economic activity; a laissez-faire approach. Government has no business interfering in the market, and increased government spending merely drains resources out of the private sector.

Keynesian (named after US economist John Maynard Keynes) economic theory believes that the market is never perfect, and that aggregate demand and spending – by individuals, businesses and government (including monetary policy) – determine the country’s economic activity. Through its spending, government plays an important part in boosting the economy, especially in times of weak consumer demand and recession. Unlike the classical economists who believe that the market is self-correcting in the long term, Keynesian theorists hold that government fiscal and monetary policies are the only solution to effect short-term corrections.

Monetarism and rational expectations:
Keynes believed that, faced with the threat of unemployment in a recession, the rational choice of consumers is to reduce expenditure and increase savings. This has the paradoxical effect of further reducing aggregate demand and GDP. Hence the need for government intervention to jump-start demand. This is known as the ‘Paradox of Thrift’.

Monetarists believe that the market will maintain employment by reducing wages (although Keynes believed that wages are downwardly ‘sticky’), and that controlling the money supply was more important than reducing unemployment. Keynes wanted to protect employment levels, and therefore a degree of inflation – in the short term – was to be expected.

Money and inflation:
Inflation is a rise in the general level of prices, measured by the Consumer Price Index (CPI), usually as a result of an increase in the money supply which exceeds the growth in the output of goods and services – ‘too much money chasing too few goods’. Inflation reduces the purchasing power of the dollar.

The classical/monetarist view is that the more government intervenes in the market, the more likely are they to fuel inflation, and ‘crowding out’ (reducing private sector spending and investment through increases in corporate taxes and selling government bonds). This view therefore advocates reduced government spending and borrowing, minimal fiscal intervention (through income and corporation taxes), and a focus on ‘supply-side’ economics.

Conducting monetary policy
The Federal Reserve is responsible for formulating US monetary policy. To do this, they use three main mechanisms: (1) open market operations, managed by the FOMC; (2) the discount rate, and (3) reserve requirements, both managed by the Board of Governors. Together, these three mechanisms determine the demand and supply of money in the system, and hence the ‘price’ of money and credit (the interest rate, known as the Federal Fund Rate).

Open market operations are conducted by buying and selling US Treasury Bills in the market. Buying will increase the money supply and reduce the interest rate; selling will reduce the money supply (take money out of the market) and increase interest rates.

The interest rate at which banks borrow money from the Federal Reserve is called the discount rate. This may be primary credit, secondary credit, or seasonal credit.

The reserve requirement is the amount of money which a bank has to keep in the Fed’s vaults to cover its liabilities against customer deposits, as decided from time to time by the Board of Governors. The higher the reserve requirement, the less money is available to the bank for loans.

Policy effectiveness
The general objectives of US monetary policy are to: (1) maximize employment; (2) maintain price stability; and (3) maintain interest rates at a moderate level over the long term.

Because it has a direct effect on interest rates, monetary policy indirectly affects stock prices, wealth, and currency exchange rates – and thereby everything else: levels of spending, investment, employment, production, and inflation.

Monetary vs. fiscal policy
Monetary policy is determined by the Federal Reserve through their activities in the open market (buying and selling government bonds by the Federal Open Market Committee – FOMC), determining the discount rate (the rate of interest at which commercial banks borrow money from the Federal Reserve), and reserve requirements (determining how much money banks must hold in reserve to protect their liquidity).

Fiscal policy is the government’s activities in determining the federal budgets, levying and collecting taxes (individual and corporate), and government spending programmes, all of which have an effect on the demand for and supply of money.

As we have seen, there are different theoretical interpretations of which of these policies – or a combination of both – is more effective in managing the economy, and what their effect is on money supply, employment, inflation and the balance of payments.

The financial crisis of 2007/2008
Throughout the late 1990s and early 2000s there had been an increasing interest by banks in issuing mortgage-backed securities (MBSs) – bonds backed by mortgages. Many of these were ‘sub-prime’ mortgages, where the property was of poor quality, and the mortgage-holder could barely afford the repayment schedule starting at 8% for the first two years, but increasing to 15% thereafter. The issuing of these bonds reached a peak in 2005-2006, so that by late 2007 many of these sub-prime mortgage holders started to default on their mortgage repayments.

The bubble burst, and banks with a large exposure to these assets had started to report losses. Investment bank Bear Stearns (5th largest in the US) was the first to go in June 2007, shutting down one of its hedge funds with a $3bn loss, and was eventually bought out by JP Morgan in March 2008 (with US government guarantees). UK investment bank Northern Rock soon followed in September 2007 and was rescued by the UK government. Lehman Brothers filed for chapter 11 bankruptcy in September 2008, and Merrill Lynch was eventually taken over by Bank of America in September 2011. Insurance giant AIG was another casualty, and was bailed out by the US government (AIG was in their opinion ‘too big to fail’) to the tune of $80bn. The Dow Jones fell by nearly 30%.

Mitsubishi bought a 21% stake in Morgan Stanley for $9bn (the largest check ever written), and the US government got Congress to approve a rescue fund in October 2008 worth $700bn – TARP, the Troubled Asset Relief Programme. It took another three years for the markets to stabilize and start to grow again.

a. International monetary institutions and the debt crisis
The international monetary system is a set of rules agreed amongst nations regarding the comparative value of their currencies and ways in which trade between countries may be carried out. The exchange of currencies and goods and services between countries through international trade benefits those countries through the improvement in their Balance of Payments (BoP).
The first attempt to establish a truly international system of exchange was the Bretton Woods meeting of 44 nations in 1944, which pegged international currencies against the dollar, which in turn was backed by gold. The Bretton Woods system was abandoned in 1971 to be replaced by a floating exchange rate system (the price of one currency in terms of another).

b. International payments and exchange rates
National currencies now tend to ‘float’, pegged to the value of one or more of that country’s major trading partners, called a ‘reserve currency’. This could be the US dollar, European euro (increasingly strong), Japanese yen, Swiss franc, or British pound. Fluctuations in these values are monitored by the International Monetary Fund. The IMF was established in 1944 as part of the Bretton Woods Agreement to help manage the fixed rate exchange system, but has evolved to make loans to governments who experience short-term trade deficits. The World Bank, established at the same time to assist with post-World War II reconstruction in Europe, continues to play a role assisting with global reconstruction where there is a need. Both of these institutions are represented at the G20 summits convened to discuss global economic issues and governance.

c. Monetary policy in conjunction with flexible exchange rates
When the US unilaterally cut its dollar/gold convertibility in 1971, most currencies continued to ‘peg’ their currencies to the value of the dollar. The dollar effectively became the reserve currency for most nations – the currency they held in their foreign exchange reserves to support the value of their own currencies. Nowadays, most countries hold a ‘basket’ of strong currencies in their foreign exchange reserves. The dollar and these other currencies have effectively become the world’s fiat money.

The IMF effectively assists governments in advising them on exchange rate and balance of payments issues, creating rules for the setting of exchange rates, and setting up instruments to provide liquidity and reserves (such as special drawing rights, or ‘paper gold’).

Although only 36% of IMF-recognised countries float their currencies, this accounts for nearly 80% of all world trade.