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Professor Yamin Ahmad, Money and Banking ECON 354

ECON 354
Money and Banking
Professor Yamin Ahmad
Lecture 1
Syllabus
Introduction to Financial
Markets and Money
Real World Observations
and Basic Definitions
Professor Yamin Ahmad, Money and Banking ECON 354
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Resources Needed For This Class
Aplia Website:
http://econ.aplia.com
Use course code: N797-QVAJ -S4W8
Mishkin, Frederick S. (2010), The Economics of
Money, Banking and Financial Markets, 9
th
Edition, Pearson
8
th
edition is also fine if you have it.
Course Homepage:
http://facstaff.uww.edu/ahmady/courses/econ354/
Professor Yamin Ahmad, Money and Banking ECON 354
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Requirements
Homework Assignments, Experiments
4 Quizzes
Multiple choice questions
One Final Exam
Multiple choice questions
Professor Yamin Ahmad, Money and Banking ECON 354
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Grades
Option A:
Homework assignments 10%
Quizzes 15% each
Final 30%
Option B:
Homework Assignments 15%
3 Best Quizzes 15% each
Final 40%
Professor Yamin Ahmad, Money and Banking ECON 354
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Extra Credit
Extra Credit will be available during the summer session
in the following manner:
Additional Extra Credit problem sets on Aplia
These are used to replace low scoring problem sets
Count only towards the homework part of the
course score
Professor Yamin Ahmad, Money and Banking ECON 354
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Success in an (Any!) Economics Course
To do well in Economics, you need to be able to
do 3 things well (in conjunction):
1. Think Mathematically: Dont be afraid of
equations!
2. Think graphically!
3. Abstract Logic! (Often the hardest part)
Professor Yamin Ahmad, Money and Banking ECON 354
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The Keys to Success in this Course
Do homework assignments on Aplia
Designed to make you think about topics! Oftentimes,
challenging
Typically, questions here are harder than those you will face in
exam
Dont be shy!
Come to class ready to ask questions! Use lecture time to fill in
the gaps!
Practice and Discuss!!!
Think about what happens if ? Its the only real way to grasp
concepts in economics and economics itself!
Utilize my office hours!!
Come chat with me about concepts you are having trouble with,
ideas you havent grasped fully etc.
Professor Yamin Ahmad, Money and Banking ECON 354
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Things to Review from Principles of Macro
Understand differences between movements
and shifts of curves!
(Aggregate) Demand and (Aggregate) Supply
Market Equilibrium
The structure of the economy
Make sure you read (and understand) Appendix of
Chapter 1 in Mishkin!
Professor Yamin Ahmad, Money and Banking ECON 354
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A Model of the Economy
As in Principles of Macro, divide the economy
into different sectors and see how those sectors
interact:
Agents in the Economy
Markets where Agents Interact
Equilibrium
Professor Yamin Ahmad, Money and Banking ECON 354
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The Agents in the System
There are four agents that we will focus on when
constructing a model of the economy:
Households
Firms
Government
The Rest of the World (ROW)
Professor Yamin Ahmad, Money and Banking ECON 354
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Markets
There are three markets that we typically focus
on in macroeconomics:
The Factor Market
The Goods Market
The Financial Market (- we examine in detail in this
course)
Professor Yamin Ahmad, Money and Banking ECON 354
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The Map of the Economy
That is: Y =C +I +G +X - M
Professor Yamin Ahmad, Money and Banking ECON 354
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The Economy
HOUSEHOLDS
FIRMS
GOVERNMENT
Overview of the Course
Financial Markets:
-Interest Rates
-Risk
-Expectations
Financial Institutions
- Financial Intermediaries
Central Banking &
Monetary Policy
REST OF THE
WORLD
Professor Yamin Ahmad, Money and Banking ECON 354
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Overview of the Course
Money
Monetary Theory and Monetary Policy
Financial Markets and Financial Intermediaries
Professor Yamin Ahmad, Money and Banking ECON 354
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Some Definitions
Money: Anything that is generally accepted in payment
for goods and services
In the United States:
M1 =Currency +Traveler's Checks +Demand Deposits +
Other Checkable Deposits
M2 =M1 +Small denomination time deposits & repurchase
agreements +Savings Deposits and money market deposit
accounts +retail Money Market mutual fund shares
There also used to be a broader measure of money, M3
which was discontinued as of March 2006.
See: http://www.federalreserve.gov/releases/h6/hist/
Professor Yamin Ahmad, Money and Banking ECON 354
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Role of Money
Medium of exchange
Form of transaction technology
Unit of account
Store of value
Purchasing Power
Hence money helps to:
Lower transaction costs
Increase Liquidity in an economy
Professor Yamin Ahmad, Money and Banking ECON 354
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Overview of the Course
Money
Monetary Theory and Monetary Policy
Financial Markets and Financial Intermediaries
Professor Yamin Ahmad, Money and Banking ECON 354
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Monetary Theory and Policy
Why study Monetary Theory and Policy?
Influence on business cycles, inflation, and interest
rates
How Central Bank (Fed) can have a big influence on
the economy
Professor Yamin Ahmad, Money and Banking ECON 354
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Money and Business Cycles
Shaded areas represent Recessions
Note: Figure above shows a decline in money growth rate
prior to every recession (except the most recent one)!
-1
1
3
5
7
9
11
13
15
1960 1962 1965 1967 1970 1972 1975 1977 1980 1982 1985 1987 1990 1992 1995 1997 2000 2002 2005 2007 2010
M
o
n
e
y

G
r
o
w
t
h

R
a
t
e

(
%
)
Money (M2) Growth and the Business Cycle: 1950 - 2010
Professor Yamin Ahmad, Money and Banking ECON 354
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Money and the Price Level
Note: Positive Relationship between Money and the Aggregate
Price Level
0
20
40
60
80
100
120
140
1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010
I
n
d
e
x

(
2
0
0
5

=

1
0
0
)
M2 GDP Deflator
Professor Yamin Ahmad, Money and Banking ECON 354
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Money Growth and Inflation
Note: Across different countries, positive correlation between avg.
money growth rates and avg. inflation rates
Professor Yamin Ahmad, Money and Banking ECON 354
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Money Growth and Interest Rates
Positive correlation between money growth rates and
interest rates in 1960s & 1970s
Relationship breaks down in 1980s
Professor Yamin Ahmad, Money and Banking ECON 354
Surpluses and Deficits
Figure 10(a) shows the
changing surplus and
deficit of the federal and
provincial governments
in the United States
since 1971.
Persistent federal deficit
during the 1970s
through 1990s.
Surplus from 1998 to
2001
More deficits following.
-7.0
-6.0
-5.0
-4.0
-3.0
-2.0
-1.0
0.0
1.0
2.0
3.0
1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002 2006
G
o
v
e
r
n
m
e
n
t

B
u
d
g
e
t

B
a
l
a
n
c
e

(
p
e
r
c
e
n
t
a
g
e

o
f

G
D
P
)
(a) U.S. Government Budget Deficit
Source: Congressional Budget Office
1980s
expansion
1990s
expansion
2002
2007
expansion
2001
2002
Recession
1991
Recession
1982
Recession
OPEC
Recession
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Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Surpluses and Deficits
International Surplus and Deficit
If a nation imports more than it exports, it has an
international (trade) deficit.
If a nation exports more than it imports, it has an
international (trade) surplus.
The current account deficit or surplus is the
balance of exports minus imports plus net
interest paid to and received from the rest of the
world.
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Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Surpluses and Deficits
Figure 10(b) shows
The U.S. current
account balance
since 1960.
Persistent current
account deficit since
1983
The deficit has
swollen during the
past few years
-7.000
-6.000
-5.000
-4.000
-3.000
-2.000
-1.000
0.000
1.000
2.000
1960 1964 1968 1972 1976 1980 1984 1988 1992 1996 2000 2004
C
u
r
r
e
n
t

A
c
c
o
u
n
t

B
a
l
a
n
c
e

(
p
e
r
c
e
n
t
a
g
e

o
f

G
D
P
)
(b) U.S. International Deficit
OPEC
Recession
1981-82
Recession
1991
Recession
2001
2002
Recession
1990s
Expansion
1980s
Expansion
2008
Recession
Source: Bureau of Economic Analysis
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Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
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Interaction of Monetary and Fiscal Policy
Surpluses good? Deficits bad?
Examine how fiscal irresponsibility can lead to
the onset of financial crises.
Why deficits might lead to a higher money
growth rate, a higher rate of inflation and higher
interest rates.
Professor Yamin Ahmad, Money and Banking ECON 354
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Overview of the Course
Money
Monetary Theory and Monetary Policy
Financial Markets and Financial Intermediaries
Professor Yamin Ahmad, Money and Banking ECON 354
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Why Study Financial Markets?
Channel funds from savers to investors, thereby
promoting economic efficiency
Affect personal wealth and behavior of business firms
Brief Introduction to:
Bond Market
Stock Market
Foreign Exchange Market
Financial Markets
Professor Yamin Ahmad, Money and Banking ECON 354
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Function of Financial Markets: Flow of Funds
Allows transfers of funds from person or business
without investment opportunities to one who has them
Improves economic efficiency
Lender-Savers
Households
Firms
Government
Foreigners
Financial
Markets
Borrowers-Spenders
Business-Firms
Government
Households
Foreigners
Direct Finance
Indirect Finance
Financial
Intermediaries
Professor Yamin Ahmad, Money and Banking ECON 354
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Bond Market: 1953 - 2010
Bonds, securities. what are they?
Bond Market (and Money Markets):
determines interest rates
0
2
4
6
8
10
12
14
16
18
20
1953 1958 1963 1968 1973 1978 1983 1988 1993 1998 2003 2008
I
n
t
e
r
e
s
t

R
a
t
e

(
%
)
3 Month T-Bills Corporate BAA Bonds U.S. Government Long-TermBonds
Professor Yamin Ahmad, Money and Banking ECON 354
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Stock Market: 1950 - 2010
Stocks:
Share of ownership in a
corporation/firm.
Stock Price volatility
Bull Market vs. Bear
Market
Stock Price Bubbles
Technology bubble in
1990s?
0
2000
4000
6000
8000
10000
12000
14000
16000
1
9
5
0
1
9
5
3
1
9
5
6
1
9
6
0
1
9
6
3
1
9
6
6
1
9
7
0
1
9
7
3
1
9
7
6
1
9
8
0
1
9
8
3
1
9
8
6
1
9
9
0
1
9
9
3
1
9
9
6
2
0
0
0
2
0
0
3
2
0
0
6
2
0
1
0
Dow J ones Industrial Average
Professor Yamin Ahmad, Money and Banking ECON 354
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Foreign Exchange Market
Foreign Exchange Market:
Transfer funds from one country to another
Changes in Exchange rate:
Changes in relative prices
0.000
0.500
1.000
1.500
2.000
2.500
3.000
Q1
1970
Q3
1972
Q1
1975
Q3
1977
Q1
1980
Q3
1982
Q1
1985
Q3
1987
Q1
1990
Q3
1992
Q1
1995
Q3
1997
Q1
2000
Q3
2002
Q1
2005
Q3
2007
Q1
2010
Dollar-Sterling Exchange Rate
Professor Yamin Ahmad, Money and Banking ECON 354
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Some Basic Definitions
Debt Instrument:
1. Debt Instrument: Contractual agreement by borrower to
pay holder of the instrument a fixed dollar amount at
regular intervals (principal +interest), until a specified
date
Example: Car loan
2. The maturity of a debt instrument is the number of
years (term) until the instrument expires
Professor Yamin Ahmad, Money and Banking ECON 354
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Classifications of Financial Markets
1. Primary Market
New security issues sold to initial buyers (often behind closed
doors)
Investment banks typically underwrite securities (i.e.
guarantees a price for the security and then sells it to the
public)
2. Secondary Market
Securities previously issued are bought and sold
E.g.: NASDAQ, Futures, Options, Foreign Exchange
Exchanges
o Trades conducted in central locations (e.g., New York Stock
Exchange, NYSE; London Stock Exchange, LSE)
Over-the-Counter Markets
o Dealers at different locations buy and sell
Professor Yamin Ahmad, Money and Banking ECON 354
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Methods of Raising Private Sector Funds
Debt Markets
Short-term (maturity <1 year): Money Market
Intermediate-term (1year <maturity <10 years)
Long-term (maturity >10 years)
Equity Markets
Common stocks: claims to share in assets and net income
No maturity date; periodic payments known as dividends
Capital Market: Intermediate +Long Term Debt +
Equity
Examples: Bonds, mortgages
Professor Yamin Ahmad, Money and Banking ECON 354
Financial Market Instruments
What are the kinds of securities traded in financial
markets?
Money Market Instruments
Because of short term to maturity, debt instruments traded in the
money market do not have much fluctuation in their prices, and
hence are the least risky
Capital Market Instruments
Debt and equity instruments with maturities greater than a year;
these have much greater fluctuations in their prices (compared to
money market instruments) and as such are considered more
risky
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Examples: Money Market Instruments
US Treasury Bills
Issued by US govt, with 1, 3, and 6 month maturities.
Pay a set amount at maturity, and have no interest
payments; effectively pay interest by selling at a discount.
Negotiable Bank Certificates of Deposit
CDs are debt instruments sold by banks to depositors that
pays an annual interest of a given amount, and pays back
the original purchase price at maturity
Commercial Paper
Short term debt instrument issued by large banks and well
known corporations (e.g. Microsoft, GM).
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Examples: Money Market Instruments
Repurchase Agreements
Repos are effectively short term loans (usually with a
maturity of less than 2 weeks) for which T-bills serve
as collateral. The most important lenders in this
market are usually large corporations.
Federal (Fed) Funds
These are typically overnight loans of reserves
between banks, of their deposits at the Federal
Reserve.
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Table 1 Principal Money Market
Instruments
Professor Yamin Ahmad, Money and Banking ECON 354
Examples: Capital Market Instruments
Stocks
These are equity claims on net income and assets of a corporation.
Issue of new stocks in any given year is typically quite small, although the
total value of stocks exceed that of any other type of security in the capital
markets.
Mortgages
Mortgage market is the largest debt market in the US
Residential mortgages are approximately 4 times the amount of commercial
and farm combined.
Corporate Bonds
Long term bonds issued by corporations with very strong credit ratings.
Typical corporate bond sends the holder an interest payment twice a year
and pays off the face value when the bond matures.
Some convertible corporate bonds allows the holder to convert them into a
specified number of shares of stock at any time up to the maturity date.
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Examples: Capital Market Instruments
US Government Securities
These are long term debt instruments issued by the US Treasury to finance
the deficits of the government.
US Government Agency Securities
Issued by various agencies such as Ginnie Mae, the Federal Farm Credit
Bank, etc, to finance such items as mortgages, farm loans or power
generating equipment.
Many of the securities are guaranteed by the federal government.
State and Local bonds
Also called municipal bonds, which are long term debt instruments issued
by the state and local governments to finance expenditures on roads,
schools, and other programs.
Interest payments from these bonds are exempt from federal income tax
and generally from the state taxes issuing the bond.
Consumer and Bank loans
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Table 2 Principal Capital Market
Instruments
Professor Yamin Ahmad, Money and Banking ECON 354
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Internationalization of Financial Markets
International Bond Market
Foreign bonds: bonds sold in a foreign country and
denominated in that countrys currency.
Eurobonds:
Now larger than U.S. corporate bond market
World Stock Markets
U.S. stock markets are no longer always the largest:
J apan sometimes larger
E.g. Dow J ones Industrial Average (U.S.); Financial
Times Stock Exchange (FTSE - London); Nikkei (Tokyo)
Professor Yamin Ahmad, Money and Banking ECON 354
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Common Confusions
Eurobond: bond denominated in a currency other than
that of the country in which it is sold
E.g. Bond denominated in Sterling, sold in the U.S.
Eurocurrencies: foreign currencies deposited in banks
outside the home country
E.g.: Eurodollar Market U.S. dollars deposited in foreign banks
outside the U.S.
Different to the Euro which is the national currency
adopted in Europe after monetary union in 2002.
Professor Yamin Ahmad, Money and Banking ECON 354
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Function of Financial Markets: Flow of Funds
Lender-Savers
Households
Firms
Government
Foreigners
Financial
Markets
Borrowers-Spenders
Business-Firms
Government
Households
Foreigners
Direct Finance
Indirect Finance
Financial
Intermediaries
Professor Yamin Ahmad, Money and Banking ECON 354
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Function of Financial Intermediaries
Financial Intermediaries:
1. Engage in process of indirect finance
2. More important source of finance than
securities markets
3. Needed because of transactions costs and
asymmetric information
Professor Yamin Ahmad, Money and Banking ECON 354
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Role of Financial Intermediaries
1. Transaction Costs
2. Risk Sharing
3. Asymmetric Information
Professor Yamin Ahmad, Money and Banking ECON 354
Primary Assets and Liabilities of Financial Intermediaries
Type of Intermediary Primary Liabilities Primary Assets
Depository Institutions (banks)
Commercial Banks Deposits Business and consumer loans,
mortgages, US Govt securities
and municipal bonds
Savings and Loans Institutions Deposits Mortgages
Mutual Savings Banks Deposits Mortgages
Credit Unions Deposits Consumer Loans
Contractual Savings Institutions
Life Insurance Companies Premium from Policies Corporate bonds and mortgages
Fire and Casualty Insurance Companies Premium from Policies Municipal bonds, corporate
bonds and stocks, US Govt
securities
Pension Funds, Government Retirement Funds Employee and Employer
Contributions
Corporate bonds and stock
Investment Intermediaries
Finance Companies Commercial paper, stock, bonds Consumer and business loans
Mutual Funds Shares Stocks and bonds
Money Market Mutual Funds Shares Money market instruments
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Financial Intermediaries and Value of Their Assets
Value of Assets (Billions of $)
Type of Intermediary 1970 1980 1990 2007 2010Q1
Depository Institutions (banks)
Commercial Banks
517 1481 3334 11809.5 14438
Savings and Loans Institutions and Mutual Savings
Banks
250 792 1365 1815.0 1262.3
Credit Unions
18 67 215 758.7 892.4
Contractual Savings Institutions
Life Insurance Companies
201 464 1367 4952.5 4919.0
Fire and Casualty Insurance Companies
50 182 533 1381.0 1386.1
Pension Funds (Private)
112 504 1629 6410.6 5726.7
State and local Government Retirement Funds
60 197 737 3198.8 2793.9
Investment Intermediaries
Finance Companies
64 205 610 1911.2 1665.8
Mutual Funds
47 70 654 7829.0 7311.9
Money Market Mutual Funds
0 76 498 3033.1 2930.7
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Regulatory Agencies
Regulatory Agency Subject of Regulation Nature of Regulation
Securities and Exchange
Commission (SEC)
Organized Exchanges and
Financial Markets
Requires disclosure of
information; restricts insider
trading
Commodities Futures Trading
Commission (CFTC)
Futures Markets Exchanges Regulates procedures for
trading in futures markets
Office of the Comptroller of the
Currency
Federally chartedcommercial
banks
Charters and examines the
books of federallychartered
commercial banks and imposes
restrictions on assets they can
hold
National Credit Union
Administration (NCUA)
Federallychartered credit
unions
Charters and examines the
books of federallychartered
credit unions and imposes
restrictions on assets they can
hold
State banking and Insurance
Commissions
State chartered depository
institutions
Charters and examines the
books of state chartered banks
and insurance companies;
imposes restrictions on assets
they can hold and imposes
restrictions on branching
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Regulatory Agencies
Regulatory Agency Subject of Regulation Nature of Regulation
Federal Deposit Insurance
Corporation (FDIC)
Commercial banks, mutual savings
banks, savings and loans
associations
Provides insurance for each
depositor. Currently it is set to
$250000 per depositor, until
12/31/2013, whereas it will revert
back to the pre-crisis level of $100000
per depositor; examines the books of
insured banks and imposes
restrictions on assets they can hold
Office of Thrift Supervision Savings and Loans Associations Examines the books of savings and
loans associations and imposes
restrictions on assets they can hold
Federal Reserve System All depository institutions Examines the books of commercial
banks that are members of the
system; sets reserve requirements for
all banks
Note: These notes are incomplete without having attended lectures
Professor Yamin Ahmad, Money and Banking ECON 354
Regulatory Agencies
Regulatory Agency Subject of Regulation New Powers
Federal Deposit Insurance
Corporation (FDIC)
Commercial banks, mutual savings
banks, savings and loans
associations
Will be able to unwind giant financial
firms in the same way it takes down
banks.
Federal Reserve System All depository institutions Fed will have powers to crack down on
interchange fees, which retailers pay to
banks to cover the operational cost of
transferring money. Fed can cap the fees
Consumer Financial Protection
Bureau
Consumer loans and credit cards Establishes an independent Consumer
Financial Protection Bureau housed
inside the Federal Reserve. Fees paid by
banks fund the agency, which would set
rules to curb unfair practices in consumer
loans and credit cards. It would not have
power over auto dealers.
Government Accountability Office Federal Reserve (excluding FOMC
and Monetary Policy)
Allows Congress to order the
Government Accountability Office to
review Fed activities, excluding monetary
policy. Audits would be allowed two
years after the Fed makes emergency
loans and gives financial help to ailing
financial firms.
Note: These notes are incomplete without having attended lectures
The new Dodd-Frank Banking reform bill that was passed during
J une 2010 gives the following agencies additional power:
Professor Yamin Ahmad, Money and Banking ECON 354
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Banking and Financial Institutions
Financial Intermediation
Helps get funds from savers to investors through
bond/equity/foreign exchange markets
Banks and Money Supply
Crucial role in creation of money
Financial Innovation