Banks are financial institutions that accept deposits and make loans. Included under
the term banks are firms such as commercial banks, savings and loan associations,
mutual savings banks, and credit unions. Banks are the financial intermediaries that
the average person interacts with most frequently. A person who needs a loan to buy
a house or a car usually obtains it from a local bank. Most Americans keep a large proportion
of their financial wealth in banks in the form of checking accounts, savings
accounts, or other types of bank deposits. Because banks are the largest financial
intermediaries in our economy, they deserve the most careful study. However, banks
are not the only important financial institutions. Indeed, in recent years, other financial
institutions such as insurance companies, finance companies, pension funds,
mutual funds, and investment banks have been growing at the expense of banks, and
so we need to study them as well.
In Chapter 9, we examine how banks and other financial institutions manage
their assets and liabilities to make profits. In Chapter 10, we extend the economic
analysis in Chapter 8 to understand why bank regulation takes the form it does and
what can go wrong in the regulatory process. In Chapters 11 and 12, we look at the
banking industry and at nonbank financial institutions; we examine how the competitive
environment has changed in these industries and learn why some financial
institutions have been growing at the expense of others. Because the economic environment
for banks and other financial institutions has become increasingly risky,
these institutions must find ways to manage risk. How they manage risk with financial
derivatives is the topic of Chapter 13.
In the good old days, when you took cash out of the bank or wanted to check your
account balance, you got to say hello to the friendly human teller. Nowadays you are
more likely to interact with an automatic teller machine when withdrawing cash, and
you can get your account balance from your home computer. To see why these
options have been developed, in Chapter 10 we study why and how financial innovation
takes place, with particular emphasis on how the dramatic improvements in
information technology have led to new means of delivering financial services electronically,
in what has become known as e-finance. We also study financial innovation,
because it shows us how creative thinking on the part of financial institutions
can lead to higher profits. By seeing how and why financial institutions have been creative
in the past, we obtain a better grasp of how they may be creative in the future.
This knowledge provides us with useful clues about how the financial system may
change over time and will help keep our knowledge about banks and other financial
institutions from becoming obsolete.
Why Study Money and Monetary Policy?
Money, also referred to as the money supply, is defined as anything that is generally
accepted in payment for goods or services or in the repayment of debts. Money is linked
Financial
Innovation
Banks and Other
Financial
Institutions
8 PA RT I Introduction
to changes in economic variables that affect all of us and are important to the health of
the economy. The final two parts of the book examine the role of money in the economy.
In 1981–1982, total production of goods and services (called aggregate output) in
the U.S. economy fell and the unemployment rate (the percentage of the available
labor force unemployed) rose to over 10%. After 1982, the economy began to expand
rapidly, and by 1989 the unemployment rate had declined to 5%. In 1990, the eightyear
expansion came to an end, with the unemployment rate rising above 7%. The
economy bottomed out in 1991, and the subsequent recovery was the longest in U.S.
history, with the unemployment rate falling to around 4%. A mild economic downturn
then began in March 2001, with unemployment rising to 6%.
Why did the economy expand from 1982 to 1990, contract in 1990 to 1991,
boom again from 1991 to 2001, and then contract again in 2001? Evidence suggests
that money plays an important role in generating business cycles, the upward and
downward movement of aggregate output produced in the economy. Business cycles
affect all of us in immediate and important ways. When output is rising, for example,
it is easier to find a good job; when output is falling, finding a good job might be difficult.
Figure 4 shows the movements of the rate of money growth over the
1950–2002 period, with the shaded areas representing recessions, periods of declining
aggregate output. What we see is that the rate of money growth has declined
before every recession. Indeed, every recession since the beginning of the twentieth
century has been preceded by a decline in the rate of money growth, indicating read more >>>
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