Reserve Requirements: The banks we have been discussing are commercial banks: whose most important economic role is to accept funds from depositors and lend those funds to borrowers • Banks have begun to resell many of their loans rather than keeping them until borrowers pay them off 1. Financial firms other than commercial banks have become important sources of credit to businesses 2. 2 developments have occurred in the financial systems • Shadow Banking System and the Financial Crisis of 2007-2009: Security: if it can be bought and sold in a financial market • If an investor resells the asset the sale takes place in the secondary market ○ When a financial asset is first sold, the sale takes place in the primary market • Prior to 1970 most loans were not securities because they could not be resold • Securitization: creates a secondary market in which loans that have just been bundled together can be bought and sold in financial markets • Securitization Comes to Banking: The financial system was transformed in the 1990s and 2000s by the increasing importance of nonbank financial firms • In the late 1990s, investment banks expanded their buying of mortgages, bundling large numbers of them together as bonds, known as mortgage-backed securities • Funds sell shares to investors and use the money to buy short term securities ○ Money market mutual funds also increased their importance in the financial system • Became an important source of demand for securitized loans by mid 2000s ○ Hedge fund raise money from the wealthy investors • Shadow banking system refers to investment banks, money market mutual funds, hedge funds and other nonbank financial firms engaged in similar activities • Shadow Banking System: Firms of shadow banking system are not regulated • Financial Crisis of 2007-2009: Lesson 10 Page 86
Firms of shadow banking system are not regulated • These firms are highly leveraged- rely heavily on borrowed money to finance operations • Fall of 2008: Troubled Asset Relief Program (TARP) the Fed and Treasury began attempting to stabilize the commercial banking system by providing funds to banks in exchange for stock • The Fed also modified its discount policy by setting up several lending facilities • Fed addressed problems in the commercial paper market by directly buying commercial paper for the first time since the 1930s • Fed's Response: Lesson 10 Page 87
A dollar bill is the official US currency • Most currency was linked to valuable commodities • Not linked to any external resource, but relying solely on government policy to decide how much to print ○ Dollar = fiat money • Monetary policy is set by the Fed ○ Which branch of government sets this policy? • Consists of 12 districts + Board of Governors ○ Not under direct control of any branch of US government ○ Fed has 12 districts • Called inflation ○ If the total amount of money increases faster than the total value of goods and services in the economy than each individual piece will be able to buy less • Opposite is deflation •
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