Certificates of Deposit

Definition

Certificates of deposit (CDs) are a type of savings account offered by banks and credit unions that typically pay a higher interest rate than a regular savings account in exchange for the customer agreeing to leave their money on deposit for a fixed period of time, known as the term or maturity date.

5 Must Know Facts For Your Next Test

1. Certificates of deposit are considered a time deposit and are included in the M2 money supply measure, but not in the narrower M1 measure.
2. CDs typically offer a higher interest rate than a regular savings account, with the interest rate being fixed for the term of the CD.
3. The term or maturity of a CD can range from a few months to several years, with longer-term CDs generally offering higher interest rates.
4. Withdrawing money from a CD before the maturity date typically results in an early withdrawal penalty, which can reduce or even eliminate the interest earned.
5. CDs are considered a low-risk investment option, as they are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 per depositor, per insured bank.

Review Questions

• Explain how certificates of deposit are classified within the M1 and M2 money supply measures.
  • Certificates of deposit are considered a time deposit and are included in the broader M2 money supply measure, but not in the narrower M1 measure. This is because M1 only includes the most liquid forms of money, such as currency, traveler's checks, and demand deposits, while M2 includes M1 plus less liquid forms of money, including savings deposits and small-denomination time deposits like CDs.
• Describe the key features that distinguish certificates of deposit from a regular savings account.
  • The primary features that distinguish CDs from a regular savings account are the fixed interest rate and the requirement to leave the money on deposit for a specified term or maturity date. CDs typically offer a higher interest rate than a savings account, but in exchange, the customer must agree to keep the money in the CD for the full term. Withdrawing the money before the maturity date usually results in an early withdrawal penalty, which can reduce or eliminate the interest earned.
• Evaluate the role of certificates of deposit in the broader financial system and their impact on monetary policy.
  • Certificates of deposit play a significant role in the financial system by providing a low-risk investment option for savers and a stable source of funding for banks. From a monetary policy perspective, the inclusion of CDs in the M2 money supply measure is important because it allows policymakers to track changes in the broader money supply, which can influence inflation, economic growth, and other macroeconomic factors. Additionally, the interest rates on CDs can be influenced by the Federal Reserve's monetary policy decisions, as changes in the federal funds rate can affect the yields on CDs and other fixed-income investments.

Related terms

M1:

M1 is a measure of the money supply that includes all physical currency, traveler's checks, demand deposits, and other checkable deposits.

M2:

M2 is a broader measure of the money supply that includes M1 plus savings deposits, small-denomination time deposits, and balances in retail money market mutual funds.

Time Deposit: A time deposit is a deposit of money that earns interest for a fixed period, such as a certificate of deposit (CD), and cannot be withdrawn before a specified maturity date without incurring a penalty.