Certificate of Deposit

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Definition of a Certificate of Deposit (CD):

A certificate of deposit or CD is a time deposit with a specific maturity date.

Detailed Explanation:

CDs are sold by commercial banks, thrifts, and credit unions. Buyers purchase a CD because it is safe and it normally bears a higher interest rate than savings accounts. CDs have no risk of default because deposits up to $250,000 are insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC is an agency of the Federal Government, so it is backed by the full faith of the government. Since it was founded in 1933, no one has lost a penny that was insured. Most CDs have a fixed rate for a defined term, so the buyer must commit to not withdrawing the deposit until the CD matures. A penalty is paid if the CD is cashed early. Terms are normally between one month and five years. Longer periods usually pay a higher interest rate. For example, a five-year CD may yield two percent, but a one-year CD may pay only 1.5 percent. 

Many security firms will make a market for CDs from major banks. This means they will find a buyer for a CD if an owner wants to liquidate it without incurring the penalty. In these cases, the CD is much like a treasury bond. The risk of default is zero, and its value fluctuates with the direction of interest rates. When rates increase, the value decreases, and when rates decrease, the value appreciates. 
Sheila has $10,000 in a checking account. Her bank does not pay any interest for checking accounts and 0.5% on savings accounts. She elects to purchase a $5,000 one-year certificate of deposit that pays 1.0% interest because she would earn $50 in interest rather than $25 if she deposited her money in savings. Sheila chooses to limit her deposit to $5,000 rather than $10,000 because she estimates she will need $5,000 during the year and wants to avoid a penalty for withdrawing her money prematurely.

Certificates of deposit are included in M2, but not M1, when measuring the money supply. This is because CDs are not quite as liquid as cash or demand deposits (money in checking accounts) because there is a penalty for early withdrawal. 

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