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:

Commercial banks, thrifts, and credit unions offer CDs. Buyers seeking safety and higher interest rates may choose to purchase a CD because they offer a higher interest rate than most savings accounts. The Federal Deposit Insurance Corporation (FDIC) ensures the absence of default risk, providing insurance for deposits up to $250,000. As a government agency, the FDIC enjoys the full backing of the government, and since its establishment in 1933, insured funds have never incurred losses. Most CDs feature a fixed interest rate for a specified term, requiring buyers to commit to keeping the deposit until maturity, with penalties for early withdrawal. Terms typically range from one month to five years, with longer periods generally yielding higher interest rates. For instance, a five-year CD may offer a two percent yield, while a one-year CD might only pay 1.5 percent. 

Security firms often facilitate a market for CDs from major banks, similar to treasury bonds. These CDs carry zero default risk, and their value fluctuates with interest rate changes. Increasing rates lead to decreased value while decreasing rates result in appreciation. 
 
Consider Sheila, who holds $10,000 in a checking account with no interest and a 0.5 percent interest rate on savings. To maximize her earnings, she opts for a $5,000 one-year certificate of deposit, paying 1.0 percent interest, anticipating $50 in interest compared to $25 from a savings deposit. Sheila limits her deposit to $5,000 to accommodate a projected $5,000 need during the year, avoiding penalties for premature withdrawal.

Certificates of deposit are part of M2 but not M1 when measuring the money supply. This distinction is due to CDs being less liquid than cash or demand deposits (money in checking accounts) because of penalties associated with early withdrawal.

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