How It Works

Students can invest in CDs with various terms. To keep the process simple, each CD pays a flat sum at maturity, instead of a percentage rate of the original investment (accumulated interest). The longer the term, the greater the reward to the investor.

CDs come in terms of 1, 3, 6, or 8 months (with 8 months being a "full-term" CD, ending just before the final auction of the school year). To simplify recordkeeping, students can invest only in $100 increments, and only on Bill Day each month.

Example: $100 invested in a 1-month CD on Bill Day will yield the student $15 at the maturity date, the next Bill Day. This table illustrates the money students can earn by investing $100 for 1, 3, 6, and 8 months:

Note: In the real economy, these earnings would be high for a typical CD. We set them at this level to help the students perceive the trade-off involved: the allure of extra income versus the opportunity cost of tying up their money for the term of the CD—a period in which they won't have it to spend at the auction, for example. As is the case with all time deposits, the longer the student's commitment in term, the larger the reward at maturity.

From the first Bill Day through the second-to-last Bill Day of the year, the students can choose to invest any amount (in $100 increments) in CDs. Initially, terms of 1, 3, or 6 months, or full-term (8 months) are available. However, as time passes, the longer-term CDs naturally become unavailable because they would extend past the end of the school year. For example, you should alert students that the full-term, 8-month CD that pays $200 at maturity is only available for purchase on the first Bill Day. Also, the 6-month CD, which pays $120, won't be available after the third Bill Day.

Questions

What factors determine how much money I get back in return for my investment?

The main factors that determine CD returns for the classroom economy are the term of the deposit and the size of the deposit:

• The term of the deposit. Longer-term CDs have a higher interest rate than shorter-term CDs because banks must compensate lenders for keeping their money longer. Banks want the money because they can use it to earn more than they are paying to the investor. Their earnings come from lending the money out at higher interest rates or putting it in higher-paying investments.
• The size of the deposit. Larger deposits (for example, jumbo CDs, which have a minimum deposit of $100,000) pay higher rates. However, to simplify recordkeeping in the classroom economy, we do not increase the payout rate for larger investments. If a student chooses to invest $200 in a 1-month CD, for example, the student will earn $30—as if it were two $100 investments.

What about interest rates?

We have simplified this investment activity by using a flat dollar amount as the return on the investment, but some students may ask about the impact of interest rates.

Students should know that an interest rate is the cost of borrowing money, or the payment for lending money. From the students' perspective as lenders, the rate needs to be high enough to compensate them for the following:

• Liquidity preference: Simply put, people want to have access to their money just in case they need it for an immediate purchase or an emergency. For example, if the student is not insured and has incurred damages to his or her desk, he or she needs to be "liquid" to be able to pay for repairs.
• Deferred consumption. By investing in a CD for 3 to 6 months, the student is deferring his or her consumption of other goods, such as anything he or she could have bought at Auction Day.
• Risk of the investment. In the real economy, a lender incurs the risk of losing money if a borrower defaults on a loan or files for bankruptcy protection. However, traditional CDs are similar to bank savings accounts in that CD purchases of up to $250,000 per depositor are insured by the Federal Deposit Insurance Corporation (FDIC) and thus are virtually risk-free to the buyer.

The concept of compounding can be described as one of the factors contributing to higher returns over time. However in our activity, we do not compound. If the students do the math, they'll notice that a 15% return compounded over 3 months will result in a $152 payout.

What if I need the money? Can I still withdraw it prior to the maturity date?

Withdrawals before maturity are usually subject to a substantial penalty. These penalties reinforce that it is generally not in a CD holder's best interest to withdraw the money before maturity—unless the holder has the opportunity to make another investment with a significantly higher return (which would typically incur more risk and is not an option in the classroom economy) or has a serious need for the money.

Banks typically charge a penalty fee if money is withdrawn from a CD before it matures.

To keep things simple in our investment activity, we do not provide the students the option to withdraw from the CD prior to maturity. However, if you have a situation where a student needs the cash (for example, to pay for damages or rent), you may want to permit an early withdrawal—if the student is willing to pay a penalty. A penalty or fine can be lost interest and/or a small percentage of the principal.