Final Paper due Monday Midnight/8 pages
cap479
eco203_chapter_12.pdf
Learning Outcomes
By the end of this chapter, you will be able to:
• Summarize how banks create money.
• Analyze the role of reserves in the creation of money and the control of the money supply.
• Discuss the history of the central bank.
• Explain what functions the Federal Reserve performs for the banking system.
• Describe the Fed’s monetary policy tools and its influence on the money supply and interest rates.
12
Banking and the Federal Reserve System
Digital Vision/Getty Images
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CHAPTER 12Pre-Test
Introduction
Have you ever noticed that banks seem to like senior citizens better than college students? People over 50 can get special accounts with no service charges, free checks, sometimes no minimum balance, and even a little interest. Students, on the other hand, are offered accounts with monthly service charges and have to pay for checks. Oftentimes landlords prefer not to rent to students because they expect them to be noisy and careless, but those problems should not matter to banks. In fact, you would think that banks would want to build customer loyalty by getting students into their banks early so they would be lifelong customers. Why the difference in treatment? Why do banks seem to have a policy of favoring older customers?
This chapter looks at the role of banks, including the central bank, in managing the mon- etary side of the economy. Once you have a better understanding of how banks oper- ate, you may also see why many of them prefer older customers. Banks are in the busi- ness of making money (in the double sense of making a profit and creating a medium of exchange). They provide the answer to the questions left unanswered in Chapter 11 about exactly where money comes from and how the money supply can be changed.
Pre-Test
1. The interest-earning assets of a bank are known as the reserves. a. True b. False
2. Currency withdrawals by the public will cause expansion of the money supply to be less than the possible maximum.
a. True b. False
3. The Federal Reserve was created by Congress to control the money supply. a. True b. False
4. Government bonds are a form of reserves. a. True b. False
5. When the Fed sells bonds, the money supply tends to increase. a. True b. False
Answers 1. b. False. The answer can be found in Section 12.1. 2. a. True. The answer can be found in Section 12.2. 3. b. False. The answer can be found in Section 12.3. 4. b. False. The answer can be found in Section 12.4. 5. b. False. The answer can be found in Section 12.5.
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CHAPTER 12Section 12.1 How Banks Create Money
12.1 How Banks Create Money
As you learned in Chapter 11, goldsmiths developed the first paper currency and were also the first modern bankers. The notes issued by goldsmiths as receipts for gold deposits began to circulate as currency. It did not take the goldsmiths long to discover that they had few day-to-day requests from depositors to redeem these notes for gold. They could safely lend out some of the depositors’ gold (as well as their own), earn- ing interest and eventually paying interest on deposits.
Suppose a prosperous medieval baron deposited 100 florins in gold with a goldsmith in exchange for a paper receipt, or note, which was redeemable as gold. This paper note served as money. The goldsmith could lend someone else 50 florins of the baron’s gold, which would also be money. The baron’s deposit expanded the money supply by 50 flo- rins. The original deposit of 100 florins was still money, but so was the 50 florins lent by the goldsmith. This kind of transaction by goldsmiths illustrates fractional reserve banking, the basis of all modern banking systems. Fractional reserve banking is the practice of holding a fraction of money deposited as reserves and lending the rest. This means that only a fraction of bank deposits are actually backed by cash and available for withdrawal. It also means that the money sup- ply can be far larger than the actual amount of currency in circulation.
The development of banking was as great an innovation as the devel- opment of money. By replacing barter, money solved the problem of matching what you had to offer with what the seller wanted to buy. With banking, it was no longer necessary to hunt for an individual who was willing to lend as much as the borrower wanted to borrow for the desired time and on accept- able terms. Just as money simpli- fied the problem of matching trad- ers with each other, banks simplified the problem of matching lenders with borrowers. The most important function of a bank is to be an intermediary in the lending business, gathering up small sums from depositors and lending larger amounts to borrowers. Banks pay some interest to depositors, charge more interest to borrowers, and make their profit out of the difference.
It is risky for individual lenders to deal with individual borrowers because a lender loses the entire amount of the loan if the borrower fails to repay. If individuals lend through a bank rather than directly, they are “buying” a piece of the whole range of loans made by the bank. Although borrowers have the potential to default, most of the loans will be repaid, reducing the risk associated with lending.
iStockphoto/Thinkstock
Fractional reserve banking allows for a larger supply of money in the economy than the amount available in actual currency.
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CHAPTER 12Section 12.1 How Banks Create Money
The Bank’s Balance Sheet
A bank is a business firm, just like a grocery store or an Internet service provider. It is in business to earn a profit for its owners, who are stockholders. The balance sheet of any firm provides a picture of its financial situation. The balance sheet of a bank lists its assets in order of liquidity (from most liquid to least liquid), its liabilities (or claims against it to be paid in the future), and its net worth. Table 12.1 is a balance sheet for A & P National Bank. The first thing you should notice is that the balance sheet balances. That is, assets equal liabilities plus net worth. A balance sheet must always balance. The fact that it bal- ances says nothing about how well the bank is doing. To determine the bank’s condition, we must look at some individual assets and liabilities.
Table 12.1: Balance sheet, A & P National Bank
Assets Liabilities
Vault cash* $1,000 Checkable deposits $50,000
Reserves* $19,000 Other deposits $5,000
Bonds $15,000 Loans from the Fed $2,000
Loans to public $20,000 Total liabilities $57,000
Building, misc. $10,000 Net worth $8,000
Total assets $65,000 Total liabilities and net worth $65,000
*These two items are usually combined as “reserves.”
For A & P National, reserves are the most liquid asset. Reserves are bank assets that can be used to pay depositors when funds are requested. Reserves consist of currency on hand (vault cash) and deposits at the central bank. It is important for a bank to keep some reserves to meet the day-to-day withdrawals of customers. However, a bank does not want to keep any more reserves than necessary because reserves do not earn interest, and loans do.
A & P National’s interest-earning assets are government bonds and loans to the public. Government bonds range from T-bills (short-term obligations) to notes (medium term) to bonds (long term). Note that a bank’s assets are someone else’s liabilities. Government bonds are liabilities of the U.S. Treasury. Loans are liabilities of households and businesses who borrowed the money. A & P National’s fixed assets consist of the bank’s building, furnishings, and other equipment. This kind of asset is the least liquid because it is very difficult to convert to cash.
This bank’s largest liability is checkable deposits of $50,000. Savings deposits and loans that the Fed has made to this bank make up the rest of the bank’s liabilities. The net worth of $8,000 represents the value of the bank to its stockholders.
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CHAPTER 12Section 12.1 How Banks Create Money
T-Accounts and Money Creation
Several items on a bank’s balance sheet play an important role in the money creation pro- cess. Rather than relisting all assets and liabilities, it is simpler to look at only those that change. A partial balance sheet, called a T-account, shows changes in assets or liabilities resulting from one or more transactions. The only items listed on a T-account are those that change. If the balance sheet balances at the start, then as long as the changes on the T-account offset each other, the balance sheet will still balance after the transaction.
Table 12.2 shows how T-accounts are used to record changes in A & P National’s bal- ance sheet for two sample transactions. Suppose Susan Smith deposits $100 in cash in her checking account, which the bank places in its vault. The T-account shows a $100 increase in assets (vault cash, or reserves) and a $100 increase in liabilities (checkable deposits). The balance sheet still balances. In the second transaction, A & P National sells a $1,000 bond and uses the proceeds to make a loan. The balance sheet would still balance after this transaction because an increase in one asset (the loan) is exactly offset by a decrease in another (the bond). T-accounts are useful for following the process of money creation in banks.
Table 12.2: Sample transactions and T-accounts
Transaction #1: Susan Smith puts $100 in cash in her checking account: A & P National adds the $100 to its reserves.
Assets Liabilities
Reserves: 1$100 Checkable deposits: 1$100
Transaction #2: A & P National Bank sells a bond and makes a loan.
Assets Liabilities
Loans: 1$1,000
Bonds: 2$1,000
Plus and minus signs in the T-account denote increases and decreases in assets or liabili- ties. The 1$100 represents an increase in reserves in transaction 1, and the 2$1,000 refers to a reduction in bonds in transaction 2.
Modern banks create money in much the same way that medieval goldsmiths created money—by making loans with the money others had deposited for safekeeping. The goldsmiths discovered that on any given day, most depositors did not withdraw any gold. A fractional amount was all goldsmiths had to hold to meet daily demand. Although gold has ceased to play much of a role in the money supply, banks still lend part of the reserves created by deposits. Banks’ checkable deposits serve as money, just as the notes issued by the goldsmiths served as money.
How much can A & P National lend? The balance sheet in Table 12.1 shows that this bank already has $20,000 in loans outstanding, as well as reserves of $20,000 (including vault cash) and checkable deposits of $50,000. To keep it simple, we will assume that banks
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CHAPTER 12Section 12.1 How Banks Create Money
keep reserves only to back up checkable deposits. A & P National’s reserves are 40% of its checkable deposits, a fairly high level of reserves. This bank can lend more and still have enough reserves to meet demands of depositors.
Assume that A & P National has decided to reduce reserves to 20% of deposits. Twenty percent of $50,000 in checkable deposits is $10,000. A & P National can expand its loans by $10,000. Remember, reserves do not earn interest, but loans do. When the next deserving borrower comes in, the bank will make a $10,000 loan. The bank will probably issue the loan by crediting the borrower’s checking account, increasing checkable deposits (liabili- ties) by $10,000. The T-account for this transaction is shown in Table 12.3.
Table 12.3: A & P National Bank lends to Joe’s Barber Shop
Assets Liabilities
Loans: 1$10,000 Checkable deposits: 1$10,000
Note: Total reserves $20,000; total checkable deposits $60,000.
The balance sheet of A & P National still balances. The money supply has increased by $10,000 in new checkable deposits. It appears that A & P National could lend still more because the note at the bottom of the T-account points out that reserves are still $20,000 and checkable deposits are $60,000. The bank only needs to keep $12,000, or 20%, in reserves to back up $60,000 in checkable deposits.
A & P National lent only $10,000 because the loan officer knew that Joe’s Barber Shop intended to spend the money very quickly. Joe will spend the money on equipment for his shop, and Joe’s supplier will probably deposit Joe’s check in another bank, such as Ulbrich Savings. When a check drawn on one bank is deposited in another, the first bank loses reserves and checkable deposits. The bank that receives a check drawn on another bank gains reserves and checkable deposits. The receiving bank can now make loans and expand the money supply. When Joe’s supplier deposits the check in Ulbrich Savings Bank, the effect on the T-accounts for the two banks is shown in Table 12.4.
Table 12.4: Transfer of reserves from one bank to another
A & P National Bank
Assets Liabilities
Reserves: 2$10,000 Checkable deposits: 2$10,000
Ulbrich Savings Bank
Assets Liabilities
Reserves: 1$10,000 Checkable deposits: 1$10,000
Note: Total reserves $10,000; total checkable deposits $50,000.
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CHAPTER 12Section 12.2 Reserves and the Money Supply
After this transfer of reserves, A & P National is “all loaned up.” It cannot make any new loans until it acquires more reserves. However, Ulbrich Savings can make new loans. If this bank also keeps a 20% reserve behind checkable deposits, then it needs only $2,000 in reserves behind the $10,000 in new checkable deposits. Ulbrich Savings can safely lend the other $8,000 of newly acquired reserves.
12.2 Reserves and the Money Supply
A & P National lent $10,000 in excess reserves, which are reserves above the level required by law. Then Ulbrich Savings Bank expanded its lending by $8,000. It is not hard to see that this bank’s lending will create new reserves for a third bank, which will in turn lend and create new reserves for a fourth bank, and so on. How long will this process continue? If you knew what ratio of reserves to deposits banks wish to maintain, you could identify the upper limit of money expansion.
A bank can expand loans as long as it has excess reserves. The banking system as a whole can expand loans as long as there are excess reserves in the system. Expansion of the money supply must stop only when there are no more excess reserves in the banking sys- tem. The only way to get rid of excess reserves is for banks to lend them.
The Reserve Ratio
Suppose all banks in the system hold reserves of 20% of checkable deposits, either vol- untarily or because this ratio is required by law. Each bank wants to lend out any excess reserves (ER) to earn interest. Money creation stops only when there are no more excess reserves. That is, no more money will be created when all bank reserves (BR) in the entire banking system have been converted to required reserves (RR). The reserve ratio (rr), also known as the liquidity ratio, is the fraction of deposits that banks are required to hold in reserves. Banks’ required reserves are rr×D, where D checkable deposits. The banking system (as well as any individual bank) is fully loaned up when RR equals BR, or
(1) RR BR rr 3 D
Dividing Equation (1) by rr gives
(2) D 1 rr
3 BR
The steps in money creation are shown in Table 12.5 for the first five banks as well as the totals for the process. Note that the bottom line satisfies Equation (2): Newly cre- ated checkable deposits are equal to the initial excess reserves multiplied by the deposit multiplier, 1/rr. The deposit multiplier is the ratio between the maximum increase in the money supply and a given increase in excess reserves. It equals the reciprocal of the reserve ratio. The deposit multiplier depends only on the ratio of required reserves to checkable deposits.
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CHAPTER 12Section 12.2 Reserves and the Money Supply
Table 12.5: Increase in money supply with initial excess reserves of $10,000 and a reserve ratio of 20%
Bank D Demand Deposits D Reserves Amount the Bank Lends
A & P National $0 $0 $10,000
Ulbrich Savings 1$10,000 1$2,000 $8,000
Bank C 1$8,000 1$1,600 $6,400
Bank D 1$6,400 1$1,280 $5,120
Bank E 1$5,120 1$1,024 $4,096
All others 1$20,480 1$4,096 $16,384
All banks $50,000 $10,000 $50,000
According to Equation (2), checkable deposits (D) can change only if the reserve ratio (rr) changes or if all bank reserves (BR) change. Using the symbol D to represent “change in,” the change in deposits (and the change in the money supply) is given by
∆D1/rr ∆BR∆Ms
The change in checkable deposits will be equal to the reciprocal of the reserve ratio (rr) multiplied by the change in bank reserves (DBR). In our example, rr 0.20, so the value of 1/rr is 5. If DBR equals $10,000, then ∆D53$10,000$50,000.
Expansion of checkable deposits can occur only when there are excess reserves. If all reserves are being held to meet the desired ratio of reserves to deposits, there are no excess reserves available. In that case, the money supply cannot increase.
Why Expansion May Be Less than the Maximum
The actual money supply may be less than the maximum determined by existing bank reserves for two reasons. First, the public may decide to hold more of its financial assets in currency and less in checkable deposits. Individuals may hold more cash because of concerns about bank safety or because they are using cash transactions to avoid income taxes or to hide illegal activities (such as drug dealing). A currency drain is an increase in cash held by the public. Because currency is part of reserves when it is in the banking system, a currency drain reduces bank reserves. When reserves fall, the banking system cannot support as many checkable deposits. For every dollar of currency flowing out of the banks and into circulation, bank reserves (BR) fall by $1. With a 20% reserve ratio (rr), $5 of potential new deposits are eliminated.
Second, banks may choose to hold more reserves than are legally required. Reserves not only meet the legal requirement, but also provide a cushion against above-average with- drawals. Usually banks like to hold reserves to the required minimum because reserves earn no interest. If economic conditions are depressed, loan prospects are risky, or inter- est rates on loans are very low, banks may choose to hold some excess reserves until
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CHAPTER 12Section 12.3 Central Banking in the United States
conditions improve. Banks may also hold more reserves if they expect larger cash with- drawals, because they will lose more reserves than they are legally allowed to lose. Even if banks are willing to lend, households and firms may not be anxious to borrow if they are already heavily in debt or have gloomy expectations.
Loss of Reserves and Money Contraction
Contracting the money supply is just like expansion in reverse. Suppose that a customer of A & P National withdraws currency from her account in the amount of $2,000. If the bank was all loaned up before this withdrawal, this withdrawal will put the bank below the required reserve level. A & P has lost $2,000 in reserves and $2,000 in deposits. With a 20% reserve ratio, the bank was holding only $400 in reserves behind that deposit. The shortfall of $1,600 must be made up by reducing loans or by selling bonds. As A & P works to rebuild its reserves, however, it gains reserves at the expense of the other banks in the system. Table 12.6 shows the first few stages of this process. The deposit multiplier is the same here as for the expansion process. The initial loss of $2,000 in reserves will lead to a maximum contraction of the money supply of $10,000 if no banks had any excess reserves before the first transaction.
Table 12.6: Decrease in money supply following a loss of reserves of $2,000
Bank D Demand Deposits D Reserves Change in Bank Lending
A & P National $0 2$2,000 2$1,600
Ulbrich Savings 2$1,600 2$1,600 2$1,280
Bank C 2$1,280 2$1,280 2$1,024
Reserves and the Central Bank
This description of the money expansion and contraction process raises two important questions. Where do reserves come from, and who sets the required reserve ratio? Depos- its and withdrawals of currency by the public are one source of changes in bank reserves, but these flows are relatively small in the U.S. banking system. The major source of bank reserves, including cash in the form of Federal Reserve notes, is the Federal Reserve Sys- tem (Fed). The Fed has the power to create reserves and set the required reserve ratio.
12.3 Central Banking in the United States
The United States was one of the last modern industrial countries to establish a cen-tral bank. The Fed was modeled partly on the Bank of England, which is almost 400 years old. The Federal Reserve System, established in 1914, is the U.S. central bank. Congress created the Fed in response to two perceived needs. The first was to regu- late banks to keep them from making risky loans that threatened the safety of deposits. The second was for a “lender of last resort” to rescue basically sound banks that were
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CHAPTER 12Section 12.3 Central Banking in the United States
threatened with failure and bankruptcy because of temporary economic conditions. Later, a third role was established: managing the size of the money supply so as to promote eco- nomic growth, high employment, and a stable price level. This final role is now the Fed’s most important function, but it was not part of the original design of the system.
The U.S. Constitution gave the federal government the power to “coin money [and] reg- ulate the value thereof.” It said nothing, however, about establishing banks. Two early attempts to establish a central bank failed. The Bank of the United States, established in 1791, was privately owned but chartered by the federal government. It supervised other banks, promoted bank safety, and served as a lender of last resort until its charter expired in 1811. In 1816, the Second Bank of the United States was created, but its charter was not renewed in 1835. Opponents of both banks felt that these banks had used governmental power to benefit the banks’ owners, their friends, and business associates.
Panics and Liquidity
Financial crises have been common over the past eight or so centuries in many parts of the world (Reinhart & Rogoff, 2011). Bank panics are sudden waves of fear that banks will not be able to pay off their depositors. Nineteenth-century banks did not issue checkable deposits. They made loans by issuing banknotes, which were supposed to be redeemable in gold. As long as noteholders believed they could redeem their notes, very few would actually do so on any given day. The day-to-day demand for redemption in gold could easily be met with fractional gold reserves.
During bank panics, some banks had problems of liquidity—not enough reserves to meet current demand. Most of their loans would eventually be repaid, but not quickly enough to meet depositors’ current withdrawals. Other banks had more serious problems of sol- vency. These banks had so many bad loans that the value of their assets was less than the value of their deposits.
Banks that followed unsound lending practices eventually found that too many notes would be presented for redemption at once, and reserves would be too low to redeem them all. When one bank could not meet demand for withdrawals, people sometimes panicked and tried to redeem notes at other banks as well. At the height of bank panics, many sound and well-managed banks were unable to redeem large numbers of notes presented in a single day. These banks failed, or closed, even though they were healthy. People lost funds they had deposited in failed banks, and people who needed loans could not get them. Even banks that did not fail had to greatly reduce their lending to build reserves against a run of withdrawals.
A run could occur at a perfectly sound bank. All that was needed was a rumor of possible failure. A lender to banks was needed to prevent sound banks from going under in a panic. A lender of last resort is a source of funds for rescuing sound banks by lending them what they need to meet temporary high demand from depositors. If sound banks could obtain funds from such a lender, depositors would be less likely to panic. Panics would be less likely to occur in the first place and would be less severe when they did occur.
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CHAPTER 12Section 12.3 Central Banking in the United States
December 10, 1930
Three million dollars in cash was rushed to the branch of the Bank of the United States at Freeman Street and Southern Bou- levard in the Bronx, to stem a run started by idle gossip of one of the neighborhood merchants. A score of clerks were rushed from the 58 other branches of the bank throughout the city to help pay out the money as officials reassured depositors there were plenty more millions to meet any demand that might be made. This photo shows a scene outside the bank as a crowd came to withdraw funds, and a larger crowd gathered to watch.
Early Attempts at Control
Without a central bank to regulate unsound banking practices in the 19th century, some larger private banks tried to fill the void. Control through private banks did not work well or last long because banks did not have the legal authority to examine other banks’ books and lending practices or to force them to stop making bad loans. Only the federal govern- ment had the effective power to regulate banks, as well as the financial resources to act as the lender of last resort. However, political battles over whether to give central banking powers to the federal government went on for nearly a century. One reason for resistance was the fear that the centralized power would be used to benefit rich and powerful bank- ers. Another source of resistance was disagreement about the importance of sound money and the dangers of inflation.
The National Banking System
During the Civil War, Congress tried again to make banks safer. The National Banking System, established in 1863, allowed banks to apply for federal instead of state charters (formal permission to incorporate and operate). Banks that receive charters from the fed- eral government are called national banks. A state bank is chartered and regulated by one of the states.
The Comptroller of the Currency in the Department of the Treasury charters and regu- lates national banks. State banks are regulated by various state agencies and commissions. After 1863, state banks continued to exist alongside national banks. Since state regulation was weak and ineffective, the National Banking Act did not substantially improve the sta- bility of banks. Furthermore, there was still no lender of last resort. That situation changed with passage of the Federal Reserve Act in 1913.
Bettmann/Corbis
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CHAPTER 12Section 12.4 Structure and Functions of the Federal Reserve System
12.4 Structure and Functions of the Federal Reserve System
The panic of 1907 and the recession that followed convinced Congress to hold hear-ings on banking problems. After a series of compromises designed to quiet oppo-nents’ fears, the Federal Reserve Act was passed in 1913, and the Fed began operat- ing in November 1914. The Federal Reserve System was intended to regulate banks and serve as a lender of last resort. It would also serve as a banker to the treasury, clear checks, and issue currency. Only later did monetary policy become its major function.
Bank Safety
Bank safety was a primary reason for establishing the Federal Reserve System. The first test of the Fed was the Great Depression. Based on numerous bank failures in 1930–1933, the Fed did not receive a very good grade as a guarantor of bank safety. Two deposit insur- ance agencies, the Federal Deposit Insurance Corporation (FDIC) and the Federal Savings and Loan Insurance Corporation (FSLIC), were created in 1935. These two insurance cor- porations were designed to protect bank depositors, not banks or bank stockholders, from
Global Outlook: Does Europe Need a “Banking Union”?
The Great Recession of 2007–2009 affected many countries other than the United States well beyond 2009. Europe was hit hard by the global recession, bank failures, and inflation. This was
referred to as the European sovereign debt crisis. Many economists and finance ministers have called for the formation of a “banking union,” or a central authority to try and resolve some of the ongoing issues, such as the difficulty for some countries in the Eurozone to refinance their government debt without the assistance of third parties. The fears were so great that as of May 2010, Europe’s finance ministers approved a rescue package (much like the United States’s Emergency Economic Stabilization Act of 2008) and created the European Financial Stability Facility to ensure financial stability across Europe.
In May 2012, the European Commission called for a “banking union” that can oversee and, if necessary, bail out banks without having to go through national governments. The hope is that this kind of entity can help cash-strapped countries such as Spain improve their finances and stabilize their economies. Spain was in a particularly difficult spot because its banks were holding shaky government bonds and sitting on huge real estate investment losses.
Greece was also having trouble. At the end of 2009, the global financial crisis and uncontrolled gov- ernment spending led to its most severe crisis since 1974. The Greek government had been spending beyond its means while hiding its true deficit from EU overseers—not 6% of GDP as originally reported, but actually 13.6%! Greece was unable to pay its debt. In May 2010, the other Eurozone countries and the International Monetary Fund agreed to a bailout package in order for Greece to avoid defaulting. In exchange for this funding, Greece was required to adopt strict austerity measures to bring its deficit under control.
Perhaps what has happened in Greece may not have happened if a banking union had been put in place for all of Europe. Can you think of any other advantages to such an entity? What about the disadvantages?
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CHAPTER 12Section 12.4 Structure and Functions of the Federal Reserve System
insolvency. Deposit insurance is required for all members of the Federal Reserve System and is financed by premiums paid by member banks. Both agencies (which merged in 1990) supervise member banks for safety and compliance with banking regulations. The bank insurance system worked well until the late 1980s, when a number of bank failures shifted the burden of protecting depositors to the federal government.
The two sources of bank failures in the 19th century are still a source of policy concern today. One reason why banks fail is a liquidity problem—a lack of ready cash to meet large withdrawals by the public. Deposit insurance and having the Fed as a lender of last resort have largely resolved that problem. The other problem is insolvency—having assets whose value is not enough to cover liabilities, such as deposits. A bank becomes insolvent if it has too many assets in loans that may never be repaid. An insolvent bank will go out of business or be taken over by another bank in a merger, often forced by the insuring agency. Insolvency has been the dominant bank problem in more recent history.
The FDIC and the Comptroller of the Currency regulate the kinds of investments that banks can make. This regulation provides stockholders and depositors some protection against insolvency. Even in a regulated industry such as banking, it is important to allow unsuccessful firms to fail and leave the industry if the market system is to function effec- tively. However, a very high failure rate, such as occurred in the late 1980s and 2008, overstrains the capacity of the regulatory authorities and the resources of the insurance corporations.
Deregulation and Bailouts
High inflation rates and high market interest rates in the 1970s led to some major changes in regulations governing the nation’s banking system. Most of the bank regulations that were eliminated in the 1980s had been enacted in the 1930s as part of a policy of prevent- ing bank failures. Regulation kept banks from competing with each other to attract depos- its by offering interest on checking accounts. They could lend funds deposited in checking accounts without having to pay depositors any interest. Consumers, whether they liked it or not, were being protected from bank failure at the sacrifice of higher yields and a greater array of accounts and services.
In the 1970s, inflation drove up market interest rates and widened the gap between what banks were allowed to pay and what competing nonbank institutions were willing to pay. Banks lost deposits to other institutions where depositors could earn higher rates. The policy response to these developments was legislation to deregulate banks so that they could compete more aggressively with nonbank financial institutions. In 1980, all depository institutions—commercial banks (with either state or national charters), sav- ings banks, savings and loan associations, and credit unions—were placed under the con- trol of the Fed. All gained access to Fed services and became subject to the same reserve ratios for the same types of deposits.
Although the benefits of deregulation were apparent, the costs of this policy change were slower to appear. Freed from interest rate ceilings, banks began to compete aggressively for deposits. With fewer restrictions on the kinds of assets they could hold, some banks— especially savings and loans—began to make riskier investments. Banks earn income by
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CHAPTER 12Section 12.4 Structure and Functions of the Federal Reserve System
charging more interest on loans than they pay on deposits. Banks’ earnings fall when there is a decline in the spread, the difference between the average interest rate earned on loans and the average interest rate paid on deposits.
Savings and loans (S&Ls), even more than commercial banks, had taken advantage of the freedom created by deregulation combined with the safety net of deposit insurance to make some very risky loans. Banks that were close to insolvency were tempted to make such loans. If the loans paid off, at high interest rates, the bank could become solvent again. If the gamble failed, depositors were protected by deposit insurance.
In the early 1980s, market interest rates dropped sharply, causing the average interest rate on banks’ loan portfolios to fall very quickly. As these assets matured, banks tried to replace them with loans and assets that earned as much or more, but most such assets involved greater risk. Average bank earnings on investments fell. With banks unable to reduce the average interest paid on deposits as quickly, the spread also fell. At the same time, there was a decline in the market value of banks’ assets. The combination of risky investments and unsound real estate lending was a recipe for disaster.
The savings and loan industry underwent a major crisis from 1986 to 1995, when the num- ber of federally insured S&Ls in the United States declined from 3,234 to 1,645 (Curry & Shibut, 2000). The market share of S&Ls for single family mortgage loans went from 53% in 1975 to 30% in 1990 (Diamond & Lea, 1993). From 1980 to 1990, 1,039 banks were closed because of solvency problems. In comparison, 80 commercial banks and 43 savings and loans closed during the 1970s, and 58 commercial banks and 43 savings and loans closed during the 1960s.
Bank Failures During the Great Recession
Although policy steps were taken to avoid repeating the banking disasters of the 1980s, the next banking crisis occurred just a few decades later. The bank failures that occurred dur- ing the Great Recession of 2007–2009 differed from those of the Great Depression mainly because the dollar value of the failed bank assets was unheard of before 2009. Although the attention was focused on the largest investment and commercial bank failings, such as Bear Stearns, Washington Mutual, and Lehman Brothers, 168 depository institutions also failed between 2007 and 2009. This number was small in comparison to the more than 1,800 banks that failed during the height of the savings and loan crisis of 1987–1993, but the difference in dollar amount is astounding.
During the 2007–2009 recession, the economy saw $540 billion of failed bank assets, or roughly 1.5 times the dollar value of assets that failed during the savings and loan crisis (Gopalan, 2010). These losses have led to several changes to the FDIC in order to prevent them from happening again. These changes were made in an effort to provide stability to the U.S. banking system and encourage greater consumer confidence. First, all accounts that do not earn interest are insured in full, regardless of the balance. Those accounts that earn interest are still covered under the standard regulations for bank accounts. Then, on July 21, 2010, President Barack Obama signed the Dodd–Frank Wall Street Reform and Consumer Protection Act into law, which permanently raises the current standard maxi- mum deposit insurance amount (SMDIA) to $250,000. Only time will tell if these policy changes will help to avoid another banking crisis like that of the Great Recession.
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CHAPTER 12Section 12.4 Structure and Functions of the Federal Reserve System
Structure of the Fed
The Federal Reserve System was designed to allay fears about concentrating financial power at the federal level. The United States is divided into 12 Federal Reserve districts, each with its own Reserve Bank (see Figure 12.1). The purpose of districts was to keep management in closer touch with the people, instead of concentrating power in Wash- ington, DC, or New York City. In addition, the board of directors of each district bank includes specific numbers of representatives of the banking industry, agriculture, and the general public in order to prevent domination by bankers.
Figure 12.1: The Federal Reserve System
There are 12 Federal Reserve districts, each with its own bank. Most of these banks have branches. The Board of Governors of the Federal Reserve System is located in Washington, DC.
Source: Federal Reserve, http://www.federalreserve.gov/otherfrb.htm.
Atlanta Chicago St. Louis Minneapolis Kansas City Dallas San Francisco*
Boston New York Philadelphia Cleveland Richmond
6 7 8 9
10 11 12
1
2
3 4
5
6
7
8
9
10
11
12
1
Federal Reserve Bank Location
District
2 3 4 5
*Hawaii and Alaska are included in the San Francisco district **The Board of Governors
is located in Washington, D.C.
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CHAPTER 12Section 12.5 The Fed and the Money Supply
The Board of Governors is the governing body of the Federal Reserve System. Seven members are appointed by the president for 14-year staggered terms, with no more than one governor from any of the 12 districts. Most governors have a background in law, bank- ing, or economics. The chairman of the Fed is chosen by the president from among the sitting governors for a 4-year, renewable term. The chairman of the Fed as of 2012 is Ben Bernanke, who was initially appointed by President Bush in 2006 and was reappointed by Pres- ident Obama and confirmed by the Senate in 2010.
Within the Fed, the most powerful group is the Federal Open Market Committee (FOMC), which super- vises the conduct of monetary policy. The FOMC consists of the Board of Governors plus the presidents of five district banks, always including the president of the New York Fed- eral Reserve Bank. When the FOMC meets regularly to decide changes in bank reserves and the money supply, all district bank presidents attend.
Associated Press
Federal Reserve chairman Ben Bernanke addresses a meeting of the Chicago Economic Club, on Thursday, June 15, 2006.
Key Ideas: Functions of the Fed
• Preventing bank crises and panics by serving as the lender of last resort • Supervising banks for safety • Providing currency and check-clearing services • Providing banking services to the treasury • Conducting monetary policy
12.5 The Fed and the Money Supply
Transactions involving bonds, reserves, loans to banks, and Federal Reserve notes are the tools of monetary policy. The Fed uses the money supply and interest rates to affect output, employment, and the price level. The Fed has three ways to influence the money supply: open market operations, changes in the discount rate, and changes in the reserve ratio. Open market operations involve buying and selling bonds to affect banks’ reserves. The discount rate affects the level of bank borrowing from the Fed. Changes in the reserve ratio affect excess reserves.
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CHAPTER 12Section 12.5 The Fed and the Money Supply
Open Market Operations
The Fed’s preferred tool is open market operations. Open market operations are pur- chases and sales of bonds by the Fed on the open market in order to affect bank reserves. Open market operations are a very flexible tool. The impact on reserves can be precisely determined to be as large or as small as desired. Open market operations can be reversed if necessary and can be done without any fanfare.
Open market operations are carried out by the Federal Reserve Bank of New York. Bonds are bought and sold through brokers in New York City. The New York district bank has this responsibility because New York is the financial center of the country. The New York Fed, however, does not buy and sell on the basis of its own decisions. It carries out the directives of the FOMC.
How do open market operations affect bank reserves? Suppose Bank A has reserves of $1,000,000 in the form of deposits with the Fed. The Fed buys $100,000 worth of gov- ernment bonds from Bank A, paying for them by writing on its books that Bank A has $100,000 more in deposits (reserves) with the Fed. Bank A’s reserves are now $1,100,000. These changes are shown on the T-accounts of Bank A and the Fed in Table 12.7. If the Fed buys a bond from an individual or a firm, the seller will deposit the check from the Fed in a bank. The bank will clear the check through the Fed, and its reserves with the Fed will increase by the amount of the sale. No matter where the Fed buys bonds, bank reserves increase by the amount of the Fed purchase. Likewise, open market sales of securities by the Fed decrease the reserves of banks. Through open market operations, the Fed can directly affect the reserves of banks.
Table 12.7: Effects of open market operations on bank A and the Fed
Bank A The Fed
Assets Liabilities Assets Liabilities
Reserves: 1$100,000 Government bonds: 1$100,000
Reserves: 1$100,000
Government bonds: 2$100,000
Contracting the Money Supply Open market purchases of bonds by the Fed are expansionary. When the Fed purchases bonds, it pays for them by increasing member banks’ reserves. If the Fed wishes to con- tract the money supply or prevent banks from expanding the money supply, it will offer to sell bonds to the banks. If banks do not wish to buy the bonds, their customers will, and the effect on reserves will be the same. When the Fed sells bonds, it accepts payment by decreasing the bank’s reserve account.
Sales of government bonds by the Fed reduce bank reserves. The deposit multiplier works on this reduction in reserves in the same way it works on an expansion. The money sup- ply that existing reserves can support is smaller than before. If banks were fully loaned up before this transaction, there would be a decrease in the money supply.
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CHAPTER 12Section 12.5 The Fed and the Money Supply
Policy Focus: Who Should Control the Fed?
Governments in many other parts of the world do not face a major political problem that confronts the president and Congress in the United States. U.S. monetary policy is controlled by an agency that operates independently of both the executive and legislative branches of the U.S. government. Cen- tral banks in many other countries are a part of the government and are under political control. This arrangement makes it easier to coordinate monetary and fiscal policy.
Because members of the Board of Governors serve such long terms, even a two-term president rarely appoints more than a bare majority of the board. Long terms give the Fed a degree of political inde- pendence. The Fed is accountable to its regional boards, its stockholders, and the banks, but there is no effective way for the president or Congress to exercise any control except by appointments to the board. Because of this independence, political insiders in Washington have labeled the chair of the Fed’s Board of Governors, currently Ben Bernanke, the second most powerful person in Washington.
Until the end of World War II, the Fed’s independence did not pose major problems for the president and Congress. With the advent of active fiscal policy, however, some observers felt a need for better coordi- nation of monetary and fiscal policy, which could be achieved if the Fed answered to the president. The first conflict surfaced over interest rates in the period immediately after World War II, when the govern- ment wanted the Fed to keep interest rates low in order to reduce the interest cost on the huge federal debt incurred during the war. The Fed accommodated the treasury until 1951, when an agreement was reached to let the Fed focus on monetary policy concerns rather than treasury financing problems. Con- flict arose again in 1979 when the Fed’s concern about inflation led to a sharp slowdown in monetary growth that resulted in record high interest rates and contributed to the 1980–1982 recession. During the 1980s, an expansionary fiscal policy was partly offset by Fed actions that limited growth of the money supply and kept interest rates high, but this policy had the approval of the Reagan administration.
The chairman of the Federal Reserve had to oversee the 2007–2009 financial crisis and the subsequent Great Recession in the United States. No one saw this crisis coming, nor did they anticipate the previ- ously unheard-of policies that Bernanke and the Fed would enact to help resolve the crisis, mainly the infusion of much-needed cash into the economy.
The Fed is sensitive to concerns of the banking and business communities. As a result, the Fed is more focused on inflation than unemployment, while Congress tends to worry more about unemployment than inflation. Congress is also more sensitive to pressure from industries that like low interest rates, such as the auto and housing industries. The tension between these two goals would be there whether or not the Fed was independent of the president. Having an independent monetary authority puts some constraints on the president and Congress, who tend to have a shorter term perspective than the appointed long-term governors at the Fed. Most of the time there is considerable
The Monetary Base and the Effective Money Supply It is worthwhile to point out the difference between the monetary base, which is the total amount of reserves and currency available for circulation, and the money supply, which is the monetary base times the deposit multiplier. When the Fed conducts open market operations to increase or decrease the monetary base, the eventual impact on the money supply will differ depending on the multiplier. For example, if the multiplier decreases while the Fed is increasing the monetary base, the money supply may not necessarily increase. Since the multiplier has the potential to change over the course of the business cycle, it is important to recognize that the actions of the Fed may be weakened or strength- ened by these changes in the multiplier.
(continued)
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CHAPTER 12Section 12.5 The Fed and the Money Supply
The Federal Funds Market
One way for banks to correct a shortage of required reserves is to borrow reserves from each other as well as from the Fed. Loans between banks are made in the federal funds market. If Bank A has excess reserves, it can lend some of these (for one day at a time) to Bank B. The rate charged is the federal funds rate. If the annual rate is 12%, it costs the borrowing bank approximately 0.03% for a 1-day loan.
The federal funds rate is an important benchmark in financial markets. The Fed does not directly set the federal funds rate, but it does set a target range for that rate, such as plus or minus .125% around 12%. If the federal funds rate drops to 11.875%, the Fed will sell bonds to drain reserves from the banking system. As excess reserves of member banks fall relative to the demand for them, the federal funds rate will be driven up. Similarly, if the rate rises to 12.125%, the Fed will buy bonds to inject reserves into banks. The supply of reserves increases relative to demand, driving the federal funds rate back down toward 12%. Many economists think that this indirect control of the federal funds rate plays an important role in monetary policy. The federal funds rate is usually slightly above the discount rate because banks prefer to borrow from other banks rather than from the Fed.
Figure 12.2 shows changes in the federal funds rate since 1955. When the federal funds rate is raised, banks are dissuaded from taking out loans, which in turn makes cash harder to come by. Dropping the interest rates, on the other hand, encourages banks to (ideally) borrow money and invest more freely. This is how the interest rate acts as a regulatory tool to control how freely the U.S. economy operates. If there is a potential slowdown, such as during the Great Recession of 2007–2009, the Fed will lower the target federal funds rate in an effort to stimulate the economy and cushion the fall. Notice in Figure 12.2 that the federal funds rate was lowered to nearly 0% in 2009. This and other unconventional mon- etary policies were used during the Great Recession in an effort to get the U.S. economy moving again.
Policy Focus: Who Should Control the Fed? (continued)
dialogue, negotiation, and compromise between monetary and fiscal authorities that may result in a better combination of policies. After lengthy debates spanning several decades, most economists would conclude that the advantages of the Fed’s independence probably outweigh the drawbacks.
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CHAPTER 12Section 12.5 The Fed and the Money Supply
Figure 12.2: Effective federal funds rate
This graph illustrates the changes in the federal funds rate from 1955 to the present.
Source: Federal Reserve Bank of St. Louis, http://research.stlouisfed.org/fred2/series/FEDFUNDS.
Discounting and the Discount Rate
Banks may also borrow directly from the Fed. Borrowing from the Fed by banks is called “using the discount window.” The interest rate the Fed charges a bank is called the dis- count rate. Changing the discount rate is another tool of monetary policy. The higher the rate, the less eager banks are to borrow. The Fed may deny use of the discount window to banks that have made unwise loans. The discount rate is normally lower than other inter- est rates at which banks could borrow.
Recall what happens when an increase in the reserve ratio leaves banks with too little reserves. Banks have to contract their deposits by selling interest-earning assets or elimi- nating loans. Such a forced contraction creates a difficult situation for both banks and their loan customers. It takes time to adjust. For this reason, the Fed may cushion the impact of a decline in bank reserves by keeping the discount window open—standing ready to make loans to banks as needed. With an open discount window, instead of immediately calling in loans and selling bonds, banks can borrow reserves from the Fed. However, banks have taken out loans with the Fed that they will eventually have to repay. They will still have to reduce their loans, but they have bought some time in which to adjust more gradually.
0.0
–2.5
7.5
5.0
12.5
20.0
17.5
15.0
Percent Shaded areas indicate U.S. recessions.
2.5
10.0
Year 1950 1960 19801970 1990 2010 20202000
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CHAPTER 12Section 12.5 The Fed and the Money Supply
Each Federal Reserve Bank sets a discount rate for the depository institutions of its dis- trict, but the rates are usually the same in all 12 districts. Normally the discount rate is slightly below the market interest rate. To keep banks from borrowing from the Fed at low rates and lending to customers at high rates, district banks ration their loans and warn banks about abusing their borrowing privileges. Many people are under the impression that the Fed sets market interest rates, but the discount rate is the only rate the Fed sets directly. The Fed’s indirect effect on market interest rates is discussed in Chapter 14.
The discount rate functions as a signal more than as a direct tool of monetary control. An increase in the discount rate indicates to banks that the Fed wants to cool down the econ- omy by reducing bank lending. A decrease signifies the Fed’s desire to stimulate the econ- omy. Changes in the discount rate also alter the profitability of borrowing from the Fed in order to relend. Raising the rate makes it more expensive to borrow. In that case, banks are expected to borrow less and hold larger excess reserves in order to avoid borrowing. A lower rate makes borrowing from the Fed more attractive and encourages banks to hold fewer excess reserves. They know they can easily borrow from the Fed if necessary.
Changing the Reserve Ratio
Another tool used by the Fed is setting and changing the reserve ratio. There are two kinds of assets that a bank can count toward meeting the required reserve. One is currency and coins, or vault cash. The second, and larger, consists of funds the bank has on deposit with its district Reserve Bank. The Fed requires depository institutions to hold reserves equal to certain fractions of the different kinds of deposits they have. The reserve ratio is higher for banks with deposits over $40 million. One reason why banks collapsed during panics before the Fed was created was that their reserves were too small or not readily available. In practice, reserves now have little to do with the safety of checking and sav- ings account deposits. Their safety is ensured by deposit insurance. However, reserves do ensure that banks will have some ready funds to meet withdrawals. The required reserve ratios (shown in Table 12.8) were changed in 2011.
Table 12.8: Reserve requirements
Liability Type Requirement
% of liabilities Effective date
Net transaction accounts
$0 to $11.5 million 0 12/29/11
More than $11.5 million to $71.0 million 3 12/29/11
More than $71.0 million 10 12/29/11
Nonpersonal time deposits 0 12/27/90
Source: Board of Governors of the Federal Reserve System, “Reserve Requirements.” http://www.federalreserve.gov/monetarypolicy/reservereq.htm.
A change in the reserve ratio changes the maximum size of the money supply, not by changing bank reserves (BR), but by changing the deposit multiplier (1/rr). The deposit
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CHAPTER 12Section 12.5 The Fed and the Money Supply
Tool Pluses and Minuses Frequency of Use Works Through
Open market operations
Flexibility Broad impact
Used frequently Changing bank reserves
Changes in the reserve ratio
Broad impact Extreme power
Used rarely Changing excess reserves
Changes in the discount rate
Usefulness as a signal
Used occasionally Changing the amount of borrowing by banks Affects interest rates
Selective credit controls
Limited effectiveness Used infrequently Changing terms of consumer loans and borrowing to buy stock
Moral suasion Limited effectiveness Used occasionally Persuading banks to change amount of lending
multiplier is the reciprocal of the reserve ratio. When the reserve ratio changes from 20% to 10%, the deposit multiplier increases from 5 to 10. A reduction in the reserve ratio has a double impact on the money supply. First, it converts some required reserves into excess reserves. Second, it increases the size of the deposit multiplier. An increase in the reserve ratio works in the opposite way. The higher reserve ratio creates a shortfall of excess reserves and also reduces the size of the deposit multiplier.
A change in the reserve ratio is more complex than open market operations because of this double impact. Because it is such a powerful tool, changes in the reserve ratio are made rarely and in small amounts. Even a change of a fraction of a percent can have a very large (and somewhat uncertain) impact on the economy and can be very unsettling to banks.
Key Ideas: Federal Reserve Tools
Both economists and politicians have disagreed over the effectiveness of the Fed in using its monetary policy tools. The debates of the 19th century over how freely banks should lend are still alive. There is still support for a policy of easy money, unlimited credit, and inflation among those who are in debt and want to be able to borrow more and pay it back with cheaper dollars. There are also groups who support a hard-money policy, ranging from those who simply want monetary growth carefully controlled to those who would like to return to full-bodied money, usually a gold standard.
Developments in banking and financial markets in the last 30 years have changed the nature of banking in the United States. The next chapter will take a closer look at some of these changes as part of a broader examination of financial markets and interest rates.
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CHAPTER 12Post-Test
Conclusion
Now that you understand how the banking system works, perhaps you will take stricter standards by banks loaning to students a little less personally. The big difference between older adults and college students is the average balance that each group keeps in checkable accounts. Older people tend to spend less often and leave a larger balance. Students tend to live month-to-month with help from home, and are often down to their last dollars by the end of the month. It is those average balances that matter to banks because those are the funds that banks can lend out to earn interest.
Banks operate on the spread—the difference between the interest earned on their loans and investments and interest paid their depositors. If depositors would just leave a little more of their funds on deposit on a regular basis, instead of constantly visiting the ATM for a little more cash, banks could get by with less excess reserves, which earn no interest, and have more available to lend. Naturally, banks are going to favor depositors who leave idle cash in their accounts and frown on the “in-and-out” patterns typical of younger people with limited incomes and lots of opportunities to spend. It may not be fair, but your turn as a favored senior citizen will come if you wait long enough.
Post-Test
1. If $ 1,000 is deposited in a bank, then the bank’s a. reserves and liabilities increase by $1,000. b. liabilities fall by $1,000. c. reserves fall by $ 1,000. d. net worth rises by $1,000. e. part of Congress.
2. Banks hold reserves in order to a. pay dividends to stockholders. b. make a profit. c. increase retained earnings. d. limit the asset size of the bank. e. meet depositors’ withdrawals.
3. If a bank has excess reserves, then a. its reserves are greater than its liabilities. b. it can make a loan if it wishes. c. it cannot make a loan if it wishes. d. it must borrow from the Fed. e. it must make a loan to the Fed.
4. When a borrower repays a bank loan by writing a check on a checkable deposit account, ceteris paribus, the
a. money supply decreases. b. money supply increases. c. interest rate tends to fall. d. discount rate tends to rise. e. currency leakage is stopped.
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CHAPTER 12Post-Test
5. The major function of the Federal Reserve today is to a. act as a banker for the U.S. government. b. act as a lender of last resort. c. prevent bank panics. d. loan money to the public. e. control the nation’s money supply.
7. Banks that are chartered and regulated by the Comptroller of the Currency in the Department of the Treasury are called
a. state banks. b. government banks. c. treasury banks. d. national banks. e. federal banks.
7. Which of the following cities is NOT the location of a Federal Reserve Bank? a. Indianapolis b. Kansas City c. St. Louis d. San Francisco e. Boston
8. Membership in the Federal Reserve System is a. limited to national banks. b. limited to state banks. c. required of national banks and open to state banks. d. forbidden to state banks. e. limited to national banks and forbidden to state banks.
9. The Federal Reserve System does all but which one of the following? a. make loans to the public b. make loans to banks c. regulate banks d. prevent bank panics e. control bank reserves
10. Which of the following is an asset for the Fed? a. reserves b. checkable deposits c. government bonds d. currency e. stocks
Answers 1. a. reserves and liabilities increase by $1,000. The answer can be found in Section 12.1. 2. e. meet depositors’ withdrawals. The answer can be found in Section 12.1. 3. b. it can make a loan if it wishes. The answer can be found in Section 12.2. 4. a. money supply decreases. The answer can be found in Section 12.2.
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CHAPTER 12Key Ideas
5. e. control the nation’s money supply. The answer can be found in Section 12.3. 6. d. national banks. The answer can be found in Section 12.3. 7. a. Indianapolis. The answer can be found in Section 12.4. 8. c. required of national banks and open to state banks. The answer can be found in Section 12.4. 9. a. make loans to the public. The answer can be found in Section 12.5. 10. c. government bonds. The answer can be found in Section 12.5.
Key Ideas
1. The banking system in the United States is based on the principle of fractional reserve banking, first developed in the Middle Ages by goldsmiths. Depository institutions make loans, which expands the money supply. The upper limit on such expansion is determined by the amount of reserves banks must keep to back up deposits. Changes in reserves lead to changes in the money supply through bank lending.
2. The amount banks can lend depends on excess reserves. Required reserves are equal to deposits multiplied by the reserve ratio. These reserves must be held in some combination of vault cash and deposits in a Federal Reserve Bank. Excess reserves are total reserves minus required reserves. As excess reserves expand, banks can increase their loans and, thus, the money supply. Reductions in excess reserves force contractions of loans and the money supply.
3. The inflation of the 1970s and accompanying high interest rates led to a loss of deposits by banks and a demand for bank reform to make it easier for banks to attract and retain deposits. Bank reforms in the early 1980s greatly reduced the differences among types of depository institutions, expanded the kinds of accounts they could offer, and eliminated regulations on the interest banks could pay. Bank deregulation and the conditions of the real estate market contributed to the failure of a large number of banks in the 1980s and again in the late 1990s and 2000s. The bailouts have been costly to taxpayers and have led to more stringent regulations of bank investments and capital.
4. The Federal Reserve System was created to protect the economy from the kinds of bank panics that occurred in the 19th and early 20th centuries. It was designed to serve as a regulator and lender of last resort to member banks, to provide banking services to the treasury, and to manage check clearing between banks. The Fed supplies reserves to member banks in the form of Federal Reserve notes and reserve deposits at the Fed. The 12 Federal Reserve districts in the United States each have a Federal Reserve District Bank. The central authority is the Board of Governors in Washington, DC. The Fed is responsible for monetary policy, which is carried out by actions that influence interest rates and the money supply.
5. The Fed has three tools of monetary policy: open market operations, changes in the discount rate, and changes in the reserve ratio. Open market operations, the main tool, are purchases and sales of government bonds by the Fed on the open market, which changes the level of bank reserves. Banks can borrow from the Fed at the discount rate to cushion reductions in reserves. Changes in the discount rate affect banks’ willingness to borrow from the Fed to increase their reserves. Changes in the reserve ratio alter banks’ excess reserves. Both the reserve ratio and the discount rate are changed infrequently.
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CHAPTER 12Critical Thinking Questions
Critical Thinking Questions
1. Why are there 12 Federal Reserve districts? In which district are you? What is the Board of Governors?
2. Which of the following items appear on the Fed’s balance sheet? For each item that appears on the balance sheet, indicate whether it is an asset or a liability.
a. government bonds b. reserves of banks c. deposits by the treasury d. deposits by the public e. loans to banks f. currency
3. Which of the following items appear on a bank’s balance sheet? For each item that appears on the balance sheet, indicate whether it is an asset or a liability.
a. government bonds b. reserves c. deposits by the treasury d. deposits by the public e. loans to the public f. currency
4. What are the three main tools of the Fed? Which one is used most often? Why? 5. List the steps by which a sale of government bonds by the Fed affects output and
the price level through aggregate supply and demand. 6. Why do banks borrow from one another instead of from the Fed? 7. How does the Fed’s role differ from what was originally envisioned? 8. Why did it take the United States so long to establish a permanent central bank? 9. List all of the actions the Fed can undertake to try to increase lending, the money
supply, and the level of economic activity. 10. Suppose the reserve ratio is 20%. If an extra $2 billion in excess reserves is
injected into the banking system through an open market purchase of T-bills by the Fed, by how much can checkable deposits rise? What would your answer be if the reserve ratio were 10%? Does the total of checkable deposits have to rise?
11. Would it make a difference in your answers to Question 10 if the increase in excess reserves came about because the Fed lowered the discount rate and thus induced banks to borrow $2 billion?
12. Suppose bank reserves are $100 billion, the reserve ratio is 20%, and banks are fully loaned up (that is, excess reserves are zero). Now suppose the reserve ratio is lowered to 10% and banks once again become fully loaned up. What is the new level of checkable deposits? Do this problem again, but assume the reserve ratio rises to 25%.
13. If the Fed sells bonds, what is likely to happen to each of the following? a. bank reserves b. interest rates c. the money supply d. output and/or prices (money GDP)
14. Should the Fed be independent of the president and Congress? Why or why not? 15. How are the effects of changes in the reserve ratio on bank lending and the
money supply different from the effects of open market operations? How do these differences affect the Fed’s choice of policy tools?
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