Introduction to Economics

Introduction to Economics Macroeconomics The US Economy

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Outline: Lecture Eight • The Banking System • The Federal Reserve

Full Reserve Banking • Dates to the Middle Ages • goldsmiths • accept customer deposits of gold • issue certificates of deposit to customer • customer can use certificates as a medium of exchange • paper money substitutes for gold money • no money creation

Assets-Liabilities Statement

Full Reserve Banking Goldsmith Assets Liabilities customer deposits of gold, e.g. 1,000 Florins certificates of deposit, e.g. 1,000 Florins Note: The goldsmith is perfectly liquid. If a customer comes in with a certificate of deposit, the goldsmith has the reserves of gold to exchange for the certificate. Note: The goldsmith is perfectly solvent. The value of the gold reserves held as assets equals the value of the certificates issued, i.e assets equal liabilities.

Banking as a Business • Goldsmiths note that only about 25% of customers want to exchange certificates for gold on a given day • This creates an incentive for the goldsmiths to use some of the remaining gold reserves to make loans and earn interest

Fractional Reserve Banking Goldsmith Assets Liabilities customer deposits of gold, e.g. 1,000 Florins certificates of deposit, e.g. 1,000 Florins loans of 500 Florins certificates of deposit, 500 Florins (money creation) Note: The goldsmith is no longer perfectly liquid. If all the customers come in with certificates of deposit and demand 1,500 Florins, the goldsmith only has reserves of 1,000 Florins in gold to exchange for the certificates. The customers panic! Note: The goldsmith may not remain solvent. If the goldsmith makes unwise loans, and the customer in debt defaults, then the value of assets, 1,000 Florins, is less than the value of liabilities, 1,500 Florins.

History of US Capitalism • Punctuated by a series of banking crises • for example: panic of 1907 • motivates the formation of the Federal Reserve, 1913

Banking Crises (continued) • widespread bank failures in 1932 • depositors lose money • Roosevelt declares a bank holiday upon assuming office • Federal Deposit Insurance Corporation , FDIC, created in 1934 • insures accounts up to $100,000

Banking Crises (continued) • Savings and Loans failures in the 1980’s • in 1989 & 1990, 100’s of insolvent thrifts taken over • bail out of depositors costs US taxpayers about $500 B

Liquidity Crisis rumors depositors lose confidence run on the banks to withdraw deposits not enough reserves to meet demands of depositors panic Bank Failures banks make unsound loans for example, make real estate loans and then the real estate market crashes debtors default on loans banks become insolvent depositors lose money Fractional Reserve Banking is subject to two threats

Economic Concept: Moral Hazard • The creation of the Federal Deposit Insurance Corporation, FDIC, and the Federal Savings and Loan Insurance Corporation, FSLIC, did not prevent the failure of S&L’s in the 80’s • with an account insured up to $100,000, a depositor then takes less care to check out the policies and practices of an S&L before depositing cash • this effect of insurance making one feel “safe” and hence taking less care to avoid loss is called moral hazard

Source: http://www.fdic.gov/

The Federal Reserve • Objectives • Tools • Organization and Structure

The Federal Reserve • Objectives • prevent liquidity crises • prevent solvency crises • control inflation and money stock growth • stabilize short term interest rates

Tools lender of last resort to private banks sets required ratio of reserves to deposits establishes sound banking practices manipulates bank reserves affects federal funds rate and sets the discount rate Federal Reserve as Central Bank

Fed: Lender of Last Resort to Banks at Discount Rate Source: Federal Reserve Bank of Minneapolis

Fed Sets Ratio of Minimum Bank Reserves to Bank Deposits • Helps Prevent Liquidity Crises • For Example: Dec 1992 • deposits of 0-$42.2M (small banks) • required minimum reserve ratio: 3% • deposits of $42.2+M- (large banks) • required minimum reserve ratio: 10%

Reserve Ratios (Continued) • For Example 1994 • deposits of 0-$4M: 0% reserve ratio • deposits of $4+M-$51.9M: 3% reserve ratio • deposits of $51.9M- :10% • Infrequent Changes in Reserve Ratios

Fed: Establish Sound Banking Practices Source: http://www.frbch.org/

Federal Reserve: Organization and Structure

http://www.bog.frb.fed.us/

Federal Open Market Committee: 12 Members Federal Open Market Committee Meetings 7 Board Governors, President of New York Fed, 4 other Presidents

Federal Reserve Open Market Operations • Tight Money Policy • Fed sells securities in secondary market • decreases bank reserves • decreases excess reserves • decreases banking system capacity to make loans • Easy Money Policy • Fed buys securities in secondary market • increases bank reserves • increases excess reserves • increases banking system capacity to make loans

FOMC Tries to Tighten CreditSells Treasuries in Secondary Market FED Commercial Banks Net Result: changes asset mix of banks & decreases total bank reserves

FOMC Tries to Loosen CreditBuys Treasuries in Secondary Market FED Commercial Banks Net Result: changes asset mix of banks & increases total bank reserves

Limitations to FOMC Efforts • FOMC can increase reserves by buying securities: this enables banks to make loans • Fed can not force banks to make loans • Fed can not force consumers or businesses to ask banks for loans • Metaphor: “you can lead a horse to water, but you can not make him drink” • Contractionary monetary policy is more direct than expansionary monetary policy • if Fed sells securities, this reduces reserves, and hence for a given level of bank deposits and required reserves, decreases excess reserves

Understanding Open Market Operations • Familiarity with the Fed’s balance sheet • Definitions of Banking Reserve Aggregates • Fed is a corporation • national banks are chartered by the US Comptroller of Currency • national banks must be members and buy stock; this provides Fed with working capital • state banks can be members if they choose • Fed’s profits, above a given level, are given to US Treasury

Federal Reserve System Balance Sheet, August 13, 1997 Source: TheWall Street Journal, Friday 8-22-97, p.C 18

Bank Reserve Aggregates, 10-21-98 * Excess Reserves = Total Reserves - Required Reserves ** Free Reserves = Excess Reserves - Borrowed Reserves Source: TheWall Street Journal, Friday 8-22-97, p.C 18

How Effective Has the Fed Been? • Fed Goals • maximum employment • stable prices • moderate long-term interest rates • Fed Objectives or Targets • quantity of reserves • price of reserves • federal funds rate, FFR, is the interest rate banks charge one another for borrowing reserves for a day or so; mostly large urban banks borrowing from small suburban and rural banks

Misery Index = Unemployment Rate + Inflation Rate Hoover Roosevelt Truman Ike LBJ Nixon/ Ford Reagan Bush JFK Carter Clinton

full reserve banking fractional reserve banking banking system crisis illiquid bank insolvent bank FDIC, FSLIC lender of last resort discount rate ratio of required reserves to deposits Federal Funds Rate Federal Reserve (FR) District Board of Governors Open Market Committee open market operations policy goals policy targets Reserve Aggregates total reserves nonborrowed reserves required reserves excess reserves free reserves secondary Treasuries market Summary-Vocabulary-Concepts

The Federal Reserve System: Purposes & Functions http://www.bog.frb.fed.us/ PDF format: Adobe Acrobat

Introduction to Economics