Key Concepts and Summary

Key Terms

bank run when depositors race to the bank to withdraw their deposits for fear that otherwise they would be lost basic quantity equation of money money supply × velocity = nominal GDP central bank institution which conducts a nation’s monetary policy and regulates its banking system contractionary monetary policy a monetary policy that reduces the supply of money and loans countercyclical moving in the opposite direction of the business cycle of economic downturns and upswings deposit insurance an insurance system that makes sure depositors in a bank do not lose their money, even if the bank goes bankrupt discount rate the interest rate charged by the central bank on the loans that it gives to other commercial banks excess reserves reserves banks hold that exceed the legally mandated limit expansionary monetary policy a monetary policy that increases the supply of money and the quantity of loans federal funds rate the interest rate at which one bank lends funds to another bank overnight inflation targeting a rule that the central bank is required to focus only on keeping inflation low interest rate on reserve balances (IORB) the interest the Federal Reserve pays banks on their reserves held at their Federal Reserve bank lender of last resort an institution that provides short-term emergency loans in conditions of financial crisis loose monetary policy see expansionary monetary policy open market operations the central bank selling or buying Treasury bonds to influence the quantity of money and the level of interest rates quantitative easing (QE) the purchase of long term government and private mortgage-backed securities by central banks to make credit available in hopes of stimulating aggregate demand reserve requirement the percentage amount of its total deposits that a bank is legally obligated to either hold as cash in their vault or deposit with the central bank tight monetary policy see contractionary monetary policy velocity the speed with which money circulates through the economy; calculated as the nominal GDP divided by the money supply

Key Concepts and Summary

15.1 The Federal Reserve Banking System and Central Banks

The most prominent task of a central bank is to conduct monetary policy, which involves changes to interest rates and credit conditions, affecting the amount of borrowing and spending in an economy. Some prominent central banks around the world include the U.S. Federal Reserve, the European Central Bank, the Bank of Japan, and the Bank of England.

15.2 Bank Regulation

A bank run occurs when there are rumors (possibly true, possibly false) that a bank is at financial risk of having negative net worth. As a result, depositors rush to the bank to withdraw their money and put it someplace safer. Even false rumors, if they cause a bank run, can force a healthy bank to lose its deposits and be forced to close. Deposit insurance guarantees bank depositors that, even if the bank has negative net worth, their deposits will be protected. In the United States, the Federal Deposit Insurance Corporation (FDIC) collects deposit insurance premiums from banks and guarantees bank deposits up to $250,000. Bank supervision involves inspecting the balance sheets of banks to make sure that they have positive net worth and that their assets are not too risky. In the United States, the Office of the Comptroller of the Currency (OCC) is responsible for supervising banks and inspecting savings and loans and the National Credit Union Administration (NCUA) is responsible for inspecting credit unions. The FDIC and the Federal Reserve also play a role in bank supervision. When a central bank acts as a lender of last resort, it makes short-term loans available in situations of severe financial panic or stress. The failure of a single bank can be treated like any other business failure. Yet if many banks fail, it can reduce aggregate demand in a way that can bring on or deepen a recession. The combination of deposit insurance, bank supervision, and lender of last resort policies help to prevent weaknesses in the banking system from causing recessions.

15.3 How a Central Bank Executes Monetary Policy

In a limited reserves environment, the central bank has three traditional tools to conduct monetary policy: open market operations, which involves buying and selling government bonds with banks; reserve requirements, which determine what level of reserves a bank is legally required to hold; and discount rates, which is the interest rate charged by the central bank on the loans that it gives to other commercial banks. In a limited reserves environment, the most commonly used tool is open market operations. Since the financial crisis, the U.S. banking system is in an ample reserves environment. The FOMC has moved away from the traditional tools of a limited reserve environment and now uses changes in the interest rate on reserve balances (IORB) as its main monetary policy tool.

15.4 Monetary Policy and Economic Outcomes

An expansionary (or loose) monetary policy raises the quantity of money and credit above what it otherwise would have been and reduces interest rates, boosting aggregate demand, and thus countering recession. A contractionary monetary policy, also called a tight monetary policy, reduces the quantity of money and credit below what it otherwise would have been and raises interest rates, seeking to hold down inflation. During the 2008–2009 recession, central banks around the world also used quantitative easing to expand the supply of credit.

15.5 Pitfalls for Monetary Policy

Monetary policy is inevitably imprecise, for a number of reasons: (a) the effects occur only after long and variable lags; (b) if banks decide to hold excess reserves, monetary policy cannot force them to lend; and (c) velocity may shift in unpredictable ways. The basic quantity equation of money is MV = PQ, where M is the money supply, V is the velocity of money, P is the price level, and Q is the real output of the economy. Some central banks, like the European Central Bank, practice inflation targeting, which means that the only goal of the central bank is to keep inflation within a low target range. Other central banks, such as the U.S. Federal Reserve, are free to focus on either reducing inflation or stimulating an economy that is in recession, whichever goal seems most important at the time.

Self-Check Questions

1 . Why is it important for the members of the Board of Governors of the Federal Reserve to have longer terms in office than elected officials, like the President? 2 . Given the danger of bank runs, why do banks not keep the majority of deposits on hand to meet the demands of depositors? 3 . Bank runs are often described as “self-fulfilling prophecies.” Why is this phrase appropriate to bank runs? 4 . If the central bank sells $500 in bonds to a bank that has issued $10,000 in loans and is exactly meeting the reserve requirement of 10%, what will happen to the amount of loans and to the money supply in general? 5 . What would be the effect of increasing the banks' reserve requirements on the money supply? 6 . Why does contractionary monetary policy cause interest rates to rise? 7 . Why does expansionary monetary policy causes interest rates to drop? 8 . Why might banks want to hold excess reserves in time of recession?