Chap. 10 - Banking Flashcards
A _____ is a liability to a bank while a ____ is an asset to a bank.
deposit, loan
What are reserves?
The funds or assets that banks hold in the form of cash, or on deposit with the central bank.
Why would a bank hold reserves in the vault when they could be lending that money out and earning interest?
The bank has to have enough money on hand for day to day operations. If someone comes into the bank and wants to withdraw $1,000 from her savings account, it would not look good if the bank had to say, “Sorry, we don’t have $1,000 right now.”
Also it is a legal requirement to have enough reserves on hand.
The maximum amount of money supply expansion that can exist in the banking system is equal to:
Total Potential Money Expansion = Excess Reserves x 1/rr
rr = reserve requirement
Total Potential Money Expansion holds completely true under which two circumstances?
1) Bank must keep only the minimum amount of reserves on hand and lend out all the excess reserves.
2) The total amount of each loan in the expansion process must be deposited into another bank.
The Federal Reserve has control over the three primary instruments of monetary policy. Name the three controls.
- Open-market Operations
- Reserve Requirements
- Discount Rate (note the difference between this and the Federal Funds Rate)
What are Open Market Operations?
Open Market Operations refers to the buying and selling of government bonds by the Federal Open Market Committee. When the FOMC decides to buy bonds they take bonds out of the hands of the public and put cash into the hands of the public. If the Fed were to buy a bond from you, you would give the Fed the bond and they would give you cash.
If the reserve requirement were 10% what would be the multiplier, and if the Fed sells $1 billion in bonds how much would the money supply increase/decrease?
Multiplier = 1/rr = 1/.10 = 10
$1 billion * 10 = $10 billion
Money supply would shrink by $10 billion, the fed is selling bonds which is not part of M1. You give cash to buy the bonds, and the Fed puts that cash in a vault and out of the money supply. Vice versa if the Fed were to buy bonds.
If the Fed wanted to expand (contract) the money supply through reserve requirements only what could they do?
The Fed could lower the reserve requirements. Banks would have additional excess reserves because of this, less money in the vault, that they can lend out. Increasing the reserve requirements would have the opposite effect and shrink the money supply.
What would happen to a commercial bank that lends out so much money that they do not have enough on hand to meet their required reserves?
When commercial banks are short on reserves, they can borrow from a Federal Reserve Bank. The interest rate they are charged on such a loan is called the discount rate.
If the discount rate is low would that increase/decrease the money supply? Why?
Increase the Money Supply.
If I lend out $50 dollars too many to a bank customer and charge him 6% interest, and the Fed sets the discount rate at 2%, it makes sense for me to just borrow the $50 from the Fed to make up my required reserves. In effect, low discount rates encourage commercial banks to loan out their required reserves and then borrow the reserves back from the Fed. Obviously, the more loans that banks make, the higher the money supply. The opposite is true if the Fed wants to contract through the Discount Window.
A decrease in the money supply would cause the interest rate to ____; an increase in the money supply would _____the interest rate.
Rise
Lower
If interest rates fall what happens with investment and interest sensitive consumption? If they rise?
Falling interest rates promote more investment by businesses and interest sensitive consumption. Businesses can borrow at a lower rate, essentially cheaper money, and expand operations. The opposite is true if they rise.
- The Fed can increase excess reserves ( How? ), which
- increases the money supply ( Why? ), which
- decreases the interest rate ( Why? ), which
- increases I and C ( Why? ), which
- increases AD ( Why? ), which
- increases Real GDP, and decreases Unemployment and the Price Level
( When? ).
How: 1. Buy bonds, Lower RR, Lower discount rates
Why: Through the lending practices of banks
Why: Because the money supply shifts to the right
Why: At lower i, businesses are more willing to invest because more investments will be profitable. Households are also more willing to borrow.
Why: Because I and C are both components of AD
When: Real GDP: in the Keynesian and Intermediate ranges of AS
Decreases unemployment: in the Keynesian and Intermediate ranges of AS
Price Level: in the intermediate and classical ranges of AS
- The Fed can reduce excess reserves ( How? ), which
- reduces the money supply ( Why? ), which
- increases the interest rate ( Why? ), which
- decreases the I and C ( Why? ), which
- decreases AD ( Why? ), which
- decreases Real GDP, and increases Unemployment and the Price Level
( When? ).
How: Sell bonds, Increase RR, Increase the discount rate
Why: Restricts bank lending
Why: Shifts money supply to the left
Why: Businesses find fewer investments profitable at higher interest rates. Households are less likely to buy big ticket items that they have to borrow money for.
Why: I and C are both components of AD
When: Real GDP: In the Keynesian and Intermediate ranges of AS
Increases unemployment: in the Keynesian and Intermediate ranges of AS
Price level: in the Intermediate and Classical ranges of AS
