Baumol & Blinder MACROECONOMICS (11th ed)

Changes in the Balance Sheet of Bank-a-mythica

(A)

Addendum: Changes

in Reserves

Actual

reser ves 2$100,000

Required

reser ves 2$20,000

Excess

reser ves 2$80,000

Loans

outstanding 2$80,000

Addendum: Changes

in Reserves

Changes in the Balance Sheet of First National Bank

(A)

Addendum: Changes

in Reserves

Actual

reser ves 2$80,000

Required

reser ves 2$16,000

Excess

reser ves 2$64,000

Loans

outstanding 2$64,000

Addendum: Changes

in Reserves

1.It is more efficient to exchange goods and services by using money as a medium of exchange than by bartering them directly.

2.In addition to being the medium of exchange, whatever serves as money is likely to become the standard unit of account and a popular store of value.

3.Throughout history, all sorts of items have served as money. Commodity money gave way to full-bodied paper money (certificates backed 100 percent by some commodity, such as gold), which in turn gave way to partially backed paper money. Nowadays, our paper money has no commodity backing whatsoever; it is pure fiat money.

4.One popular definition of the U.S. money supply is M1, which includes coins, paper money, and several types of checking deposits. Most economists prefer the M2 definition, which adds to M1 other types of checkable accounts and most savings deposits. Much of M2 is held

outside of banks by investment houses, credit unions, and other financial institutions.

5.Under our modern system of fractional reserve banking, banks keep cash reserves equal to only a fraction of their total deposit liabilities. This practice is the key to their profitability, because the remaining funds can be loaned out at interest. But it also leaves banks potentially vulnerable to runs.

6.Because of this vulnerability, bank managers are generally conservative in their investment strategies. They also keep a prudent level of reserves. Even so, the government keeps a watchful eye over banking practices.

7.Before 1933, bank failures were common in the United States. They declined sharply when deposit insurance was instituted.

8.Because it holds only fractional reserves, the banking system as a whole can create several dollars of deposits for each dollar of reserves it receives. Under

certain assumptions, the ratio of new bank deposits to new reserves will be $1/m, where m is the required reserve ratio.

9.The same process works in reverse, as a system of money destruction, when cash is withdrawn from the banking system.

10.Because banks and individuals may want to hold more cash when the economy is shaky, the money supply would probably contract under such circumstances if the government did not intervene. Similarly, the money supply would probably expand rapidly in boom times if it were unregulated.

1.Suppose banks keep no excess reserves and no individuals or firms hold on to cash. If someone suddenly discovers $12 million in buried treasure and deposits it in a bank, explain what will happen to the money supply if the required reserve ratio is 10 percent.

2.How would your answer to Test Yourself Question 1 differ if the reserve ratio were 25 percent? If the reserve ratio were 100 percent?

3.Use tables such as Tables 2 and 3 to illustrate what happens to bank balance sheets when each of the following transactions occurs:

a.You withdraw $100 from your checking account to buy concert tickets.

b.Sam finds a $100 bill on the sidewalk and deposits it into his checking account.

c.Mary Q. Contrary withdraws $500 in cash from her account at Hometown Bank, carries it to the city, and deposits it into her account at Big City Bank.

4.For each of the transactions listed in Test Yourself Question 3, what will be the ultimate effect on the money supply if the required reserve ratio is one-eighth (12.5 percent)? Assume that the oversimplified money multiplier formula applies.

1.If ours were a barter economy, how would you pay your tuition bill? What if your college did not want the goods or services you offered in payment?

2.How is “money” defined, both conceptually and in practice? Does the U.S. money supply consist of commodity money, full-bodied paper money, or fiat money?

3.What is fractional reserve banking, and why is it the key to bank profits? (Hint: What opportunities to make profits would banks lose if reserve requirements were 100 percent?) Why does fractional reserve banking give bankers discretion over how large the money supply will be? Why does it make banks potentially vulnerable to runs?

4.During the 1980s and early 1990s, a rash of bank failures occurred in the United States. Explain why these failures did not lead to runs on banks.

5.Each year during Christmas shopping season, consumers and stores increase their holdings of cash. Explain how this development could lead to a multiple contraction of the money supply. (As a matter of fact, the authorities prevent this contraction from occurring by methods explained in the next chapter.)

6.Excess reserves make a bank less vulnerable to runs. Why, then, don’t bankers like to hold excess reserves? What circumstances might persuade them that it would be advisable to hold excess reserves?

7.If the government takes over a failed bank with liabilities (mostly deposits) of $2 billion, pays off the depositors, and sells the assets for $1.5 billion, where does the missing $500 million come from? Why?

Victorians heard with grave attention that the Bank Rate had been raised. They did not know what it meant. But they knew that it was an act of extreme wisdom.

JOHN KENNETH GALBRAITH

A rmed with our understanding of the rudiments of banking, we are now ready to bring money and interest rates into our model of income determination and the price level. Up to now, we have taken investment (I) to be a fixed number. But this is a poor assumption. Not only is investment highly variable but it also depends on interest rates—which are, in turn, heavily influenced by monetary policy. The main task of this chapter is to explain how monetary policy affects interest rates, investment, and aggregate demand. By the end of the chapter, we will have constructed a complete macroeconomic model, which we will use in subsequent chapters to investigate a vari-

ety of important policy issues.

Monetary policy refers to actions that the Federal Reserve System takes to change interest rates and the money supply. It is aimed at affecting the economy.

AMERICA’S CENTRAL BANK: THE FEDERAL RESERVE SYSTEM

When Congress established the Federal Reserve System in 1914, the United States joined the company of most other advanced industrial nations. Until then, the United States, distrustful of centralized economic power, was almost the only important nation without a central bank. The Bank of England, for example, dates back to 1694.

Origins and Structure

It was painful experiences with economic reality, not the power of economic logic, that provided the impetus to establish a central bank for the United States. Four severe banking panics between 1873 and 1907, in which many banks failed, convinced legislators and bankers alike that a central bank that would regulate credit conditions was not a luxury but a necessity. The 1907 crisis led Congress to study the shortcomings of the banking system and, eventually, to establish the Federal Reserve System.

Although the basic ideas of central banking came from Europe, the United States made some changes when it imported the idea, making the Federal Reserve System a uniquely American institution.1 Because of the vastness of our country, the extraordinarily large number of commercial banks, and our tradition of shared state-federal responsibilities, Congress decided that the United States should have not one central bank but twelve.

Technically, each Federal Reserve Bank is a corporation; its stockholders are its member banks. But your bank, if it is a member of the system, does not enjoy the privileges normally accorded to stockholders: It receives only a token share of the Federal Reserve’s immense profits (the bulk is turned over to the U.S. Treasury), and it has virtually no say in corporate decisions. In fact, the private banks are more like customers of the Fed than owners.

Who, then, controls the Fed? Most of the power resides in the seven-member Board of Governors of the Federal Reserve System in Washington, and especially in its chairman. The governors are appointed by the President of the United States, with the advice and consent of the Senate, for fourteen-year terms. The president also designates one of the members to serve a four-year term as chairman of the board and thus to be the most powerful central banker in the world.

The Federal Reserve is independent of the rest of the government. As long as it stays within the authority granted to

it by Congress, it alone has responsibility for determining the nation’s monetary policy. The power of appointment, however, gives the president some long-run influence over Federal Reserve policy. For example, it was President George W. Bush in 2006 who selected Ben Bernanke, a former adviser, to be the Fed’s next chairman.

Closely allied with the Board of Governors is the powerful Federal Open Market Committee (FOMC), which meets eight times a year in Washington. For reasons to be explained shortly, FOMC decisions largely determine short-term interest rates and the size of the U.S. money supply. This twelve-member committee consists of the seven governors of the Federal Reserve System, the president of the Federal Reserve Bank of New York, and, on a rotating basis, four of the other eleven district bank presidents.2

A central bank is a bank for banks. The United States’ central bank is the

Federal Reserve System.

Meetings of the Federal Open Market Committee are serious and formal affairs. All 19 members—7 governors and 12 reserve bank presidents—sit around a mammoth table in the Fed’s cavernous but austere board room. A limited number of top Fed staffers join them at and around the table, for access to FOMC meetings is strictly controlled.

At precisely 9 A.M.—for punctuality is a high virtue at the Fed— the doors are closed and the chairman calls the meeting to order. No press is allowed and, unlike most important Washington meetings, nothing said there will leak. Secrecy is another high virtue at the Fed.

After hearing a few routine staff reports, the chairman calls on each of the members in turn to give their views of the current economic situation. District bank presidents offer insights into their local economies, and all members comment on the outlook for the national economy. Committee members also offer their views on what changes in monetary policy, if any, are appropriate. Disagreements are raised, but voices are not, for politeness is another virtue. Strikingly, in this most political of cities, politics is almost never mentioned.

Once he has heard from all the others, the chairman summarizes the discussion, offers his own views of the economic situation and of the policy options, and recommends a course of action. Most members normally agree with the chairman, though some note differences of opinion. Then the chairman asks the

secretary to call the roll. Only the 12 voting members answer, saying yes or no. Negative votes are rare, for the FOMC tries to operate by consensus and a dissent is considered a loud objection.

The meeting adjourns, and at precisely 2:15 P.M. a Fed spokesman announces the decision to the public. Within minutes, financial markets around the world react.

SOURCE: Courtesy of the Federal Reserve Board

Central bank independence refers to the central bank’s ability to make decisions without political interference.

Central Bank Independence

For decades a debate raged, both in the United States and in other countries, over the pros and cons of central bank independence.

Proponents of central bank independence argued that it enables the central bank to take the long view and to make monetary policy decisions on objective, technical criteria—thus keeping monetary policy out of the “political thicket.” Without this independence, they argued, politicians with short time horizons might try to force the central bank to expand the money supply too rapidly, especially before elections, thereby contributing to chronic inflation and undermining faith in the country’s financial system. They pointed to historical evidence showing that countries with more independent central banks have, on average, experienced lower inflation.

Opponents of this view countered that there is something profoundly undemocratic about letting a group of unelected bankers and economists make decisions that affect every citizen’s well-being. Monetary policy, they argued, should be formulated by the elected representatives of the people, just as fiscal policy is.

The high inflation of the 1970s and early 1980s helped resolve this issue by convincing many governments around the world that an independent central bank was essential to controlling inflation. Thus, one country after another has made its central bank independent over the past 20 to 25 years. For example, the Maastricht Treaty (1992), which committed members of the European Union to both low inflation and a single currency (the euro), required each member state to make its central bank independent. All did so, even though several have still not joined the monetary union. Japan also decided to make its central bank independent in 1998. In Latin America, several formerly high-inflation

When it wants to change interest rates, the Fed normally relies on open-market operations, which is the tool it relied upon when it lowered interest rates in response to the financial crisis of 2007–2008. Open-market operations either give banks more reserves or take reserves away from them, thereby triggering the sort of multiple expansion or contraction of the money supply described in the previous chapter.

How does this process work? If the Federal Open Market Committee decides to lower interest rates, it can bring them down by providing banks with more reserves. Specifically, the Federal Reserve System would normally purchase a particular kind of short-term U.S. government security called a Treasury bill from any individual or bank that wished to sell them, paying with newly created bank reserves. To see how this open-market operation affects interest rates, we must understand how the market for bank reserves, which is depicted in Figure 1, works.

Open-market operations refer to the Fed’s purchase or sale of government securities through transactions in the open market.

FIGURE 1

The Market for Bank Reserves

The federal funds rate is the interest rates that banks pay and receive when they borrow reserves from one another.

FIGURE 2

The Effects of an Open-

Market Purchase

D

Interest Rate

S0 S1

There is more to the story, however, for we have not yet explained why the the demand curve DD slopes down and the supply curve SS slopes up. The interest rate measured along the vertical axis of Figure 1 is called the federal funds rate. It is the rate that applies when banks borrow and lend reserves to one another. When you hear on the evening news that “the Federal Reserve today cut interest rates by 1⁄4 of a point today,” it is the federal funds rate that the reporter is talking about.

Now where does this borrowing and lending come from? As we mentioned in the previous chapter, banks sometimes find themselves with either insufficient or excess reserves. Neither situation leaves bankers happy. Keeping actual reserves below the required level is not allowed. Holding reserves in excess of requirements is perfectly legal, but since reserves pay no interest, a bank can put excess reserves to better use by lending them out rather than keeping them idle. So banks have developed an active market in which those with excess reserves lend them to those with reserve deficiencies. These bank-to-bank loans provide an additional source of both supply and demand—and one that (unlike required reserves) is interest sensitive.

Dwould therefore shift from point E to point A, which, as the diagram shows, implies a lower interest rate and more bank reserves. That is precisely what the Fed does when it wants to reduce interest rates.4