Answers to End-Of-Chapters Questions

CHAPTER 2: The Federal Reserve

Answers to End-of-Chapters Questions

1. Explain why the banking system was so unstable prior to the establishment of the Federal System in 1912?

The period between the termination of the Second Bank of the United States, 1836, and the passage of the Federal Reserve Act in late 1912 meant that the U.S. did not have a central bank. While a few state banks did serve a few central bank functions, there was no overall control of the growth of the money supply. High economic growth periods, with bank loans and bank note issuance were followed by loan default, bank failure and severe money supply contraction. Banking was a state-controlled industry and states often competed with one another to promote bank formation and growth. Regulation was limited and bank failure was common.

2. What is a “call loan” and how did call loans contribute to economic recessions?

Call loans are loans that may be “called” by the issuing bank at any time. In boom times when loan default was uncommon, loans remained on the books, earning interest for the bank. When loan default increased, usually with over-expansion and failed speculation, the bank needed liquidity to redeem bank notes that were presented, often in large amounts. There was no central bank to lend to banks, so each bank had to generate cash on its own, calling loans. The “call” often prompted more defaulted loans, bank note redemption, and eventually, bank failure and economic collapse since the payments mechanism and liquidity source (banks) were not available.

3. What were the four goals of the legislation that established the Federal Reserve System? Have they been met today?

The goal of the Federal Reserve Act was to: 1. Establish a monetary authority that could/would control the rate of growth of the nation’s money supply. 2. Establish a “Lender-of-Last Resort” that could infuse liquidity into the financial system at any time. 3. Develop an efficient payments system that supports a rapidly developing industrial economy. 4. Establish an effective bank supervision system to reduce the risk of bank failure.

With some failures and more successes, the Federal Reserve System has developed into an effective central bank over the 20th century. The evolution of the FOMC into an effective system for money supply/interest rate policy to stabilize the wild economic fluctuation of this capitalistic economic system has been most effective, as has the Federal Reserve’s “Lender- of-Last Resort” policy during financial panics. The payments system has slowly evolved as the legal system and special interests has struggled to keep up with technological developments in data processing, communications, and computing. The classic battle 2

between urban/rural, industry/agriculture, states vs. federal authority, large vs. small bank, bureaucratic self-preservation, and an ever-developing economy has been a challenge for the Federal Reserve. The current structure, evolving with every Congressional session for ninety years, works and serves to balance all the special interests present.

4. Explain why the Board of Governors of the Federal Reserve System is considered so powerful? What are its major powers and which is the most important?

The Board of Governors, and especially the Chairman, has concentrated the authority/power of the Federal Reserve System into their meeting room over the last fifty years. The Board appoints a majority of board members for Federal Reserve Banks and has gradually collected the “tools” of monetary policy into its “tool shed.” The seven members of the Board make up a majority of the twelve-member FOMC, the most important power of the Board.

5. Explain why the FOMC is the key policy group within the Federal Reserve?

The Federal Open Market Committee, made up of the seven members of the Board of Governors, the president of the New York Federal Reserve, and four of the remaining eleven presidents of the Federal Reserve Banks, is the key policy making group within the Federal Reserve. The FOMC establishes the monetary policy of the world’s largest, powerful country, impacting interest rates, exchange rates, and economic growth. Its decisions at election time can effect presidential and Congressional elections. At the helm of the FOMC, the Chairman of the Board of Governors is the second most powerful person in Washington, D.C.

6. Explain why Regulation Q caused difficulties for banks and other depository institutions, especially during periods of rising interest rates.

Regulation Q, one of many “lettered” Federal Reserve regulations, was used for a variety of reasons since the time of the Great Depression. Forbidding interest on demand deposits, Regulation Q served to limit price competition for deposits in a period when stability was the primary objective. Later, Regulation Q served to reinforce “tight money” policies of the Federal Reserve. By establishing deposit rate maximums below market rates, deposit withdrawal (disintermediation) further drained liquidity from banks at a time when the Federal Reserve wanted banks to curtail lending. Later, in the 1960’s and 1970’s Regulation Q served to promote home ownership by allowing savings associations to pay higher rates on deposits than commercial banks. At present, except for business demand deposits, Regulation Q is on “stand-by,” with the Federal Reserve depending on market factors to determine the flow of funds through markets and financial institutions. 3

7. Explain the sense in which the Federal Reserve is independent of the Federal Government. How independent is the Federal Reserve in reality? What is your opinion about the importance of the Federal Reserve’s independence for the U.S. economy?

With a budget (revenues from the large portfolio of U.S. Treasuries) independent from Congress and fourteen-year term for members of the Federal Reserve Board of Governors, a power-hungry president would have a hard time pulling off a classic coup: take over the military, TV station, and the central bank! In times less drastic, Presidents have been able to have their nominees dominate the Board of Governors. Congressional members, at every semi-annual meeting with the Chairman of the Board of Governors, reminds the Federal Reserve that Congress created the Federal Reserve. Keeping the money supply out of the hands of Congress and President is one of the key and necessary separation of powers.

8. A bank has $3,000 in reserves, $9,000 in bank loans, and $12,000 of deposits. If the reserve requirement is 20%, what is the bank’s reserve position? What is the maximum dollar amount of loans the bank could make?

With a 20% required reserve ratio the bank has required reserves of $2,400 ($12,000 x 0.2) and excess reserves of $600. A bank can lend only to the extent of its excess reserves, in this case, $600. If the required reserve ratio were decreased to 10%, the bank would have required reserves of $1,200 ($12,000 x 0.1) and excess reserves of $1,200 to lend and expand deposits. For all banks, a halving of the required reserve ratio would double the potential deposit level - a good reason not to use the required reserve ratio as an active monetary policy tool.

____ Beginning 20% RR Ratio 10% RR Ratio__

Reserves Deposits Reserves Deposits Reserves Deposits $3,000 $12,000 $2,400 $12,000 $1,200 $12,000

Loans Loans Loans $9,000 $9,600 $10,800

9. Why does the Federal Reserve not use the discount rate to conduct monetary policy? How does the Federal Reserve use the discount rate?

In the early part of the twentieth century, it was common for businesses to discount their accounts receivable with financial institution. When the Federal Reserve was formed, the discount rate was the primary tool of monetary policy. The Federal Reserve would discount “commercial paper” (bank loans and bills of exchange), providing liquidity to business via banks. This was a time before money markets as we know it and the federal funds markets were developed. The banking industry was the primary source of seasonal and working capital loans and the Federal Reserve’s discount policy was reasonably effective. As the money markets evolved, the federal funds market developed, and the FOMC developed its processes, discounting became history. Today changes in the discount rate serves as a signal of policy intent or changes, and the open market operations reigns as monetary king! There 4

are three components of discount window policy: borrowing for reserve deficiency (monetary policy), seasonal credit for agricultural banks, and loans to problem banks. So, to small “agricultural” banks and large banks in distress, discount policy is an important item!

10. Explain how the Federal Reserve changes the money supply with an open market purchase of Treasury securities.

There are three requisites for U.S. monetary policy: (1) banks must keep reserves against transaction deposits, (2) the banks must keep their reserves in the Federal Reserve or in vault cash, and (3) the Federal Reserve controls the level/growth of bank reserves via open market operations. Every Federal Reserve transaction with the private sector clears through the bank reserve account. When the Federal Reserve purchases U.S. Treasury securities the Federal Reserve pays with a credit to their bank reserve account, giving banks immediate excess reserves to lend/invest and create deposits and increase the money supply.