Chap 26

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$MATH 219 - Differential Equations Quiz 3 Name Solutions Date ...$

234 CHAPTER 10 ability to spread the monitoring costs over many borrowers, lower the average cost of monitoring borrowers. 4. Depository institutions pool risk because they use funds obtained from many depositors to make loans to many borrowers. As a result, if a borrower defaults, no one depositor bears the entire loss because the loss is spread over all depositors. By spreading the risk, depository institutions are pooling risk. 5. Anyone opening a bank, taking deposits, and making loans faces several restrictions or regulations. The restrictions can be divided into two general types: deposit insurance and balance sheet rules. Deposit insurance reflects the fact that the deposits generally are insured by the Federal Deposit Insurance Corporation (FDIC). Because of this insurance, banks face balance sheet regulations to minimize their incentive to make high-risk loans. The balance sheet regulations are: capital requirements (regulations giving the minimum amount of an owner’s own wealth that must be invested in the bank); reserve requirements (rules telling the minimum percentages of deposits that must be retained as currency or at the Federal Reserve); deposit rules (regulations restricting the types of deposits an intermediary can accept); and, lending rules (regulations limiting the proportions of different types of loans an intermediary can make). 6. The financial deregulation that occurred in the 1980s made commercial banks more like other depository institutions primarily because the deregulation made other depository institutions more like banks. In particular, the deregulation eased constraints on the type of loans that other depository institutions (savings and loan associations and savings banks) could make and allowed these institutions the right to make types of loans similar to those made by commercial banks. 7. Financial innovation is influenced by the economic environment, technology, and regulation. For instance, when the economic environment was such that interest rates were high, variable rate mortgages were developed that took some of the risk out of extending mortgage loans. Gains in technology, by lowering the cost of computing and communication, have lead to increased usage of credit cards. And regulation, by limiting the profits that intermediaries can earn, constantly spur intermediaries to develop ways to avoid regulation and thereby earn larger profits. 8. Deregulation and innovation have changed the composition of money. Today new types of checking accounts (NOW and ATS) accounts are a large fraction of money even though these types of accounts did not exist in 1960. In M2, “traditional” savings deposits have declined, while new deposits, such as money market funds, have expanded. Page 243 (page 615 in Economics) 1. Banks create deposits by making loans because part or all of the loans they make will be deposited in another bank. For instance, a student given a loan may purchase books at the local bookstore. The bookstore will then deposit the proceeds into its bank as part of the bookstore’s checking account. Thus the loan has created new deposits at the bookstore’s bank. The factors that limit the amount of deposits and loans a bank can make are the bank’s reserves and the required reserve ratio. A bank must maintain at least the amount of reserves set by the required reserve ratio and so if the bank does not have enough excess reserves—reserves above the amount that legally must be maintained—the bank cannot make additional loans. 2. Though the manager does not see the entire process, nonetheless the loans the manager makes will create more deposits and hence more money. Point out to the manager that when he or she makes a loan, the deposits at his or her bank do not change. And, when the loan is spent, the recipient selling the goods or services that have been purchased will deposit part or all of the proceeds in his or her bank. When the recipient makes this deposit, the total amount of the nation’s deposits increase and, because deposits are part of the nation’s money, the quantity of money also increases.
MONEY, BANKS, AND THE FEDERAL RESERVE 235 3. When banks receive new deposits of $100 million dollars, they also have received new reserves of $100 million. The total amount of deposits will stop changing when deposits are at the level that makes required reserves equal to actual reserves. Page 247 (page 619 in Economics) 1. The Federal Reserve is the central bank of the United States. The Federal Reserve conducts the nation’s monetary policy and supervises the financial system. 2. The seven Federal Reserve board members are appointed by the President of the United States and confirmed by the Congress. Each member is appointed to a 14-year term and the terms are staggered so that a seat becomes vacant every two years. 3. The Federal Reserve has three policy tools: changes in required reserve ratios; changes in the discount rate; and, open market operations. 4. The Federal Open market Committee (FOMC) is the main policy-making group within the Federal Reserve System. It decides upon the nation’s monetary policy as conducted through open market operations. 5. The FOMC meets approximately once every six weeks. Page 251 (page 623 in Economics) 1. When the Federal Reserve buys securities in the open market, bank reserves increase so that banks have excess reserves. Because banks have excess reserves, they loan the excess and a multiple expansion of the quantity of money results. The initial increase in bank reserves from the Fed’s purchase of securities means that the monetary base increases when the Fed buys securities. When the Federal Reserve sells securities in the open market, bank reserves decrease so that banks have deficient reserves. Because banks have deficient reserves, they must call in loans and a multiple contraction of the money supply results. The initial decrease in bank reserves from the Fed’s sale of securities means that the monetary base decreases when the Fed sells securities. 2. With excess reserves, the banks increase their lending and the quantity of money increases. 3. With a shortage of reserves, the banks decrease their lending and the quantity of money decreases.
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Chap 26

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