Monetary Policy and Bank Regulation

Bank Regulations

• Bank regulation is intended to maintain the solvency of banks by avoiding excessive risk

• Regulation falls into several categories, including:

  • Reserve requirements

  • Capital requirements

  • Restrictions on the types of investments banks may make

reserve requirements

most are held at the Fed to cover withdrawals by depositors

capital requirements

banks are required to maintain a minimum net worth, usually expressed as a % of their assets, to protect their depositors and other creditors

Restrictions on investments

loans to businesses, individuals, and other banks are OK, purchasing US treasury securities is OK; investing in stock market is NOT

bank run

when depositors race to the bank to withdraw their deposits for fear that otherwise they would be lost (example: scene from It’s a Wonderful Life); bank runs during the Great Depression only served to worsen the economic situation

deposit insurance

an insurance system that makes sure depositors in a bank do not lose their money, even if the bank goes bankrupt; about 70 countries in the world have deposit insurance; banks pay an insurance premium to the FDIC; “FDIC‐ insured” ‐> up to $250k in each eligible account

lender of last resort

An institution that provides short‐term emergency loans in conditions of financial crisis to lend money to banks and other financial institutions when they cannot obtain funds from anywhere else (the Fed)

how a bank operates (monetary)

• A central bank has 3 traditional tools to implement monetary policy in the economy:

  • Open market operations

  • Changing reserve requirements

  • Changing the discount rate

open market operations

• Most common tool of monetary policy

• takes place when the central bank sells or buys US Treasury bonds in order to influence the quantity of bank reserves and the level of interest rates

• The specific interest rate charged is the federal funds rate; a very short‐term interest rate, but one that reflects credit conditions in the financial markets very well

• The Federal Open Market Committee (FOMC) makes the decisions regarding these open market operations; made up of the 7 members of the Fed ‘s Board of Governors plus 5 voting members drawn from the regional Fed Reserve banks

federal funds rate

the interest rate charged by commercial banks making overnight loans to other banks

Changing Reserve Requirements

• If banks are required to hold a greater amount in reserves, they have less money available to lend; if banks are allowed to hold a smaller amount in reserves, they will have a greater amount of money available to lend out

• Small changes are made almost every year; in practice, large changes in reserve requirements are rarely used to execute monetary policy →disruptive, difficult to manage

reserve requirement

the % of each bank’s deposits that it is legally required to hold either as cash in their vault or on deposit with the central bank

Changing the Discount Rate

• If the central bank raises the discount rate, then commercial banks will reduce their borrowing of reserves from the Fed, and instead all in loans to replace those reserves. Since fewer loans are available, the money supply falls and market interest rates rise.

• If the central bank lowers the discount rate it charges to banks, the process works in reverse.

• In recent decades, the Fed has made relatively few discount loans; the banks are expected to first borrow from other available sources ‐> changing the discount rate does little to change behavior

discount rate

the interest rate charged by the central bank on the loans that it gives to other commercial banks

Expansionary monetary policy (aka loose monetary policy)

monetary policy that lowers interest rates and stimulates borrowing

Contractionary monetary policy (aka tight monetary policy)

monetary policy that raises interest rates and reduces borrowing in the economy

effect of monetary policy

• Monetary policy affects interest rates and the available of quantity of loanable funds, which in turn affects several components of aggregate demand.

• Tight or contractionary monetary policy that leads to higher interest rates and a reduced quantity of loanable funds will REDUCE two components of aggregate demand:

  • Business investment will decline because it is less attractive for firms to borrow money; with higher interest rates, it is relatively more attractive to put those funds in a financial investment than to make an investment in physical capital

    • Higher interest rates will discourage consumer borrowing for big‐ticket items like houses and cards

• Loose or expansionary monetary policy that leads to lower interest rates and a higher quantity of loanable funds ‐> increase business investment and consumer borrowing for big‐ticket items

countercyclical

it should act to counterbalance the business cycles of economic downturns and upswings

quantitative easing

the purchase of long‐term government and private mortgage‐backed securities by central banks to make credit available so as to stimulate aggregate demand

velocity of money

the speed with which money circulates through the economy; calculated as the nominal GDP divided by the money supply

B

What is the main purpose of the Federal Reserve’s open market operations?
A. To adjust tax rates
B. To influence bank reserves and interest rates
C. To regulate stock market behavior
D. To set government spending limits

B

Which of the following is NOT one of the Fed’s three main responsibilities?
A. Conducting monetary policy
B. Regulating private insurance companies
C. Providing services to commercial banks
D. Promoting financial system stability

B

Who currently serves as the Chair of the Federal Reserve (as mentioned in the notes)?
A. Janet Yellen
B. Jerome Powell
C. Scott Bessent
D. Alan Greenspan

C

What is the role of the Federal Open Market Committee (FOMC)?
A. To manage consumer loans
B. To supervise credit unions
C. To make decisions on open market operations
D. To set the reserve requirement

C

What happens if the Fed increases the reserve requirement?
A. Banks have more to lend
B. Inflation will rise immediately
C. Banks have less to lend
D. Interest rates drop

C

Which of the following is a risk of using monetary policy?
A. It changes consumer tastes
B. It takes immediate effect
C. Banks may hold excess reserves
D. It requires Congressional approval

B

What is the discount rate?
A. The rate banks charge each other for credit
B. The rate charged by the Fed to commercial banks
C. The interest rate on savings accounts
D. The average tax rate

C

What does contractionary monetary policy aim to do?
A. Decrease interest rates
B. Increase GDP growth
C. Raise interest rates and reduce borrowing
D. Expand consumer credit

C

What is “quantitative easing”?
A. Raising taxes to fight inflation
B. Lowering the reserve requirement
C. Purchasing long-term securities to stimulate demand
D. Selling foreign currency to stabilize exchange rates

D

What happens when the Fed uses expansionary monetary policy?
A. Aggregate demand shifts left
B. Loanable funds become scarcer
C. Interest rates rise
D. Borrowing and investment increase