Wednesday, November 14 Lecture: The Banking System and the Federal Reserve Board

Transcription

1 Amherst College Economics Department Economics 111 Section 3 Fall 2012 Wednesday, November 14 Lecture: The Banking System and the Federal Reserve Board Banking System The following table is the consolidated balance sheet of the commercial banking system on July 28, 2010 (billions of dollars): Cash 1,260 Deposits 7,780 Loans 6,780 Borrowing 1,980 Securities 2,385 Other liabilities 870 Other assets 1,600 Banks = 1, , , ,600 = 12,025 Banks = 7, , = 10,630 Two Types of Bank Crises: Liquidity and Solvency Liquidity Crisis Because we have a fractional reserve banking system, any bank could potentially have a liquidity crisis. No bank has enough cash on hand to cover all its customers deposits, if the customers wanted to withdraw their deposits at the same time. While a liquidity crisis might create a short run problem for a bank, it is not a long term problem when the banks assets exceed its liabilities. As long as assets exceed liabilities, the bank can eventually sell its assets to obtain the funds needed to cover its liabilities.

2 2 Solvency Crisis: The Recent Financial Crisis in the U. S. As we have seen in the last couple years, a solvency crisis is serious; it occurs whenever a bank s assets fall short of its liabilities; that is, a solvency crisis occurs whenever the bank s net worth is negative: Net Worth = In this case, the bank does not have enough assets to cover all its liabilities; that is, a bank does not have enough assets to pay everything that it owes others. Question: How can a bank get into this situation? Answer: One way to do so is by approving bad loans. To illustrate this, suppose that a bank has given a group of developers a $500 million loan to build an office complex in Belchertown. The assets of the bank reflect this loan: Loans Belchertown developers $500 million The developers spend the $500 million to construct the office complex. While the complex is beautiful, it is essentially empty. There are not enough businesses in Belchertown to support such a large complex. The developers cannot make their loan payments because they were counting on the rental income from the complex to repay the loan. The developers default and the bank now takes possession of the office complex. How is the bank s balance sheet affected? Since the developers have defaulted on the loan, the $500 million loan has disappeared, but now it owns the office complex whose book value is $500 million because $500 million were spent to build the complex: Loans Belchertown developers $500 million Other assets Belchertown office complex $500 million At first glance it looks like everything is fine. Instead of having $500 million of loan assets, the bank has $500 of other assets. But, is the value of the complex really $500 million? No. An office complex is only valuable if office space can be rented out. Since there are few businesses in Belchertown, the complex will be worth far less than the $500 million it took to build it. The complex might only be worth $10 million. Loans Belchertown developers $500 million Other assets Belchertown office complex $500 million Belchertown office complex $10 million As a consequence of the bad loan, the banks assets have fallen by $90 million. This was what happened about years ago in the saving and loan crisis. While there are some differences between banks and saving and loan institutions, the distinction is not important here. Many saving and loans made bad loans, so many bad loans that their assets fell below their liabilities. These saving and loans could not cover all their liabilities. The federal government then stepped in to make good on these liabilities so the saving and loans customers did not lose their deposits. In total, this cost the federal government $200 billion (nearly $1,000 for each American).

3 3 Simplified banking balance sheet To understand how the banking system works, we shall consider the banking system as a whole. That is, we will lump all the banks together as though there was a single bank in the U.S. Note that this is much in the spirit of macroeconomics: in macro we consider the economy as a whole. Also, we shall simplify the balance sheet to include only the crucial items. We have changed the numbers to keep the arithmetic straightforward: RES 50 DEP 400 Vault cash 30 Dep at Fed 20 LOAN 380 BOR 10 What is net worth? Total assets = = 490 Total liabilities = = 410 Net Worth = 80 Recall that we have a fractional reserve banking system. In a fractional reserve banking system, the required reserve ratio is crucial. The Federal Reserve Board is not only the banks bank, but it also regulates banks. The Fed sets the required reserve ratio. This ratio determines how many reserves banks are required to keep. Currently, the required reserve ratio for large commercial banks is 10 percent: Required Reserve Ratio = 10% In general, the banks required reserves equal the required reserve ratio times deposits: Required Required reserves = reserve Deposits ratio What are required reserves in our simplified example? Required Required reserves = reserve Deposits ratio = 10% 400 = 40 The actual reserves are 50 and the required reserves are 40; the actual reserves exceed what is required. The bank has excess reserves of 10. How would the banks respond? Banks earn profits from making loans. Like any firm, banks are interested in profits; consequently, banks will increase loans. By how much? Since actual reserves are 50 and required reserves are 40, what would happen if the bank president issued a memo instructing the loan officer to issue 10 more loans? Suppose that a friend, Sam, walks into a bank and applies for a $10 thousand loan to buy a used car. Since the loan officer has just received the bank president s memo, the officer approves the loan. What would the loan officer do? He/she could walk into the bank s vault take out $10 thousand of cash and give it to Sam. If this occurred, the cash in the bank s vault would fall by 10 and its loans would rise by 10: RES DEP 400 Vault cash 20 30

4 4 Dep at Fed 20 LOAN BOR 10 Sam s loan +10 What are required reserves now? Required Required reserves = reserve Deposits ratio = 10% 400 = 40 If this were all that happened, the story would end here; now, both actual reserves and required reserves are 40. This is not the end of the story, however. What would Sam now do? Would Sam feel comfortable walking down the street with $10 thousand of cash in his pocket? I think not. Before Sam left the bank, he would no doubt go to a teller s window and deposit the $10 thousand in his checking account at the bank. After all, isn t one reason we have checking accounts? A checking account allows us to avoid carrying around large sums of cash. What happens to the balance sheet when Sam deposits the $10 thousand? Sam s deposits rise by 10; hence, deposits rise by 10. Also, the $10 thousand of cash are back in the bank s vault; accordingly, cash in the vault returns to 30 and reserves return to 50. RES 50 DEP Vault cash 30 Sam +10 Dep at Fed 20 LOAN BOR 10 Sam s loan +10 So, let us see what has happened. When the bank issues a new loan: LOAN and DEP have increased by the amount of the new loan; RES are unaffected. In reality, loan officers know that their customers do not like to walk around with large sums of cash. Accordingly, loan officers never go into the bank vault for cash. Instead, when a loan is approved the loan officer simply credits the customer s account with the amount of the loan. For example, the loan officer would simply credit Sam s checking account with the $10 thousand. Sam account balance rises by $10 thousand.

5 5 What are required reserves now? Required Required reserves = reserve Deposits ratio = 10% 410 = 41 The banks actual reserves are 50, their required reserves are 41; the bank has excess reserves of 9. After Sam s loan of 10, the bank still has excess reserves. Since the bank loans provide the banks with profits, the banks will issue more loans. How many additional loans can banks issue? To answer this question, first keep in mind that when a bank issues a new loan: LOAN and DEP have increased by the amount of the new loan; RES are unaffected. Then, consider the following question: Question: With a required reserve ratio of 10% and actual reserves of 50, how many deposits can the bank be liable for? Answer: 500. Therefore LOAN can increase by an additional 90: RES 50 DEP Vault cash 30 Sam +10 Dep at Fed 20 Others +90 LOAN BORRROWING 10 Sam s loan +10 Loans to others +90 Note that when the banks issue the 90 additional loans: LOAN and DEP increase by the amount of the new loans, by 90; LOAN rise from 390 to 480 and DEP rise from 410 to 500; RES are unaffected, RES remain at 50. What are required reserves now? Required Required reserves = reserve Deposits ratio = 10% 500 = 50

6 6 What happens when Sam goes auto dealer and purchases his car. Since the car costs $10 thousand, Sam will write out a check for $10 thousand. Sam hands the check to the dealer and after checking to be certain that Sam has $10,000 in his checking account, the dealer gives Sam the keys. What does the dealer do with Sam s check? The dealer deposits the check at its bank. What happens to the balance of Sam s account and the dealer s account? Sam s account will decline by 10 the dealer s will rise by 10: RES 50 DEP Vault cash 30 Sam Dep at Fed 20 Others +90 Dealer +10 LOAN BORRROWING 10 Sam s loan +10 Loans to others +90 While the transaction, the sale of the car, changes the composition of deposits at the bank (Sam s account balance falls by 10 the dealer s rises by 10), it has not changed the overall level of deposits that remain at 500. Next, what happens when the dealer pays the salesman a $1 thousand commission for selling the car? The dealer will write out a $1 thousand check and hand it to the salesman. What will the salesman do with the check? The salesman will deposit it. When the check is deposited, the salesman s account balance will rise by 1 and the dealer s will fall by 1: RES 50 DEP Vault cash 30 Sam Dep at Fed 20 Others +90 Dealer Salesman +1 LOAN BORRROWING 10 Sam s loan +10 Loans to others +90 Again, we observe that the transactions that occur after the loan has been made will change the composition of bank deposits, but not the overall level of deposits. Summary: When a bank issues a new loan: LOAN and DEP increase by the amount of the new loan; RES are unaffected; Subsequent transactions change the composition of deposits, but not the overall level. To determine how many new loans a bank can issue, ask the following question: Question: With a required reserve ratio of and actual reserves of, how many deposits can the bank be liable for?

7 7 Federal Reserve Board's Policy Tools The U.S. Treasury and the Federal Reserve Board are two different government agencies. The U.S. Treasury is part of the President s cabinet. The Treasury Secretary serves at the pleasure of the President. The President could fire the Treasury Secretary at any time. On the other hand, the Federal Reserve Board is a semi-autonomous government agency. The President nominates members to the Federal Reserve Board and the Senate must confirm them. Once confirmed, however, members of the Federal Reserve Board have a specified term of fourteen years. Unlike the Treasury Secretary, members of the Federal Reserve do not serve at the President s pleasure; the President cannot fire them. This gives the Federal Reserve Board considerable independence. Primarily, the Federal Reserve Board uses three policy tools to control the money supply: Open market operations; Discount rate; Required reserve ratio. In reality, the first tool, open market operations, is the most important tool. Accordingly, we shall focus on it. Open Market Operations The Fed performs an open market purchase whenever it buys or sells a government bonds. Note that the Federal Reserve Board does not issue government bonds. Who issues them? The U.S. Treasury issues government bonds whenever the federal government runs a deficit. When the Fed performs an open market operation, it is buying or selling government bonds that have been issued previously by the U.S. Treasury. To understand how an open market operation affects the banking system we shall use our simplified illustration: RES 50 DEP 500 Vault cash 30 Dep at Fed 20 LOAN 480 BOR 10 Required Reserves =10% x 500 = 50 Actual reserves equal required reserves. Accordingly, banks cannot make any additional loans. Now, suppose that the Federal Reserve Board performs an open market purchase of 5 by buying $5 worth of government bonds from individuals. Suppose that they are purchased from Kate. The Fed gives Kate one of its checks, a Federal Reserve Board check made out for $5. What will Kate do with this check? Kate will deposit the check in her bank account by taking the check to her bank and handing it to the bank teller. What will the bank do with the check? Just as you and I deposit the checks that we receive at our banks, a bank deposits the checks that it receives at its bank. Remember that the bank s bank is the Federal Reserve Board. So, what will happen to the balance sheet? Kate s deposits will rise by 5 and the banks deposits at the Fed will rise by 5:

8 8 RES DEP Vault cash 30 Kate +5 Dep at Fed LOAN 480 BOR 10 Remember that deposits at the Fed are part of the banks reserves. Accordingly, reserves have risen by 5, from 50 to 55. What has happened to required reserves? Deposits have risen by 5 from 500 to 505: Required Required reserves = reserve Deposits ratio = 10% 505 = 50.5 Actual reserves are 55 and required reserves are The banks have excess reserves of 4.5. When a bank has excess reserves what will they do? They will issue more loans. How many additional loans? To address this question we pose the following query: Question: With a required reserve ratio of 10% and actual reserves of 55, how many deposits can the bank be liable for? Answer: 550. Why? 10% x 550 = 55 Claim: The bank can issue 45 additional loans. To understand why, recall that when a bank issues a new loan: LOAN and DEP increase by the amount of the new loan; RES are unaffected; subsequent transactions only change the composition of deposits, not the overall level. So, when 45 additional loans are issued to other parties: LOAN and DEP increase by 45; LOAN increase from 480 to 525 and DEP increase from 505 to 550; RES are unaffected, RES remain at 55. RES DEP Vault cash 30 Kate +5 Dep at Fed Others +45 LOAN BOR 10 Others +45

9 9 Now, what are required reserves? Required Required reserves = reserve Deposits ratio = 10% 550 = 55 Actual reserves equal required reserves. Since there are no excess reserves, banks cannot issue any more new loans. Summary: an open market purchase of 5: actual reserves increase by 5; deposits increase by 50; loans increase by 45. This is referred to as an expansionary monetary policy because the supply of loans has increased. Market for Borrowing and Lending Real Int Rate (%) Investment Component of AE Real Int Rate (%) S S Equ Int Rate D Funds ($) I Investment In the market for borrowing and lending, the supply curve shifts to the right; consequently, the equilibrium interest rate decreases. The lower interest rate makes borrowing less costly; hence, firms will now undertake more investment projects. Now we can understand why the Federal Reserve Board s actions are closely watched. Expansionary monetary policy will increase GDP and hence reduce unemployment.

10 10 C C Investment Component of Aggregate Expenditures Fed pursued a expansionary monetary policy Real interest rate falls Lower real interest rates increase the level of investment. Investment component of aggregate demand shifts up I G I I G NX NX GDP=Y The aggregate expenditures curve shifts down. The equilibrium level of GDP increasess. AE = C + I + G + NX AE = C + I + G + NX

11 11 {LabLink} Open Market Purchase of 5.0 Base New Open Mar Pur GDP 2, ,004.0 Con Pur 1, ,407.4 Inv Pur Govt Pur Net Exp.0.2 Int Rate (%) We have already seen how an open market purchase of 5 affects the banks balance sheet: RES DEP Vault cash 30 Kate +5 Dep at Fed Others +45 LOAN BOR 10 Others +45 The increase in Loan shifts the supply curve for funds to the right: Market for Borrowing and Lending Real Int Rate (%) Investment Component of AE Real Int Rate (%) S S D Funds ($) I Investment The interest rate falls from 12.0 to 10.7 resulting in an increase in investment from to The investment component of aggregate expenditures shifts up causing the aggregate expenditures curve to shift up. GDP increases from 2,000.0 to 2,004.0.

12 12 Reagan Tax Cut Revisited In August, 1981 the President and Congress enacted an approximately 25 percent reduction in individual income tax rates that was phased in over the next three years: 1982: 5 percent reduction 1983: 10 percent reduction 1984: 10 percent reduction Unemp Real Inflation Investment Govt Real Interest Year Rate (%) GDP Rate (%) Pur Pur Rate (%) , , , , , , , , Market for Borrowing and Lending Real Int Rate (%) Investment Component of AE Real Int Rate (%) S S D I Funds ($) Investment The Fed did the opposite of what we just analyzed. It performed an open market sale. This shifted the supply curve in the market for borrowing and lending to the left thereby increasing the interest rate from 4.8 percent to 7.7 percent. A higher interest rate reduced investment the level of investment from 782 to 673.

13 13 Now, let us put all this together. Question: What happened in 1982? Consumption Component of Aggregate Expenditures President and Congress enacted a 5 percent tax cut The tax cut increased DI at each level of Y. Consumption increased at each level of Y. Consumption component of aggregate demand shifts up C I C C Investment Component of Aggregate Expenditures Fed pursued a contractionary monetary policy Real interest rate rose from 4.8% to 7.7% Higher real interest rates reduce the level of investment. Investment component of aggregate demand shifts down Government Component of Aggregate Expenditures Government expenditures rose from 1,371 to 1,395 Government component of aggregate demand shifts up G NX I I G G NX GDP=Y AE = C + I + G + NX AE = C + I + G + NX In net: The aggregate expenditures curve shifts down. The equilibrium level of GDP falls. 5,987

14 14 Question: What happened in 1983? Consumption Component of Aggregate Expenditures: Shifts up as a consequence of the tax cut. Investment Component of Aggregate Expenditures: Shifts up perhaps as a consequence of improved business confidence. Government Component of Aggregate Expenditures: Shifts up as a consequence of increased government purchases. Aggregate Expenditures Curve: Shifts up; hence, GDP increases. Question: What happened in 1984? Consumption Component of Aggregate Expenditures: Shifts up as a consequence of the tax cut. Investment Component of Aggregate Expenditures: Shifts up perhaps as a consequence of improved business confidence. Government Component of Aggregate Expenditures: Shifts up as a consequence of increased government purchases. Aggregate Expenditures Curve: Shifts up; hence, GDP increases.