SOLUTIONS TO SELF-CHECK QUESTIONS

12.1 The Federal Reserve Banking System and Central Banks

Longer terms insulate the Board from political forces. Since the presidency can potentially change every four years, the Federal Reserve’s independence prevents drastic swings in monetary policy with every new administration and allows policy decisions to be made only on economic grounds.

12.2 Bank Regulation

1. Banks make their money from issuing loans and charging interest. The more money that is stored in the bank’s vault, the less is available for lending and the less money the bank stands to make.
2. The fear and uncertainty created by the suggestion that a bank might fail can lead depositors to withdraw their money. If many depositors do this at the same time, the bank may not be able to meet their demands and will, indeed, fail.

12.3 How a Central Bank Executes Monetary Policy

1. The bank has to hold $1,000 in reserves, so when it buys the $500 in bonds, it will have to reduce its loans by $500 to make up the difference. The money supply decreases by the same amount.
2. An increase in reserve requirements would reduce the supply of money, since more money would be held in banks rather than circulating in the economy.

12.4 The Fed’s New Policy Tools

1. 1. Deposit reserves at the Fed; earn IORB.  2. Loan to a bank; earn FFR.  3. Invest in Treasuries; earn current rate.
2. Beginning in 2008 the US banking systems shifted from a limited reserves framework to an ample reserves framework.
3. After 2008 the federal reserve systems asset portfolio changed from holding only U.S. Treasury Securities to holding Mortgage-Backed Securities and Federal Agency Debt Securities along with Treasuries.

12.5 Monetary Policy and Economic Outcomes

1. Contractionary policy reduces the amount of loanable funds in the economy. As with all goods, greater scarcity leads a greater price, so the interest rate, or the price of borrowing money, rises.
2. An increase in the amount of available loanable funds means that there are more people who want to lend. They, therefore, bid the price of borrowing (the interest rate) down.

12.6 Pitfalls for Monetary Policy

1. In times of economic uncertainty, banks may worry that borrowers will lose the ability to repay their loans. They may also fear that a panic is more likely and they will need the excess reserves to meet their obligations.
2. If consumer optimism changes, spending can speed up or slow down. This could also happen in a case where consumers need to buy a large number of items quickly, such as in a situation of national emergency.