1) Based on the attached article that was written by Kimberly
Amadeo of The Balance, updated March 21, 2018, respond to the
following questions:
a) The money multiplier is the amount of money that banks
generate with each dollar of reserves. What is the formula for the
money multiplier?
b) Explain the following statement made by the author: “The
higher the reserve requirement, the less profit a bank makes with
its money.”
c) The author states, “When the Fed reduces the reserve
requirement, it's exercising expansionary monetary policy.” Explain
why reducing the reserve requirement is expansionary policy.
d) Define both expansionary and contractionary monetary
policy.
e) Explain how the Fed lowers and raises the federal funds
rate.
f) Who makes up the Federal Reserve Board of Governors?
Reserve Requirement and How It Affects Interest Rates
How Banks Lend $9 Out of Every $10 You Deposit
The reserve requirement is the amount of funds a bank must have on
hand each night. It is a percent of the bank's deposits. The
nation's central bank sets the percentage rate.
In the United States, the Federal Reserve Board of Governors
controls the reserve requirement for member banks. The bank can
hold the reserve either as cash in its vault or as a deposit at its
local Federal Reserve bank.
The reserve requirement applies to commercial banks, savings banks,
savings and loan associations, and credit unions.
It also pertains to U.S. branches and agencies of foreign banks,
Edge Act corporations, and agreement corporations.
How It Works
The reserve requirement is the basis for all the Fed's other tools.
If the bank doesn't have enough on hand to meet its reserve, it
borrows from other banks. It may also borrow from the Federal
Reserve discount window. The money banks borrow or lend to each
other to fulfill the reserve requirement is called federal funds.
The interest they charge each other to borrow fed funds is the fed
funds rate. All other interest rates are based on that rate.
The Fed uses these tools to control liquidity in the financial
system. When the Fed reduces the reserve requirement, it's
exercising expansionary monetary policy. That creates more money in
the banking system. When the Fed raises the reserve requirement,
it's executing contractionary policy. That reduces liquidity and
slows economic activity.
The higher the reserve requirement, the less profit a bank makes
with its money. A high requirement is especially hard on small
banks. They don't have much to lend out in the first place. The Fed
has exempted small banks from the requirement. A small bank is one
with less than $15.5 million in deposits.
Changing the reserve requirement is expensive for banks. It forces
them to modify their procedures. As a result, the Fed Board rarely
changes the reserve requirement. Instead, it adjusts the amount of
deposits subject to different reserve requirement ratios.
Reserve Requirement Ratio
On January 18, 2018, the Fed updated its reserve requirement table.
It required that all banks with more than $122.3 million on deposit
maintain a reserve of 10 percent of deposits. Banks with $16
million to $122.3 million must reserve 3 percent of all deposits.
Banks with deposits of $16 million or less don’t have a reserve
requirement.
The Fed raises the deposit level that is subject to the different
ratios reach year. That gives banks an incentive to grow. The Fed
can raise the low reserve tranche and the exemption amount by 80
percent of the increase in deposit in the prior year (June 30-June
30).
Deposits include demand deposits, automatic transfer service
accounts, and NOW accounts. Deposits also include share draft
accounts, telephone or preauthorized transfer accounts, ineligible
banker’s acceptances, and obligations issued by affiliates maturing
in seven days or less.
Banks use the net amount. That means they don't count the amounts
due from other banks and any cash that's still outstanding.
Since December 27, 1990, non-personal time deposits and
eurocurrency liabilities have not required a reserve.
How the Reserve Requirement Affects Interest Rates
Central banks don't adjust the requirement every time they shift
monetary policy. They have many other tools that have the same
effect as changing the reserve requirement. For example, the
Federal Open Market Committee sets a target for the fed funds rate
at its regular meetings. If the fed funds rate is high, it costs
more for banks to lend to each other overnight. That has the same
effect as raising the reserve requirement. Conversely, when the Fed
wants to loosen monetary policy and increase liquidity, it lowers
the fed funds rate target. That makes lending fed funds cheaper. It
has the same effect as lowering the reserve requirement.
The Federal Reserve can't mandate that banks follow its targeted
rate. Instead, it influences the banks’ rates through its open
market operations. The Fed buys securities, usually Treasury notes,
from member banks when it wants the fed funds rate to fall. The Fed
adds credit to the bank's reserve in exchange for the security.
Since the bank wishes to put this extra reserve to work, it will
try to lend it to other banks. Banks cut their interest rates to do
so.
The Fed will sell securities to banks when it wants to increase the
fed funds rate. Banks with less fed funds to lend can raise the fed
funds rate. That how open market operations work.
If a bank can't borrow from other banks, it can borrow from the Fed
itself. That’s called borrowing from the discount window. Most
banks try to avoid this. That's because the Fed charges a discount
rate that's slightly higher than the fed funds rate. It also
stigmatizes the bank. Other banks assume no other bank is willing
to lend to it. They assume the bank has bad loans on its books or
some other risk.
As the fed funds rate rises, these four interest rates also
rise:
1. Libor is the interest rate banks charge each other for
one-month, three-month, six-month and one-year loans. Banks base
their rates for credit cards and adjustable-rate mortgages on
Libor.
2. The prime rate is the rate banks charge their best customers.
Other bank loan rates are a little higher for other customers.
3. Interest rates paid on savings accounts and money market
deposits also increase.
4. Fixed rate mortgages and loans are indirectly influenced.
Investors compare these loans to the yields on longer-term Treasury
notes. A higher fed funds rate can drive Treasury yields a bit
higher.
During the financial crisis, the Fed lowered the fed funds rate to
zero. Banks were still reluctant to lend. The Fed massively
expanded its open market operations with the quantitative easing
program. The Fed also removed some unprofitable mortgage-backed
securities from its member banks.
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