Question

Question 5 includes two of the DISCUSSION QUESTIONS from chapters 10-13 in the Baumol and Blinder text book.

            a. What is fractional reserve banking, and why is it the key to bank profits? Why   

                 does fractional reserve banking give bankers discretion over how large the

                 money supply will be? Why does it make banks potentially vulnerable to runs?

b. From 2003 to 2011, the federal government’s budget deficit rose sharply

                because of tax cuts and increased spending. If the Federal Reserve wanted to

                maintain the same level of aggregate demand in the face of large increases in

                the budget deficit, what should it have done? What would you expect to happen

                to interest rates?

Answer 1

a)

Banks can create credit in money market, but it depends on fractional reserve system. Banks can not create money if they are mandated to keep 100 percent reserve. Under fractional reserve system, banks keep certain percent of deposit as reserve and lend out rest of amount. Thus, in this way, bank creates money supply. It generates profit for banks.

Banks do not keep full amount of deposit as reserve or there is shortage of liquidity. If all customers reach to withdraw their amount, banks can not honor it. So bank run would lead to failure of bank.

b)

Government increased its spending significantly during the economic crisis. It pushed up aggregate demand as well. In order to reduce the Aggregate demand in economy. Central bank must follow the contractionary monetary policy. Fed will reduce money supply, Fall in money supply will cause rise in interest rate in market. So eventually, private spending will fall. It will drive down aggregate demand to previous level.