Question

a. Explain the difference between 100-percent-reserve banking and fractional-reserve banking.
b. Suppose that the Federal Reserve wants to increase the money supply in the economy. What is the main channel for the Fed to do this?

Answer 1

a ) Fractional reserve banking is a system in which only a fraction of bank deposits are backed by actual cash on hand and available for withdrawal. This is done to theoretically expand the economy by freeing capital for lending.Full-reserve banking (also known as 100% reserve banking) is a proposed alternative to fractional-reserve banking in which banks would be required to keep the full amount of each depositor's funds in cash, ready for immediate withdrawal on demand.

The fractional reserve advocates, who disagree with the 100-percenters, also base their arguments on free market principles. In a free market, they say, anyone can do what he wants as long as he doesn’t use force against others.

The 100-percenters have shown that the fractional reservers are advocating fraud. The fractional reservers have shown that the 100-percenters advocate force (by legally prohibiting the freedom to issue partially backed notes).

b ) Fed can increase the money supply in following ways -

Reserve ratios. Banks are required to maintain a certain proportion of their deposits as a "reserve" against potential withdrawals. By varying this amount, called the reserve ratio, the Fed controls the quantity of money in circulation. Suppose, for example, it orders banks to hang on to an extra 1 percent of their deposits. They would then have 1 percent less to lend. One percent may not sound like a lot, but it translates into billions of dollars that are siphoned out of the economy.

Discount rate. When banks temporarily overcommit themselves, they occasionally have to borrow from the Fed to secure the necessary funds to meet their reserve requirements. The interest rate charged for these loans is the discount rate, and it too affects the money supply. If the Fed raises the discount rate, banks cannot afford to borrow as heavily as before and have to curtail their lending and raise their own interest rates. That results in less money flowing into the economy. Conversely, if the Fed relaxes its discount rate, financial institutions have more dollars for their customers. Seen from this perspective, the discount rate has a snowball effect: Raising it means that other interest rates go up as well and, other things being equal, economic activity slows down; lowering it has the opposite effect.

Open-market operations. By far the most important of the Fed's activities are open-market operations, the buying and selling of government securities. After Congress approves an increase in the national debt, the Treasury Department prepares a mix of bonds, bills, and notes that it auctions to private dealers who are authorized to trade government securities. When it wants to influence economic activity, the Fed buys or sells these assets through its Federal Open Market Committee (FOMC) or open-market desk, as it is commonly known.The process works this way: If the Fed decides to increase the money supply, its open-market manager buy back treasury securities from private dealers, paying for them by simply crediting their bank accounts