This country has Federal Reserve BankingoBanks Only hold a fraction of deposits on reserveoTypically, banks only keep 10% on reserve, meaning 90% of deposits are used up and not there.Holding reserves is costly (foregone profit)oBefore 2008, reserves earned no interestoThe opportunity cost of holding reserves is the interest payments on loansReasons banks hold reserves:1.To accommodate customer withdrawals 2. Requirements by Federal ReserveRequired Reserve Ratio(rr): proportion of deposits banks are required to keep on reserveThe current rris 10%Bank Run: oMany depositors attempt to withdraw funds from a bank at one timeoMay end with bank in default since virtually no bank can sustain significant deposit outflowThe dollar amount of Required Reserves: oRequired reserves = rr * deposits Excessive reservesoReserves over the required leveloGenerally small (again, its costly to hold them!)oExcess reserves = total reserves – required reservesExample: A bank has $1 million in deposits and required reserve ratio is 12%. It also has excess reserves of $10,000…. So, $1,000,000 * .12= 120,000, 120,000 + 10,000= 130,000Moral Hazard and the FDIC – Creates more Risky Behaviorbecause Deposits are Insured by the Federal GovernmentoIs the reserve requirement necessary?oNeed to satisfy deposit withdrawals.oBank run would ruin the bank.oBut 10% is not enough during the bank run!oFederal Deposit Insurance Corporation (FDIC)oGovernment program that insures your bank depositsoGoal: increase bank stability, decrease bank runsoBefore FDIC: 9,000 bank failures from 1929 to 1933oCreated moral hazard situationMoral hazard: lack of an incentives to guard against riskoMoral Hazard: ExampleoType A banksConservative, no risk, earn low returns on their loansAlmost never fail, but not very profitable
oType B banksTake big risks in hopes of earning big returnsFail often, but the surviving ones pay huge returnsEven if the bank fails, deposits are insured by the FDICHow Banks Create MoneyoThe money supply includes both currency and depositsoEven though banks can’t print currency, they do create moneyoThis is because of fractional reserve bankingoBanks lend out reserves and their lending ability is what creates most of money.