Final Exam Notes.docx - Final Exam Notes Chapter 17 Business of Banking Banks do not print money but their actions affect the total money supply Basic

Final Exam Notes.docx - Final Exam Notes Chapter 17...

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Final Exam Notes Chapter 17 Business of Banking
This country has Federal Reserve Banking o Banks Only hold a fraction of deposits on reserve o Typically, banks only keep 10% on reserve, meaning 90% of deposits are used up and not there. Holding reserves is costly (foregone profit) o Before 2008, reserves earned no interest o The opportunity cost of holding reserves is the interest payments on loans Reasons banks hold reserves: 1.To accommodate customer withdrawals 2. Requirements by Federal Reserve Required Reserve Ratio (rr): proportion of deposits banks are required to keep on reserve The current rr is 10% Bank Run: o Many depositors attempt to withdraw funds from a bank at one time o May end with bank in default since virtually no bank can sustain significant deposit outflow The dollar amount of Required Reserves: o Required reserves = rr * deposits Excessive reserves o Reserves over the required level o Generally small (again, its costly to hold them!) o Excess reserves = total reserves – required reserves Example: 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= 130,000 Moral Hazard and the FDIC – Creates more Risky Behavior because Deposits are Insured by the Federal Government o Is the reserve requirement necessary? o Need to satisfy deposit withdrawals. o Bank run would ruin the bank. o But 10% is not enough during the bank run! o Federal Deposit Insurance Corporation (FDIC) o Government program that insures your bank deposits o Goal: increase bank stability, decrease bank runs o Before FDIC: 9,000 bank failures from 1929 to 1933 o Created moral hazard situation Moral hazard: lack of an incentives to guard against risk o Moral Hazard: Example o Type A banks Conservative, no risk, earn low returns on their loans Almost never fail, but not very profitable
o Type B banks Take big risks in hopes of earning big returns Fail often, but the surviving ones pay huge returns Even if the bank fails, deposits are insured by the FDIC How Banks Create Money o The money supply includes both currency and deposits o Even though banks can’t print currency, they do create money o This is because of fractional reserve banking o Banks lend out reserves and their lending ability is what creates most of money.

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