CHAPTER 12

MONEY AND THE BANKING SYSTEM

TEST YOURSELF

 2. With a reserve ratio of 25 percent, the money multiplier is 1/.25, or 4; the money supply would rise by $48 million. With a reserve ratio of 100 percent, the money multiplier is 1/1, or 1; the money supply would rise by $12 million.

DISCUSSION QUESTIONS

2.   Money is defined as whatever a society uses as its medium of exchange. The U.S. money supply is all fiat money. The narrowest definition, M1, includes currency in circulation plus certain demand deposits at banks and savings institutions. A broader definition, M2, includes M1 plus most savings accounts, checking deposits not counted in M1, and shares in money market mutual funds. There are even broader definitions as well.

3.     A fractional reserve banking system is one in which the reserves held by the banks are only a fraction of their deposit liabilities. The banks lend out the rest, in order to earn a return. (If reserve requirements were 100 percent, banks could not make loans with funds that were deposited, and could therefore earn no income—unless the banks actually charged their depositors a fee instead of paying them interest). While the minimum reserve ratio is stipulated by the regulatory agency, banks are permitted to hold excess reserves above the minimum—and the greater the actual reserve ratio they decide upon, the lower the money supply that can be supported with a given amount of reserves. Fractional reserves make banks liable to runs. If people notice other people making withdrawals in large amounts, they may realistically fear that the banks will run out of reserves and go bankrupt, so to avoid losing their savings they take the precaution of withdrawing their own funds, thereby creating the very situation they feared.

6.   Banks are safer when they hold excess reserves, but they have to balance this advantage against the advantage of increasing their lending and thereby raising their interest income and their profits. They may prefer to hold excess reserves if they predict large withdrawals in the future, or if loan demand is slack and they find it difficult to lend out their reserves safely at profitable rates.

7. The Federal Deposit Insurance Corporation insures deposits up to $250,000 and insures noninterest-bearing accounts to an unlimited extent (for December 2010 to December 2012). If the government can sell the assets for only $1.5 billion, then the FDIC must pay the remaining $500 million to the depositors, unless the accounts exceeded the relevant limits at that time. The FDIC funds come from insurance premiums previously paid by the financial institutions. In the crisis of the 1980s, however, these funds were inadequate, and so the $500 million was in all likelihood paid by the U.S. Treasury, out of tax revenues.

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