Microsoft Word - Money, Banking, and Int Finance(scribd).docx

Money, Banking, and International Finance

When banks start lending their excess reserves out as loans, these loans return as deposits,
expanding the money supply, creating the multiple deposit expansion. Consequently, the Fed
can increase the reserve requirement ratio, switching some excess reserves to required reserves.
Money multiplier (1 ÷ rr) increases if the Fed reduces the reserve requirement, and vice
versa. For example, if the required reserve ratio equals 10%, and the Fed buys a $10,000 T-bill
using a Fed check, subsequently, the money supply could potentially expand by $100,000 (or
$10,000 ÷ 0.10). If the Fed lowered the reserve requirement to 5%, and it purchased a $10,000
T-bill, then the money supply can potentially increase to $200,000 (or $10,000 ÷ 0.05). Thus,
the Fed rarely changes the reserve requirements because this tool is too powerful. Small changes
in the reserve requirement could have an enormous impact on the banking system and the
money supply.
Economists and policymakers believe reserve requirements are not an effective monetary
policy tool because the following reasons:

 Changing the reserve requirements is too powerful because small changes in reserve

requirements have a great impact on the money multiplier and the money supply.

 Required reserves impose a cost to the banks because they cannot lend these reserves to

borrowers, and therefore, do not earn interest income on required reserves. Instead, the

reserves sit in a vault as cash or as deposits at the Fed.

 Purpose of reserve requirements is to make deposits safe and maintain a stable banking

system. However, if the majority of the depositors came to their bank to withdraw their

deposits, then the bank would still fail. Unfortunately, the banks hold fewer than 10% of

the deposits as vault cash and/or deposits at the Fed. Thus, reserve requirements would not

prevent bank runs and does not stabilize the banking system. Only deposit insurance can

help prevent bank runs.

 Reserve requirement ratios are components of the money multiplier. Thus, the Fed must

maintain a constant money multiplier and reserve requirements in order for the Fed to

control the money supply. No empirical evidence indicates reserve requirements improve

the stability of the money multiplier. Moreover, banks would still hold reserves to meet

depositors’ withdrawals if a central bank did not impose reserve requirements.

Milton Friedman, a Nobel laureate, suggested the central bank should impose a 100%
reserve requirement on banks. Accordingly, the banks would hold all deposits either at the Fed
and/or vault cash. Banking system could not create multiple deposit expansion, and the money
multiplier would be one. For example, if the Fed purchased a $10,000 T-bill, both the monetary
base and the money supply would expand by exactly $10,000. Consequently, the Fed has
complete control over the money supply with a 100% reserve requirement. Banks would hold all
deposits as reserves, so they could meet depositor’s withdrawals. Moreover, the U.S.
government could eliminate federal deposit insurance and substantially reduce bank regulations.
However, banks could not lend under this system, causing the financial intermediation process