Download 22 - The Citadel

22. Lender of Last Resort
48. Discuss how the Fed can prevent a loss of business confidence from causing
self-fulfilling expectations. Give the advantages and disadvantages of two
approaches.
45. Discuss the advantages and disadvantages of a central bank.
46. Given the consequences of a loss in business confidence for factors
influencing the money multiplier, be able to calculate the change in base
money necessary to keep the money supply on target. Be able to determine
exactly what the Fed must do to cause the necessary change in base money.
Lender of Last Resort
One important benefit of a central bank like the Fed is that it can
prevent a loss of business confidence from causing self-fulfilling
expectations by acting as lender of last resort. That implies that the
Federal Reserve can serve as a substitute for deposit insurance.
The Fed can act as a lender of last resort in two ways.
It can either
increase advances or make open market purchases.
To increase advances, the Fed decreases the discount rate so that banks
find it more attractive to borrow. The Fed creates new reserves out of thin
air and lends them to the banks by crediting their reserve accounts. The
result is an increase in base money equal to the additional amount the Fed
lends.
The advantage of increasing advances is that the newly-created reserves
are lent to the banks that have reserve deficiencies.
The disadvantage of using advances is that banks might not want to borrow
reserves from the Fed when they expect business losses, increased
bankruptcies, and layoffs. They may prefer to contract loans causing a
multiple contraction in the supply of money and credit.
To use open market purchases, the Fed purchases T-bills. It creates the
funds to pay for the T-bills out of thin air. The Fed credits the reserve
accounts of the sellers' banks. Base money increases by the market value of
the T-bills the Fed purchases.
The advantage of using open market purchases is that the Fed can always
buy T-bills from someone, even when banks are not interested in borrowing at
the discount window. So the Fed can create all the reserves banks want to
hold and all the currency the public wants to hold "out of thin air".
The disadvantage of open market purchases is that the reserves don't
immediately go to the banks that have a reserve deficiency. But as banks with
excess reserves buy money market instruments and banks with reserve
deficiencies
sell money market instruments, the newly-created reserves will rapidly move to
the banks with reserve deficiencies.
Since the Fed is creating new base money by increasing advances or open
market purchases, the banks can all increase their economic reserve ratios and
members of the nonbanking public can hold more currency without causing a
reserve deficiency in the banking system. Even though there is a loss of
business confidence, there is no multiple contraction in the supply of money
and credit and liquidity crunch. Financial panic and recession can be
avoided. If the Fed acts as lender of last resort, expecting business losses,
bankruptcies, and lay-offs doesn't necessarily cause business losses,
bankruptcies, and lay-offs.
Further Benefit of the Fed
Even if the banking system is reasonably stable, the Federal Reserve can
cause changes in the money supply aimed at stabilizing real income and the
price level. It can try to offset shocks to velocity--either shocks to money
demand or real expenditures. If it does so correctly, these shocks will be
offset without any adverse effect on spending, real income, or the price
level.
Possible Disadvantage of the Fed
A possible disadvantage of the Fed is that it might fail to make advances
or open market purchases in a financial panic. Failure by the Fed to act as
"lender of last resort" implies that reserve deficiencies lead to financial
panic, liquidity crunch and recession or depression. Since private solutions
to financial panic disappear when the banking system comes to depend on the
Fed, the result of mistakes by the Fed can be worse than if the Fed didn't
even exist!
The Fed's Great Failure: The Great Depression
During the 1930's, bank runs developed all over the United States. In the
past, the New York Clearinghouse would have suspended cash payments,
moderating the problem. But the US had a central bank, so the Secretary of
the Treasury prohibited a suspension of cash payments. The Fed was supposed
to freely advance reserves and make open market purchases.
The Fed did advance reserves to member banks that suffered runs. But the
Fed's attitude about nonmember banks was "tough, let them fail." This would
have made little difference if the Fed had made sufficient open market
purchases. It could have created enough reserves to cover all the withdrawals
of Federal Reserve notes by the public. The Fed did make some open market
purchases, but not enough.
The bank runs resulted in a multiple contraction in the supply of credit
and money. The money supply fell about 30% during the early 1930's. Because
the Fed failed to take the appropriate action, the result was the Great
Depression.
Major Danger of the Federal Reserve system
The major disadvantage of the Fed is that it can cause inflation. Often
this is because of pressure by the government to serve as fiscal agent and
help finance a budget deficit.
When the government has a budget deficit, it finances its budget deficit
by selling bonds, including T-bills.
Sometimes the government puts pressure on the Fed to make open market
purchases. This increases the demand for T-bills, allowing the government can
finance its budget deficit at a lower interest rate.
But the open market purchases imply that new reserves are created "out of
thin air". Assuming this isn't necessary because of a loss of business
confidence, the resulting increase the quantity of reserves creates excess
reserves in the banking system. This causes a multiple expansion in the
supply of credit and money. If the supply of money grows more rapidly than
the demand for money, the result is inflation.
Final Disadvantage of the Fed
Even if the Federal Reserve tries to act as lender of last resort and
avoids pressure to finance the budget deficit by creating excessive money, it
might still make mistakes. The Fed might change in the money supply in the
false belief that it is offsetting a change in velocity. If no change in
velocity exists, then the Fed would cause an undesirable change in real income
and the price level because of its error.