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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.