Financial Crisis from 2007 to 2009
I want 250 words writing.
Overview
From our earlier discussion on economic growth, we know that capital formation (generated through investment) is one of the three main pillars for long-run economic growth. The Financial System, introduced in Chapter 8 via the circular flow diagram, is a group of institutions in the economy that helps with this effort. Broadly defined, the role of the Financial System in the economy is to facilitate the movement of money from saving to investment. In the U.S. economy, financial institutions can be categorized as financial markets (bond market, stock market) that directly move funds from lenders (saving) to borrowers (investment), or as financial intermediaries (banks, mutual funds) that indirectly move funds from lenders to borrowers.
This week’s readings, Chapter 12 from the textbook, gives us a brief look at the banking system (a group of financial intermediaries), and its role in creating money for investment in the economy.
Assignment
Consider the financial crisis from 2007 to 2009 which was punctuated with a rash of bank failures occurring up to 2014 in the United States. Also consider the banking regulations which were designed to control the money supply while ensuring the safety of depositors’ funds. One key observation from the past two decades is that while there were several bank failures, these failures did not lead to runs on banks. In fact, if the government took over a failed bank with liabilities (mostly deposits) of $2 billion (for example), it would pay off the depositors, and sells the assets for $1.5 billion.
Why did these failures not lead to runs on banks? And with the specific example, where would the missing $500 million come from to complete the transaction?
Task
1. From Chapter 12, review the banking system and the challenges of money creation (sections 12-3 and 12-4). The power point slides provided may help.
2. As your first post, create a thread addressing the two questions posed above: 1. Why the bank failures did not lead to bank runs? and 2. Given the specific example, where does the missing $500 million come from?. Since the questions are related, a paragraph summarizing your answers should be sufficient.
Additional Details
2. Initial posts should be about 250 words
3. Grading is based on your participation in this discussion. Grading system: 6 points for content, 2 point for participation, and 2 point for timeliness. The grading rubric is available for review through the Grading Information tab below.
Helpful slides are provided in the attachment section
Economics: Principles and Policy
William J. Baumol, Alan S. Blinder, John L. Solow
14th edition
Powerpoint Slides prepared by: Philip Heap, James Madison University
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
in part.
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Part 3
Fiscal and Monetary Policy
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Chapter 12
Money and the Banking System
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
An Opening Quote
[Money] is a machine for doing quickly and commodiously what would be done, though less
quickly and commodiously, without it.
John Stuart Mill
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
The Circular Flow Diagram
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Why are Banks So Heavily Regulated?
• Regulation and deregulation of banks since the 1970s
• Banks regulated for two main reasons
• Allows better control of the money supply
• Concern for safety of depositors
• Run on a bank
• Many depositors withdraw cash from their accounts all at once
• Runs could lead to bank failure, which could spread
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Figure 1 Bank Failures in the United States, 1921–2017
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
The Nature of Money 1 of 4
• Barter versus Monetary Exchange
• Barter
• System of exchange in which people trade one good for another
• Money is not used as an intermediate step
• Requires the double coincidence of wants
• Money
• Greases the wheels of exchange and makes the economy more productive
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
The Nature of Money 2 of 4
• Money and its functions:
• Medium of exchange
• The object or objects used to buy and sell other items such as goods and services
• Unit of account
• Standard unit for quoting prices
• Store of value
• Store wealth from one point in time to another
• Why may money not be a good store of value?
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
The Nature of Money 3 of 4
• What serves as money?
• Cattle, stones, candy bars, cigarettes, woodpecker scalps, porpoise teeth, giraffe tails, cigarettes, large disk shaped boulders
• Commodity money
• An object in use as a medium of exchange that also has a substantial value in alternative nonmonetary uses
• To be useful as a medium of exchange, a commodity must be:
• Easily divisible
• Uniform or readily identifiable quality
• Storable and durable
• High value per unit of volume and weight
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
The Nature of Money 4 of 4
• Commodity money
• Gold and silver
• Fiat money
• Money that is decreed as such by the government
• Little value as a commodity
• Maintains its value as a medium of exchange because
• People have faith that the issuer will stand behind the pieces of printed paper and limit their production
• Evolution of money
• Commodity money → Full-bodied paper money → Partially backed money → Fiat Money
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
How the Quantity of Money is Measured 1 of 2
• Two measures of the money supply:
• M 1: Narrowly defined money supply
• Coins and paper money in circulation
• Traveler’s checks
• Conventional checking accounts and other checkable deposit balances
• M 2: Broadly defined money supply
• M 1
• Money market deposit accounts
• Money market mutual funds
• Savings accounts
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Figure 2 Two Definitions of the Money Supply, Aug 2018
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
How the Quantity of Money is Measured 2 of 2
• Other measures of the money supply:
• M 3 and beyond
• Near moneys
• Liquid assets that are close substitutes for money
• Liquidity – the ease with which it can be converted into cash
• Should we include credit cards in the money supply?
• We will assume that money consists of coins, paper money, and checkable deposits (most of M 1)
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
The Banking System 1 of 6
• How banking began
• Gold used as commodity money
• Gold stored at goldsmiths who issued paper receipts backed by gold
• Clever goldsmiths started lending out “gold”
• Fractional reserve banking system
• A system under which bankers keep only a fraction of deposits as reserves
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
The Banking System 2 of 6
• Three features of a fractional reserve banking system:
1. Bank profitability
• Interest on loans minus interest on deposits
2. Discretion over the money supply
• By lending, banks essentially create money
• Amount of money created depends on how much banks hold in reserve
3. Exposure to runs
• Keep prudent reserves and lend out money carefully
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
The Banking System 3 of 6
• Principles of bank management: Profit vs. Safety
• How do banks maintain a reputation for prudence?
• Maintain a sufficient level of reserves to minimize vulnerability to runs
• Be cautious in making loans and investments since large losses undermine confidence
• Failure during the housing boom of 2003-2006
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
The Banking System 4 of 6
• What government regulations are in place to ensure the safety of the banking system?
• Bank regulations
• Rules designed to ensure depositors’ safety and to control the money supply
• Deposit insurance
• Guarantees that depositors will not lose money even if their bank goes bankrupt
• Federal Deposit Insurance Corporation (F D I C 1933)
• Why might deposit insurance lead to a system that is less safe?
▶ Moral hazard problem
⁃ If insured against consequences of risk people engage in riskier behavior
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
The Banking System 5 of 6
• Another government regulation in place to ensure the safety of the banking system:
• Bank supervision
• Periodic bank examinations
• Tighter regulation since 2006
• Bureau of consumer financial protection
• Mechanism for dealing with potential failure of giant banks
• Limit the kinds and quantities of assets in which banks may invest
▶ Banks can own only limited amounts of common stock
▶ Limits on proprietary trading
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
The Banking System
• One more regulation:
• Reserve requirements
• Minimum amount of reserves required by law
• Proportional to the volume of deposits
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Systemic Risk and the “Too Big to Fail” Doctrine 1 of 2
• Systemic risk
• Risks to the entire system of banks or financial institutions
• Arises because these institutions (large) are linked in many ways
• banks runs spread
• exchanging funds with other banks and non-bank financial institutions
• Systemically important (or “too big to fail”)
• A financial institution that by virtue of its size or interconnectedness, can threaten the entire system if it runs into trouble
• Lehman Brothers and American International Group (A I G)
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Systemic Risk and the “Too Big to Fail” Doctrine 2 of 2
• The Dodd-Frank Act, 2010
• The Fed given powers to supervise systemically important financial institutions
• Tougher regulatory regime than ordinary banks
• New procedure in case of failure
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
The Origins of the Money Supply
• A Banker’s Books
• Asset
• An item of value that an individual or firm owns
• Liability
• An item of value that an individual or firm owes
• Many liabilities are known as debts
• Balance sheet – accounting statement
• Left side: values of all assets
• Right side: values of all liabilities and net worth
• Net worth = Asset – Liabilities
• Assets = Liabilities + Net Worth
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Table 1a Balance Sheet of Bank-a-Mythica, Dec 31, 2018
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 1 of 12
• Suppose someone deposits $100,000 into their checking account. How does that lead to a multiple expansion of the money supply?
• Deposit creation:
• The process by which a fractional reserve banking system turns $1 of bank reserves into several dollars of bank deposits
• Assume the required reserve ratio is 20%. How much excess reserves does the bank have?
• Excess reserves are reserves held in excess of the legal minimum
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Table 1b Balance Sheet of Bank-a-Mythica, Dec 31, 2018
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 2 of 12
• We will use a T Account to trace the $100,000 checking deposit
• Shows changes in balance sheets rather than the balance sheets themselves
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Table 2 Changes in Bank-a-Mythica’s Balance Sheet, January 2, 2019
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
Table 3 Changes in Bank-a-Mythica’s Balance Sheet, January 3–6, 2019
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
Table 4 Changes in Bank-a-Mythica’s Balance Sheet, January 2–6, 2019
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 3 of 12
• What we have so far:
• $100,000 less in cash
• $100,000 more in checkable deposits
• $80,000 loan so new cash in circulation
• So money supply up by $80,000
• What happens when that $80,000 is deposited into a different bank: First National Bank?
• First National bank has excess reserves
• It lends out those reserves, which get deposited at Second National Bank
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Table 5 Changes in First National Bank’s Balance Sheet
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Table 6 Changes in Second National Bank’s Balance Sheet
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 4 of 12
• We could go on to the Third National Bank, Fourth, Fifth . . .
• When does it end?
• Assumptions
• Each bank holds exactly 20% required reserves
• Each loan recipient redeposits entire proceeds into the next bank
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
Figure 3 The Chain of Multiple Deposit Creation
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 5 of 12
• Suppose someone deposits $100,000 into their checking account. How does that lead to a multiple expansion of the money supply?
• Putting it all together:
• Initial deposit of $100,000 in cash
• Led to $500,000 in new deposits
• Money supply rises by $400,000
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 6 of 12
• The math behind expansion of the money supply:
• Each column forms a geometric progression
• In the last figure, each entry is 80% of the previous entry or 20% less
• From before we learned:
▶ 1 + R + R2 + . . . = 1 / (1 – R)
• Applying this to the $100,000 initial deposit:
▶ $100,000 + $80,000 + $64,000 + $51,200 +. . .
▶ = $100,000 x (1 + 0.80 + 0.802 + 0.803 + . . .)
▶ = $100,000 x 1/(1 – 0.80)
▶ = $500,000 in new deposits
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 7 of 12
• In general
• If the required reserve ratio = m
• Deposit multiplier = 1/m
• Banking system can convert each $1 of reserves into $1/m in new deposits
• Oversimplified Deposit Multiplier
• Ratio of newly created bank deposits to new reserves
• Change in deposits = (1/m) ˣ change in reserves
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 8 of 12
• Oversimplified Deposit Multiplier
• Ratio of newly created bank deposits to new reserves
• Change in deposits = (1/m) ˣ change in reserves
• Our example:
• m = 20%
• Change in reserves: $100,000
• Change in deposits = (1/0.20) x $100,000
• = $500,000
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition
Banks and Deposit Creation 9 of 12
• What has happened to to the money supply?
• Cash: – $100,000
• Deposits created: + $500,000
• Money supply: + $400,000
• What happens if someone withdraws $100,000 from Bank A Mythica?
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Table 7 Changes in the Balance Sheet of Bank-a- Mythica
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 10 of 12
• At Bank Mythica:
• Loses $100,000 in checkable deposits
• Required reserves fall by $20,000
• Actual reserves fall by $100,000
• Excess reserves short by -$80,000
• Outstanding loans paid off and no new loans until bank has accumulated enough reserves
• Where did the borrowers get the money to pay off the loans?
• They made withdrawals from other banks: First National
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Table 8 Changes in the Balance Sheet of First National Bank
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
• At First National Bank:
• Loses $80,000 in checkable deposits
• Required reserves fall by $16,000
• Actual reserves fall by $80,000
• Excess reserves short by -$64,000
• Outstanding loans paid off until bank has accumulated enough reserves
• And the process continues:
• Change in deposits = -$100,000 – $80,000 – $64,000 – . . .
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Banks and Deposit Creation 12 of 12
• What is the overall effect?
• Deposits: -$500,000
• = (1/ 0.20) x – $100,000
• Loans: -$400,000
• Reserves: -$100,000
• Money supply: -$400,000
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Why the Deposit-Creation Formula Is Oversimplified
• Our money multiplier only accurate under two circumstances
• Every recipient of cash must redeposit cash to another bank rather than hold it
• Every bank must hold reserves no larger than the legal minimum
• What happens if individuals and business firms hold more cash?
• Fewer dollars of cash available for use as reserves
• Limits the multiple expansion of bank deposits
• Smaller money supply
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Figure 3 Chain of Multiple Deposit Creation
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Why the Deposit-Creation Formula Is Oversimplified 1 of 3
• What happens if individuals and business firms hold more cash?
• Fewer dollars of cash available for use as reserves
• Limits the multiple expansion of bank deposits
• Smaller increase in the money supply
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Why the Deposit-Creation Formula Is Oversimplified 2 of 3
• What happens if banks decide to hold on to some excess reserves?
• Limited multiple expansion of bank deposits
• Smaller supply of money
• Excess reserves after September 2008
• Failure of Lehman Brother led to financial panic
• Banks held excess reserves at a massive scale
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Figure 4 Excess Reserves in the U.S. Banking System, 2008–2018
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
Why the Deposit-Creation Formula Is Oversimplified 3 of 3
• Excess reserves after September 2008
• From $2 billion to $267 billion by October 2008, $800 billion by January 2009.
• Currently at $1.9 trillion
• 10 fold increase in excess reserves, but M1 less than tripled
• Banks holding on to excess reserves reduces the multiplier effect
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
The Need for Monetary Policy 1 of 2
• Government regulates money supply to maintain stability
• During a recession
• Banks prone to reduce money supply
• Increase excess reserves
• Decrease lending to less creditworthy applicants
• Without government intervention contraction in money supply would aggravate recession
• Federal Reserves during the Great Depression
• and the recent financial crisis and Great Recession
Baumol, Blinder and Solow, Economics: Principles and Policy, 14th Edition.
The Need for Monetary Policy 2 of 2
• During an economic boom
• Banks expand money supply
• Undesirable momentum to economy
• Without government intervention rapid money growth could lead to inflation