No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 286 CHANGING RESERVE REQUIREMENTS EXTENDED THE GREAT DEPRESSION The U.S. economy finally started recovering from the Great Depression in 1936, but this made the Fed very nervous. Maybe a robust expansion will lead to inflation? Milton Friedman and Anna Schwartz blamed the extension of the Great Depression in the 1937-38 timeframe with the Fed’s decision to double required reserves (see A Monetary History of the United States, 1867-1960 , Ch. 9). The Fed did not intend for the policy change to be contractionary; nevertheless the economy tanked subsequently (after a modest recovery in 1933-1936). Changing reserve requirements is something that needs to be handled with care! The Fed’s final tool is to change the interest rate it charges banks for short-term loans. These loans, which may be used by a bank to meet their reserve requirement, are called discount window loans. Since banks have the ability to borrow excess reserves from other banks, to borrow from the Fed may suggest to the bank’s depositors that the bank cannot borrow from other banks; that is, it may suggest that other banks believe they are too risky to loan money to. If the bank’s depositors believe this, they may withdraw their money and put additional pressure on the bank, which already lacks sufficient reserves. Further, the Fed itself may more closely scrutinize a bank that repeatedly asks for loans. For fear of depositor withdrawals and the Fed’s “frown factor,” most banks tend to avoid borrowing from the Fed. And since most banks don’t borrow much from the Fed, raising the rate of interest on discount window loans doesn’t have too much effect on monetary policy. In a crisis, however, the usual rules are often thrown out the window. During the financial crisis of 2008, many banks did seek Fed help, and many more were encouraged to do so. The Fed didn’t want people to know which banks were “in trouble,” lest that lead to a run on troubled banks, so they lent to them all, forcing even healthy banks that had no need of reserves to borrow from them. And then they forced additional regulations on those healthy banks because they borrowed from them! LOANABLE FUNDS FRAMEWORK To understand how Fed policy affects the economy, we need to have a model of how loan markets work. This is because in our economy, as we’ve shown in chapter 11, new money enters into the economy when debt is created through the banking system as people take out loans. To understand this, take a mental step back and ask, why do people want a loan? The answer, of course, is that they want to buy something today that they don’t have the money for. They don’t have sufficient savings set aside (at least for that purpose). So they are saying to the bank, “I want to consume today, and pay back later. Do you know of someone who wants to consume later that has extra cash available now?” This process of matching borrowers and savers is called financial intermediation. Borrowers want command over resources today, while savers are willing to give up command over resources today in exchange for additional consumption in the future. Financial Discount window: Banks needing additional reserves have the option of borrowing from the Federal Reserve, paying the discount rate. This is referred to as borrowing at the Discount window.