Part I
Consider a world in which there is no currency and depository institutions issue only checkable deposits and desire to hold no excess reserves. The required reserve ratio is 20 percent. The central bank sells $1 billion in government securities. What happens to the money supply? Give reasons to support your answer.
Part II
Some economists argue in favor of abolishing the government-sponsored deposit insurance.
Do you agree or disagree with this argument? Write a well-reasoned argument defending your stance.
If deposit insurance were abolished, explain how would this change the incentive structure facing depository institutions?
I) The money multiplier is 1/rr. In this proplem 1/.2=5. (For more info on the money multiplier, see www.wikipedia.org/wiki/Money_creation#Money_multiplier)
Since the central bank is selling securities, the public is buying using their demand deposits. I say the money supply goes down by $5B.
II) Take a shot, what do you think. (hint: strong arguments can be made for both keeping the insurance and eliminating the insurance. You may need to do a little research)
Part I:
In order to understand the impact of the central bank selling $1 billion in government securities on the money supply, we need to consider the relationship between these actions and the banking system's behavior.
When the central bank sells government securities, it reduces the reserves held by depository institutions. In a world without currency, the only form of money is checkable deposits, which are held by these institutions. The required reserve ratio is the percentage of checkable deposits that banks must keep as reserves and not lend out.
So, if the required reserve ratio is 20 percent and the central bank sells $1 billion in securities, the banks' reserves will decrease by 20 percent of that amount, which is $200 million (20% × $1 billion).
Now let's look at the impact on the money supply. The money supply is determined by the supply of money in the economy, which includes both the currency in circulation and the checkable deposits held by individuals and institutions. Since there is no currency in this scenario, the checkable deposits represent the entirety of the money supply.
When the central bank sells government securities, it reduces the reserves of the depository institutions. This reduction in reserves reduces the ability of banks to extend new loans. As a result, the money supply contracts by a multiple of the reduction in reserves. This is due to the money multiplier effect, which magnifies the impact of changes in reserves on the money supply.
The money multiplier is calculated as the reciprocal of the reserve requirement ratio. In this case, with a reserve requirement ratio of 20 percent, the money multiplier would be 1/0.20, which is 5. This means that a $200 million reduction in reserves can lead to a decrease in the money supply by $200 million multiplied by the money multiplier of 5, which equals $1 billion.
Therefore, in this scenario, the selling of $1 billion in government securities by the central bank would lead to a contraction of the money supply by $1 billion.
Part II:
The argument for abolishing government-sponsored deposit insurance is a complex one, with valid points on both sides. Let's consider and discuss some of the arguments in favor of this perspective.
One argument in favor of abolishing deposit insurance is the idea of moral hazard. Deposit insurance guarantees that depositors' funds will be protected in the event of a bank failure. However, this guarantee can create a moral hazard problem as it incentivizes depositors to take excessive risks without fully considering the reliability and stability of the banks they choose to deposit with. In other words, depositors may be less inclined to carefully assess the riskiness of a bank if they know their deposits are insured.
Additionally, the presence of deposit insurance can distort the free market by providing an implicit subsidy to insured banks. If banks know that they are protected by insurance, they may take on more risk or engage in imprudent lending practices, knowing that potential losses will be covered by the government. This can lead to misallocation of resources and an inefficient allocation of credit.
Moreover, the costs associated with deposit insurance are ultimately borne by taxpayers. Insuring deposits requires funding from the government or a dedicated agency, which relies on taxpayer money. In instances where deposit insurance is poorly managed or abused, taxpayers can end up shouldering the burden of banks' failures. This redistribution of wealth can be seen as unfair, as it forces responsible taxpayers to bear the costs of others' poor decisions.
If deposit insurance were abolished, the incentive structure facing depository institutions would change significantly. Without the safety net of insurance, banks would need to be more cautious in their lending practices and risk management. They would have to prioritize the stability and reliability of their operations to maintain customer trust and attract deposits. In this scenario, depositors would likely be more vigilant and selective about where they put their money, favoring institutions with better financial health and track records.
However, it's crucial to consider the potential drawbacks and risks of abolishing deposit insurance. The absence of such insurance could lead to increased depositor runs on banks during times of financial distress, as people may rush to withdraw their funds out of fear of losing them. This could amplify systemic risks and jeopardize the stability of the banking system as a whole. Confidence in the banking system is crucial for economic stability, and without deposit insurance, the likelihood of bank runs and financial panics may increase.
Ultimately, whether one agrees or disagrees with abolishing deposit insurance depends on weighing these various considerations and the specific context of the financial system in question. There are arguments for and against deposit insurance, and policymakers must carefully evaluate the trade-offs and potential consequences before making any significant changes.