Page 331 - Krugmans Economics for AP Text Book_Neat

Section 5 Summary

12. Banks have sometimes been subject to bank runs, most shares, and purchased private debt. Because much of
notably in the early 1930s. To avert this danger, deposi- the crisis originated in nontraditional bank institu-
tors are now protected by deposit insurance, bank tions, the crisis of 2008 raised the question of whether a
owners face capital requirements that reduce the incen- wider safety net and broader regulation were needed in
tive to make overly risky loans with depositors’ funds, the financial sector.
and banks must satisfy reserve requirements, a legally 19. The monetary base is controlled by the Federal Reserve,
mandated required reserve ratio. the central bank of the United States. The Fed regu-
13. When currency is deposited in a bank, it starts a multi- lates banks and sets reserve requirements. To meet
plier process in which banks lend out excess reserves, those requirements, banks borrow and lend reserves in
leading to an increase in the money supply—so banks the federal funds market at the federal funds rate.
create money. If the entire money supply consisted of Through the discount window facility, banks can bor-
checkable bank deposits, the money supply would be row from the Fed at the discount rate.
equal to the value of reserves divided by the reserve 20. Open -market operations by the Fed are the principal
ratio. In reality, much of the monetary base consists of tool of monetary policy: the Fed can increase or reduce
currency in circulation, and the money multiplier is the monetary base by buying U.S. Treasury bills from
the ratio of the money supply to the monetary base. banks or selling U.S. Treasury bills to banks.
14. In response to the Panic of 1907, the Fed was created to 21. The money demand curve arises from a trade -off be-
centralize holding of reserves, inspect banks’ books, and tween the opportunity cost of holding money and the
make the money supply sufficiently responsive to vary- liquidity that money provides. The opportunity cost of
ing economic conditions. holding money depends on short -term interest rates,
15. The Great Depression sparked widespread bank runs not long -term interest rates. Changes in the aggregate
in the early 1930s, which greatly worsened and length- price level, real GDP, technology, and institutions shift
ened the depth of the Depression. Federal deposit insur- the money demand curve.
ance was created, and the government recapitalized 22. According to the liquidity preference model of the in-
banks by lending to them and by buying shares of terest rate, the interest rate is determined in the money
banks. By 1933, banks had been separated into two market by the money demand curve and the money
categories: commercial (covered by deposit insurance) supply curve. The Federal Reserve can change the inter-
and investment (not covered). Public acceptance of de- est rate in the short run by shifting the money supply
posit insurance finally stopped the bank runs of the curve. In practice, the Fed uses open -market operations
Great Depression. to achieve a target federal funds rate, which other short-
16. The savings and loan (thrift) crisis of the 1980s term interest rates generally follow.
arose because insufficiently regulated S&Ls engaged in 23. The hypothetical loanable funds market shows how
overly risky speculation and incurred huge losses. De- loans from savers are allocated among borrowers with
positors in failed S&Ls were compensated with taxpayer investment spending projects. In equilibrium, only
funds because they were covered by deposit insurance. those projects with a rate of return greater than or
However, the crisis caused steep losses in the financial equal to the equilibrium interest rate will be funded. By
and real estate sectors, resulting in a recession in the showing how gains from trade between lenders and bor-
early 1990s. rowers are maximized, the loanable funds market shows
17. During the mid -1990s, the hedge fund LTCM used why a well -functioning financial system leads to greater
huge amounts of leverage to speculate in global finan- long -run economic growth. Government budget deficits
cial markets, incurred massive losses, and collapsed. can raise the interest rate and can lead to crowding out
LTCM was so large that, in selling assets to cover its of investment spending. Changes in perceived business
losses, it caused balance sheet effects for firms around opportunities and in government borrowing shift the
the world, leading to the prospect of a vicious cycle of demand curve for loanable funds; changes in private
deleveraging. As a result, credit markets around the savings and capital inflows shift the supply curve.
world froze. The New York Fed coordinated a private 24. Because neither borrowers nor lenders can know the fu-
bailout of LTCM and revived world credit markets. ture inflation rate, loans specify a nominal interest rate
18. Sub prime lending during the U.S. housing bubble of rather than a real interest rate. For a given expected fu-
the mid -2000s spread through the financial system via ture inflation rate, shifts of the demand and supply
securitization. When the bubble burst, massive losses curves of loanable funds result in changes in the under-
by banks and nonbank financial institutions led to lying real interest rate, leading to changes in the nomi-
widespread collapse in the financial system. To prevent nal interest rate. According to the Fisher effect, an
another Great Depression, the Fed and the U.S. Treas- increase in expected future inflation raises the nominal
ury expanded lending to bank and nonbank institu- interest rate one-to-one so that the expected real inter-
tions, provided capital through the purchase of bank est rate remains unchanged.

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