Why might deposit insurance mechanisms (like the FDIC) encourage banks to take o

Question

Why might deposit insurance mechanisms (like the FDIC) encourage banks to take on too much risk? Is deposit insurance, then, a bad idea? Briefly explain.

List and fully explain three (3) of the tools available to the Fed to engage in monetary policy, as presented in class.

Use the AD-AS model to make the case for “non-activist” monetary policy when it comes restoring the economy to full employment after a negative demand shock. Important: For full credit, make sure to briefly explain in words what your graph is showing. Hint: How will the self-adjustment process happen?

Explanation / Answer

1) FDIC creates a problem of moral hazard in banks. This problem can be described as the possibility of dishonest or otherwise inappropriate behavior in situations where behavior is imperfectly monitored.

The problem of moral hazard is particularly associated with the insurance market. Here an insured person has an incentive to initiate actions that are harmful to the product insured simply because they are insured. Banks, knowing that they are backed by FDIC indulge in risky behaviour as they have a clear incentive to do so. The introduction of FDIC was not a bad idea. The Banking Act of 1933, through an amendment made to the Federal Reserve Act, created the Federal Deposit Insurance Corporation in order to mitigate the impact of bank failures that the economy at that time experienced.

Monetary policy is the policy of the central bank of an economy that has clear macroeconomic goal of maintaining equilibrium in the money market and therefore assist the economy in realizing its fundamental goals. In the United States the Fed carries out monetary policy. There are three main policy tools of the Fed:

a) The discount rate - The discount rate is the interest rate the Fed charges on loans that it makes to banks. If the Fed wants to lower the money supply, it increases the discount rate. Higher the discount rate, less encouragement will the banks get to borrow from the Fed. When the borrowing is reduced, the Fed, the amount of loan granted is reduced in tandem and so the money supply reduced.

b) Reserve requirements - Higher reserve requirements would reduce the bank profits as it limit the amount of loans they can grant. It is just like a tax. The lending capacity will be reduced and so the money supply will fall.

c) Open market operation - Open market operations is the process of the buying and selling of government securities by the Fed in the open market. When the Fed has an aim to reduce the money supply, it enters the money market and sells government securities. Currency in circulation, deposits all are reduced and through the multiplier effect, money supply is reduced.

2) In case of a negative Aggregate Demand shock like bussiness pessimiss, both inflation and real GDP growth rate fall due to a fall in total spending growth. Consumer start reducing their consumption and businesses start curtailing or at least postponing their investments. This means a shift of AD to the left. Stocks of goods pile up and wage growth remains high. Producers thus start laying-off workers, reducing cost and hence the price falls.

An expansionary monetary policy will do the job. It will stimulate the liquidity in the market and encourage lending by the banks. More loans implies more consumption and investments and so real GDP will rise. With price level remain unchanged in short run, AD shifts to the right and the economy reaches at its long run level of real GDP.

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