econ module 5

Subprime Lending and the Housing Crisis

By 2003, interest rates in the United States had reached historically low levels. Two factors contributed to this situation. First, the Federal Reserve had pursued an expansionary policy for an extended period of time; second, a large influx of capital from foreign countries, especially China, had increased banks' available funds, allowing them to make more loans at lower interest rates.5 These low interest rates, combined with a consistent increase in the value of houses, motivated financial institutions to take risks by making loans to subprime borrowers. Subprime loans are given to people who do not meet the typical requirements needed for most home loans. These borrowers might have a history of bad credit and, under normal circumstances, would be considered risky borrowers. However, during the first decade of the 21st century, bankers and mortgage companies grew increasingly willing to take this risk. They believed that even if some people could not make their mortgage payments, those people could sell their houses at a higher price than what they originally paid and then repay the debt. For example, suppose Bob takes out a loan to buy his house for $120,000. Suppose the house's market value increases to $160,000. If he cannot make his monthly mortgage payments, he can easily sell his house for $135,000—$25,000 below its market value—then pay back the $120,000 loan, and make $15,000 in profit. This theory works as long as housing prices increase. However, that is not what happened in the United States. Instead, in fall 2006, a large number of homebuyers began defaulting on their mortgage payments, meaning that they could not pay off what they owed on their houses. At the same time, housing prices began to decline rapidly. As a result, they could not sell their houses for enough money to pay back their loans. Let's return to Bob's example. He owes $120,000 on his house. Rather than increasing, though, suppose his house's market value decreases to $100,000. Even if he can sell his house for $100,000, he still would not have enough money to pay back his loan. Instead, he just defaults on his mortgage and walks away from the entire deal. Even though he loses any money he has already paid to the bank, he does not have to keep paying the bank or sell his house for a $20,000 loss. In fall 2006, this scenario began occurring all across the United States. It may sound like banks would benefit—they get to take possession of the house and keep any mortgage payments made up to that point. However, with a record number of people selling their houses—or walking away from their loans—the market for houses became depressed, which meant that the banks had trouble reselling them. People who had invested in home loans also lost money. This concept might seem a bit complicated, but the key issue is simple. Mortgages were bundled together and sold to investors—in other words, investors received a percentage of the income made from loans; however, they also shared the risks of loans not being paid off. When hundreds of loans are bundled together and just one or two are not repaid, investors still make money on the deal. But if 20 or 30 are not repaid, the investors end up losing money. This is what happened with increasing regularity beginning in fall 2006—investors suffered substantial losses when a record number of people defaulted on their mortgages. The Federal Reserve and the U.S. Treasury had to loan several major financial institutions, like Bear Stearns and AIG, money (known as a bailout) to prevent bankruptcy. During this period, some of the nation's largest financial companies and many banks failed. All of these factors contributed to the recession that began in 2007 and eventually led to stricter credit rules.

the national debt

The national debt is growing at an increasing rate. Most economists agree that running a budget deficit for a short time period does not necessarily harm a country's economy. Remember the example of the car loan? The person needed to borrow money to buy the car, which was required for getting to work and earning income. At some point, the person who bought the car will pay the loan off with the income he or she earned from working. By paying off the loan, his or her debt for the car purchase will be eliminated. However, over a long period of time, a budget deficit can be a problem. Imagine if you had to keep paying for the car long after it was rusting away in a junkyard. That is what some people fear will happen with the U.S. national debt—future generations will have to continue paying off the debt long after the benefits have been received.

The Government & The Economy

Did you know that the federal government shut down for a short time in 1995 and again in 1996?1 During a shutdown, the government ceases to provide all services that are considered non-essential (or not needed). What services are considered non-essential? During the 1995 and 1996 government shutdowns, non-essential federal programs such as the National Park Service as well as national museums closed. Many federal employees were sent home, especially those who were placed in the non-essential category. In fact, over 1,000,000 federal employees could not go to work as a result of the government shutdowns between 1995 and 1996. How would a U.S. government shutdown affect national spending levels? How might it improve or worsen the effects of a recession? The following section describes a national government's role in affecting spending levels.

Tools Used by the Fed to Affect the Money Supply

As we have studied in previous modules, money supply refers to the specific amount of money circulating in a country's economy at a particular period of time. Decreasing the money supply's growth rate is associated with low spending levels throughout the economy, while increasing the growth rate is associated with higher spending levels. In order to affect the money supply and the spending levels throughout the economy, the Federal Reserve uses any or a combination of these three tools: the reserve requirement ratio the discount rate and target federal funds rate the open market operation

surplus and deficit

A government has income and expenses. It collects revenue, or income, but also has expenses. Each year, a government looks at its income and expenses and determines a budget. A balanced budget is when income equals expenses. When income exceeds expenses, there is a budget surplus. When income is less than expenses, there is a budget deficit. The government has to borrow money to pay the difference; this results in a debt (or money owed). You will learn about government debt in a future module.

The Open Market Operation

An open market operation is the principal monetary tool used by the Federal Reserve System. It is directed by the FOMC and executed by the Federal Reserve System of New York. It consists of the purchase and sale of government bonds, which are an example of government debt issued by the U.S. Treasury Department. Suppose the Fed is worried about inflation, so it wants to slow down economic growth by decreasing the money supply. If the FOMC wants to decrease the money supply, and therefore decrease spending in the economy, it will sell bonds. The sale of these bonds is paid for with money held in banks. When the money is taken out, it decreases the reserves held by the banks and therefore the amount of money available for consumers and investors to borrow and spend. Now suppose that the Fed is worried that the economy may be headed for a recession. The FOMC wants to increase the money supply, and therefore increase spending in the economy, so it will buy bonds. By paying for the bonds, the Fed makes more money available for borrowing. When consumers and businesses borrow money, both consumption and investment increase, which helps the economy grow.

The Target Federal Funds Rate and Discount Rate

As you learned in Module 65, the federal funds rate is the interest rate that the Federal Reserve banks charge to other banks for lending their money overnight. The federal funds rate is affected by the discount rate, which is established by the Federal Reserve Board of Governors. An increase in the target federal funds rate makes borrowing between commercial banks more expensive. This reduces the number of loans made between commercial banks, which in turn decreases the number of private loans those banks make to individuals and businesses.4 Eventually, as the number of loans decreases, the country's money supply shrinks. The graph below shows the trajectory of the federal funds rate since 1954. Notice that the federal funds rate was higher in the late 1970s and early 1980s. During this period, the United States experienced high levels of inflation due to an increase in oil prices. The Federal Reserve pursued a contractionary monetary policy to control inflation by increasing the target federal funds rate. Since the early 1990s, the target funds rate has remained at a relatively low percentage.

What Is the National Debt?

As you learned in Module 68, a budget surplus occurs when the federal government's revenues are greater than its expenses. A budget deficit occurs when the revenues collected are less than expenses. Each time there is a deficit, the government must borrow money to pay for the difference. This creates debt, or money owed. The national debt, also called the public debt, is the sum of all past annual budget surpluses and deficits—which includes the amount the government has borrowed from individuals, corporations, and foreign governments, plus the accumulated interest on this borrowed money. Remember, interest is the cost of borrowing money. The longer it takes the federal government to pay off these loans, the more interest the government will have to pay—which increases the total debt. This is similar to the way Taylor's credit card debt grew. Since he did not pay off his entire bill, the credit card company added interest. The next month, Taylor will owe interest on his previous balance AND any new charges that he cannot pay off. Now think of this on a larger scale. Suppose that at the beginning of 1980, the U.S. government sold a security for $1 million and agreed to pay the security holder 10% in interest every year for 30 years. So how much did the federal government pay to borrow that $1 million? In other words, in 2010, how much total money did the federal government owe on that $1 million security? Assuming that it had not paid off any of the money borrowed, or any of the interest accrued during that 30 years, it would have owed more than $17 million.

Why Don't We Just Print More Money?

At the beginning of 2011, the United States had a national debt of more than $14 trillion.1 If you spent $1 million every hour, it would take you more than 1,500 years to spend that much money! Take a dollar bill out of your pocket. What is it worth? Of course, it is worth $1. You could trade it in to the federal government for another dollar bill or trade it for goods or services worth $1. Why? Because, the federal government backs its currency with its reputation. If the currency was not backed by the government, it would be worth only six or seven cents—the cost of the cotton and ink used to make the bill. One question that is inevitably asked about the national debt is, "Why can't the United States simply print more money to pay off the debt?" Recall from Module 56 that printing more money can cause inflation and possibly hyperinflation. If the government printed more than $14 trillion overnight, the money would be worthless. Your dollar would buy a lot less than it does now. Suppose the government suddenly gave everyone in the United States $1 million. Prices for everything would increase. Why sell a loaf of bread for a few dollars when people could easily pay a few hundred dollars? Think back to the example of hyperinflation in Germany after World War I and its effect on German consumers (see Lesson 56).

M5 L66: FDIC and Stability Measures

At the end of 2007, the U.S. economy began to decline rapidly. By the end of 2008, many large banks were on the verge of collapse. They were experiencing huge financial losses for a number of reasons, including the collapse of the housing market. Many banks faced no alternative but to request bailouts from the government, the Federal Reserve, and the Federal Deposit Insurance Corporation (FDIC). A bailout is a loan or financial gift given to a financial institution or company on the verge of closing. This module discusses the FDIC, an organization that has significantly contributed to U.S. financial stability since its creation in 1933. In particular, it shows how the FDIC has reduced the fear of bank runs.

The Discount Rate and the Target Federal Funds Rate

At the end of each business day, a bank needs to determine whether it has the required reserve ratio. If it does not have the required amount in reserve, the bank needs to borrow money from another bank or from a Federal Reserve System. This type of loan is called an overnight loan. The interest rate that the Federal Reserve charges to commercial banks on overnight loans is called the federal funds rate. The target for the federal funds rate is determined during FOMC meetings, and announced to the public after every meeting (eight times a year). This rate is also affected by the discount rate. The discount rate is the interest rate charged by a Federal Reserve System to depository institutions, such as your local bank, to borrow short-term funds. The Board of Governors determines the discount rate. Remember, interest rates are the costs incurred from borrowing money. If the discount rate falls, borrowing money becomes less expensive, so depository institutions will borrow more money from a Federal Reserve System. These institutions will have more money available to lend, which can increase spending. For example, during a financial crisis, the Fed could lower the discount rate in order to make more funds available for banks to lend out to consumers and businesses. This increases consumption and investment, leading to more economic growth. The Fed could also raise the discount rate and make fewer funds available if it expects inflation to increase. This will decrease borrowing by consumers and businesses, leading to less economic growth and, possibly, a lower general price level.

how banks work

During any period of time, a bank will maintain a percentage of its deposits in its vaults and lend the remainder to borrowers. You learned in Module 65 that this minimum percentage of customer deposits depends on the reserve requirement ratio, which is established by the Federal Reserve. For example, a bank may be required to maintain 10% of the money deposited into checking accounts. High reserve requirement ratios reduce the ability of banks to lend money and to make higher profits. For example, if a bank has $1 million in checking account deposits and the reserve requirement ratio changes from 10% to 12%, the bank will have to increase its reserves from $100,000 to $120,000, leaving it with $20,000 less to loan. Remember, banks earn money when they provide loans and charge interest—the cost of borrowing money. The more loans that banks make, the more money they earn from interest (assuming that borrowers repay their loans). Banks use a portion of their earnings to pay interest on people's savings accounts and certificates of deposit (CDs). Now suppose the reserve requirement ratio decreases to 0%. In this case, banks would be allowed to lend every penny they receive from their customers' deposits. If they lent all their money, the banks would not have any cash on hand to meet their customers' demands. The inability of even one bank to pay back its debts (like money owed to its customers) can generate widespread panic about whether other banks can pay back their customers, too. This, in turn, can cause more and more people to withdraw their deposits, resulting in banks likely defaulting on their payments; a default is when one party is unable to repay a debt to another party. When many people rush to withdraw their bank deposits at the same time, this is known as a bank run. Widespread bank runs can create havoc in a country's economy. Prior to the Great Depression, periodic bank runs occurred in the United States; during the Great Depression, the bank runs became more regular and many people lost their savings. To address this problem and to increase people's confidence in the banking system, Congress passed and President Franklin D. Roosevelt signed into law the Glass-Steagall Act of 1933.1 This act included the establishment of the FDIC.

government expenses - pie charts

Each level of government is responsible for paying for different goods and services. Local governments pay for services in cities, towns, or counties, such as picking up the trash, maintaining public roads, maintaining city parks, etc. State governments pay for goods and services offered throughout a state; these could include the state police, hospitals, and public schools. The federal government provides services for the entire country; these duties are outlined in the U.S. Constitution. As you can see, in the Commonwealth of Virginia, the biggest expenditures are dedicated to education, health and human resources, transportation, and public safety. Compare these goods and services to the programs funded by the federal government, which include Social Security, Medicare, and defense and security. You can click on each slice.

What Contributes to the National Debt?

Every year that the federal government runs a budget deficit, it increases its debt. So what are the major contributors to the national debt? Any time the federal government needs to increase spending dramatically (in excess of its revenues), it has to sell securities to raise money. Can you think of examples when this might happen? Wars: During every major war it has fought, the United States has increased its national debt. These increases have been more dramatic than others, especially during the Revolutionary War, Civil War, World War I, World War II, and the 21st century actions in Iraq and Afghanistan. Economic Downturns: During recessions (or depressions, depending on the severity of the situation), unemployment increases, which decreases national income because fewer people are earning or spending money. As a result, government tax collections suffer. Reduction of Tax Rates: Historically, tax cuts often account for economic growth because people can buy more consumer goods (increasing consumption) or make more investments with the extra money they get to keep. On the other hand, when taxes are cut, the government collects less in revenues. If its expenses remain the same, the government may need to borrow money to make up for the lost revenues—this increases its debt.

deficit spending

Every year, the federal government drafts a new budget. The government has to project how much it will spend and which programs to fund. To pay for these programs, the government must also project how much money it will collect in taxes. Every year, these expenses and revenues change. When the federal government runs a budget deficit, it has two choices: reduce spending or collect more revenue. Typically, the government increases revenues to cover expenses. One option for increasing revenue is to raise taxes. But this is unpopular among voters because it means that many households (and possibly businesses) will have less money to spend on nonessentials (disposable income). Another option for increasing revenue is to sell securities. A security is an investment contract, or a loan to the federal government. The federal government sells securities to corporations, financial institutions, foreign governments, and individuals. The buyer gets a "security," or a loan, which earns interest. The longer the federal government takes to pay back the buyer of the security, the more it has to pay in interest. When you buy securities, you pay a certain amount of money in return for a promise that the federal government will pay you back a certain amount of money in a given amount of time. For example, if you buy a $50 security, the government might promise to repay you the $50 plus another $45 in the future. In other words, you are loaning the government $50 so you can receive $95 back in the future. Here are some of the typical types of federal securities: Treasury Bills—Also called T-bills, these short-term securities can reach full value in only a few days or possibly a year. You pay less than face value for a T-bill, and it takes a specific amount of time for it to "mature," or reach its face value. For example, suppose you buy a $100 T-bill for $60. When the T-bill matures, you receive $100 (a $40 return on your investment!). Treasury Notes—Also called T-notes, these are slightly longer-term securities. As with T-bills, you pay less than face value, but it takes two, three, five, seven, or ten years for them to mature. Treasury Bonds—These long-term securities take 30 years to mature. Savings Bonds—Unlike Treasury bills, Treasury notes, and Treasury bonds, saving bonds are registered to a single person or group who are not allowed to resell them. At some point in your life, you may have received a savings bond as a birthday gift. After a given amount of time, you can redeem it (or "cash it in") for a certain amount of money. There are several different types of savings bonds.

Fiscal Policy

Fiscal policy refers to the use of a national government's budget to affect that country's total level of spending. To understand how a government's budget can affect national spending, let's review the components of a country's GDP. If you recall from Module 51, GDP includes four components: (1) consumption, (2) investments, (3) government spending, and (4) net exports (exports minus imports). A government has direct control over the quantity of goods and services it purchases in any particular year. However, it can also influence the level of households' spending and even investments by affecting taxes and transfer payments. Consumers pay taxes in many ways. Sales taxes are imposed on the purchase of goods and services, such as when you buy clothes or groceries. Taxes can be collected from businesses based on percentages of their incomes or profits. In addition, businesses and homeowners pay taxes to local governments every year based on the assessed values of their properties. Transfer payments, unlike taxes, are given by the government to select households. In the United States, transfer payments include Social Security, Medicare, Medicaid, food stamps, and unemployment benefits. If you recall, a household's disposable income includes payments received from employment, interest, profits, and transfers. This is the amount of money that households can spend after subtracting taxes. More disposable income means more household spending and less disposable income means less household spending. Disposable income = [income from profits, employment, interest - taxes] + transfers

How Changes in Taxes or Transfer Payments Affect Spending

Governments implement fiscal policy during periods of slow economic growth or high levels of inflation. For instance, a government can increase aggregate spending to counteract slow economic growth or decrease aggregate spending to reduce high inflation. The fiscal policy that increases aggregate spending is called expansionary fiscal policy, while policy that reduces aggregate spending is called contractionary fiscal policy. Governments use three tools to affect aggregate spending: (1) taxes, (2) transfer payments, and (3) government purchases. During an expansionary fiscal policy, a government can increase aggregate spending by increasing transfers, reducing taxes, or increasing government purchases. These can impact the variables "C" or "G" in the GDP equation. As you saw, an increase in transfers or a reduction in taxes will increase disposable income and thus increase consumption (C increases). Conversely, during a contractionary policy, a government can reduce aggregate spending by decreasing transfers and/or increasing taxes—leading to decreased consumption (Cdecreases). The government might also reduce government expenditures (G decreases). In an expansionary policy, GDP (aggregate output) will increase because government and/or consumer spending increases. Conversely, a contractionary fiscal policy reduces aggregate output through decreased national spending. During the 1990s, the Japanese government pursued an expansionary fiscal policy to increase output and encourage economic growth. Its fiscal policy consisted mainly of increasing government purchases of goods and services. After the recession of 2008, the U.S. government combined tax cuts and transfer payments to boost economic growth.

the budget

How do local, state, and federal governments decide what to spend money on? Just like individual households and businesses, governments must create budgets. For the federal government, the president proposes a budget to Congress, which revises the numbers and sends an alternate proposal back to the president. If the president signs Congress's budget, it becomes law; if he rejects or vetoes it, Congress must again revise the budget and sent it back to the president. The process potentially can go back and forth a number of times and tends to be time-consuming. Remember, when a government's income equals expenses, it is called a balanced budget. When income is greater than expenses, there is a budget surplus. When income is less than expenses, there is a budget deficit. There can be serious consequences for lawmakers whenever local, state, or federal governments do not pass balanced budgets. In fact, many cities and towns and some states—including Virginia—have laws that require balanced budgets. In these places, when a budget is not balanced, the government is forced to reduce certain expenses, such as laying off teachers. While this approach keeps the government out of debt, it also can have a downside. For instance, when people lose their jobs, they cannot spend as much money as before, which cuts down on the amount of money the government can collect in taxes. In addition, they may draw unemployment benefits, which also cost the government money. As an alternative to reducing expenses, the government may decide to increase taxes. Yet this also reduces the amount of money families have to spend and can hurt the economy. Neither "solution" is popular with voters. The federal government is not required to balance its budget. In fact, since 1969, the federal government has passed a balanced annual budget only four times (1998-2001). Every other year, it has operated with a deficit. Since the federal government must protect its citizens and provide popular social services, such as unemployment benefits and other programs, most lawmakers are reluctant to cut the federal budget. However, many object to increasing federal taxes. In 2011, President Obama and Congress faced this dilemma. Many lawmakers—mostly Republican—publicly declared they would not increase taxes and demanded steep budget cuts to reduce the growing budget deficit. On the other hand, many Democratic lawmakers argued for increased taxes or a compromise that combined budget cuts and tax increases. In the end, Congress passed and the president signed a deficit budget that cut some spending but not to the degree that many Republicans had recommended.

Differences between the FDIC and the Federal Reserve System

It can be difficult to distinguish the roles of the FDIC and the Federal Reserve. This confusion became even more persistent during the recent recession as both institutions worked together to stabilize the American financial system. Remember, the main mission of the Federal Reserve is to maintain a stable national financial and monetary system. For example, on March 18, 2009, at the height of the recession, the Federal Reserve announced that it would purchase $1.25 trillion in securities representing home mortgages guaranteed by the federal government and $300 billion in long-term Treasury securities.7 The purpose was to counteract the negative effects of a recession by increasing the country's money supply and aggregate spending and ensuring that mortgage lenders would support the failing housing market by continued lending. The FDIC's main mission, on the other hand, is to protect Americans' bank deposits. It does not plan or execute the country's monetary policy, which is the Federal Reserve's job. In 2010, the Wall Street Reform and Consumer Protection Act permanently expanded the maximum insurance limit to $250,000 per depositor. This change came following a temporary increase to $250,000 as the maxiumum insurance limit when Congress passed the Emergency Economic Stabilization Act in 2008. Since so many banks failed during the recession, the FDIC also implemented the Temporary Liquidity Guarantee Program8 and the Legacy Loans Program to protect depositors and to restore confidence in the banking system.

Monetary Policy

Monetary policy includes the set of regulations and tools used by a country's central bank primarily to affect the nation's money supply and the availability of credit. In doing so, this affects the country's overall levels of spending and employment and the prices of goods and services. Similar to fiscal policy, monetary policy can be expansionary or contractionary. An expansionary monetary policy increases the money supply to encourage economic growth. In the United States, the Federal Reserve conducts this policy during periods of economic contractions or recessions. Remember, when more money circulates in the economy, economic activity (like consumer spending and investments) typically increases. On the other hand, a contractionary monetary policy reduces the money supply, normally to combat high inflation. For example, when an economy grows too quickly, inflation can be a concern. The Federal Reserve might decrease the money supply to reduce the amount of money circulating in the economy; this diminishes the level of economic activity and usually inflation, too. As you learned in Module 56, an economy performs well when inflation is low because it generates economic stability and leads to higher levels of investment. As such, one of the Federal Reserve's goals is to maintain a low and stable inflation rate. As you learned in Module 65, the Federal Reserve Bank uses three tools to affect the U.S. money supply: reserve requirement ratio target federal funds rate and discount rate open-market operation Let's see how each of these tools can affect money supply, credit availability, and consumer spending.

Why Deficits? Are They Always Bad?

Often, when people talk about the federal government running a budget deficit, they simply call it the national debt. However, a budget deficit is not the same as the national debt. As you learned in Module 68, a budget deficit occurs when the amount of money the federal government spends on its programs exceeds the amount of income it receives. In 2010, the U.S. budget deficit (adjusted for inflation) was $1,312.37 billion. The national debt, sometimes called the public debt, is the sum of all federal budget surpluses and deficits to date, meaning that it is the total amount of money the U.S. government still owes. As of 2011, the U.S. national debt was more than $14 trillion.

Interest on National Debt

Over 30 years, the government paid more than $16 million in interest on that original $1 million in debt! How does this happen? The chart below shows how much the government owed in interest after just three years of the debt. Amount Borrowed Through Security SalesInterest RateInterest To Be Paid by U.S. Government (For This Year)Total Owed at the End of the Year1980$1 million10%$100,000$1,100,0001981010%$110,000$1,210,0001982010%$121,000$1,331,000 As you see, by the end of the third year, the government owed not only the principal debt of $1 million but also an additional $331,000 in interest. See how interest adds up quickly? Assume that our government does not pay off any of the debt. In other words, the interest owed just keeps adding to the total debt. To calculate the amount of interest the government must pay each year, you must add three things: The interest on the $1 million borrowed. The interest from the previous year that was not paid off. The interest owed on the unpaid interest (That's right. Interest must be paid on the interest!). For example, the amount of interest owed at the end of 1981 was: 10% on the $1 million loan = $100,000 The unpaid interest from 1980 = $100,000 The interest on the unpaid interest from 1980 = $100,000 × 10% = $10,000 This adds up to $210,000: (10% of $1,000,000) + ($100,000) + (10% of $100,000) = ($100,000) + ($100,000) + ($10,000) = $210,000 Notice that the total amount of interest accelerates each year. This is due to the unpaid interest (also called compound interest). The buildup in interest has a negative effect on the national debt and government spending. First, the government must set aside money to repay the loan. Second, the government cannot spend that money on other programs. This represents an opportunity cost. As discussed in Module 69, borrowing money for essential expenses can be necessary; however, as this example demonstrates, failing to repay a loan over an extended period of time can be very harmful—to an individual (remember Taylor's credit card troubles) or the federal government.

The Open Market Operation

Recall that the Federal Reserve's open market operation involves the purchase and sale of government bonds. When the FOMC decides to purchase or sell government bonds, it will affect the money supply when money flows into or out of banks' deposit accounts. This indirectly impacts the federal funds rate because the amount of reserve funds in the banking system has changed. Here is a simple explanation of how this happens. Suppose the FOMC decides to buy bonds. These purchases from bond dealers introduce new money into the nation's economy. The bond dealers will then deposit the money from the sales into their banks. The money supply will increase further as the bank loans this money out. Because banks have more money to loan, the price of borrowing money decreases. Note that as money flows into the bond dealers' accounts, the amount of reserves in the banking system will increase. As such, banks will not need to borrow as much money to maintain their reserve requirement ratio. This eventually will lead to a decrease in the federal funds rate. Conversely, the sale of government bonds will lead to an increase in the federal funds rate as the reduction in reserve funds decreases the bank's ability to make loans. Instead of buying bonds, suppose the FOMC decides to sell bonds. Bond dealers will have to withdraw money from their bank accounts to make the purchases. This will reduce the banks' reserves, which means they will be less able to make loans. This will decrease the money supply and force banks to borrow more money to maintain their reserve requirement ratio, eventually leading to an increase in the federal funds rate. The following table summarizes the tools used by the Fed as part of expansionary and contractionary monetary policies.

Responsibilities of the Federal Reserve System

Supervise and regulate banks within the country to promote reliability and confidence in the banking system. Maintain stability in the financial markets by controlling the money supply (amount of money in the economy). Ensure that all banks comply with the laws and regulations that apply to them. Supply paper currency and coins to banks. Process checks and electronic payments.

The Role of the FDIC in the Recent Economic Slump

The 2007 financial crisis led to the failure of several U.S. banks. According to the FDIC's "Failed Bank List," in 2008, approximately 25 banks filed for bankruptcy and were taken over by the FDIC. However, the largest bank failure occurred when Washington Mutual experienced a 10-day bank run. By the end of 2009, approximately 140 banks had filed for bankruptcy—the highest number since 1992. In 2010, 157 more banks declared bankruptcy. In all cases, the FDIC took over and managed the failed banks and protected the depositors' money up to the maximum insured limit.

A) The Board of Governors

The Board of Governors is located in Washington, D.C. It has seven members who are called governors. Each governor is appointed by the president of the United States, and then confirmed by the Senate, to a 14-year term. The appointments are staggered, with one appointment expiring every two years, meaning that any president can appoint two members during a four-year term. Among the seven governors, two are appointed by the U.S. president as chair and vice chair of the board for a period of four years. In 2011, the chair of the Fed was Ben Bernanke. He was appointed chair in February 2006 by President George W. Bush and reappointed by President Barack Obama in 2010. Before Bernanke's appointment, Alan Greenspan served for more than 18 years under four different presidents.2 Together, the seven governors and a skilled staff formulate and execute the policies that make the banking system in the United States stronger and more reliable. In particular, the Board participates in the Federal Open Market Committee (FOMC), which controls the country's monetary policy. In addition, the Board oversees the activities of all twelve regional banks and approves the appointment of their presidents.

C) The Federal Open Market Committee (FOMC)

The FOMC is responsible for conducting the country's decisions concerning monetary policy. According to the Federal Reserve Board, monetary policy refers to the control of the country's money supply by the central bank for the purpose of promoting economic growth. The FOMC includes all members of the Board of Governors and the 12 presidents from the regional Federal Reserve Systems. However, only the seven members of the Board of Governors, the president of the Federal Reserve System of New York, and four other Reserve bank presidents vote on monetary policies. Excluding the president of the Federal Reserve System of New York, each president of the reserve banks serves a one-year voting term on the FOMC, on a rotating basis. The FOMC members meet approximately eight times a year to decide whether to change or continue the current monetary policies. Their primary objective is to choose policies that will generate economic growth and stability based on national, international, and regional information.

What is the FDIC?

The Federal Deposit Insurance Corporation (FDIC) is an independent agency of the federal government. Its headquarters are located in Washington, D.C., but it conducts extensive business at six regional offices and two area offices. The six regional offices are located in Atlanta, Chicago, Dallas, Kansas City, New York, and San Francisco. The two area offices are in Boston and Memphis.2 The map shows the specific areas that each FDIC regional and area office serves. The FDIC currently employs more than 7,000 workers across the country. It is managed by a five-member board of directors appointed by the president of the United States and confirmed by the U.S. Senate. To avoid political bias, no more than three members on the Board of Directors can be from the same political party. The FDIC insures only bank deposits, which include savings and checking accounts and certificates of deposits (savings certificates with fixed interest rates). It does not insure other types of financial investments that banks offer, such as mutual funds (pools of investment tools, like stocks and bonds) and U.S. Treasury bonds (government-issued debt obligations with fixed interest rates). Currently, the FDIC insures more than $7 trillion in deposits in U.S. banks.3 Each of these insured banks pays a premium to the FDIC. These premium payments and investments in U.S. Treasury bonds are the FDIC's main sources of income.

The Federal Reserve's Structure and Function

The Federal Reserve System, also known as the "Fed," is the central bank of the United States. It was created on December 23, 1913, during a time when the United States experienced several financial crises caused by multiple bank runs.1 Bank runs occur when a large number of people race to withdraw their deposits from a bank because they believe the bank will not be able to pay back the money to depositors. Bank runs reflect a lack of trust in financial institutions. Initially, the Fed's role was to address the causes and consequences of bank runs. However, its responsibilities gradually increased. Let's take a closer look at some of them.

Composition of the Federal Reserve

The Federal Reserve seeks to balance the interests of private banks and society. It is supervised by Congress and must work within clearly defined goals. However, it still carries out many of its responsibilities independent of political pressure. It is composed of three parts: a) the Board of Governors, b) the regional reserve banks, and c) the Federal Open Market Committee. These three entities work independently from the government to carry out their core decisions. The following paragraphs will describe each of these three components in greater detail.

income

The United States has multiple levels of government. A local government typically governs a small area—a county, city, or town. The next level up is a state government, which governs a state. The largest is the federal government, which governs the country as a whole. Each type of government operates programs that cost money. To acquire revenue to pay for these programs, governments collect different kinds of taxes. Any time you buy food at a store in the U.S., look at the bottom of the receipt. You will see a line that says "sales tax" or "tax." This tax applies to most goods and services you purchase. It is based on a percentage of the goods or services you purchased and generates revenue for the state government.

role of the FDIC

The primary roles of the FDIC are to increase people's confidence in the country's banking system and to eliminate bank runs. The FDIC makes sure that if a bank closes or goes bankrupt, all of the bank's customers will receive their deposits and interest earnings—up to a maximum limit for each person. In the table below, notice how the maximum insurance limits have increased over time. The insurance limit of 2008 was passed as a temporary increase but was made permanent by the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. In addition to providing insurance to bank customers, the FDIC also helps supervise financial institutions and their business practices, takes over and manages failed banks, and carries out other consumer-protection tasks. Since the FDIC's creation in 1933, depositors have not lost any money that was covered by federal deposit insurance. By responding to more than 3,000 bank failures, the FDIC has helped stabilize the U.S. banking system.

Reserve Requirement Ratio (RRR)

The reserve requirement ratio refers to the percentage of deposits a bank must keep in its vaults or at the Federal Reserve at all times. The following table lists the reserve requirement ratios for both checkable and savings deposits as of the end of 2011. Notice how the reserve requirement ratio increases as the value of the deposits increases. Any bank with more than $71.0 million in checkable deposits (any accounts such as checking accounts, money market accounts, and NOW accounts from which customers may withdraw money on short notice) must keep at least 10% of these deposits in its vaults or at the Federal Reserve. However, there is no requirement ratio for savings deposits or banks with less than $11.5 million in checkable deposits. Banks cannot make loans or earn interest from money held in reserve. As a result, the reserve requirement ratio reduces a bank's potential profits. Remember, when the Federal Reserve increases the reserve requirement ratio, it reduces a bank's ability to make loans and earn higher profits from these loans. In addition, because fewer loans are made when the reserve requirement ratio is increased, the U.S. money supply decreases. For example, suppose the reserve requirement is 10%. If a bank receives a $1,000 deposit, it must put $100 in reserves and can loan the remaining $900. If the reserve requirement is increased to 15%, the bank would be required to put $150 in reserves and could loan only $850. Fewer loans lead to a decrease in the money supply and the level of economic activity (like consumer spending and investments).

B) Regional Federal Reserve Systems

There are 12 regional Federal Reserve Systems in the United States. Each bank is named after the location of its headquarters. For instance, the Federal Reserve System located in Richmond, Virginia, is called the Federal Reserve System of Richmond. The map below shows the regions administered by each of the Reserve Banks. The primary roles of the regional Federal Reserve Systems include: 1. Providing perspectives and expertise about their local economies. For example, they can inform the Board of Governors about potential employment and investment consequences of specific economic policies in their region. 2. Storing excess cash from local commercial banks. 3. Processing checks and electronic payments. 4. Conducting research on local and regional economies. Each reserve bank also has its own board of directors with nine members in total; six of them, including the bank's chairman, represent the public. The remaining three members represent the banking industry. The reserve banks execute the regulations established by Congress and its Board of Governors.

Are Federal Budget Deficits Bad?

There are several reasons why the government often spends more money than it brings in. For instance, during a recession, or decrease in economic activity, government programs are in great demand. There may be an increased need for welfare payments; more people may receive unemployment compensation. At the same time, income tax payments will decrease because people have lost their jobs—remember, income taxes are based on workers' paychecks. In addition, the government already has other financial commitments, such as the military. Plus, not only is the government spending money, it is also paying interest on the money it has borrowed. At the end of 2010, interest on the U.S. debt of $13 trillion was nearly $414 billion.3 This interest increases over time. You can consider deficits on a personal level, too. Think about something that you want to buy that is very expensive—maybe a new car. Very few people can afford to pay the entire cost of a new car up front, so they borrow the money from a bank and pay for the car over time in installments (periodic payments). Of course, when you borrow money, you end up paying more than the purchase price—because you have to pay interest with every installment. In the long term, it would be cheaper to save up your money and buy the car at a later time without a loan. But what if you need the car to go to work and earn money? It's Complicated! In favor of spending during a budget deficit: The government needs to spend money in order to create new jobs and stimulate the economy. Opposed to spending during a budget deficit: The money that the federal government borrows today, and the interest that money accrues over time, adds to the national debt. Future generations will be responsible for paying off this debt. It is important for the U.S. to pay the national debt in order to retain the full creditability of its Treasury department.

The Reserve Requirement Ratio

When you deposit your savings in your bank account, only a percentage of it is kept in the bank's vaults. The rest of your savings are lent out by the bank to other individuals or firms. The percent of the bank's funds that are held in its vaults, or on deposit at a Federal Reserve System, is called the reserve requirement ratio (RRR). Suppose that a bank receives $10,000 in deposits, and the reserve requirement ratio established by the Federal Reserve is 5%. This means that the bank must keep $500 from its deposits as reserves and the remaining $9,500 can be used to make loans or investments. But do not worry. Even though a bank makes loans with most of the money that people deposit, your money will still be there when you want to withdraw it. The Fed can use the reserve requirement ratio (RRR) to impact how much money banks loan out. For example, if the reserve requirement ratio is changed from 5% to 3%, the bank has to keep $300 in the vault instead of $500. This means more money can be loaned out. By increasing the money available for lending, the Fed can inject more money into the economy and likely increase the level of spending.