Question

Which of the following Fed actions will increase bank lending? LO36.3 Select one or more answers from the choices shown. a. The Fed raises the discount rate from 5 percent to 6 percent. b. The Fed raises the reserve ratio from 10 percent to 11 percent. c. The Fed initiates reverse repos involving S10 billion worth of Treasury bonds with nonbank financial firms. d. The Fed lowers the discount rate from 4 percent to 2 percent.

Short answer

Option d will increase bank lending.

Step-by-step solution

Understanding the Discount Rate

The discount rate is the interest rate the Federal Reserve charges commercial banks for short-term loans. A lower discount rate makes borrowing from the Fed cheaper, encouraging banks to borrow more, thereby increasing the amount of money they can lend to customers. Conversely, raising the discount rate discourages borrowing and reduces lending capacity.

Analyze Option a

Option a states that the Fed raises the discount rate from 5 percent to 6 percent. This action makes borrowing more expensive for banks, thereby reducing their ability to lend. Therefore, it does not increase bank lending.

Understanding the Reserve Ratio

The reserve ratio is the fraction of deposits a bank must hold in reserve and not lend out. By increasing the reserve ratio, banks are required to hold more money in reserve and therefore have less money available to lend to customers.

Analyze Option b

Option b mentions raising the reserve ratio from 10 percent to 11 percent. This action means banks have to hold a larger portion of their deposits in reserve, decreasing their lending capacity. Thus, it does not increase bank lending.

Understanding Reverse Repos

A reverse repo (repurchase agreement) is a monetary policy used by the Fed to absorb liquidity from the banking system by selling securities with an agreement to repurchase them later. This action decreases the reserves available in the banking system, thus reducing lending capacity.

Analyze Option c

Option c states that the Fed initiates reverse repos involving $10 billion worth of Treasury bonds with nonbank financial firms. This action decreases the amount of reserves in the banking system, which reduces the ability of banks to lend out money.

Analyze Option d

Option d involves the Fed lowering the discount rate from 4 percent to 2 percent. This decrease makes borrowing cheaper for banks from the Federal Reserve, providing them more funds to lend out to borrowers, which generally increases bank lending.

Key concepts

Discount Rate

The discount rate is key to understanding how the Federal Reserve (often referred to as the "Fed") influences banking practices and monetary policy. This rate is essentially the interest charged to commercial banks when they take out short-term loans from the Federal Reserve. A lower discount rate makes it less costly for banks to borrow funds, spurring them to accept more loans.
This results in increased liquidity for these banks, thereby allowing them to extend more loans to their customers.

• If the Fed lowers the discount rate, it acts as an incentive for banks to borrow more money.
• Conversely, raising the discount rate diminishes banks' borrowing due to higher costs, and subsequently reduces their lending capabilities.

Changes in the discount rate are therefore a powerful tool for regulating the amount of money banks can inject into the economy through loans.

Reserve Ratio

The reserve ratio is a critical component of economic stability and of the regulatory framework governing banks. This ratio defines the proportion of customer deposits that banks must keep on hand, without lending it out.
Higher reserve ratios mean banks have less capital available to lend to their customers, impacting their overall ability to generate loans. Conversely, a lower reserve ratio allows more funds to be accessible for lending.

• An increase in the reserve ratio forces banks to keep a larger percentage of deposits in reserve, thus decreasing available funds for new loans.
• Contrastingly, reducing the reserve ratio boosts the lending potential as banks can extend more credit, circulating more money throughout the economy.

This aspect of monetary policy is crucial as it can either restrict or encourage the flow of money through lending practices.

Bank Lending

Bank lending is a pivotal aspect of economic dynamics, directly influenced by Federal Reserve policies. Lending enables consumers and businesses to make significant purchases or investments without needing upfront capital. The Fed's policies around the discount rate and reserve ratio directly affect how much banks can lend.
When borrowing costs (like the discount rate) are low, banks find it favorable to offer more loans owing to the liquidity they can access.
Similarly, if the reserve ratio allows banks to have a large share of deposits available for lending, this increases their capacity to issue loans. These dynamics of bank lending are a real-time gauge of economic health; increased lending often translates into higher consumer spending and business investment.

Monetary Policy

Monetary policy involves the strategic actions undertaken by the Federal Reserve to control the supply of money in the economy. This control impacts inflation rates, employment levels, and overall economic growth and stability.
The Fed employs several tools to carry out monetary policy:

• Discount Rate Adjustments: By altering this rate, the Fed can encourage or discourage bank borrowing, thereby influencing the total financial resources available for lending.
• Reserve Requirements: Adjusting the amount banks need to hold impacts their capacity to lend, directly affecting consumer access to capital.

Each of these actions can moderate economic extremes, either by stimulating growth or cooling an overheated economy. Through these tools, the Fed aims to achieve its dual mandate: promoting maximum employment and stable prices.