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Even if the long-term nominal interest rate is 0 percent we still have:
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We also know that the Fed controls the inflation rate in the long-run so if the Fed can
commit to increasing the inflation rate then the expected inflation will increase and the
long-term real interest rate will decrease. This should increase consumption, investment
and net exports.
Second, long-term nominal interest rates depend not only on the current nominal federal
funds rate, but also expected future nominal interest rates. If the Fed can credibly
commit to keeping the nominal federal funds rate low in the future then this can reduce
the long-term nominal interest rate today. Assuming that expected inflation is constant,
the long-term real interest rate will decrease.
Third, the Fed has an unlimited ability to create bank reserves so it has an unlimited
ability to purchase financial assets such as long-term U.S. Treasury securities and
mortgage backed securities. The Fed can use this to purchase lots of long-term U.S.
Treasury securities directly which will reduce the long-term nominal interest rate and
assuming that expected inflation is constant the long-term real interest rate will also
decrease. By purchasing lots of mortgage backed securities this can lead banks to issue
more new mortgages because the banks know that they can quickly sell the mortgages to
the Fed.
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2.
a. A bank run occurs when depositors lose confidence in a bank and become concerned
that their checking account deposits, savings account deposits etc. are not safe. As a
result, depositors simultaneously withdraw the funds from the bank which can exhaust
the banks liquid assets. A banking panic occurs when many bank runs occur at exactly
the same time.
Financial institutions are vulnerable to bank runs for three reasons. First, banks operate
under a fractional reserve system where the banks keep less than 100% of their deposits
on hand as cash. Therefore, there is never enough cash or other liquid assets in a bank to
pay out all depositors simultaneously. Second, banks have short-term liabilities
(deposits), but long-term assets (mortgages, car loans, etc.). These assets can be
converted into cash to pay out depositors, but it takes time which banks may not have
during a bank run. Third, there is asymmetric information between the bank and the
depositors. The bank has far better information than the depositors about the quality of
the banks loans and the bank has far better information about how many liquid assets the
bank owns. Therefore, if a depositor even thinks that a bank is running out of liquid
assets or thinks that other depositor might think that then the depositor has an incentive to
withdraw his or her funds immediately.
b. One way for a financial institution to deal with a bank run is to sell its long-term
assets. However, to raise enough cash the financial institution may have to sell a large
amount of their long-term assets which can cause the price of those assets to decrease.
Therefore, a bank run can reduce the value of a financial institutions assets and may turn
an otherwise solvent financial institution into an insolvent financial institution.
c. Central banks can prevent bank runs by lending freely to solvent financial institutions
that do not have enough liquid assets to meet the surge in withdraws by depositors. The
financial institution can use its illiquid assets such as mortgages and other loans as
collateral for the loans. Therefore, the financial institution will not be forced to sell
assets at low prices so it should remain solvent and depositors should have confidence
that they will get their funds if they want them. This later effect should reduce or
eliminate the bank run.
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