Chapter 2: ANSWERS to DO YOU UNDERSTAND TEXT QUESTIONS

Chapter 2: ANSWERS TO "DO YOU UNDERSTAND" TEXT QUESTIONS

DO YOU UNDERSTAND?

1. What were the objectives of the National Banking Acts and what problems existed in the U.S. banking system before those acts were passed in the 1860s?

Solution: The acts tried to provide a sound currency by printing it at the U.S. Treasury to reduce counterfeits, requiring that it be backed with government bonds, and taxing state banknotes out of existence. The acts also required that national banks be examined regularly by the Office of the Comptroller of the Currency, and that banks hold adequate reserves. In addition, the acts prevented national banks from investing in certain risky ventures such as real estate or making loans that were too large relative to their capital. Also, it required that banks have adequate capital to absorb losses before opening. Finally, the acts tried to get national banks to help finance the Civil War by buying government bonds so they would be able to issue banknotes. The acts were passed because counterfeiting, tax regulation, and periodic bank failures had made many banknotes sell at a discount and had contributed to periodic bank runs and panics when people lost confidence in individual banks or the banking system in general during the free banking period.

2. What were the problems posed by the National Banking Acts?

Solution: The currency was inelastic once debt issuance to finance the war ended. Banks could pyramid reserves by counting reserves held with other banks as part of their required reserves, so multiple contractions in reserves occurred when cash was drained from banks during harvest seasons or banking panics. There was no lender of last resort to provide banks with additional reserves when they needed them. Checks often were not cleared at par but rather were discounted from their face value—which made them less popular as a means of payment.

3. Why was the Fed initially established?

Solution: The Fed was initially established to provide an elastic currency, be a lender of last resort, improve bank supervision (particularly for state-chartered member banks), and provide for a more efficient payments system.

4. How did the Federal Reserve System try to solve problems from the National Banking Act period?

Solution: The Fed could act as a “lender of last resort” to its members who needed extra liquidity. The Fed could legally create currency and put it into circulation so the country would have an elastic currency supply when needed. The Fed provided free check clearing services to member banks and required that checks cleared through it be cleared at par so checks would become more popular as a means of payment. The Fed required that all member banks in the Federal Reserve System be examined regularly to ensure that they were sound and maintained adequate reserves.

5. Why is the Fed chairman called the second most powerful person in the country?

Solution: The Fed Chairman can have a major effect upon the monetary policy that the Fed pursues, and resulting changes in interest rates, inflation, or recession can affect everyone in the country.