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The Banking System and Money Creation

PRINCIPLES OF ECONOMICS

 

Learning Objectives

1. Explain what banks are, what their balance sheets look like, and what is meant by a fractional reserve banking system.
2. Describe the process of money creation (destruction), using the concept of the deposit multiplier.
3. Describe how and why banks are regulated and insured.

Where does money come from? How is its quantity increased or decreased? The answer to these questions suggests that money has an almost magical quality: money is created by banks when they issue loans. In effect, money is created by the stroke of a pen or the click of a computer key.

We will begin by examining the operation of banks and the banking system. We will find that, like money itself, the nature of banking is experiencing rapid change.

Banks and Other Financial Intermediaries

An institution that amasses funds from one group and makes them available to another is called a financial intermediary. A pension fund is an example of a financial intermediary. Workers and firms place earnings in the fund for their retirement; the fund earns income by lending money to firms or by purchasing their stock. The fund thus makes retirement saving available for other spending. Insurance companies are also financial intermediaries, because they lend some of the premiums paid by their customers to firms for investment. Mutual funds make money available to firms and other institutions by purchasing their initial offerings of stocks or bonds.

Banks play a particularly important role as financial intermediaries. Banks accept depositors’ money and lend it to borrowers. With the interest they earn on their loans, banks are able to pay interest to their depositors, cover their own operating costs, and earn a profit, all the while maintaining the ability of the original depositors to spend the funds when they desire to do so. One key characteristic of banks is that they offer their customers the opportunity to open checking accounts, thus creating checkable deposits. These functions define a bank, which is a financial intermediary that accepts deposits, makes loans, and offers checking accounts.

Over time, some nonbank financial intermediaries have become more and more like banks. For example, some brokerage firms offer customers interest-earning accounts and make loans. They now allow their customers to write checks on their accounts.

As nonbank financial intermediaries have grown, banks’ share of the nation’s credit market financial assets has diminished. In 1972, banks accounted for nearly 30% of U.S. credit market financial assets. In 2007, that share had dropped to about 15%.

The fact that banks account for a declining share of U.S. financial assets alarms some observers. We will see that banks are more tightly regulated than are other financial institutions; one reason for that regulation is to maintain control over the money supply. Other financial intermediaries do not face the same regulatory restrictions as banks. Indeed, their freedom from regulation is one reason they have grown so rapidly. As other financial intermediaries become more important, central authorities begin to lose control over the money supply.

The declining share of financial assets controlled by “banks” began to change in 2008. Many of the nation’s largest investment banks—financial institutions that provided services to firms but were not regulated as commercial banks—began having serious financial difficulties as a result of their investments tied to home mortgage loans. As home prices in the United States began falling, many of those mortgage loans went into default. Investment banks that had made substantial purchases of securities whose value was ultimately based on those mortgage loans themselves began failing. Bear Stearns, one of the largest investment banks in the United States, required federal funds to remain solvent. Another large investment bank, Lehman Brothers, failed. In an effort to avoid a similar fate, several other investment banks applied for status as ordinary commercial banks subject to the stringent regulation those institutions face. One result of the terrible financial crisis that crippled the U.S. and other economies in 2008 may be greater control of the money supply by the Fed.

 

Bank Finance and a Fractional Reserve System

Bank finance lies at the heart of the process through which money is created. To understand money creation, we need to understand some of the basics of bank finance.

Banks accept deposits and issue checks to the owners of those deposits. Banks use the money collected from depositors to make loans. The bank’s financial picture at a given time can be depicted using a simplified balance sheet, which is a financial statement showing assets, liabilities, and net worth. Assets are anything of value. Liabilities are obligations to other parties. Net worth equals assets less liabilities. All these are given dollar values in a firm’s balance sheet. The sum of liabilities plus net worth therefore must equal the sum of all assets. On a balance sheet, assets are listed on the left, liabilities and net worth on the right.

The main way that banks earn profits is through issuing loans. Because their depositors do not typically all ask for the entire amount of their deposits back at the same time, banks lend out most of the deposits they have collected—to companies seeking to expand their operations, to people buying cars or homes, and so on. Banks keep only a fraction of their deposits as cash in their vaults and in deposits with the Fed. These assets are called reserves. Banks lend out the rest of their deposits. A system in which banks hold reserves whose value is less than the sum of claims outstanding on those reserves is called a fractional reserve banking system.

Table 24.1 “The Consolidated Balance Sheet for U.S. Commercial Banks, October 2010” shows a consolidated balance sheet for commercial banks in the United States for October 2010. Banks hold reserves against the liabilities represented by their checkable deposits. Notice that these reserves were a small fraction of total deposit liabilities of that month. Most bank assets are in the form of loans.

Table 24.1 The Consolidated Balance Sheet for U.S. Commercial Banks, October 2010

Assets		Liabilities and Net Worth
Reserves	$1,040.2	Checkable deposits	$1,792.0
Other assets	1,743.7	Other deposits	6,103.6
Loans	6,788.7	Borrowings	1,927.5
Securities	2,452.6	Other liabilities	855.8
Total assets	$12,025.2	Total liabilities	10,678.9
		Net worth	1,346.4

This balance sheet for all commercial banks in the United States shows their financial situation in billions of dollars, seasonally adjusted, on October 2010.

 

Source: Federal Reserve Statistical Release H.8, December 3, 2010.

 

 

In the next section, we will learn that money is created when banks issue loans.

 

Money Creation

To understand the process of money creation today, let us create a hypothetical system of banks. We will focus on three banks in this system: Acme Bank, Bellville Bank, and Clarkston Bank. Assume that all banks are required to hold reserves equal to 10% of their checkable deposits. The quantity of reserves banks are required to hold is called required reserves. The reserve requirement is expressed as a required reserve ratio; it specifies the ratio of reserves to checkable deposits a bank must maintain. Banks may hold reserves in excess of the required level; such reserves are called excess reserves. Excess reserves plus required reserves equal total reserves.

Because banks earn relatively little interest on their reserves held on deposit with the Federal Reserve, we shall assume that they seek to hold no excess reserves. When a bank’s excess reserves equal zero, it is loaned up. Finally, we shall ignore assets other than reserves and loans and deposits other than checkable deposits. To simplify the analysis further, we shall suppose that banks have no net worth; their assets are equal to their liabilities.

Let us suppose that every bank in our imaginary system begins with $1,000 in reserves, $9,000 in loans outstanding, and $10,000 in checkable deposit balances held by customers. The balance sheet for one of these banks, Acme Bank, is shown in Table 24.2 “A Balance Sheet for Acme Bank”. The required reserve ratio is 0.1: Each bank must have reserves equal to 10% of its checkable deposits. Because reserves equal required reserves, excess reserves equal zero. Each bank is loaned up.

Table 24.2 A Balance Sheet for Acme Bank

Acme Bank
Assets		Liabilities
Reserves	$1,000	Deposits	$10,000
Loans	$9,000

We assume that all banks in a hypothetical system of banks have $1,000 in reserves, $10,000 in checkable deposits, and $9,000 in loans. With a 10% reserve requirement, each bank is loaned up; it has zero excess reserves.

 

 

Acme Bank, like every other bank in our hypothetical system, initially holds reserves equal to the level of required reserves. Now suppose one of Acme Bank’s customers deposits $1,000 in cash in a checking account. The money goes into the bank’s vault and thus adds to reserves. The customer now has an additional $1,000 in his or her account. Two versions of Acme’s balance sheet are given here. The first shows the changes brought by the customer’s deposit: reserves and checkable deposits rise by $1,000. The second shows how these changes affect Acme’s balances. Reserves now equal $2,000 and checkable deposits equal $11,000. With checkable deposits of $11,000 and a 10% reserve requirement, Acme is required to hold reserves of $1,100. With reserves equaling $2,000, Acme has $900 in excess reserves.

At this stage, there has been no change in the money supply. When the customer brought in the $1,000 and Acme put the money in the vault, currency in circulation fell by $1,000. At the same time, the $1,000 was added to the customer’s checking account balance, so the money supply did not change.

Figure 24.3

Because Acme earns only a low interest rate on its excess reserves, we assume it will try to loan them out. Suppose Acme lends the $900 to one of its customers. It will make the loan by crediting the customer’s checking account with $900. Acme’s outstanding loans and checkable deposits rise by $900. The $900 in checkable deposits is new money; Acme created it when it issued the $900 loan. Now you know where money comes from—it is created when a bank issues a loan.

Figure 24.4

Presumably, the customer who borrowed the $900 did so in order to spend it. That customer will write a check to someone else, who is likely to bank at some other bank. Suppose that Acme’s borrower writes a check to a firm with an account at Bellville Bank. In this set of transactions, Acme’s checkable deposits fall by $900. The firm that receives the check deposits it in its account at Bellville Bank, increasing that bank’s checkable deposits by $900. Bellville Bank now has a check written on an Acme account. Bellville will submit the check to the Fed, which will reduce Acme’s deposits with the Fed—its reserves—by $900 and increase Bellville’s reserves by $900.

Figure 24.5

Notice that Acme Bank emerges from this round of transactions with $11,000 in checkable deposits and $1,100 in reserves. It has eliminated its excess reserves by issuing the loan for $900; Acme is now loaned up. Notice also that from Acme’s point of view, it has not created any money! It merely took in a $1,000 deposit and emerged from the process with $1,000 in additional checkable deposits.

The $900 in new money Acme created when it issued a loan has not vanished—it is now in an account in Bellville Bank. Like the magician who shows the audience that the hat from which the rabbit appeared was empty, Acme can report that it has not created any money. There is a wonderful irony in the magic of money creation: banks create money when they issue loans, but no one bank ever seems to keep the money it creates. That is because money is created within the banking system, not by a single bank.

The process of money creation will not end there. Let us go back to Bellville Bank. Its deposits and reserves rose by $900 when the Acme check was deposited in a Bellville account. The $900 deposit required an increase in required reserves of $90. Because Bellville’s reserves rose by $900, it now has $810 in excess reserves. Just as Acme lent the amount of its excess reserves, we can expect Bellville to lend this $810. The next set of balance sheets shows this transaction. Bellville’s loans and checkable deposits rise by $810.

Figure 24.6

The $810 that Bellville lent will be spent. Let us suppose it ends up with a customer who banks at Clarkston Bank. Bellville’s checkable deposits fall by $810; Clarkston’s rise by the same amount. Clarkston submits the check to the Fed, which transfers the money from Bellville’s reserve account to Clarkston’s. Notice that Clarkston’s deposits rise by $810; Clarkston must increase its reserves by $81. But its reserves have risen by $810, so it has excess reserves of $729.

Figure 24.7

Notice that Bellville is now loaned up. And notice that it can report that it has not created any money either! It took in a $900 deposit, and its checkable deposits have risen by that same $900. The $810 it created when it issued a loan is now at Clarkston Bank.

The process will not end there. Clarkston will lend the $729 it now has in excess reserves, and the money that has been created will end up at some other bank, which will then have excess reserves—and create still more money. And that process will just keep going as long as there are excess reserves to pass through the banking system in the form of loans. How much will ultimately be created by the system as a whole? With a 10% reserve requirement, each dollar in reserves backs up $10 in checkable deposits. The $1,000 in cash that Acme’s customer brought in adds $1,000 in reserves to the banking system. It can therefore back up an additional $10,000! In just the three banks we have shown, checkable deposits have risen by $2,710 ($1,000 at Acme, $900 at Bellville, and $810 at Clarkston). Additional banks in the system will continue to create money, up to a maximum of $7,290 among them. Subtracting the original $1,000 that had been a part of currency in circulation, we see that the money supply could rise by as much as $9,000.

Heads Up!

Notice that when the banks received new deposits, they could make new loans only up to the amount of their excess reserves, not up to the amount of their deposits and total reserve increases. For example, with the new deposit of $1,000, Acme Bank was able to make additional loans of $900. If instead it made new loans equal to its increase in total reserves, then after the customers who received new loans wrote checks to others, its reserves would be less than the required amount. In the case of Acme, had it lent out an additional $1,000, after checks were written against the new loans, it would have been left with only $1,000 in reserves against $11,000 in deposits, for a reserve ratio of only 0.09, which is less than the required reserve ratio of 0.1 in the example.

 

 

The Deposit Multiplier

We can relate the potential increase in the money supply to the change in reserves that created it using the deposit multiplier (m_d), which equals the ratio of the maximum possible change in checkable deposits (∆D) to the change in reserves (∆R). In our example, the deposit multiplier was 10:

Equation 24.1

$m_d=\frac{\Delta D}{\Delta R}=\frac{\$10,000}{\$1,000}=10$

To see how the deposit multiplier m_d is related to the required reserve ratio, we use the fact that if banks in the economy are loaned up, then reserves, R, equal the required reserve ratio (rrr) times checkable deposits, D:

Equation 24.2

$R=rrrD$

A change in reserves produces a change in loans and a change in checkable deposits. Once banks are fully loaned up, the change in reserves, ∆R, will equal the required reserve ratio times the change in deposits, ∆D:

Equation 24.3

$\Delta R=rrr\Delta D$

Solving for ∆D, we have

Equation 24.4

$\frac{1}{rrr}\Delta R=\Delta D$

Dividing both sides by ∆R, we see that the deposit multiplier, m_d, is 1/rrr:

Equation 24.5

$\frac{1}{rrr}=\frac{\Delta D}{\Delta R}=m_d$

The deposit multiplier is thus given by the reciprocal of the required reserve ratio. With a required reserve ratio of 0.1, the deposit multiplier is 10. A required reserve ratio of 0.2 would produce a deposit multiplier of 5. The higher the required reserve ratio, the lower the deposit multiplier.

Actual increases in checkable deposits will not be nearly as great as suggested by the deposit multiplier. That is because the artificial conditions of our example are not met in the real world. Some banks hold excess reserves, customers withdraw cash, and some loan proceeds are not spent. Each of these factors reduces the degree to which checkable deposits are affected by an increase in reserves. The basic mechanism, however, is the one described in our example, and it remains the case that checkable deposits increase by a multiple of an increase in reserves.

The entire process of money creation can work in reverse. When you withdraw cash from your bank, you reduce the bank’s reserves. Just as a deposit at Acme Bank increases the money supply by a multiple of the original deposit, your withdrawal reduces the money supply by a multiple of the amount you withdraw. And just as money is created when banks issue loans, it is destroyed as the loans are repaid. A loan payment reduces checkable deposits; it thus reduces the money supply.

Suppose, for example, that the Acme Bank customer who borrowed the $900 makes a $100 payment on the loan. Only part of the payment will reduce the loan balance; part will be interest. Suppose $30 of the payment is for interest, while the remaining $70 reduces the loan balance. The effect of the payment on Acme’s balance sheet is shown below. Checkable deposits fall by $100, loans fall by $70, and net worth rises by the amount of the interest payment, $30.

Similar to the process of money creation, the money reduction process decreases checkable deposits by, at most, the amount of the reduction in deposits times the deposit multiplier.

Figure 24.8

 

The Regulation of Banks

Banks are among the most heavily regulated of financial institutions. They are regulated in part to protect individual depositors against corrupt business practices. Banks are also susceptible to crises of confidence. Because their reserves equal only a fraction of their deposit liabilities, an effort by customers to get all their cash out of a bank could force it to fail. A few poorly managed banks could create such a crisis, leading people to try to withdraw their funds from well-managed banks. Another reason for the high degree of regulation is that variations in the quantity of money have important effects on the economy as a whole, and banks are the institutions through which money is created.

Deposit Insurance

From a customer’s point of view, the most important form of regulation comes in the form of deposit insurance. For commercial banks, this insurance is provided by the Federal Deposit Insurance Corporation (FDIC). Insurance funds are maintained through a premium assessed on banks for every $100 of bank deposits.

If a commercial bank fails, the FDIC guarantees to reimburse depositors up to $250,000 (raised from $100,000 during the financial crisis of 2008) per insured bank, for each account ownership category. From a depositor’s point of view, therefore, it is not necessary to worry about a bank’s safety.

One difficulty this insurance creates, however, is that it may induce the officers of a bank to take more risks. With a federal agency on hand to bail them out if they fail, the costs of failure are reduced. Bank officers can thus be expected to take more risks than they would otherwise, which, in turn, makes failure more likely. In addition, depositors, knowing that their deposits are insured, may not scrutinize the banks’ lending activities as carefully as they would if they felt that unwise loans could result in the loss of their deposits.

Thus, banks present us with a fundamental dilemma. A fractional reserve system means that banks can operate only if their customers maintain their confidence in them. If bank customers lose confidence, they are likely to try to withdraw their funds. But with a fractional reserve system, a bank actually holds funds in reserve equal to only a small fraction of its deposit liabilities. If its customers think a bank will fail and try to withdraw their cash, the bank is likely to fail. Bank panics, in which frightened customers rush to withdraw their deposits, contributed to the failure of one-third of the nation’s banks between 1929 and 1933. Deposit insurance was introduced in large part to give people confidence in their banks and to prevent failure. But the deposit insurance that seeks to prevent bank failures may lead to less careful management—and thus encourage bank failure.

 

Regulation to Prevent Bank Failure

To reduce the number of bank failures, banks are severely limited in what they can do. They are barred from certain types of financial investments and from activities viewed as too risky. Banks are required to maintain a minimum level of net worth as a fraction of total assets. Regulators from the FDIC regularly perform audits and other checks of individual banks to ensure they are operating safely.

The FDIC has the power to close a bank whose net worth has fallen below the required level. In practice, it typically acts to close a bank when it becomes insolvent, that is, when its net worth becomes negative. Negative net worth implies that the bank’s liabilities exceed its assets.

When the FDIC closes a bank, it arranges for depositors to receive their funds. When the bank’s funds are insufficient to return customers’ deposits, the FDIC uses money from the insurance fund for this purpose. Alternatively, the FDIC may arrange for another bank to purchase the failed bank. The FDIC, however, continues to guarantee that depositors will not lose any money.

 

Central Banks, Their Functions and Role

BY
KIMBERLY AMADEO
REVIEWED BY
MICHAEL J BOYLE

on June 30, 2020

A central bank is an independent national authority that conducts monetary policy, regulates banks, and provides financial services including economic research. Its goals are to stabilize the nation’s currency, keep unemployment low, and prevent inflation.

Most central banks are governed by a board consisting of its member banks. The country’s chief elected official appoints the director. The national legislative body approves him or her. That keeps the central bank aligned with the nation’s long-term policy goals. At the same time, it’s free of political influence in its day-to-day operations. The Bank of England first established that model. Conspiracy theories to the contrary, that’s also who owns the U.S. Federal Reserve.1

Monetary Policy
Central banks affect economic growth by controlling the liquidity in the financial system. They have three monetary policy tools to achieve this goal.

First, they set a reserve requirement. It’s the amount of cash that member banks must have on hand each night.2 The central bank uses it to control how much banks can lend.

Second, they use open market operations to buy and sell securities from member banks. It changes the amount of cash on hand without changing the reserve requirement. They used this tool during the 2008 financial crisis. Banks bought government bonds and mortgage-backed securities to stabilize the banking system. The Federal Reserve added $4 trillion to its balance sheet with quantitative easing.3It began reducing this stockpile in October 2017.

Third, they set targets on interest rates they charge their member banks. That guides rates for loans, mortgages, and bonds. Raising interest rates slows growth, preventing inflation. That’s known as contractionary monetary policy. Lowering rates stimulates growth, preventing or shortening a recession. That’s called expansionary monetary policy. The European Central Bank lowered rates so far that they became negative.4

Monetary policy is tricky. It takes about six months for the effects to trickle through the economy. Banks can misread economic data as the Fed did in 2006. It thought the subprime mortgage meltdown would only affect housing. It waited to lower the fed funds rate. By the time the Fed lowered rates, it was already too late.5

But if central banks stimulate the economy too much, they can trigger inflation.6 Central banks avoid inflation like the plague. Ongoing inflation destroys any benefits of growth. It raises prices for consumers, increases costs for businesses, and eats up any profits. Central banks must work hard to keep interest rates high enough to prevent it.

Politicians and sometimes the general public are suspicious of central banks. That’s because they usually operate independently of elected officials. They often are unpopular in their attempt to heal the economy. For example, Federal Reserve Chairman Paul Volcker (served from 1979-1987) sent interest rates skyrocketing.7 It was the only cure to runaway inflation. Critics lambasted him. Central bank actions are often poorly understood, raising the level of suspicion.

Bank Regulation
Central banks regulate their members.8They require enough reserves to cover potential loan losses. They are responsible for ensuring financial stability and protecting depositors’ funds.

In 2010, the Dodd-Frank Wall Street Reform Act gave more regulatory authority to the Fed. It created the Consumer Financial Protection Agency. That gave regulators the power to split up large banks, so they don’t become “too big to fail.” It eliminates loopholes for hedge funds and mortgage brokers. The Volcker Rule prohibits banks from owning hedge funds. It bans them from using investors’ money to buy risky derivatives for their own profit.9

Dodd-Frank also established the Financial Stability Oversight Council.10 It warns of risks that affect the entire financial industry. It can also recommend that the Federal Reserve regulate any non-bank financial firms.

Dodd Franks keeps banks, insurance companies, and hedge funds from becoming too big to fail.
Provide Financial Services
Central banks serve as the bank for private banks and the nation’s government. They process checks and lend money to their members.

Central banks store currency in their foreign exchange reserves. They use these reserves to change exchange rates. They add foreign currency, usually the dollar or euro, to keep their own currency in alignment.11

That’s called a peg, and it helps exporters keep their prices competitive.

Central banks also regulate exchange rates as a way to control inflation. They buy and sell large quantities of foreign currency to affect supply and demand.12

Most central banks produce regular economic statistics to guide fiscal policy decisions. Here are examples of reports provided by the Federal Reserve:

• Beige Book: A monthly economic status report from regional Federal Reserve banks.
• Monetary Policy Report: A semiannual report to Congress on the national economy
• Credit Card Debt: A monthly report on consumer credit.

History
Sweden created the world’s first central bank, the Riksbank, in 1668. The Bank of England came next in 1694. Napoleon created the Banquet de France in 1800. Congress established the Federal Reserve in 1913.13 The Bank of Canada began in 1935,14 and the German Bundesbank was reestablished after World War II. In 1998, the European Central Bank replaced all the eurozone’s central banks.

Who Really Owns the Federal Reserve?

The Federal Reserve is the central bank for the United States. Its decisions affect the U.S. economy and, therefore, the world. This position makes it the most powerful actor in the global economy. It is not a company or a government agency. Its leader is not an elected official. This makes it seem highly suspicious to many people because it is not subject to either voters or shareholders.1
Who Owns the Federal Reserve?
The Federal Reserve is an independent entity established by the Federal Reserve Act of 1913. At that time, President Woodrow Wilson wanted a government-appointed central board. But Congress wanted the Fed to have 12 regional banks to represent America’s diverse regions. The compromise meant that the Fed has both.2

Congress and the Fed
The president and Congress must approve all members of the Federal Reserve Board of Governors, but the board members’ terms deliberately don’t coincide with those of elected officials. The president appoints the Federal Reserve chair, currently Jerome Powell.3 Congress must approve the president’s appointment. The chair must report on the Fed’s actions to Congress.4

Congress can alter the statutes governing the Fed. For example, the Dodd-Frank Wall Street Reform and Consumer Protection Act limited the Fed’s powers. It required the Government Accountability Office (GAO) to audit the emergency loans the Fed made during the 2008 financial crisis. It also required the Fed to make public the names of banks that received any emergency loans or TARP funds. The Fed must get Treasury Department approval before making emergency loans, as it did with Bear Stearns and AIG.5

The Fed’s Board is an independent agency of the federal government, but its decisions don’t have to be approved by the president, legislators, or any elected official.
Funding
Equally as important, the Fed does not receive its funding from Congress. Instead, its funds come from its investments. It receives interest from U.S. Treasury notes it acquired as part of open market operations. It receives interest on its foreign currency investments. Its banks receive fees for services provided to commercial banks. These include check clearing, funds transfers, and automated clearinghouse operations.

The Fed also receives interest on loans it makes to its member banks. It uses these funds to pay its bills, then turns any “profit” over to the U.S. Treasury Department.6

Bank Members
The 12 regional Federal Reserve banks are set up similarly to private banks. They store currency, process checks, and make loans to the private banks within their area that they regulate. These banks are also members of the Federal Reserve banking system. As such, they must maintain reserve requirements. In return, they can borrow from each other at the fed funds rate when needed. As a last resort, they can also borrow from the Fed’s discount window at the discount rate.7

To be a member of the Federal Reserve system, commercial banks must own shares of stock in the 12 regional Federal Reserve banks. But owning Federal Reserve bank stock is nothing like owning stock in a private company. It can’t be traded and doesn’t give the member banks voting rights. These pay out dividends, mandated by law to be 6%. But the banks must return all profits, after paying expenses, to the U.S. Treasury.6

Why the Fed Must Remain Independent
The Fed’s monetary policy can do its job better when it is shielded from short-term political influence. It must be free to set expectations, especially about inflation. It cannot do that when its leaders are worried about being fired by an elected official.
Fed chairs are predominantly well-respected academic economists.8 Their expertise is in public policy, finance, and central banking. They are valued for that expertise, not for charisma, a large fan base, or public speaking skills. They are accustomed to an environment where ideas are rationally discussed, debated, and evaluated. If the Fed were beholden to the politics of the day, it could not attract people of that professional caliber.

How the Fed Is Held Accountable
Although it is independent, the Fed is still accountable to the public and to Congress. The Fed can best guide expectations if it is transparent about its actions. It must also clearly communicate its reasons for its actions.

The Fed communicates through frequent and detailed reports. First, the Fed chair and other board members testify frequently before Congress. Second, the Fed submits to Congress a detailed Monetary Policy Report twice per year. Third, the Federal Open Market Committee (FOMC) publishes a statement after each meeting. It also provides detailed meeting minutes three weeks later. Verbatim transcripts are available five years later.9

How the Fed Works
The Fed’s primary function has been to manage inflation. It has a variety of tools to accomplish that.

During the financial crisis of 2008, it created innovative tools to avert a depression. Since the recession, it also pledged to reduce unemployment and spur economic growth.10

Monetary Policy Tools
The Fed works by using its monetary policy tools.

Setting low-interest rates is called “expansionary monetary policy.” That makes the economy grow faster. If the economy grows too fast, it triggers inflation.

Increasing interest rates is called “contractionary monetary policy.” It slows economic growth by making loans and other forms of credit more expensive. That restricts the money supply. As demand falls, businesses lower prices. This creates deflation. That further lowers demand, because consumers delay buying while waiting for prices to fall further.11

How does the Fed cut interest rates? It lowers the target for the fed funds rate. Banks usually follow the Fed’s lead, cutting benchmark rates such as the prime rate. The Fed can also use its other tools, such as lowering the discount rate that banks use to borrow funds directly from the Fed’s discount window.

Historical Examples
To combat the financial crisis of 2008, the Fed got creative. It bought mortgage-backed securities from banks directly as a way to pump liquidity into the financial system. It also started buying Treasuries. Both purchases became known as “quantitative easing.”12

Critics worried that the Fed’s policies would create hyperinflation. They argued that the Fed was just printing money. But banks weren’t lending, so the money supply wasn’t growing quickly enough to cause inflation. Instead, they hoarded cash to write down a steady stream of housing foreclosures. The situation didn’t improve until 2011. By then, the Fed had cut back on quantitative easing.

 

Capital Gains vs. Income Tax — Why Investors Pay Less Than Employees
ByJanet Berry-Johnson

In 2011, American businessman and investor Warren Buffett wrote an op-edfor the New York Times in which he famously claimed he pays a lower tax rate than any of the other 20 people in his office — including his secretary.
He said his prior year’s federal tax bill was only 17.4% of his taxable income that year, compared to tax burdens ranging from 33% to 41% for the rest of his team.
With Buffett’s estimated net worthtopping more than $80 billion, how is that possible? The answer lies in the difference between how capital gains and income from employment are taxed.
Capital Gains vs. Ordinary Income
Few people take the time to analyze their tax returns. However, if you did, you might notice that different income types get taxed at different rates.
Ordinary Income
The IRS taxes most income at the ordinary income tax rates — these are the familiar tax brackets that determine the tax rate you pay on income from wages and salaries, income from a business or rental property, most interest income, and some dividends.
For the 2020 tax year, the ordinary income tax brackets are:

Rate	Single	Married Filing Jointly	Head of Household	Married Filing Separately
10%	Up to $9,875	Up to $19,750	Up to $14,100	Up to $9,875
12%	$9,876 – $40,125	$19,751 – $80,250	$14,101 – $53,700	$9,876 to $40,125
22%	$40,126 – $85,525	$80,251 – $171,050	$53,701 – $85,500	$40,126 – $85,525
24%	$85,526 – $163,300	$171,051 – $326,600	$85,501 – $163,300	$85,526 – $163,300
32%	$163,301 – $207,350	$326,601 – $414,700	$163,301 – $207,350	$163,301 – $207,350
35%	$207,351 – $518,400	$414,701 – $622,050	$207,351 – $518,400	$207,351 – $311,025
37%	Over $518,400	Over $622,050	Over $518,400	Over $311,025

Capital Gains
Capital gains income results from selling a “capital asset” for a price that is greater than its “basis.”
The IRS considers almost everything you own, including your home, personal effects, and investments to be capital assets.
Each capital asset has a basis. Basis is the price you paid for the asset, plus any money you put into improvements.
For example, say you own a vacation home. You paid $250,000 for the property, and after you purchased it, you spent $10,000 renovating the kitchen. Your basis in the vacation home would be $260,000. If you later sold the house for $300,000, you would have a capital gain of $40,000.
We calculate capital gains on investments like stocks and mutual funds in much the same way.
If you purchase 100 shares of Apple stock (AAPL) at $100 per share, your basis in the shares is $10,000. If you later sell the stock when the price per share is $120, your capital gain would be $2,000 — that’s the $12,000 selling price minus your $10,000 basis in the investment.
On the other hand, if you decided to sell your shares after the price falls to $80 per share, you would have a $2,000 capital loss.
Short-Term vs. Long-Term Capital Gains
Capital gains and losses are categorized as either short-term or long-term, depending on how long you owned the asset.
Generally, if you owned the asset for more than one year, it’s a long-term capital gain or loss. If you held it for one year or less, it’s a short-term gain or loss.
The IRS taxes short-term gains at the same rate as ordinary income. But long-term capital gains have their own lower tax brackets. Here they are for 2020:

Rate	Single	Married Filing Jointly	Head of Household	Married Filing Separately
0%	Up to $40,000	Up to $80,000	Up to $53,600	Up to $40,000
15%	$40,001 – $441,450	$80,001 – $496,600	$53,601 – $469,050	$40,001 – $248,300
20%	Over $441,450	Over $496,600	Over $469,050	Over $248,300

You can use capital losses to offset capital gains.
For example, say you had that $2,000 gain on Apple stock mentioned above, but you also sold 100 shares of Facebook (FB) at a $1,000 loss. You would net the two together and pay taxes on a net capital gain of $1,000.
Capital Gains vs. Ordinary Income: An Example
Now that we’ve explained the different tax brackets that apply to ordinary income and capital gains, let’s return to the question of why an investor like Warren Buffet pays a lower tax rate than his secretary. We’ll do this with a hypothetical example.
Let’s say Iris is a single taxpayer who has $70,000 in wages from her full-time job. Iris is in the 22% tax bracket, but that doesn’t mean she pays 22% on all $70,000 of income.
Instead, the first $9,875 of her income is taxed at 10%, the next $30,250 at 12%, and the final $29,875 at 22%. That works out to a total federal income tax bill of $11,190 ($987.50 + $3,630 + $6,572.50).
Iris is in the 22% tax bracket, but her effective tax rate is 16% — she pays $11,190 out of her $70,000 income.
But wait. If you’ve ever looked at a pay stub, you know that federal income taxes aren’t the only taxes deducted from your paycheck.
In addition to Iris’ federal income tax bill, she also pays Social Security tax at a rate of 6.2% and Medicare tax of 1.45% on her earnings. That’s another $5,355 out of her pocket.
Between federal income taxes and payroll tax, Iris is giving 24% of her income to the federal government.
Now let’s compare Iris’ tax rate to Keith’s. Keith is also a single taxpayer with $70,000 of income. But thanks to Keith’s grandparents, who left him a pile of money, Keith doesn’t work.
Instead, all of his income comes from long-term capital gains. The first $40,000 of Keith’s income isn’t taxed at all, because it falls into the 0% capital gains tax bracket. He pays just 15% on the next $30,000, for a total tax bill of $4,500.
Keith’s effective tax rate is just 6%. Plus, Keith doesn’t have any Social Security or Medicare taxes deducted from his capital gains. As a result, Investor Keith pays a much lower effective tax rate than Worker Iris.
Note: Iris’ and Keith’s tax bills might actually be lower due to deductions and credits that would reduce their taxable income and offset their tax liability. To keep this illustration simple, we’ve ignored the potential impact of tax deductions and credits.
Why Capital Gains Tax Rates Are Lower
In looking at the example above or reading Buffett’s op-ed, you might wonder why there’s such a big difference in how the U.S. Tax Code treats ordinary income and capital gains. Well, it depends on who you ask.
According to the Tax Foundation, a low capital gains tax rate encourages people to save and invest in the U.S. economy, and low capital gains tax rates have historically raised more in tax revenues than higher capital gains rates.
The Tax Policy Center, on the other hand, argues that tax rates on capital gains aren’t a major factor in economic growth, and the benefits of lower capital gains rates disproportionately benefit the wealthy.
That’s why some lawmakers have proposed higher taxes on investment income over the past several years. One example, the so-called “Buffett Rule,” would apply a minimum tax rate of 30 percent on all taxpayers with income greater than $1 million, no matter where their money came from.
Although that initiative didn’t pass, the Health Care and Education Reconciliation Act of 2010 created the Net Investment Income Tax (NIIT). The NIIT applies a 3.8% surtax on investment income, including interest, dividends, capital gains, and rent and royalty income for high-income taxpayers.
For these purposes, “high income” means single taxpayers with income greater than $200,000 or married couples filing a joint tax return who make more than $250,000.
Final Word
Capital gains tax rates are a highly debated topic. Advocates for lowering capital gains tax rates argue that it would increase economic growth and promote entrepreneurship. Their opponents believe raising the tax rates on capital gains would raise additional revenues and promote a more equitable tax system.
Whatever happens to capital gains tax rates in the future, it helps to understand how our tax laws treat different types of income. You can use that knowledge in your own tax planning, or simply have a better understanding of what it means when politicians and lawmakers debate the issue.
JUMP TO

• Capital Gains vs. Ordinary Income
• Capital Gains vs. Ordinary Income: An Example
• Why Capital Gains Tax Rates Are Lower
• Final Word

 

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