Lecture 18: Monetary Policy

What this lecture covers

This lecture traces how central banks emerged and explains the tools modern central banks use to manage the financial system. Professor Shiller starts with the Bank of England's founding in 1694 and the private U.S. banking arrangements that preceded the Federal Reserve, then moves to how the Federal Reserve System, the European Central Bank and other modern central banks operate today. It follows the course's earlier lecture on commercial banks and builds toward the following lecture on investment banks.

The second half works through a detailed worked example of how bank capital requirements function, and why the 2007-2008 crisis exposed weaknesses in relying on banks to raise capital during a downturn. After watching, you should be able to explain the difference between reserve requirements and capital requirements, and why central banks acted as lenders of last resort during the crisis.

Key ideas

• Goldsmith bankers: early paper money began as receipts from goldsmiths holding gold on deposit, a system that lasted, in modified form, until the gold standard ended in the 1970s.
• Bank of England (1694): the first modern central bank, stabilizing the U.K. system by requiring other banks to hold deposits with it, a model later copied worldwide.
• Federal Reserve System (1913): created after repeated 19th-century U.S. banking crises, structured as 12 regional banks under a Washington board rather than one central bank.
• Lender of last resort: central banks lend to troubled banks through a discount window against collateral, a role that helped prevent a second Great Depression in 2007-2008.
• Reserve requirements vs. capital requirements: reserve requirements are a fraction of a bank's liabilities (currently non-binding for most banks); capital requirements are a fraction of risk-weighted assets and became central under Basel III.
• Interest on reserves: since the 2008 Emergency Economic Stabilization Act, the Fed pays interest on bank reserves, giving it a new tool distinct from setting the federal funds rate.
• Central bank independence: long, fixed terms for policymakers (14 years at the Fed) are meant to insulate monetary policy from short-term political pressure.
• Basel III's procyclicality problem: requiring banks to raise capital by selling assets or issuing shares is hardest exactly when a crisis makes both options unattractive.

Walkthrough

Origins of central banking: the Bank of England (0:00)

Shiller frames central banking as a financial invention that spread by imitation, tracing it back through goldsmith bankers to the Bank of England's 1694 founding. The Bank of England stabilized the U.K. system by requiring other banks to hold deposits with it, later becoming the template for central banks worldwide.

U.S. banking before the Fed (6:27)

The lecture covers Boston's Suffolk Bank, which stabilized New England currency from 1819 to 1860, the messy pre-1863 system of discounted regional bank notes, and the 1863-64 National Banking Act, which fixed currency problems but not banking panics like those of 1893 and 1907.

The founding of the Federal Reserve System (12:08)

Congress created the Federal Reserve in 1913 as 12 regional banks under a Washington board, requiring member banks to hold reserves and offering a discount window as lender of last resort. Shiller connects this to the 1930s banking collapse, Roosevelt's banking holiday, and the creation of the FDIC, and notes the Fed's evolving role in smoothing the business cycle through interest rates.

Making central banks independent (25:46)

Covering the European Central Bank (founded 1998, ahead of the euro's 1999-2002 rollout) and the Bank of Japan (independent since 1997), the lecture argues that giving central bankers long, secure terms, as the Fed does, helps prevent political pressure toward inflation and has supported price stability.

U.S. monetary policy tools: the federal funds rate and reserve requirements (30:49)

The Federal Open Market Committee sets a target range for the federal funds rate, the overnight unsecured rate banks charge each other, which stood near zero in April 2011 due to high unemployment. Shiller explains reserve requirements (10% on transaction accounts, zero on time deposits) and how the 2008 policy of paying interest on reserves changed bank incentives, leaving over a trillion dollars in excess reserves.

Capital requirements and rating agencies (45:23)

The lecture shifts to capital requirements under Basel III, which are based on risk-weighted assets rather than liabilities. It touches on the role of credit rating agencies like Moody's and Standard & Poor's, and how the Dodd-Frank Act's ban on using their ratings in regulation complicates Basel III implementation in the U.S.

A worked capital-requirements example (52:34)

Through a simplified bank balance sheet, Shiller shows how a bank must raise common equity to meet a roughly 7% capital requirement, how making corporate loans raises risk-weighted assets, and how a 20% loan default wipes out equity and forces the bank either to sell assets or issue new shares to stay compliant.

Capital requirements in a crisis (1:05:30)

The example extends to show why raising capital is hardest during a systemic crisis: investors won't buy new shares in a failing bank, and every bank trying to sell assets at once collapses prices. Central banks stepped in as lenders of last resort to prevent this collapse, while Basel III's added countercyclical buffer and the Dodd-Frank Act's limits on discretionary bailouts aim to address the same problem differently going forward.

Before you watch

• Review the earlier lecture on commercial banks for background on how bank balance sheets and lending work.
• Familiarity with the course's discussion of Basel III capital standards, introduced in the lecture on investment banks, is useful but not required.

Check your understanding

1. How did the Bank of England use bank deposits to stabilize the U.K. banking system, and how did the Suffolk Bank apply a similar idea in New England?
2. What problem did the 1863 National Banking Act solve, and what problem did it leave unsolved?
3. What is the difference between a reserve requirement and a capital requirement?
4. In the worked example, why does a 20% default on corporate loans force the bank out of compliance with its capital requirement, and what two options does it have to fix this?
5. Why does the lecture argue that requiring banks to raise capital during a crisis can make a crisis worse rather than better?