Exercise 10.1 (Macro):
Why was the Federal Reserve concerned about the start of a new millenium?

As 1999 came to a close, consumers and businesses became increasingly concerned that computer programs written decades earlier would be unable to safely handle the transition to a new century. The possible result: widespread computer glitches on January 1, 2000 that could lead to disruptions in the production, delivery, and sale of goods and services in the U.S. and around the world. Despite public assurances from the U.S. government that such a scenario was unlikely, many consumers stockpiled water, canned food, generators, and other supplies—just in case. At the same time, the Federal Reserve had its own "Y2K" concerns and was quietly taking measures to handle potential problems related to the start of a new millenium. Why was the Federal Reserve concerned and what was it doing about those concerns?

The Federal Reserve was particularly concerned that, in addition to stockpiling food, water, and power-generating supplies, individuals would begin hoarding cash near the end of 1999, leading to a potential liquidity problem for banks as concerned savers withdrew their deposits. Some savers worried that computers used to monitor bank account balances and operate automatic teller machines would malfunction on January 1, 2000, leaving them without a means of paying for goods and services. In a national poll carried out in December, 1999, 35% of those surveyed indicated that they planned to prepare for possible "Y2K" problems by taking additional money out of the bank before New Year's Day. Holding on to cash, these savers reasoned, would be safer than keeping their money in the bank.

However, widespread withdrawals of deposits (and reserves) over a short period of time could cause financial problems for banks, who normally keep only a small fraction of depositors' money on hand as cash. As concerned depositors swamped banks with withdrawal requests, it was feared, banks could find themselves short of cash, causing disruptions in service or—in a worst-case scenario—a banking panic which could jeopardize the safety of the banking system. To deal with the anticipated heavy demand for currency and avoid financial system disruptions, the Federal Reserve significantly increased the amount of cash available to the banking system during 1999. As a result, the money supply grew dramatically during the fourth quarter of 1999.

However, the increase in the money supply was short-lived. New Year's Day 2000 came and went with few computer disruptions and no financial panics. Only a handful of small banks requested additional currency from the Federal Reserve; most banks had more currency than they needed—or wanted. By January 3, 2000, banks were already beginning to send excess cash back to the Federal Reserve. As one of the Federal Reserve governors remarked, "Depository institutions want to get that excess cash out of their vaults and off their balance sheets as fast as they can. They're just storing it—it's a non-interest-earning asset." What did the Federal Reserve do with this additional cash? It simply stored it in its vaults until it was needed to meet the normal demands of the banking system.

While the widely-anticipated Year-2000 computer problems failed to materialize, the Federal Reserve's actions illustrate the Federal Reserve's role in maintaining the safety of the banking system. By acting proactively to increase the amount of currency in the banking system in anticipation of depositors' increased demand for cash, they were able to minimize depositors' concerns about the availability of their funds and avoid widespread disruptions in the financial system.