Economic analysis of deposit insurance Essay

Custom Student Mr. Teacher ENG 1001-04 29 September 2016

Economic analysis of deposit insurance

Federal deposit Insurance Corporation was an institution set by government back in 1930s to protect depositors fund held by bank. In the great depression of 1930 most depositors lost their fund following the collapse of many banks. After the stock market crash in 1929, financial market was adversely affected and by March 1933 more than 9,000 banks had already failed and this facilitated establishment of FDIC. Henceforth it has been evolving and finding alternative ways of insuring depositors fund against potential bank insolvency.

FDIC guarantees a specific amount of deposit and checking for member banks. Since it establishment FDIC paid depositors in 1988 following the banking crisis fueled by high interest rate, inflation, recession and deregulation in the banking sector. More than 200 banks were in a liquidity problem and FDIC had to intervene to settle claims by depositors.

Role of deposit insurance in the economy

The main purpose of deposit insurance is to create financial stability in the economy. Majority of people did not bother to check whether their deposit was insured under deposit insurance but following the current financial crisis which started in mid 2007 which saw many banks and other company becoming insolvent most people are  increasingly becoming aware of the role and importance of deposit insurance in the economy. The Emergency Economic Stabilization Act of 2008 temporarily increased the basic limit of deposit insurance from $100,000 to $250,000 (Robert, 2009).

Advocates of free market view deposit insurance as part of government intervention in the market and criticize it on the basis that a competitive market is self regulating and will act to correct any deviation that occurs in the market. however the great depression of 1930s and the current financial crisis  has proved that the market is not always self regulating and therefore there is a need for government intervention as proposed by Keynes in order to correct deviation in the market. although the classical economist argued that  in a competitive market system price, wages and interest rate would automatically adjust to restore the economy to full employment levels there existed certain factors such as investment demand, money demand, union and monopoly power that inhibited the automatic mechanism assumed by classical writers.

Keynes advocate for discretion fiscal policies given the failure of automatic forces as a counter cyclical device to oppose advance trends in business cycles. In period of massive unemployment and depression, expansionary fiscal policy was required by government to solve the problem in less time than automatic forces ever could (Stephen, 2008).

Deposit insurance creates confidence among the public and avoid panic withdrawals as those occasioned in UK when information reached the public that northern bank was experiencing liquidity problem and many account holder were queuing to withdraw there money from the bank. During the current financial crisis where many bank were declared insolvent FDIC compensated many deposit holders who would otherwise lost their deposit. This not only helps to maintain financial stability but also improve economic growth (Robert & George, 2006).

Where people receive compensation they will be able to increase the level of spending on goods and services. This increase in aggregate demand forces supplies to increase output in order to satisfy the growing demand. Supplies will in turn require additional input in term of labor, material and capital which reduces unemployment and increase economic growth.  The graph below indicates the role that deposit insurance can play during economic crisis for instance the current financial crisis.

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