Question

What specific actions did the Federal Reserve take in response to the 2007-2009 financial crisis: i) Using the lender of last resort tool? ii) Using the monetary policy tool?

Answer 1

The financial crisis of 2007-2009 led to recessionary gap in the economy with output being less than potential level of output in the economy and fall in the economic growth of the economy. This led government to use expansionary monetary policy tool to increase the level of money supplied in the economy.

Using the lender of last resort tool, the Federal Reserve increased the amount of money supplied in the economy by bailing out banks and providing funding helps to banks to prevent liquidity shortages that these banks were facing. Thus, by acting as lender of the last resort it infused liquidity in the banks by infucion of capital to prevent any losses to these banks.

ii. Using the monetary policy tool, it started purchasing government securities in the open market and massive scale Quantitative Easing was done to increase the amount of money supplied in the economy which will help in decreasing rate of interest and increasing the level of aggregate demand in the economy.