Question

Banking during the Great Recession. During the Great Recession of 2008-2009, US commercial banks grew nervous about the economic outlook, in particular borrowers’ ability to repay loans. As a consequence, commercial banks increased the ratio of reserves to deposits (i.e. they lent out a smaller fraction of their deposits).

a. within the AS/AD model, what are the short-run effects on inflation, real GDP and unemployment of this change in banks’ behavior? Please illustrate using graphs, assuming that the economy starts at the long-run equilibrium.

b. Suppose, to start with, that policy makers do not respond to this change in commercial banks’ behavior and that the classical dichotomy holds. What would be the long run effect on the price level and output? Please make sure to carefully explain how and why this happens.

c. Next, suppose that you sit on the Board of Governors of the Fed. Given the mandate of the Fed, what would you do in response to the change in commercial banks’ behavior? Please carefully describe how your preferred policy would be implemented, including its (potential) ef- fect on money supply, the Fed’s balance sheet and the interest rate. Please also illustrate its impact on the economy in the AS/AD framework.

Answer 1

Now, as reserve ratio increases, liquidity will reduce. This reduction in liquidity will move AD leftwards.

Inflation will reduce, real GDP will reduce, and unemployment will increase.

b)

As there is downward wage pressure at this point as shown in the above graph, cost of production reduces, this will move SRAS rightwards.

Output comes back to normal, i.e. potential output, price levels are reduced.

c)

As the commercial banks increase reserve requirement, liquidity will reduce and economy will contract.

To negate this effect, as Fed, interest rates can be reduced (reduction in policy rate)

This reduction in rates will increase liquidity and will be expansionary monetary policy.

This will help economy come back at equillibrium as shown in the first equillibrium graph and also below graph.