Question

The Fed adopted both conventional monetary policy and unconventional policy to fight against the 2007-2009 financial criss:

(a) List how did the Federal Reserve react to the Financial Crisis. Explain in detail what they.

(b) Which monetary policy causes the money base to increase significantly from 2007 -2014? Which component of money base, currency or reserve, increased more significantly during this period?

(c) Why did the huge expansion in the money base not lead to a similar increase in money supply measured by M1? (Hints: infer what happens to money multiplier and reserve deposit ratio when excess reserve explodes)

Answer 1

1)

Provided liquidity: As short-term markets collapsed, the Federal Reserve expanded its lending to financial institutions to ensure that they had access to the critical funding needed for day-to-day operations. The maturity of discount window loans was extended and the interest rate reduced. In March 2008, the Federal Reserve created programs to provide short-term secured loans to primary dealers similar to discount-window loans provided to banks.

New Regulations: Prohibit lenders from making higher-priced loans without due regard for consumers' ability to make the scheduled payments and require lenders to verify the income and assets on which they rely when making the credit decision. Also, for higher-priced loans, lenders now will be required to establish escrow accounts so that property taxes and insurance costs will be included in consumers' regular monthly payments.

Supported financial markets: The Federal Reserve acted to improve conditions in vital markets that broke down during the panic in the fall of 2008.  The commercial paper market is a key source of funds for many businesses. But when the investment bank Lehman Brothers declared bankruptcy, investors feared that more failures could make some commercial paper nearly worthless. They began pulling money out of money market mutual funds that held commercial paper. Interest rates on commercial paper increased.

The Fed and other central banks conducted open market operations to ensure member banks have access to funds. These were effectively short-term loans to member banks collateralized by government securities. Central banks also lowered the interest rates charged to member banks for short-term loans.

The Fed used the Term Auction Facility to provide short-term loans to banks. The Fed increased the monthly amount of auctions to $100 billion during March 2008, up from $60 billion in prior months. In addition, term repurchase agreements expected to cumulate to $100 billion were announced, which enhance the ability of financial institutions to sell mortgage-backed and other debt.

Supported important financial institutions In 2008, the investment bank Bear Stearns nearly failed, which risked a domino effect that would have severely disrupted financial markets. To contain the damage, the Federal Reserve facilitated the purchase of Bear Stearns by the bank JPMorgan Chase by providing loans backed by certain Bear Stearns assets.

Several months later the investment bank Lehman Brothers collapsed because no private company was willing to acquire the troubled investment bank and Lehman did not have adequate collateral to qualify for direct loans from the Federal Reserve. As a result, financial panic threatened to spread to several other key financial institutions, including the giant insurance company American International Group (AIG). To contain this threat, the Federal Reserve provided secured loans to AIG.

2) Expansionary monetary policy caused the money base to increase significantly from 2007 -2014. Expansionary monetary policy refers to policy initiative by a country's central bank to raise, or expand, its money supply. This can be accomplished with open market purchases of government bonds, with a decrease in the reserve requirement or with decrease in the discount rate.

Bank reserve increased during this period.

3)The huge expansion in the money base not lead to a similar increase in money supply measured by M1 because most of the new money created by the Fed is being held by banks as reserves. Banks would rather earn than lend out their excess reserves.

If the Federal Reserve increases reserves, a single bank can make loans up to the amount of its excess reserves, creating an equal amount of deposits. The banking system, however, can create a multiple expansion of deposits. An increase in bank reserves can support a multiple expansion of deposits. The value of the multiplier depends on the required reserve ratio on deposits. A high required-reserve ratio lowers the value of the multiplier.