Question

n October 2007, the U.S. entered a recession, unemployment increased dramatically, and business capacity utilization went down. What should (did) the Fed do to the money supply (including what tool did they use to affect the money supply) to help the economy out of the recession? How did this lead to a change in aggregate demand?

Answer 1

The response taken by Fed in 2007 towards recession was an aggressive one which included implementation of numerous programs designed to support the liquidity of financial institutions and foster improved conditions in financial markets.

Federal Reserve expanded its traditional tool of open market operations (OMO) to support the functioning of credit markets, reducing the interest rates. The Fed boosts the economy by reducing the interest rate that banks pay each other for overnight loans known as the federal funds rate. The cuts to the federal funds rate lead to lower interest rates throughout the economy. Those low rates lead businesses to make new investments, people to buy houses and increase purchases of goods like cars. When the economy is depressed and has lots of excess capacity — unemployed workers, vacant offices and storefronts, idle factories — increased spending leads to an increase in employment and economic output.

Fed reduced interest rates until June 2008. During the crisis years, unemployment was very high and inflation below the 2 percent target. During the crisis years, Fed never managed to generate enough demand.