Restoring Financial Stability

Restoring Financial Stability in a Financial Crisis

At a time of financial instability and panic, banks’ assessments of risk increase. Banks slash their loans and hold more of their assets in safe, reserve deposits at the Fed. The demand for reserves skyrockets, which raises the federal funds interest rate.

To avoid the rise in the interest rate and the decrease in bank lending that would shrink the quantity of money, all of which would intensify a recession, the Fed uses quantitative easing and credit easing to drastically increase bank reserves.

Quantitative Easing

The most powerful and commonly used of the three traditional tools of monetary policy—open market operations—works by expanding or contracting the money supply in a way that influences the interest rate. In late 2008, as the U.S. economy struggled with recession, the Federal Reserve had already reduced the interest rate to near-zero. With the recession still ongoing, the Fed decided to adopt an innovative and nontraditional policy known as quantitative easing (QE) . This is the purchase of long-term government and private mortgage-backed securities by central banks to make credit available so as to stimulate aggregate demand.

Quantitative easing (QE) differed from traditional monetary policy in several key ways. First, it involved the Fed purchasing long-term Treasury bonds, rather than short-term Treasury bills. In 2008, however, it was impossible to stimulate the economy any further by lowering short-term rates because they were already as low as they could get. Therefore, the Fed’s Chairman, Bernanke sought to lower long-term rates utilizing quantitative easing.

This leads to a second way QE is different from traditional monetary policy. Instead of purchasing Treasury securities, the Fed also began purchasing private mortgage-backed securities, something it had never done before. During the financial crisis, which precipitated the recession, mortgage-backed securities were termed “toxic assets,” because when the housing market collapsed, no one knew what these securities were worth, which put the financial institutions that were holding those securities on very shaky ground. By offering to purchase mortgage-backed securities, the Fed was both pushing long-term interest rates down and also removing possibly “toxic assets” from the balance sheets of private financial firms, which would strengthen the financial system. (19)

Quantitative easing (QE) occurred in three episodes:

  1. During QE1, which began in November 2008, the Fed purchased $600 billion in mortgage-backed securities from government enterprises Fannie Mae and Freddie Mac.
  2. In November 2010, the Fed began QE2, in which it purchased $600 billion in U.S. Treasury bonds.
  3. QE3, began in September 2012 when the Fed commenced purchasing $40 billion of additional mortgage-backed securities per month. This amount was increased in December 2012 to $85 billion per month. The Fed has stated that, when economic conditions permit, it will begin tapering (or reducing the monthly purchases). This has not yet happened as of early 2014.

The quantitative easing policies adopted by the Federal Reserve (and by other central banks around the world) are usually thought of as temporary emergency measures. If these steps are, indeed, to be temporary, then the Federal Reserve will need to stop making these additional loans and sell off the financial securities it has accumulated. The concern is that the process of quantitative easing may prove more difficult to reverse than it was to enact. The evidence suggests that QE1 was somewhat successful, but that QE2 and QE3 have been less so. (19)

The Fed Fights a Recession

If the Fed believes that real GDP is less than potential GDP, the Fed will undertake expansionary monetary policy: it lowers the federal funds rate using an open market sale. The monetary policy is transmitted as outlined in the Figure 7.7.

Figure 7.7 shows the transmission mechanism from the money market to the aggregate supply and aggregate demand. When the Fed purchases government securities, it lowers the federal funds rate. The increase in reserves increases the quantity of money and short-term interest rates fall. This increases the supply of loanable funds. This increase lowers the real interest rate, and increases the quantity of loanable funds. The increase in loanable funds primarily goes to raise investment, so investment increases. Finally, the increase in consumption expenditure, investment, and net exports increases aggregate demand so that the aggregate demand curve shifts right. The increase in AD is larger than the initial increases in expenditures because of the multiplier effect. As the AD-AS diagram shows, the expansionary monetary policy raises the price level and increases real GDP. (19)

The graphs show the example of the ripple effects of monetary policy.
Figure 7-7: The Fed Fights a Recession by FSCJ is licensed under CC-BY-4.0.

If the Fed believes that real GDP is greater than potential GDP so that inflation is a problem, the Fed will undertake contractionary monetary policy: it raises the federal funds rate using an open market sale. The effects of the monetary policy are transmitted, but the directions of the changes are reversed. Real GDP decreases. The AD-AS diagram in this case will look just like the one in Figure 7.6. The Money Market diagram will differ in terms of the direction of the shift of the MS curve, which now shifts to the left, causing interest rates to increase, which in turn negatively affect Investments, known as the “crowding out” effect, which shrinks the AD curve, by shifting it to the left, as shown on Figure 7.6. (19)

Loose Links and Long and Variable Lags

In reality, the ripple effects of monetary policy are not as precise as shown on Figure 7.7. The long-term real interest rate that influences expenditure plans is linked only loosely to the federal funds rate. In addition, the response of expenditure plans to the real interest rate is also not tight. The transmission channels described in this module take time to operate and the time can vary from one episode to the next.

In the United States, it takes about a year from when a monetary policy action is undertaken until real GDP is affected. It takes about two years for monetary policy to affect the inflation rate. The long and variable time lags make monetary policy difficult to implement. However, in comparison with fiscal policy, monetary policy has shorter time lags. (19)