Monetary-policy-toolkit

RESPONDING TO THE FINANCIAL CRISIS: HOW THE FED PREVENTED A FAR WORSE DOWNTURN

If the Federal Reserve had not acted as lender of last resort and had not responded to banks’ demand for extra liquidity after the 2007-08 financial crisis, the fall in US output would have been greater, inflation would have fallen by an additional 2-3% and employment would have been around 2% lower. What’s more, the US economy would have taken roughly twice as long to return from recession.

These are among the conclusions of research by Jagjit Chadha, Luisa Corrado and Jack Meaning, presented at the Royal Economic Society annual conference 2013. Their study analyses the effect of providing liquidity to the banking sector to give a measure of how effective the policy was for the overall economy.

The study looks at the use of alternative monetary policy at a time when nominal interest rates are near zero – known as the ‘zero lower bound’. It argues that when faced with shocks to areas such as productivity, asset prices, interest rates or aggregate demand, commercial banks need access to more ‘liquidity’ to move funds from different areas of the bank as needed. Without the central bank providing extra lending, commercial banks may be forced to cut their lending to firms and households.

Applying the model to the financial crisis of 2007-2008, the researchers suggest that US banks’ demand for additional liquidity increased by around 10%. By supplying such liquidity, the Federal Reserve was not only counteracting the large-scale withdrawals by private investors but also providing a stimulus to output, inflation and employment, which is consistent with its mandate.

More…

The financial crisis has led to a number of new challenges for monetary policy-makers, which have stemmed directly from emergent problems following the use of only one instrument, namely the short-term nominal interest rate.

The first challenge, clearly, is increased awareness of the role that conditions in the financial sector can play in affecting the real economy. The second is how to gain traction when the policy rate is constrained at or near zero.

These challenges have reignited a debate about the extent to which monetary policy-makers need explicitly to base their interest rate paths on other financial prices and more broadly whether the adoption of ‘macroprudential’ policy objectives will act to complicate or complement monetary policy objectives.

Accordingly, this study examines the consequences of providing liquidity, in the form of reserves, to the banking sector as either or both a possible substitute or complement to standard interest rate setting. Essentially the results show that following shocks, such as to productivity, asset prices, interest rates or aggregate demand, commercial banks’ liquidity preference may shift in quite a sustained manner, which if not met by the provision of liquidity, via reserves, may lead to deleterious changes in either or both of the external finance premium and the quantity of loans extended to the private sector.

The researchers find that commercial banks would ideally want to hold a different mix of liquid to illiquid assets over the business cycle and that by proving more variation in the supply of liquid assets, central banks can help commercial banks to smooth the costs on the loan provision in a manner that attenuates the business cycle.

Next, the researchers examine analytically the extent to which meeting the demand for bank liquidity improves the welfare of the representative household, by reducing the extent of unwarranted variance in the supply of loans.

They then apply the model to the US financial crisis of 2007-08 and find that it suggests US banks’ demand for additional liquidity increased by around 10%. By supplying substantive liquidity injections the Federal Reserve was not only counteracting the large-scale withdrawals of liquidity from private investors, which characterised the period, and instilled confidence, but also provided a stimulus to output, inflation and employment, which is consistent with its mandate.

A simple counterfactual suggests that if liquidity had been allowed to fall and the Fed had not acted as lender of last resort, the contraction in output would have been greater, inflation would have fallen by an additional 2-3% and employment would have been some 2% lower. The recovery would also have been more protracted, taking roughly twice as long to return from recession.

Finally, the researchers discuss the possible role of liquidity instruments, either through changes in the quantity of liquid reserves or via changing the interest rate on reserves, on monetary and macroprudential policy.

ENDS


Contact:

Mr Jack Meaning on jm583@kent.ac.uk

Dr Luisa Corrado on luisa.corrado@econ.cam.ac.uk

Professor Jagjit Chadha on jsc@kent.ac.uk

RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh

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