Reserve system is the central bank of United States. The Great Financial Crisis
of 2007-2009 was the most severe financial crisis in the post-war era. The U.S.
experienced this type of systemic failure during 2007-2008 and continues to
struggle with its consequences as we enter 2009.The financial crisis was
triggered in the first quarter of 2006 when the housing market turned. In this
report, we have analyzed how an incomplete understanding at the Federal Reserve
of the relationship between the central bank’s balance sheet and the money
supply contributed to the Great Depression. Furthermore, we have also discussed
Fed’s behavior during the financial crisis of 2007–2009 and the valuable lesson
learnt from the Great Depression.
An incomplete understanding at the
Federal Reserve of the relationship between the central bank’s balance sheet
and the money supply contributed to the Great Depression
During the Great Depression, Fed
officials didn’t fully understand how their actions affected the supply of
credit in the economy. The financial system collapsed because FED officials had
failed to provide the liquidity that sound banks needed to stay in business.
There are numerous financial transactions leading to changes bank’s balance
sheet. The structure of the bank’s balance sheet gives us a window through
which we can study how the institution operates. Central banks publish their
balance sheets regularly. The central bank’s balance sheet (Table1) shows three
basic assets, securities, foreign exchange, and loans. Securities and Foreign
exchange are needed that the central bank can perform its role as the
government’s bank. The loan is a service to commercial banks.
On the liabilities side of the
central bank’s balance sheet (Table 1), we see three major entries, currency,
the government’s deposit account and the deposit accounts of the commercial
banks. Currency and the government’s deposit account allow the central bank to
perform its role as the government’s banks while the deposit accounts of the
commercial banks allow it to fulfill its role as the bankers’ bank.
TABLE 1: The Central Banks’ Balance Sheet
Foreign Exchange Reserves
Accounts of the commercial banks
While banking system reserves
usually aren’t the central bank’s largest liability, they are the most
important in determining the amount of money in the economy. Together, currency
in the hands of the public and reserves in the banking system make up the
monetary base. The central bank can control the size of the monetary base. When
the monetary base increases by a dollar, the quantity of money typically rises
by several dollars.
Banks and the banking system that
supply money, but basically the central bank supplies the monetary base. When
the crisis happened in 2008, the deposit expansion assumes multiplier decreased
rapidly to a fraction of its normal value. Banks will lend out most of the
additional dollar reserves supplied by the FED based on the standard process of
deposit expansion. However, bank became panic and request to hold more excess
reserves to prevent from collapsing the deposit expansion multiplier.
Central bank liabilities form the
base on which the supplies of money and credit are built. This is why they are
called the monetary base. The central bank controls the monetary base.
various factors affecting the quantity of money change over time. The cost of
holding both excess reserves and currency is affected because of market
interest rates. As the interest rates increases, we expect to see economic
growth to fall. This increases the money multiplier and the quantity of money.
If these changes in money multiplier were predictable, the central bank might
choose to exploit this link in its policymaking. Although this made sense in
the US in the 1930s, it no longer does.
emerging countries like China and India, it might still. In countries like US,
Europe, and Japan, the link has become too weak and unpredictable to be
exploited. The purpose of central bank can’t exploit for short-run policy for the
relationship between the monetary base and the quantity of money is not
something that a. For short-run policy, interest rates have become the monetary
policy tool of choice. In a financial crisis, other balance-sheet tools help
address liquidity needs and market disruptions more directly.
The mistake done by FED is when FED
saw its balance sheet grows. Officials did not realize that the money
multiplier was falling. Without knowing it, the FED ran a contractionary policy
during the Depression. Central bankers need to look at both the monetary base
and the money multiplier to see if policies are working.
Fed’s behavior during the financial
crisis of 2007–2009
The financial crisis of 2007?09 highlighted
the role of bank behavior in U.S. money supply. The impacts of the crisis was
most evident in five key areas: the U.S. residential housing market financial
institutions’ balance sheets, the shadow banking system, global financial
markets and the headline-grabbing failures of major firms in the financial
In September 2008, following the
collapse of Lehman Brothers, bank behavior changed in a way that sharply
depressed the deposit expansion multiplier. Multiple deposit expansion occurs
as the banking system repeatedly lends the extra asset until the excess
reserves are used up. Therefore, banks preferred to hold many more excess
the deposit expansion process. The decline of market liquidity following the
Lehman collapse made it difficult for banks to sell assets to meet unexpected
withdrawals. At the same time, the loss of funding liquidity meant that banks
might be compelled to sell assets just to survive.
Reserves that banks hold at the
Federal Reserve are the most liquid assets in the U.S. financial system. A bank’s
excess reserves can be used at any time to satisfy claims. They can be
transferred or converted into cash almost immediately. Fear of failure in the
crisis led to an astronomical increase in banks’ demand for excess reserves at
the Fed. While the Fed flooded the banking system with reserves in an
unprecedented fashion, most of the increase flowed into excess reserves,
because banks had little interest in lending these reserves to others. The
collapse of the usual demand expansion process can be seen in the unprecedented
halving of the M2 money multiplier, which measures the ratio of M2 to the Fed’s
monetary base – currency plus reserves.(Figure 1)
Figure 1 M2 Multiplier: The Ratio of M2 to the
Source: Federal Reserve Board and authors’
In addition, the subprime mortgage
market took off after the recession ended in 2001. By 2007, it had become over
a trillion-dollar market. The asset- price boom in housing (Figure 2) also
helped to stimulate the growth of the subprime mortgage market which increased
the demand for houses and so fueled the boom in housing prices, result in a
housing price bubble.
Figure 2 Housing Prices and the Financial Crisis of
Federal Reserve Bank of ST. LOUIS
The declines in asset prices in the
stock market (which fell by over 50% from October 2007 to March 2009, as shown
in Figure 3) and more than 30% drop in residential housing prices (shown in
Figure 2) weakened the firms and households’ balance sheets. This worsening of
financial frictions manifested itself in expanding credit spreads, causing
higher costs of credit for households and businesses and tighter lending
standards which also resulting decline in consumption expenditure and
investment causing economy to contract. The
Fed’s behavior in the 2007?2009
crisis contrasts sharply with its actions during the Great Depression.
Figure 3 Stock
prices and the Financial Crisis of 2007-2009
Financial Crisis 2007-09, Wikipedia
Valuable lesson from the Great
In a financial panic, the central
bank needs to lend freely to halt runs and restore market functioning.
Therefore, highly accommodative monetary policy helps support economic recovery
and employment. Heeding those lessons, the Federal Reserve and the federal
government took vigorous actions to stem the financial panic, support key
financial markets and institutions, and limit the contraction in output and
employment. Besides, similar actions were taken by foreign central banks and
governments. The Fed learned a key
lesson from its 1930s failure that it was determined not to repeat. In a
crisis, the variability of the deposit multiplier makes the monetary base a
poor indicator of the quantity of money. Avoiding a collapse in the money
supply may require a huge increase in the monetary base, at least until the
crisis recedes and bank demand for excess reserves abates.
This paper has reviewed the causes and effects
of the most disastrous ?nancial crisis since the Great Depression, and the
policy responses undertaken by central banks to deal with the crisis.We have
also learned the important lessons from the Great Depression.