Between February 2008 and Summer 2009 the Fed supplemented its open market operations with a greatly expanded program of direct lending (both overnight and short term 28 and 84 day loans) to commercial banks, investment banks, brokerage and primary dealer units of bank holding companies. It also agreed to accept a wider range of short term securities (instead of accepting only T-Bills) as collateral on these loans and even initiated a program to buy commercial paper from money market funds.
a) Explain why the Fed created all these extraordinary direct lending facilities, instead of simply relying on traditional open market purchases of Treasury securities. (hint: You may wish to look at Bernanke’s recent lecture series at GW university (on the Federal Reserve Website)---particularly the 3rd in the 4 lecture series. A link to it is on the main Federal Reserve site page)
b) As conditions in short term financial markets improved by summer of 2009 the Fed closed down its lending under almost all these programs. However, since then the Fed has engaged in 3 campaigns in which for a period of months it has increased substantially its purchases of longer term mortgage backed securities and treasury notes from banks. These programs were called “Quantitative Easing 1, 2 and 3. At the time, the Fed indicated that this will be maintained until real economic growth strengthens and the unemployment rate declines.
What is the effect of these QE programs on banks’ balance sheets? Explain briefly
c) What would believers in the quantity theory of money (monetarists) expect to result from these large scale purchases of securities by the Fed? Explain your answer in a few sentences and discuss the concept of the velocity of circulation in your answer.
d) Assume that at some point in the next year or two both lender & borrower confidence levels start to return to normal and financial and physical investment levels start to rise much more strongly than in the last 2 years. What potential problem will the balance sheet effects of Quantitative Easing described in your answer to part B create then for the Fed?
How does the Fed’s authorization to pay interest to banks on their reserve accounts at the Fed help the Fed deal with this problem? Explain.