Problem:
Since February 2008 the Fed has been supplementing 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 and commercial bank holding companies. It also initiated a program to buy commercial paper from money market funds.
A) Explain how this expanded Federal Reserve lending and commercial paper purchases affect supply and demand conditions in the Federal funds market.
B) As conditions in short term financial markets have improved the volume of funds lent under these programs by the Fed has decreased from a high of 1.5 trillion to about 600 billion outstanding. However, the Fed has increased substantially its purchases of longer term mortgage backed securities and treasury notes from banks. Thus, bank reserves are still vastly higher than then they were a year ago at this time. Why has this huge increase in reserves not touched off a surge in inflation.?
C) Once economic conditions improve and lender & borrower confidence levels start to return to normal how will the Fed’s ability to pay interest on bank’s reserve deposits help it prevent a sharp, inflationary, rise in the growth of lending and spending?