The country has been in a prolonged recession, some might say we have recovered

Question

The country has been in a prolonged recession, some might say we have recovered from a depression, but are still in the recession that started in 2007. What changes would you suggest are needed from open market operations (quantitative easing), the discount rate at which banks pay for money from the Fed, and reserve requirements at banks. Explain how each change would affect bank reserves, the money supply, interest rates and aggregate demand and how this would help improve the economy. At least 150 words please.

Explanation / Answer

During the period 2007-2009, a financial crisis hit the United States. A financial crisis occurs when financial firms and financial markets undergo a major disruption, making it difficult for persons to obtain loans from banks and other financial institutions. Problems contributing to the crisis included people not paying back loans they took out from banks, depositors becoming afraid that their deposits were not safe at the banks and en masse trying to withdraw them, banks having a hard time getting loans from other banks, and banks finding themselves with declining asset values, moving them toward insolvency (the condition when liabilities exceed assets).

Problems in the financial sector can bleed over into the real sector, producing problems such as decreased borrowing and lending, decreased economic activity, a decline in sales, a rise in unemployment, and much more. This is what happened in the U.S. in the crisis of 2007-2009.

The Fed conducts open market purchases (the buying of government securities by the Fed) and pays for those purchases by simply changing the balance in the reserve account of the bank from whom it buys the government security. This increases excess reserves for the bank in question, allowing it to create a loan in that amount

The discount rate is the interest rate that the Fed charges when it makes loans to financial institutions. The federal funds rate is the interest rates that financial institutions charge when they make loans to other financial institutions.

            The Fed lowers the discount rate to increase the money supply. Lower discount rates increase the likelihood that banks will borrow from the Fed, thus increasing their excess reserves, which they will use to create new loans (which is money creation).

            If the current federal funds rate is higher than the Fed%u2019s target, the Fed will conduct an open market purchase to inject reserves into the banking system.

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