Karen Dynan, a former Federal Reserve economist, was quoted as stating: The size
ID: 1195666 • Letter: K
Question
Karen Dynan, a former Federal Reserve economist, was quoted as stating: The size of the Fed’s balance sheet, which has more than doubled since the financial crisis of 2008, and the large amount of reserves sitting at the Fed has made officials at the central bank nervous about the potential for rapid inflation once banks decide to start lending more vigorously again.
a. Why do you think the Fed’s balance sheet has doubled since 2008?
b. What is the connection between the Fed’s balance sheet having doubled and the large increase in bank reserves at the Fed? Explain using the Fed’s T-account.
c. Why might the banks’ decision to start lending more vigorously again lead to inflation? Explain.
Explanation / Answer
(a) In 2008, US economy entered into the recession. Due to severity and magnitude of this recession, it was also referred to as the Great Recession.
In its response to fight the Great Recession, Fed has undertaken many monetary policy initiatives. Some of these initiatives were rather unconventional in nature.
One such policy initiative was implementation of large-scale asset purchase program which is also known as quantitative easing program.
This large scale asset purchase program has resulted in Fed’s balance sheet getting doubled since 2008.
(b) A representative Performa of Fed’s T Account is as follows –
Fed’s T – Account
Assets
Amount
Liabilities
Amount
T- bills
Bank reserves
Other securities
The asset side of Fed’s T-account contains T-bills and other securities held by Fed and liability side contains bank reserves or reserves held by banks with Fed.
It is known fact that Fed generally purchases securities from banking institutions. As it purchases securities from banks’, it increases the reserve account of banks’ it maintains with itself by respective purchase amount.
So, the connection between the Fed’s balance sheet having doubled and the large increase in bank reserves at the Fed is that as Fed has purchased more and more securities from banking institutions leading to doubling of its balance sheet, it credited the banking institutions account with itself with equivalent purchase amount leading to large increase in bank reserves at Fed.
(c) The banks’ decision to start lending vigorously might again lead to inflation because as banks’ will start lending at rapid pace, money supply in economy will also increase at rapid pace and rapid increase in money supply fuels inflation.
Fed’s T – Account
Assets
Amount
Liabilities
Amount
T- bills
Bank reserves
Other securities
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