The Federal Reserve has acted much more competently during the 2008 financial crisis, known as the Great Recession, than during the 1929 Great recession. It is understood that during financial crises the confluence of excessive excess capacity and the strong demand for cash reduces money supply and undermines the money multiplier. The ensuing result is a collapse in aggregate demand. This current crisis is no different. The Fed understood this phenomenon very well. While on the lookout, Fed has not been inadequately alarmed by inflation as it did in 1932. This time the Fed did the right thing. But this was not the case during the 1929 Great Depression. The Fed was then over concerned with inflation and had reduced money supply which helped exacerbate the depression. The Fed failed miserably at that time.
During the process of quantitative easing in the current financial crisis, the Fed tripled its balance sheet in 2009, dropped the short term interest rate to zero and brought the economy into a liquidity trap. On the other front, the consumers understandingly increased the demand for cash and reduced demand deposits. Banks have not acted as financial intermediaries whose job is to increase credit. They borrowed money at zero interest rate and used it in buying government securities. This rent-seeking behavior does not contribute to economy growth because the money was not lent to consumers and business.
Hindsight is 20/20. The Fed helped us so far from having a second Great Depression. But the Fed overreacted in its quantitative easing. Perhaps the Fed should not have tripled its balance sheet. Perhaps the Fed should not have dropped short term interest rate to zero. In this case, banks would have acted as financial intermediaries and would not have been able to borrow money from the Fed at zero interest rate and invested in the unproductive government securities. But this places the analysis in an awkward framework. Should the Fed increase the short term rates to make banks re-channel the borrowed money into activities that give a return higher than the short term rate and government securities? If so, how far should the Fed increase the short term rate?
Do not be surprised by this analysis. Many countries including Germany and other European countries are calling for austerity measures now to deal with the deficit in order to get the economy to grow.
The appropriate and adequate steps are not extreme cases. But appropriateness and adequacy in the middle of a deep and prolonged recession are very hard to measure.
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