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Monetary Policy and the Recent Extraordinary Measures Taken by the Federal Reserve




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1 Monetary Policy and the Recent Extraordinary Measures Taken by the Federal Reserve Testimony before the Committee on Financial Services U.S. House of Representatives John B. Taylor Professor of Economics Senior Fellow, Hoover Institution Stanford University February 26, 2009 Thank you Chairman Frank, Ranking Member Bachus, and other members of the House Committee on Financial Services for inviting me to testify on monetary policy and the “extraordinary measures” taken by the Federal Reserve over the past 18 months. The best way to begin examining these extraordinary measures is to look at the extraordinary increase in reserve balances at the Fed shown in Figure 1. Reserve Figure 1. Reserve Balances The solid line shows the actual movements and the dashed line shows the implied future movements. balances, or deposits at the Fed, are the key component—along with currency—of base money or central bank money which the Federal Reserve is responsible for controlling and which ultimately brings about changes in the broader money supply measures. The sharp increase in reserve balances began in mid September 2008. For the week ending September 10, banks and 0 400 800 1,200 1,600 2,000 2,400 00 01 02 03 04 05 06 07 08 09 Billions of dollars 9/11 Implied future reserve path if used to finance - MBS $437B - TALF $200B - Treasury CBLI $800B with no other offsets Actual reserve path 2 other depository institutions held $8 billion in reserve balances at the Fed. By the week ending December 31, 2008, they held $848 billion. The Fed had increased the supply of reserve balances by 100-fold in a very short period of time. Note also how large this increase is compared with the then-extraordinary increase around the time of 9/11 and the physical damage to the financial markets. The recent increase came about as a direct result of the Fed’s decision to purchase securities and make loans to certain sectors and financial institutions. More specifically, the Fed financed these securities purchases and loans by creating reserve balances—creating money. The Federal Reserve has since called this action credit easing.1 It is more like selective credit easing, or perhaps an industrial policy, because expansions of the Fed’s balance sheet always lead to credit easing in some form. Moreover, the Fed has been financing these actions by creating money; that is why I had earlier used the term mondustrial policy as a way to help explain this complex combination of monetary policy and industrial policy to those not familiar with monetary issues or with the details of the Fed’s balance sheet.2 As a matter of accounting the Fed can obtain additional funds to finance its purchases of private securities and lending in the three ways. First, it can create money; that is, it can pay for the purchases by crediting banks with deposits at the Fed. Second, the U.S. Treasury can borrow the funds and deposit them at the Fed. Third, the Fed can borrow the funds itself by issuing debt. Of course, the Fed can ...





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