Question

Discuss the issues the Fed faced when trying to increase the level of bank reserves using open market operations (OMOs) in 2007 after the crisis began.

Answer 1

When financial crisis and recession of 2007 deepened, the measures with an aim to revive economic growth were implemented on a global basis. Monetary base is a key determinant of money supply. It is affected by the open-market operations and discount rate. The open market operations (OMOs) has a direct impact on money supply. When Fed in the open market buys bonds, it increases the money supply in the economy with the swapping out bonds to the general public in exchange for cash. Similarly when Fed sells bonds, it reduces the money supply with the removal of cash from the economy with the exchange for bonds.

Before the crisis, there was a widely-held conviction that monetary policy could focus more on short term demand management since the inflation was firmly under control. Historically it has been proven that whenever policy makers tried to broaden the role of monetary policy beyond its original role as a guardian of the value of a currency then had to compromise on its goal of price stability in the long run. For monetary policy to remain effective, its responsibilities must remain within clear limit, thus it was the main cause monetary policy failed to restore the economy to long run equilibrium. The Federal Reserve after the financial crisis of 2008 has tripled the monetary base since 2008 without inflation surging. With interest rates at historically reduced to the bottom levels and the economy still struggling for survival, the process of normal money multiplier has broken down and pressure of inflation remain subdued