First published in Social Education #75(2), pp. 76–81
The recent financial crisis brought about dramatic changes in the way that the Federal Reserve, the nation’s central bank, conducts monetary policy. One challenge for high school educators going forward will be to strike a balance between the teaching of traditional monetary policy and the teaching of the monetary policy used during these turbulent times. In this paper, we show how the Federal Reserve implemented monetary policy in “ordinary times” before the financial crisis. We also provide an overview of the monetary policy tools created during the financial crisis and a summary of the Fed’s expansion of its balance sheet. Finally, we provide a set of suggestions on how to approach the teaching of monetary policy in the post-financial crisis world (see sidebar).
For decades, high school and college textbooks were predictable in their coverage of monetary policy. The textbook version would define money, pointing out that the definition goes well beyond currency to include money in checking accounts. The text would describe the Federal Reserve, its Board of Governors, and the 12 regional Federal Reserve Banks. The text would explain that commercial banks are required to hold funds in reserve against their deposits, and that the Federal Reserve can change the quantity of money to achieve economic goals. For example, if the Federal Reserve reduces the reserves that banks are required to hold, banks have a greater ability to lend, and can expand lending, creating multiple new deposits through the process summarized in the “money multiplier.” Next, students would be shown how the Federal Reserve can encourage lending through changes in the discount rate, or the interest rate it charges member banks for loans. Finally, students would see how the Federal Reserve’s purchases and sales of government securities, called open market operations, can change bank reserves and therefore the quantity of money (see Table 1).
The order in which textbooks present the elements of monetary policy makes sense because reserve requirements, coming first, are the easiest of the Fed’s policy tools to understand. Open market operations are the hardest. And yet the textbook treatment leaves the impression that changes in reserve requirements are a viable monetary policy option for the Federal Reserve in ordinary times. In fact, reserve requirements have not been changed since the 1990s, and were not changed during the crisis that began in 2007. The textbook treatment also tends to leave students believing that discount rate changes are important. In fact, discount rate policy has become passive in ordinary times, in that the discount rate only reflects other Federal Reserve policies — rather than being an independent way of influencing the quantity of money.
As the Federal Reserve Board states on its website, open market operations are the Fed’s “principal tool for implementing monetary policy.”1 For teachers, the implication is that the most important tool of monetary policy is the hardest one for students to learn. The Federal Open Market Committee (FOMC) guides open market operations by specifying targets for an important short-term interest rate, the federal funds rate. It is open market transactions, usually carried out on a daily basis, which affect the amount of money and credit available in the banking system. In turn, these changes in the supply of money and credit affect interest rates, which in turn affect the spending decisions of households and businesses and ultimately the overall performance of the U.S. economy.2
The financial crisis that began to take hold in 2007 significantly affected the way the Federal Reserve implemented monetary policy. Beginning in September 2007, the FOMC began dropping its target for the federal funds to near zero. In 10 steps, the target was taken from 5.25% to a band of 0 to 0.25% as of December 2008. And, once the federal funds rate target reached almost zero at the end of 2008, traditional open market operations were no longer able to ease monetary policy further to deal with the crisis. Practically speaking, the rate could go no lower. Targeting the federal funds rate, the Fed’s primary tool of monetary policy, had reached its zero bound and was therefore at its limit as a tool of monetary policy during these turbulent times.
The most important idea for students to understand about financial crisis management is the concept of liquidity. Liquidity is the ability to quickly convert something of value into spendable money. For example, a savings account has a great deal of liquidity for an individual bank depositor. The depositor can get cash with a quick visit to the bank — or can convert the savings to checking money with the click of a mouse. A home has much lower liquidity, in that an individual could convert its value to spendable cash only with a long process of selling the real estate.
Just like individuals, banks and other financial institutions sometimes need more liquidity. Think about a bank that has valuable holdings, such as sound and well-secured loans. Because the payments on the loan come in periodically over time, the bank does not have immediate access to the amount of the loan. It can therefore face liquidity troubles if it is confronted by sudden demands. In ordinary times, banks and the Federal Reserve work together to ensure sufficient amounts of liquidity. In a crisis, however, liquidity can dry up. At such a point, the Federal Reserve will almost certainly be called on to restore liquidity.
Beginning in summer 2007, the Federal Reserve initiated a number of temporary liquidity measures aimed at improving credit conditions and economic conditions nationwide. Initially, the Federal Reserve Board of Governors enabled additional borrowing at the discount rate. Specifically, the Board extended the availability of discount window lending beyond the usual overnight basis to up to 30 days with possible renewal. This measure was put in place to provide greater assurances to depository institutions that they could borrow from the regional Reserve Banks.3
The sweeping changes to the framework of monetary policy in recent years present a huge challenge to high school and college instructors. While it is clearly important to teach students about the critical work that the Federal Reserve did through monetary policy to avert a second Great Depression, it’s very easy to get drawn into the details of the Fed’s programs and over teach. There are a number of things that we absolutely must teach our students about monetary policy in order to make them well-informed citizens participating knowledgeably in our economy:
As the crisis unfolded, the Federal Reserve implemented new monetary policy tools. Some of these new tools required the Fed to invoke a special provision of the Federal Reserve Act — referred to as Section 13(3) — that gives the Fed the authority to lend to any individual, partnership, or corporation in “unusual and exigent circumstances.”4 Three of the new tools were directed at providing short-term liquidity to banks and other financial institutions. These tools, summarized in Table 1, were implemented in late 2007 and early 2008:
These initial new tools of monetary policy — the TAF, the TSLF, and the PDCF8 — were closely aligned with the Federal Reserve’s long-established role as lender-of-last-resort.9 They all provided short term credit to sound financial institutions. In February 2009, Federal Reserve Chairman Ben Bernanke explained that
In fulfilling its traditional lending function, the Federal Reserve enhances the stability of our financial system, increases the willingness of financial institutions to extend credit, and helps to ease conditions in interbank lending markets, thereby reducing the overall cost of capital to banks.10
As the financial crisis expanded further in 2008, it became apparent to policymakers at the Federal Reserve that additional liquidity measures were needed to address instability in a number of key credit markets. As Ben Bernanke explained,
lending to financial institutions does not directly address instability or declining liquidity in critical nonbank markets, such as the commercial paper market or the market for asset-backed securities, which under normal circumstances are major sources of credit for U.S. households and firms.11
“Commercial paper” is used when companies need to borrow large amounts of money for short periods of time. In ordinary times, commercial paper is quite safe and therefore is favored by highly conservative investors, such as money market mutual funds.
With the goal of reducing key instabilities, late in 2008 the Federal Reserve announced four additional liquidity measures, again summarized in Table 1. These measures involved providing liquidity directly to borrowers and investors:
In 2008 and 2010, the Federal Reserve put in place two additional tools of monetary policy, again summarized in Table 1. The first involves paying interest on reserves held by banks and other financial institutions. Traditionally, no interest was paid on the reserves these institutions held. The financial disadvantage operated like a tax. In 2008, this implicit tax was eliminated.13 More importantly for the conduct of monetary policy, paying interest on reserves provides the Federal Reserve with an additional tool for controlling the aggregate size of reserves in the banking system. By increasing the interest rate paid on reserves, the Fed can entice depository institutions to put more of their reserves in their accounts at the Federal Reserve Banks and reduce the amount of excess reserves those depository institutions have available to make loans. Conversely, reducing the interest rate paid on reserves would entice depository institutions to reduce their balances at the Federal Reserve Banks and likely increase the amount they lend to consumers and businesses.14
In 2010, the Federal Reserve put in place another method for managing reserves, the Term Deposit Facility (TDF). The TDF works in reverse of the Term Auction Facility. In the TDF, the Fed is offering term deposits on an auction basis. When a depository institution purchases a term deposit from the Federal Reserve, the funds are removed from its reserve account at a Federal Reserve Bank, thereby reducing the amount of bank reserves for the specified term of the deposit. Both paying interest on reserves and the TDF provide the Fed with strong tools for reducing aggregate bank reserves and will be very useful when it comes time to tighten monetary policy and reduce the size of the Fed’s balance sheet.
Any financial institution’s balance sheet shows what it owns (its assets) and what it owes (its liabilities). The Federal Reserve’s balance sheet provides an important summary of its overall position.
From fall 2008 onwards, the Federal Reserve has significantly expanded the size of its balance sheet from around $900 billion in summer 2008 to over $2.3 trillion in fall 2010. The majority of that expansion occurred during the height of the crisis from September through December 2008. This substantial expansion of the Fed’s balance sheet has been a key factor in its ability to provide large amounts of additional liquidity to the U.S. economy during the crisis. Initially, the expansion of the balance sheet allowed for the significant expansion of the Fed’s lending facilities. In 2009 and 2010, as the lending facilities shrank in size and eventually closed, the Fed carried out large purchases of U.S. Treasury and agency securities and U.S.-backed mortgage-backed securities. These purchases, often called “quantitative easing,” increased the amount of reserves in the banking system and worked to keep interest rates low to spur economic growth.
In Table 2, we show four snapshots of the Fed’s balance sheet at different periods of time. We have simplified the balance sheet in order to ease the discussion.15 In Panel 1 of Table 2 is the Fed’s simplified balance sheet on July 9, 2008. At that point, the Fed’s balance sheet was about $900 billion with its lending programs totaling just over 18% of total assets. In order to fund those programs, the Fed had sold a portion of its portfolio of U.S. Treasury securities, which at one time had totaled over $700 billion.
As shown in Panel 2, by middle October 2008, the height of the crisis, the Fed’s lending programs totaled about 40% of its assets. The Fed’s total balance sheet had grown from $900 billion in July 2008 to over $1.7 trillion in October 2008. The growth in the balance sheet was facilitated by an increase in U.S. Treasury deposits to $523 billion and an expansion of depository institutions’ reserves at the Fed to over $270 billion.
By December 2008, as shown in Panel 3, the Fed’s balance sheet had expanded to over $2 trillion and lending represented nearly 46% of total assets. While Treasury’s deposits had shrunk slightly, reserve deposits had grown to nearly $780 billion. This growth in reserve deposits allowed for the expansion of the lending programs on the asset side of the balance sheet.
Fast forwarding nearly two years to September 2010, as shown in Panel 4, the Fed’s balance sheet was over $2.3 trillion. While the Fed’s overall lending had shrunk to less than 1% of assets, the Fed’s extensive purchases of U.S. Treasury securities, agency securities, and mortgage-backed securities replaced the lending programs on the asset side of the balance sheet. Depository institutions no longer needed assistance from the Fed’s lending programs and the Fed had carried out extensive quantitative easing through its securities purchases.16 In turn, depository institutions’ reserve deposits at the Reserve Banks increased to over $980 billion. The Fed continued to provide a very large amount of liquidity to the economy through its expanded balance sheet.17
Andrew T. Hill is the economic education advisor at the Federal Reserve Bank of Philadelphia and adjunct professor of economics at Temple University. He can be reached at firstname.lastname@example.org .
William C. Wood is professor of economics and the director of the center for economic education at James Madison University. He can be reached at email@example.com .
The views expressed here are those of the authors and do not necessarily reflect the views of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.