During the 2007–2009 financial crisis, banks faced liquidity problems, in part due to the illiquidity of some of their assets. This in turn made some banks reluctant to lend, causing problems for households and firms that needed to borrow funds, which in turn caused economic activity to decline.
a. Explain how the Fed can use the bank lending channel to solve this problem.
b. Even with increased liquidity due to the Fed’s actions, it appeared that banks became so risk averse that they were reluctant to lend. Evaluate the effectiveness of the bank lending channel in stimulating economic activity during this period.