Explain the Quantitative Easing,

Direct Lending, The Reserve Requirement and Other Regulations below using economic terminology, economic logic, and economic reasoning

1) Quantitative Easing

The Fed had cut the fed funds rate to near zero by the end of 2008, but the economy kept deteriorating. Despite everything the Fed was doing, the unemployment rate continued to rise until well into 2009, and then stayed stubbornly high.

The Fed was facing a tough problem: It couldn't push short-term interest rates any lower than zero. What's more, banks were reluctant to lend to businesses and consumers.

In response, the Fed employed a relatively new tool: It used open market operations, as described in the previous section, to influence long-term interest rates, such as mortgage rates, rather than short-term rates. This tool, known asquantitative easing (QE), is too complicated to describe here in detail. But it had the effect of pumping more money into the financial system, even with the fed funds rate at close to zero. As one Fed publication wrote:

From the end of 2008 through October 2014, the Federal Reserve greatly expanded its holding of longer-term securities through open market purchases with the goal of putting downward pressure on longer-term interest rates and thus supporting economic activity and job creation by making financial conditions more accommodative.

Source: Federal Reserve Bank, "Open Market Operations," www.federalreserve.gov/monetarypolicy/openmarket.htm

The current use of quantitative easing is unprecedented. Some economists worry that it will eventually lead to inflation because so much money is being added to the economy. However, as of early 2019, inflation is still quiet.

2) Direct Lending

When the two planes hit the World Trade Center on September 11, 2001, they destroyed the two towers and killed almost 3,000 people. The attack also shut down Wall Street, the biggest financial center in the world, and paralyzed the New York operations of many banks and other large financial institutions. The danger: a chain of massive bankruptcies that could devastate the global financial system.

To prevent this economic disaster from happening, the Federal Reserve immediately lent banks more than $45 billion to make sure they didn't run out of money. In fact, no banks failed in the aftermath of the terrorist attacks, and the economy kept functioning.

The response to the 9/11 attacks illustrates a crucial role of the central bank: to serve as the ultimate safeguard for the financial system when an unexpected crisis hits. To accomplish this role, the Fed can lend vulnerable financial institutions as much money as they needmoney that's backed by the full faith and credit of the federal government. This usually ensures that banks and other financial institutions will have enough money to meet their financial obligations to depositors or to any other creditors.

To provide money to struggling financial institutions, the Fed has historically used a monetary policy tool called thediscount window. (Although this isn't what actually happens, you can think of bank executives lined up at a teller's window.) In fact, a few hours after the September 11, 2001, terrorist attacks, the Fed announced, "The Federal Reserve System is open and operating. The discount window is available to meet liquidity needs."

The purpose of the discount window is to give financial institutions access to funds if they run short. To use the discount window, a bank would come to the Fed and ask to borrow money. It would then be charged thediscount rate. The Fed usually sets the discount rate for banks 3/4 to 1 percentage point higher than the fed funds rate and adjusts them both at the same time. (The bank also has to put up collateral to prove that it can pay back the loan.) Under normal circumstances, the use of the discount window is usually viewed as a sign that a bank is mismanaged, so banks are reluctant to use it. But in a financial crisis it is an indispensable tool for getting money into the financial system quickly.

Example: The Fed's Response to the2007-2009Financial Crisis

In 2007, the housing boom turned to bustin part because too many homes had been built and because too many loans had been made to borrowers with low incomes or bad credit historiesthe so-called subprime mortgages. Home prices started to plunge, and many people with subprime mortgages couldn't afford to pay them back. The falling housing prices meant that residential construction dropped sharply. Homeowners also had to cut back on their spending because they could no longer easily borrow against the value of their homes.

The Fed addressed these problems by cutting the fed funds rate from 5.25 percent in summer 2007 to 2.0 percent by April 2008. That helped the economy by making borrowing cheaper.

But interest rate cuts weren't enough. As people started to have trouble paying back their loans, banks and other large financial institutions began reporting big losses. People feared that the troubles would spread and that a big bank might fail. There was an enormous amount of worry in the financial markets.

In response, Fed Chairman Ben Bernanke opened the discount window by encouraging financial institutions to borrow from the Fed as needed. But the discount window, in its usual form, was not enough to deal with the developing financial crisis either.

So the Fed came up with several new ways to lend to financial institutions, with complicated names like theterm auction facility(TAF), theprimary dealer credit facility(PDCF), themoney market investor funding facility(MMIFF), and theterm securities lending facility(TSLF). With one exception, these new ways of lending were all closed down by 2010 after the crisis subsided (so you don't have to remember the names). But while they were in place, they enabled the Fed to get financially stressed banks and other financial institutions the funds they needed to stay afloat.Figure 12.6shows the total of all the crisis-related lending by the Fed, which peaked at about $1.6 trillion at the end of 2008.

Figure 12.6 Fighting the Financial Crisis: The Fed Extends Credit to the United States and the World, 2007-2010

To fight the financial crisis, the Fed lent dollars to a wide variety of financial institutions, both in the United States and abroad. In addition, the Fed provided other central banks with dollars to help stem the crisis in other countries. The amount outstanding peaked at about $1.6 trillion at the end of 2008. (The figure shows the four-week moving average of all credit extended by the Fed through the discount window, temporary direct lending programs, and lending to specific companies such as AIG.)

Source: The Federal Reserve, www.federalreserve.gov.

3) The Reserve Requirement and Other Regulations

Increasingly over time, the Federal Reserve has taken the lead role in setting the regulations by which financial institutions can borrow and lend. By tweaking these, the Fed can exert control over the economy.

Three important regulations that the Fed controls are the reserve requirement, the interest on reserves, and the margin requirement. Remember from earlier in this chapter that banks have to keep a portion of their deposits either in cash in their vaults or on reserve with the Fed. For most banks, thisreserve requirementis 10 percent of deposits (it's less for smaller banks).

In theory, the Fed can exert influence over bank lending by controlling the reserve requirement. The more money they have to keep on reserve, the less money banks have available to lend. Less lending by banks means less spending by borrowers, which helps slow the economy. Alternatively, cutting the reserve requirement could give an extra boost to borrowing and lending.

The Fed also controls theinterest rate on reservesthat it pays banks. This is a new policy tool, so it's not clear how it will work in practice. However, cutting the rate on reserves should make banks more willing to use their funds for lending.

Themargin requirementdetermines how much people can borrow when they buy stock. The higher the margin requirement (now at 50 percent for most stock purchases), the higher the percentage of cash down payment a purchaser must make when borrowing to buy securities. Raising the margin requirement makes it harder for investors to buy stock, and this has the effect of holding down the stock market.

However, changing either the reserve requirement or the margin requirement is a blunt tool for monetary policy that the Fed rarely uses. For example, the last time the Fed changed the reserve requirement was 1992. These instruments are always available, though, if the Fed needs them.