Economics For Dummies, 3rd Edition
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The worldwide Great Recession of 2007 to 2009 began in the economy when a housing bubble in the United States popped in 2006. Trillions of dollars had been invested in the financial markets on the premise that residential housing prices would never decline significantly.

As the bubble burst and home prices began to plummet, the economy took a hit as dozens of large banks as well as many hundreds of financial firms were threatened with bankruptcy.

Lending ceased not only for home mortgages but for business loans, and if it hadn’t been for aggressive interventions by governments and central banks, the entire worldwide financial system might have collapsed, such that nobody would have been able to obtain a loan for any purpose.

Because the world economy is highly dependent on borrowed money to finance everything from credit card purchases to factory construction, another Great Depression loomed just over the horizon.

The Fed and other central banks to the rescue

To calm the immediate crisis, the Fed and other central banks became lenders of last resort, ensuring that businesses could still obtain financing directly from the Fed even if banks were reluctant to loan.

The Fed also protected banks from banking panics by increasing the insurance limits offered to checking account depositors. These and other steps limited the recession to only being moderately severe.

Yet, the Great Recession was still much more severe than your typical recession. So it wasn’t surprising that the Fed and other central banks undertook innovative new monetary policy measures to stimulate the economy. These came to be known as unconventional monetary policy.

Under conventional monetary policy, central banks like the Fed use open-market operations to purchase short-term (less than 1-year maturity) government bonds to increase the money supply and drive short-term interest rates toward zero in order to stimulate the economy.

A strategy known as quantitative easing

But given the severity of the Great Recession, the Fed and other central banks found that conventional monetary policy wasn’t going to be enough to drive short-term interest rates to zero.

Additional stimulus was needed. So the Fed and other central banks began to purchase trillions of dollars worth of longer-term government bonds (with 5-year, 10-year, and 20-year maturities), private-sector bonds (including mortgage-backed securities), and even stocks.

The goal in all cases was to increase the quantity of money available to be loaned out. It was hoped that more borrowing and lending would take place, thereby stimulating both consumption and investment.

These policies became known as quantitative easing (or QE), since their goal was to ease the constraints on lending and borrowing by increasing the quantity of money in circulation.

By contrast, conventional monetary policy targets not the quantity of money in circulation but rather the price of money — the interest rate. Conventional monetary policy attempts to simulate the economy by lowering the price of loans. Unconventional monetary policy (quantitative easing) attempts to increase the sheer volume of loans.

Setting a target for inflation

Another unconventional monetary policy was setting an explicit target for inflation, so that people would know how aggressive central banks were going to be with changes in the money supply.

The inflation target was set at 2 percent in the United States, which could only be met if the Fed were increasing the money supply faster than any increase in money demand. By setting a 2 percent target, the Fed was committing itself to continually pushing the AD curve to the right and thus always attempting to stimulate the economy.

This commitment was intended to give consumers and businesses confidence that the Fed would stimulate as long as necessary until the Great Recession was over and the economy had fully recovered.

About This Article

This article is from the book:

About the book author:

Sean Flynn, PhD, is an associate professor of economics at Scripps College in Claremont, California. A specialist in behavioral economics, Dr. Flynn has provided economic commentary for numerous news outlets, including NPR, ABC, FOX Business, and Forbes.

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