Monetary Policy & Financial Crises
The Fed moves the nominal rate; inflation inertia means π barely budges, so r = i − π moves too. Then C, I and NX all fall and Y falls by the multiplier. But the Fed controls r only in the short run — in the long run r must equal r*.
The Fed and its tools
- Dual mandate
- Low, stable inflation and full employment. The key lever is the real interest rate.
- Open-market operations
- The Fed is the only institution allowed to put dollars into circulation; it creates money and trades it for financial assets, usually short-term government debt. Not fiscal policy — an asset swap, not spending or transfers.
- Two conventional tools
- The interest rate paid on bank reserves, and the supply of reserves.
The transmission chain
The Fed controls r in the short run, not the long run. In the long run r must equal r*, the rate that equilibrates saving and investment. Unit 23 explains what forces it back.
Three reasons a central bank acts
- Countercyclical
- Offsetting a shock to PAE — the Fed cutting the funds rate through 2007–08.
- Another objective
- Chiefly controlling inflation, which is Unit 23.
- A mistake
- The Great Depression: the money stock and bank reserves contracted and the real rate soared, on top of the collapse in autonomous consumption. Two downward shifts of PAE, one self-inflicted.
Hence independence. Erdoğan fired Turkey's central bank chief in March 2021 for raising rates, claiming that lowering rates would reduce inflation by cutting borrowing costs. Turkey hit 72% annual inflation in 2022.
Financial crises
- Financial intermediation
- Getting saving into productive investment — banks, investment banks, money market funds, pension funds.
- Financial crisis
- Many institutions in danger of failing, confidence lost, intermediation widely disrupted.
- Insolvency
- Assets are loans, reserves and bonds; liabilities are short-term borrowing and equity. If assets fall below obligations the bank is insolvent — and merely believing it might be makes depositors withdraw and lenders stop, causing the insolvency.
Silicon Valley Bank, 2023 is a present value question. It held many long-term Treasury bonds; when rates rose, the present value of those fixed payments fell, so assets were worth far less than book value. A run on 9 March by Founders Fund and other venture investors depleted its cash — a bank lends deposits out rather than vaulting them. SVB was allowed to fail, but the FDIC covered all deposits beyond the $250,000 limit, and other banks acquired it cheaply.
| Contagion channel | Mechanism |
|---|---|
| Confidence | Doubt spreads to institutions with no connection at all — First Republic's shares dived days after SVB |
| Linkage | Direct exposure: loans, insurance contracts, counterparties |
| Fire sale | Dumped assets drive down prices of assets everyone else holds |
| Macroeconomic | Trouble reduces PAE and hence Y, which harms everyone |
A crisis hits PAE by raising credit spreads, tightening lending standards and damaging confidence. Prevention: higher capital requirements, deposit insurance, regulating risk-taking and interlinkage, keeping the macroeconomy stable.
When rates hit zero
Nominal rates cannot go much below zero: currency offers a guaranteed zero nominal return. Hence forward guidance — statements shaping expectations about future rates, as in the Fed's December 2008 and March 2009 language about "exceptionally low levels ... for an extended period" — and quantitative easing, buying bonds other than short-term government debt using reserves.
Rules that earn points
- Run the chain explicitly: i → r → C, I, NX → PAE → Y, multiplied.
- Always say why changing i changes r: inflation moves slowly, so r = i − π shifts with i.
- For bank failures, reach for present value. Rates up ⇒ bond prices down ⇒ assets impaired.
- For crisis spread, name which of the four contagion channels applies.
- Calling Fed actions government spending. Open-market operations are asset swaps.
- Saying the Fed sets the real rate in the long run. It cannot — r must equal r*.
- Forgetting inflation inertia as the reason the Fed has short-run traction at all.
Why does a change in the Fed's nominal interest rate change the real interest rate in the short run?
- AThe Fed sets the real rate directly through open-market operations
- BInflation is inertial, so π barely moves and r = i − π moves with i
- CExpected inflation adjusts instantly to the new nominal rate
- DIn the short run the real and nominal rates are the same thing
Answer
B — inflation inertia.
Prices are sticky, so π is roughly fixed over the horizon in which the Fed acts. With π fixed, moving i moves r one-for-one. Everything else in the chapter hangs off this.
A is the trap: the Fed only ever trades in nominal instruments. Its grip on r is indirect and temporary, which is exactly why it disappears in the long run.
In the long run, the real interest rate is determined by:
- AThe Fed's reaction function
- BThe Fed's inflation target
- CSaving and investment, at r*
- DThe nominal rate, since long-run inflation is zero
Answer
C — saving and investment, at r*.
The Fed cannot hold r away from r* indefinitely. Any persistent gap between r and r* keeps Y away from Y*, which keeps inflation drifting, which forces the Fed to respond.
A is the trap and it is half-right in a way that makes it dangerous: the reaction function determines long-run inflation (Unit 23), not the long-run real rate.
Why were Silicon Valley Bank's assets worth far less than their book value in 2023?
- AIt had lent heavily to startups that defaulted
- BInterest rates rose, so the present value of its long-term Treasury bonds fell
- CThe US Treasury defaulted on the bonds it held
- DThe FDIC's $250,000 limit left most of its deposits uninsured
Answer
B — present value, Unit 14.
The F's are fixed, so a higher i shrinks the price. SVB held long-term Treasuries and rates rose.
A is the trap: it is the intuitive "bank made bad loans" story, and it is wrong here. SVB held the safest credit in the world — its problem was interest-rate risk, not credit risk. (D describes why the run happened, not why the assets were impaired.)
Days after SVB failed, First Republic's shares dived even though it had no direct exposure to SVB. This is which contagion channel?
- ALinkage
- BFire sale
- CConfidence
- DMacroeconomic
Answer
C — confidence.
Trouble at one institution creates doubt about others even with no connection between them. The phrase "no direct exposure" in the stem is the giveaway.
A is the trap: linkage is the channel that requires exactly the direct exposure the stem rules out — loans, insurance contracts, counterparty relationships.
(a) Trace the full chain from a Fed rate cut to higher GDP, naming every link. (b) Give the three reasons a central bank changes rates, with a historical example for two of them. (c) What stops the Fed running this indefinitely?
Model answer
(a)
- The Fed lowers the nominal rate i via open-market operations and the rate paid on reserves.
- Because of inflation inertia, π barely moves, so by r = i − π the real rate falls too.
- A lower r raises IP (present values of future MRPK rise), raises C (saving is less attractive — think new car purchases and housing), and raises NX (the dollar depreciates, Unit 24).
- PAE shifts up at every level of Y.
- Y rises by more than the shift, because of the multiplier.
(b) Countercyclical policy — offsetting a PAE shock, as when the Fed cut the funds rate through 2007–08. Another objective, chiefly controlling inflation. A mistake — the Great Depression, when the money stock and bank reserves contracted, the real rate soared, and PAE shifted down a second time on top of the collapse in autonomous consumption.
(c) The Fed controls r only in the short run. In the long run r must equal r*, the rate that equilibrates saving and investment, so the stimulus cannot be held in place forever. Separately, at the zero lower bound the Fed runs out of conventional room, because currency offers a guaranteed zero nominal return — hence forward guidance and quantitative easing.
- Step 2 stated explicitly. Inflation inertia is the link students skip and it is the reason the policy works at all.
- All three of C, IP and NX moving, not just investment.
- Saying Y moves by more than the PAE shift, and naming the multiplier.
- All three reasons in (b), with the Depression named as an error rather than a choice.
- r returning to r* in the long run, with r* set by saving and investment.
One large bank fails. Explain how a single failure becomes a financial crisis, how that crisis reduces PAE, and name two measures that reduce the risk.
Model answer
A financial crisis is many institutions in danger of failing at once, confidence collapsing, and financial intermediation — the process of getting saving into productive investment — being widely disrupted. One failure becomes many through four channels:
- Confidence — trouble at one institution creates doubt about others with no connection at all. First Republic's shares dived on contagion fear days after SVB.
- Linkage — direct exposure through loans, insurance contracts and counterparty relationships.
- Fire sale — a troubled institution dumps assets to raise cash, driving down the price of assets everyone else holds and impairing them too.
- Macroeconomic — the trouble reduces PAE and hence Y, which harms every institution's borrowers.
The crisis reaches PAE by raising credit spreads, tightening lending standards and damaging confidence, all of which cut C and IP. PAE shifts down and Y falls by a multiplied amount.
Prevention: higher capital requirements so assets can fall further before a bank is insolvent, and deposit insurance so depositors have no reason to run. The course also lists regulating risk-taking and interlinkage, and keeping the macroeconomy stable.
- All four channels named, with confidence distinguished from linkage by the absence of direct exposure.
- The self-fulfilling point: believing an institution may become insolvent can cause the insolvency.
- Three distinct PAE effects, not just "confidence fell".
- Preventions tied to the mechanism — capital buffers absorb asset losses, insurance removes the run incentive.