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The Fed, liquidity, and credit allocation

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  • Daniel L. Thornton

Abstract

The current financial turmoil has generated considerable discussion of liquidity. Moreover, it has been widely reported that the Federal Reserve played a major role in supplying liquidity to financial markets during this distressed time. This article describes two ways in which the Fed has supplied liquidity since late 2007. The first is traditional: The Fed supplies liquidity by providing credit through open market operations and by lending to depository institutions at the so-called discount window. The second is by enhancing the liquidity of portfolios of some institutions by replacing their less-liquid assets with more-liquid assets. The Fed has used the second approach since late 2007. Unlike several previous occasions, however, it began supplying liquidity in the first, more traditional way only recently-in September 2008. This article notes that the Fed departed from its long-standing tradition of minimizing its effect on the allocation of credit by supplying liquidity to institutions that it believed to be most in need; at the same time, it neutralized the effects of these actions on the total supply of liquidity in the financial market. The article also discusses the Fed's reasons for reallocating credit this time rather than simply increasing the total supply of financial market liquidity.

Suggested Citation

  • Daniel L. Thornton, 2009. "The Fed, liquidity, and credit allocation," Review, Federal Reserve Bank of St. Louis, vol. 91(Jan), pages 13-22.
    • Handle: RePEc:fip:fedlrv:y:2009:i:jan:p:13-22:n:v.91no.1
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    References listed on IDEAS

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    1. Thornton, Daniel L., 2001. "The Federal Reserve's operating procedure, nonborrowed reserves, borrowed reserves and the liquidity effect," Journal of Banking & Finance, Elsevier, vol. 25(9), pages 1717-1739, September.
    2. Milton Friedman & Anna J. Schwartz, 1963. "A Monetary History of the United States, 1867–1960," NBER Books, National Bureau of Economic Research, Inc, number frie63-1.
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    4. Small David H. & Clouse James, 2005. "The Scope of Monetary Policy Actions Authorized Under the Federal Reserve Act," The B.E. Journal of Macroeconomics, De Gruyter, vol. 5(1), pages 1-43, April.
    5. John Taylor & John Williams, 2008. "Further Results on a Black Swan in the Money Market," Discussion Papers 07-046, Stanford Institute for Economic Policy Research.
    6. Christopher J. Neely, 2004. "The Federal Reserve responds to crises: September 11th was not the first," Review, Federal Reserve Bank of St. Louis, vol. 86(Mar), pages 27-42.
    7. Todd Keister & Antoine Martin & James J. McAndrews, 2008. "Divorcing money from monetary policy," Economic Policy Review, Federal Reserve Bank of New York, vol. 14(Sep), pages 41-56.
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    Cited by:

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    2. Roberto Motto & Massimo Rostagno & Lawrence J. Christiano, 2010. "Financial Factors in Economic Fluctuations," 2010 Meeting Papers 141, Society for Economic Dynamics.
    3. Leonardo Gambacorta & Boris Hofmann & Gert Peersman, 2014. "The Effectiveness of Unconventional Monetary Policy at the Zero Lower Bound: A Cross‐Country Analysis," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 46(4), pages 615-642, June.
    4. Selgin, George & Lastrapes, William D. & White, Lawrence H., 2012. "Has the Fed been a failure?," Journal of Macroeconomics, Elsevier, vol. 34(3), pages 569-596.
    5. Bassett, William & Demiralp, Selva & Lloyd, Nathan, 2020. "Government support of banks and bank lending," Journal of Banking & Finance, Elsevier, vol. 112(C).
    6. Phillip Anthony O’Hara, 2011. "International Subprime Crisis and Recession: Emerging Macroprudential, Monetary, Fiscal and Global Governance," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 58(1), pages 1-17, March.
    7. Daniel L. Thornton, 2012. "How did we get to inflation targeting and where do we need to go to now? a perspective from the U.S. experience," Review, Federal Reserve Bank of St. Louis, vol. 94(Jan), pages 65-81.
    8. Lothian, James R., 2009. "U.S. Monetary Policy and the Financial Crisis," The Journal of Economic Asymmetries, Elsevier, vol. 6(3), pages 25-40.
    9. William T. Gavin, 2009. "More money: understanding recent changes in the monetary base," Review, Federal Reserve Bank of St. Louis, vol. 91(Mar), pages 49-60.

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