Give a hypothetical example that shows how commercial banks can counteract the Fed’s monetary policy.

Question

What will be an ideal response?

Answer 1

Examples will vary but should show a thorough understanding of how banks can offset the Fed’s monetary policy. For example, suppose that Country A has been going through a recession that might develop into a depression. To avoid this, the government begins an expansionary policy by increasing the reserves held by commercial banks in the hope that doing so will lower interest rates and increase loans. However, the predictions of a possible depression make many banks skittish about giving out more loans. Even though they have significant sums provided by the government in reserve, they sit on this money and collect the interest to guard themselves against a possible financial collapse. Doing this partially counteracts the government’s attempt to stimulate the economy and contributes to the possibility of a depression.