Explain why monetary policy is needed specifically with regard to the existence of excess reserves. Compare and contrast the effectiveness of monetary policy during the Great Depression and the Great Recession?

Answer 1

During a recession, banks will maintain excess reserves because their opportunities to make loans and generate profits decline. By holding excess reserves, banks transform the deposit-creation process into a deposit-destruction process. Such a decrease in deposits and the money supply is precisely what is not needed during a recession. In such a case, a decrease in the money supply would make the recessionary gap larger. During an economic boom, banks respond in the opposite manner decreasing excess reserves in order to make as many loans and as much profit as possible.

During the Great Depression the money supply decreased because banks preferred to hold onto excess reserves in order to maintain funds for the depositors and avoid loans that were unlikely to be repaid. As a result of the decrease in the money supply and the lack of available credit, the economic conditions deteriorated further. In contrast, during the Great Recession of 2007-2009 the Federal Reserve stepped in and flooded the banking system with excess reserves in order to assist financial institutions in making credit available to some degree.