International Timeline clearly shows that banks around the world were failing throughout 2007 due to the mortgage-backed-securities they were holding. Nevertheless it is not until December of 2007 that our Federal Reserve Bank created the first special facility, the Term Auction Facility, to support bank liquidity (Appendix B - Facilities Created). Looking at Data Set-3, the first two tables showing Bank Reserves, a very clear picture emerges of bank distress in 2007 and 2008. Can you describe in a few sentences what is happening to liquidity preference in the banksby looking at the evolution of their reserve position? Consider these two points:

a. At what point do banks suddenly start borrowing money from the Fed? And what are they doing with the borrowed money? Is it sitting in their excess reserves, or are they using it to offset other assets that have devalued? (You can tell the answer to this by looking at non-borrowed excess reserves in the same year.)

b. At what point do the non-borrowed excess reserves start to balloon?

2. If you go back to Data Set-1, from Unit 1, and look at real growth, you see that it went negative at the very beginning of 2008, popped up a little bit in the second quarter of 2008, and then went into a long downward slide that lasted until the very end of 2009. The inflation rate was also negative during that time period. The Fed definitely did not intend a contractionary policy, but do you think a Fed policy can be unintentionally contractionary? - if, for example, banks are pulling money out the economy faster than the Fed is putting it in? We can get an idea of how fast the Fed is trying to put money in to the economy by looking at borrowed reserves. Consider:

a. Can you do a quick thumbnail calculation of the annual rate of growth in borrowed reserves from 2007 to 2010? And another quick thumbnail calculation of the annual rate of growth in non-borrowed excess reserves? How do these rates compare?

b. At what point does the inflation rate become positive again? (Data Set-1 in Unit 1 gives you quarterly data. Data Set 3 in this Unit is annual, so it won't be quite as easy to see the evolution of prices.) At what point do borrowed reserves start to drop? Is the relationship between borrowed reserves and the inflation rate consistent with our understanding that the price level rises when the banks borrow more in order to increase lending? Why is this recession so different from expectation, in your opion? Have you formed an opinion about it yet?

3. In Appendix B - Facilities Created, you can see that Fed determination to help banks recover gains momentum as time passes. At first the Fed accepts only prime mortgage backed securities in exchange for cash, but by the end of 2008 the Fed is accepting just about anything. We know that it was the toxic assets (the overvalued sub-prime mortgage assets) that were ruining the banks, and that the Fed wished to avoid creating a moral hazard by bailing out the banks for these poor choices, but do you think we could have avoided the plunge into a very deep recession if the Fed had been more realistic about the problem and absorbed the toxic assets first instead of last?

4. On October 8, 2008 the Fed announced that it would begin paying interest on required and excess reserves. Are you able to explain in your own words why high excess reserves represent a significant opportunity cost for the bank when the economy is moving into a recession?

5. As a matter of bank accounting, when the TARP fund was legislated in November 2008 it was intended to be an additional lending vehicle, but the Treasury Secretary restructured the fund so that it would be used to buy preferred stock in the banksinstead (and then in other companies as well, like GM). How does this affect the balance sheet of the banks, when the money comes in as Equity instead of Borrowed Reserves? Given that the crisis was caused by a crash in the value of assets, what is the practical difference between (a) buying the toxic assets and replacing them with cash reserves (b) loaning money to the banks and increasing their liabilities (c) buying preferred stock in the banks and increasing their equities?