Chapter 9
Can’t Monetary Stimulus Overcome a Severe Recession?
In this chapter I explain why monetary stimulus is not enough in a severe recession. To avoid misunderstanding, I want to underline the important role of the Federal Reserve in helping to combat a severe recession. As I emphasized in c hapter 3, in a severe recession the Fed must act as a lender of last resort by aggressively performing financial rescues and unfreezing credit markets, and must cut interest rates to zero in order to help maintain borrowing and spending by households and firms. These actions are essential, but they are not sufficient to overcome a severe recession because cutting interest rates to zero cannot fully reverse the plunge in aggregate demand that caused a severe recession. To raise aggregate demand all the way to normal, the Fed needs substantial help from fiscal stimulus. There is another channel by which standard monetary stimulus—the buying of Treasury bonds in the open market by the Fed—can work: the portfolio rebalancing effect. If the Fed injects money into the economy by buying Treasury bonds, it will raise their price and reduce their yield. In response, financial investors will try to shift their portfolios toward other 157
