Saturday, August 21, 2010

Reserves Don't Necessarily Lead to Loans

One of the analogies we often use when teaching monetary policy is "pushing on a string". The idea behind the analogy is that banks are imperfect transmission mechanism. The Fed can loosen policy in an effort to stimulate the economy, but just because the Fed loosens doesn't mean the economy will respond quickly - other parties (banks and borrowers) have to respond to the conditions and take up the slack.

Here is a good, short piece from the Federal Reserve Bank of St. Louis's Monetary Trends that should help explain that a bit more thoroughly, using the current economy as an example.

Read it through and share your thoughts. Would this help your students better understand the transmission mechanism and how it can limit the effectiveness of policy? Would you use it directly with your students, or just as your own background?  And if you wouldn't use it, what is missing?

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