So, how did the Federal Reserve perform its role as lender of last resort during the financial crisis of 2007/08? At the start of the crisis, in mid-August 2007, the Federal Reserve lowered the discount rate to just 0.5 percentage points above the federal funds rate, in contrast to the normal 100 basis points (1 percentage point). However, the Fed’s most important action as lender of last resort came in March 2008, when JP Morgan bought Bear Stearns. Bear Stearns was America’s fifth-largest investment bank, and the Federal Reserve decided to buy up $30 billion of its mortgage-related assets when their liquidity dried up. As the fifth-largest investment bank in the US, the Fed believed that Bear Stearns was so interconnected with the rest of the market that their collapse would lead to an increase in sales in assets in the market. Other important actions taken by the Federal Reserve was to lend over $100 billion and to pump more liquidity into AIG, and to absorb 90% of Citigroup’s risky assets, worth over $200 billion. The result of the Fed’s actions as lender of last resort resulted in an expansion in its balance sheet by over one trillion dollars. …show more content…
The Central Bank can do this through three channels, namely open market operations, changes in borrowed reserves and changes in reserve requirements. As I mentioned earlier in the text, the Federal Reserve lowered the discount rate in mid-August by 50 basis points. By introducing a conventional monetary policy could the Federal Reserve cut short-term rates, and because of this long-term rates, to help stimulate the economy. A cut in federal funds rates tend to encourage purchases of long-term assets like