Fall of the Lehman – narrating in the Econ101 way: part 2

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Continuing from our earlier post on the same topic (Fall of the Lehman – narrating in the Econ101 way: part 1), we now move on to discuss government (U.S.) rescue measures that followed after the news of the weekend made stock markets plunge on Monday.

Government rescue packages:

· The Federal Reserve (or the Fed) pumped in $70 billion in reserves to the banking system on Monday, September 15, 2008.

· The Fed did not lower the federal funds rate on Tuesday, September 16, 2008.

· The government announced $85 billion taxpayers’ money to the American International Group, Inc (AIG) as a two-year secured revolving credit to ensure the company can meet its liquidity needs.

Why does the economy need more money?

As the news about Lehman Brothers surfaced, banks panicked that they will not have enough funds to give out loans (popularly known as the “credit crunch”). Usually, in order to get adequate funds quickly, they borrow from other banks. However, as banks scurried for limited amount available for borrowing, they in turn, bid up the price for borrowing (interest rate).

As a response to increasing interest rate for inter-bank loans (federal funds rate), Fed increased supply of reserves to cover for the immediate credit (money) needs for banks. The objective was to lower the interest rate. Now let’s review the consequences of lowering the interest rate this way.

Theoretically, if interest rate falls, banks have more money to loan out, and since interest rates are lower, people will ask for more loans. Basically this will increase investment in the economy. If investment increases, demand for goods and services will go up and in order to meet up with higher demands, more goods and services will be produced. Hence, more workers will be hired to produce the extra amount. So, does it ring a bell? Yes, that implies an economy with less job cuts. Good News!

However, there is a problem. Higher demand for goods can lead to inflation (rising prices of goods and services). American people are still reeling from the economic hardship faced due to increase in gas prices. They are spending more on food and other necessities now than they were doing a year back. So, this increase in demand for goods can put further pressure on their pockets. However, in August, as the gas price eased a bit, it brought down inflation. So, it looked perfect! But was this enough?

Reaction of the economy to increased money supply and speculation about further federal funds rate cut

According to Bloomberg and ICAP Plc., federal funds traded at over 4 percentage points above the set federal funds rate on September 12. After the injection of reserves by Fed, the rate dropped to as low as 0.5 percent. Well, this was not enough to bring back the economy on its feet.

On September 16, when the Fed met for deciding whether they should further lower federal funds rate, speculations were high that Fed will lower rate by at least 25 to 50 basis points. However, the Fed decided to leave the funds rate as it is. The main concern was that further lowering the rate can lead to inflation.