TAILIEUCHUNG - Zero Interest Rates and the Fall in U.S. Bank Lending

The wholesale interbank market (where banks trade with each other) reduces the risk for banks making forward commitments to lend at retail— to households and firms, including exporters and importers. The collapse of the . housing bubble in 2007-08 impaired bank balance sheets so that banks became reluctant to lend to each other from counterparty risk. Consequently retail bank credit fell sharply, thus worsening the crisis. By 2009, the . government had responded by re-capitalizing large commercial banks and by flooding the system with liquidity so as to drive short-term interest rates close to zero. Although counterparty risk is now. | Zero Interest Rates and the Fall in . Bank Lending Ronald McKinnon1 Stanford University October 2009 Forthcoming in Journal of Economic Asymmetries Abstract The wholesale interbank market where banks trade with each other reduces the risk for banks making forward commitments to lend at retail to households and firms including exporters and importers. The collapse of the . housing bubble in 2007-08 impaired bank balance sheets so that banks became reluctant to lend to each other from counterparty risk. Consequently retail bank credit fell sharply thus worsening the crisis. By 2009 the . government had responded by re-capitalizing large commercial banks and by flooding the system with liquidity so as to drive short-term interest rates close to zero. Although counterparty risk is now in abeyance forcing short-term interest rates to zero is a serious mistake. Wholesale interbank lending is still inhibited so that retail bank credit is unlikely to recover and continues to fall in 2009. JEL Classification E4 and E5 Key Words Liquidity trap exit strategies interbank market credit crunch Introduction Since the credit crunch and global downturn in 2008 governments everywhere have responded to the shortfall in aggregate demand in a standard textbook Keynesian fashion. To degrees they have adopted fiscal stimuli ramping up government expenditures and cutting taxes. Central banks followed the lead of the . Federal Reserve by driving down short-term interest rates toward zero almost exactly zero for overnight interbank rates in the . Japan and Canada and generally less than 1 percent in Europe into the Fall of 2009. In a statement on September 23 2009 following a two-day meeting by the Fed s policy makers the central bank repeated that it would keep its benchmark overnight interest rate at virtually zero for an extended period . That almost certainly means at least some time in 20102. But are these near-zero interest rates the appropriate policy response 1 I .

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