Chapter 04 - The Federal Reserve System, Monetary Policy, and Interest RatesSolutions KeyChapter FourAnswers to Chapter 4 Questions:7. In the fall of 2008, the Federal Reserve implemented several measures to provide liquidity to financial markets that had frozen up as a result of the financial crisis. The liquidity facilities introduced by the Federal Reserve in response to the crisis created a large quantity of excess reserves at DIs. For example, in October 2008 the Federal Reserve began paying interest on excess reserves, for the first time. Further, during the financial crisis, the Fed set the interest rate it paid on excess reserves equal to its target for the fed funds rate. This policy essentially removed the opportunity cost of holding reserves. That is, the interest banks earned by holding excess reserves was approximately equal to what was previously earned by lending to other FIs. As a result, banks dramatically increased their holdings of excess reserves at Federal Reserve Banks. For example, in March 2010, depository institution reserves were 45.1 percent of total liabilities and equity of the Fed. This is up from 3.5 percent in June 2008, prior to the start of the financial crisis. Some observers claim that the large increase in excess reserves implied that many of the policies introduced by the Federal Reserve in response to the financial crisis were ineffective. Rather than promoting the flow of credit to firms and households, it was argued that the increase in excess reserves indicated that the money lent to banks and other FIs by the Federal Reserve in late 2008 and 2009 was simply sitting idle in banks’ reserve accounts. Many asked why banks were choosing to hold so many reserves instead of lending them out, and some claimed that banks’ lending of their excess reserves was crucial for resolving the credit crisis. In this case, the Fed’s lending policy generated a large quantity of excess reserves without changingbanks’ incentives to lend to firms and households. Thus, the total level of reserves in the banking system is determined almost entirely by the actions of the central bank and is not necessarily affected by private banks’ lending decisions.