Reply To: Money sitting on the side


Demand for credit has collapsed, which is not unusual during a bust. Both consumers and entrepreneurs take on too much debt during the boom and pay it down during the bust.

Interest rates move down if either demand declines or supply increases. You can tell the difference between the two cases because a decline in demand will reduce the quantity of the good traded (in this case present money lent) while an increase in supply will increase the quantity of the good traded. Since both the interest rate and the quantity of credit have declined, we know that demand for credit fell.,

The banks did an asset swap with the Fed during the crisis. They sold mortgage backed securities to the Fed in exchange for reserves (bank accounts at the Fed that pay interest). Reserves serve as the basis for issuing fiduciary media. Banks have, so far, been content to hold reserves and not issue more fiduciary media by creating new credit. This is in part because the prospects for the loans will not pay high enough interest rates to compensate them for putting risky assets back on their balance sheets. There is some evidence, however, that bank credit may be thawing, in which case we’ll get to see if Bernanke’s tools work to restrain monetary inflation.