Liquidity Crises in the Small and Large

Abstract

The financial crisis of 2008 was a liquidity crisis— that is, a period when some creditworthy households and firms could not obtain sufficient liquid (money) balances to complete necessary transactions. Most visible was the closure of the repurchase agreement (repo) market, in which both banks and non-banking firms alike typically exchange securities for short-term cash. The Federal Reserve responded to the crisis by initiating an extraordinary set of assistance programs under the authority of Section 13(3) of the Federal Reserve Act. 1 An unusual aspect of these programs was that they sought to assist individual firms or industries. In normal times, the Federal Open Market Committee (FOMC) sets a target for the federal funds rate and enforces it by changing the size of the Fed’s balance sheet to change the aggregate amount of liquidity that it provides to financial markets. The allocation of liquidity among households and firms, in turn, is determined by financial markets. Beyond the liquidity crises of individual firms, an interesting question is whether the aggregate amount of liquidity in the economy was appropriate before and during the crisis: Was there a liquidity crisis in the “large” as well as the “small”?