In the fall of 2008, the US monetary base exploded. The Fed bought up tonnes of assets, thereby pumping all sorts of reserves into the monetary system. See this graph:
That action should have set off a gigantic monetary expansion and thwarted the deflationary/recessionary pressures the economy was suffering then, but it didn't.
There are two reasons the sky-rocketing monetary base did not head off or at least dampen the depth and length of the recession:
- There was a truckload of liquidity that dried up when the shadow banking system collapsed. That by itself probably caused broadly-based measures of the money supply to shrink somewhat, but the increase in the monetary base should have more-than-offset that effect.
- More importantly, the Fed began paying interest on the required reserves that commercial banks held with the Fed. Rather than lend and create more money and stimulate the economy with all the new reserves created by the Fed, instead the commercial banks just sat tight, reduced their risks, and made buckets of profits, paying next to nothing on deposits while earning a bit more than that with their deposits at the Fed.
Here is a graph to show what happened:
I see there was a much smaller effect in the Euro area, and I have no idea what caused such a huge drop in the UK.
But this graph (h/t Kais) likely highlights an important reason for the depth of the recession and the slow recovery. I wrote about this bizarre policy change back in 2008 here. So did Scott Sumner. The rationale for the policy still puzzles me.
I gather the Fed (along with Paulson and Geitner, et al.) were trying to shore up the solvency, not to mention liquidity, of the major banks in the US by having the Fed give them some money that otherwise would have reverted to the US treasury (net profits of the Fed, to the extent that the Fed is unable to spend or hide them, go to the Treasury). At the same time, it looks like a monumental transfer of wealth to their friends on Wall Street. Ugh.