Monetary policy, financial crises, and the business cycle: implications of the change in Federal Reserve policy during the 1982–90 business-cycle expansion

Abstract

Monetary policy during the 1982–90 business-cycle expansion was different from its pattern in earlier business cycles in the postwar period. Typically, monetary policy is generally easy in the early expansion, and then switches to a much tighter stance in the late phases of the expansion. In contrast, in the 1982–90 expansion, monetary police was tighter earlier, maintained a relatively tighter stance for a significant portion of the expansion, and became relatively looser near the peak. The changed monetary policy contributed to a different situation near the expansion peak: there was not an inflationary investment boom, interest rates were generally declining, and banks were not under pressure to restrict credit because of pressures on their reserves, nor forced to rely upon expensive, volatile and uninsured purchased funds. Thus, conditions that had led to financial crises at the expansion peaks of previous business cycles were absent near the July 1990 peak. This paper, then, attempts to explain why a financial crises nevertheless occurred during the recession of 1990–91. It also explores the reasons for the Federal Reserve–s changed approach to monetary policy.