I posed this question to my Money and Banking professor at the University of Delaware, Dr. James Butkiewitz:
I am following the happenings in the financial sector like everyone else. I hear lots of politicians complaining about taxpayers being on the hook for AIG. Did the Fed issue the loan? If so, isn't the loan an increase in the money supply and not an increase in government debt? Isn't it similar to an open market operation, where this time the Fed is exchanging money for equity?
His response:
As I understand this, they are making the equivalent of a discount loan to AIG. By itself, this action increases the money supply, and would cause the federal funds rate to fall below the target. To keep the funds rate near the target, the Fed could undertake defensive open market sales to drain reserves from the banking system. However, as you probably have also read, the Fed is running low of T-bills to sell, and has made arrangements with the Treasury to obtain more T-bills to be able to maintain overall liquidity in the system at the desired level
To that end, Congress appears willing to authorize paying interest on banks’ reserve deposits with the Fed, effectively instituting the channel/corridor system we discussed this past summer. Thus, if the primary credit rate is 2.25% and the reserve deposit rate is 1.75% (just a hunch) the fed funds rate will stay close to the current 2% target, and will not fluctuate outside of the limits of the channel/corridor (1.75 – 2.25). Also, given the risk of lending, even for 24 hours, to some of the riskier banks, there may be a risk premium involved in fed funds lending that keeps the funds rate about the reserve deposit rate (I’m honestly not familiar with these intricate details of the fed funds market).
He also cited this release from the Federal Reserve.
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