Question

explain what effect would an increase in loan defaults, like during the mortgage crisis, can have upon (1) the money supply, (2) the bank's balance sheet, and (3) the effectiveness of an expansionary monetary policy given the circumstances as described in the previous question?

Answer 1

1) money supply

When there is increase in loan default, banks become reluctant to lending money due to fear of not being repaid. The supply of loan decreases which further decreases supply of money.

2) the loans on the assets side of bank decreases and reserves on the asset side increases as banks hold part of loan was to be Lent as reserves.

3) the effectiveness of expansionary monetary policy reduces due to lower mulplier effect. Banks lend less and hold more reseves which reduces the money supply. Thus even when central bank decreases discount rate or use any other tool to increase money supply, the multiplier effect is going to be less due to lower amount of money lent by banks.