In conducting expansionary monetary policy, even if the Federal Reserve Bank is providing reserves to the banking system, during a recession or during periods of slow economic growth, banks may choose not to lend out their reserves when interest rates are low and potential borrowers look risky. This is known as a “credit crunch.” How does a credit crunch affect aggregate demand?
A “credit crunch” reduces aggregate demand (AD). When it does this, it will (all other things being equal) reduce gross domestic product (GDP) and increase unemployment.
When banks will not lend money, AD goes down a great deal. There are two reasons for this. First, when banks will not lend money, consumers cannot buy as many “big ticket” items. Consumers typically have to borrow money to buy things like cars or boats or even refrigerators. If loans are not forthcoming, they will not buy these things as much and AD will go down. Second, when banks will not loan money, businesses cannot invest as much. They typically have to borrow money to do things like expanding their factories. When investment decreases, AD goes down as well.
When AD goes down, the overall economy is hurt. A decrease in AD will, all other things being equal, lead to a decrease in GDP. This is because fewer things are being bought. When fewer things are being bought, there is not so much need for workers to make things, and unemployment rises. Thus, a credit crunch will typically lead to a drop in AD and, thereby, a drop in GDP and a rise in unemployment.