The U.S. Federal Reserve is reaching into its 'new tool box' to use quantitative easing to help jump-start the U.S. economy from it worst recession in decades, and it begs the question: is there a limit to amount of money the Fed can create?

"That depends," economist David H. Wang told BloggingStocks. "There are very few case studies for quantitative easing, and there is not a consensus on what is the maximum amount of money available."

Money: it makes the world go round

Quantitative easing involves increasing funds in the financial system after the Fed loses the ability to lower the cost of money from an interest rate standpoint. Basically, the Fed adds cash by purchasing Treasuries, agency debt, and if the need arises, other asset-backed securities, hoping that some of that money will be lent or otherwise deployed in commercial operations.

The Fed's balance sheet has surged to $2.3 trillion from about $924 million in September, when the first wave of the financial crisis began to freeze credit markets and decimate stock markets around the world.

Moreover, the Fed's balance sheet is likely to increase as other interventions become necessary to stabilize the financial system. For example, the Fed is on the hook for up to another $240-$265 billion as a result of the rescue of financial services giant Citigroup (NYSE: C).

Gosh. Golly. Gee Whiz.

That was the reaction Monday of traders and economists to the European Union's coordinated decision to invest a staggering $2.4 trillion in interbank loan guarantees and bank recapitalizations, ft.com reported, to end the global financial crisis.

(Of course, 'gosh, golly' etc. were not exactly the reactions of traders and economists -- this is a family-appropriate financial blog -- but you get the point.)

Europe's decision sparked a global rally in stocks. The Dow closed up 936.42 points -- the largest one-day point gain in its history -- to 9,387.61.

Europe takes the lead

At minimum, Europe is saying that its economic stake in the current global financial system is so large that it's willing to err on the side of over-committing public funds, economist Peter Dawson said.

"Europe's response is very large, unexpected, and it could prove to be the pivotal move in this crisis," Dawson said. "Europe appears to be saying, 'well the United States is doing what it can do, given its political constraints' now let's do what our political culture allows. Basically, Europe is saying 'the storm of fear starts to lose its strength here.' "

The measures were both sweeping and unprecedented in size and scope, Dawson said. Germany said it offered about $680 billion in loan guarantees and will invest $108 billion in its banking system, ft.com reported. France said it would provide up to $435 billion in loan guarantees and invest as much as $52 billion. The United Kingdom has committed about $70 billion for investment in key banks, along with a guarantee for banks deposits and interbank lending. The Netherlands, Spain, and other nations announced similar plans.

Thus far, credit conditions remain a cold as Rutland, Vermont on a January night, but there are hints of a thaw in the making.

Interest rates for three-month loans in dollars dipped Monday, after policy makers in the United States and Europe offered unlimited dollar funds and Europe governments took actions to recapitalize and bolster banks.

The London three-month rate decreased 7 basis points to 4.75%, Bloomberg News reported Monday. Also, the euro interbank offered rate, or Euribor, for one-week loans dropped 26 basis points to 4.37%.

Short-term rates, including overnight rates, are key sources of cash for corporations and other large institutions, which use the cash to pay suppliers, make payroll, roll over debt etc. Hence, very high overnight and short-term rates will discourage corporations from conducting business, restricting commerce and slowing the economy, economists say.

Actions seen lowering banks' anxiety

Economist Peter Dawson told BloggingStocks Monday the actions taken this weekend and Monday by industrialized nations and their respective central banks will help loosen credit markets and decrease anxiety that's tightened the flow of money, globally.

"Central bank actions to supply dollars will help re-liquify the markets. I can't say if this one action will stop the pack-rat-like hoarding of dollars, but eventually players in the system are going to realize that no matter how many dollars they hoard, central banks have more to add," Dawson said. "Regarding fiscal policy, the guarantees by governments to banks will help reduce bank-to-bank fear that banks they lend to are insolvent, which should inch us back toward more-typical bank-to-bank lending."

The U.S. Federal Reserve has agreed to channel $30 billion into the global financial system by establishing temporary reciprocal currency arrangements, also called swap lines, with four more central banks, the Fed announced Wednesday.

The Fed said it established the currency exchange to address "elevated pressures" in dollar funding in the markets. The lines were established with the Reserve Bank of Australia, the Sveriges Riksbank (Sweden), the Danmarks Nationalbank (Denmark), and the Norges Bank (Norway).

The Fed's action occurs after overnight interest rates rose on concern the U.S. Treasury's proposed $700 billion bailout of the financial system will likely encounter revisions and a vote delay in the U.S. Congress.

Economist Richard Felson said he approved of the Fed and other central banks' effort to maintain both liquidity and an adequate flow of dollars in international markets.

"The swap lines will help maintain liquidity and address pressures building in the Asia Pacific region," Felson said. "Among other benefits, this will increase the amount of dollars available for money markets."

Felson added that the Fed and other central banks' goal is to maintain liquidity and "keep the credit creation process in motion." Bank concern about the ability of fellow banks to repay money has periodically led to decreased bank-to-bank lending during the financial crisis. If that tactic continues, it could eliminate a source of credit companies and others need to conduct business, restricting commercial activity.