The crisis first started with the crush of prices in securities which were dependent on the US real estate. There was reduced availability of credit where many major firms filed for bankruptcy while other firms collapsed (Doyran 23). Credit tightened and consumer confidence declined in all stock markets of the world leading to reduction in prices of securities. Consumer spending was reduced significantly and as a result economic growth declined which in turn led to mass unemployment (Bernanke 12). The Federal Reserve Bank was consequently compelled to take step to cushion the economy from further effects
Expansionary Monetary policy
In March 2009, following the effects of the financial crisis the Federal Reserve Bank opted for an expansionary monetary policy. The FED announced its intentions to buy $300 billion longer-term securities, as well as increasing purchases for agency debt to $200bilion and mortgage-backed securities to $1.25 trillion. The expansionary monetary policy meant that there was an increase in money supply, which increased the amount of money that people were holding. Many people had money they were willing to deposit in banks while banks held a lot of money they were willing to lend (Bernanke 17) Interest rates were reduced to discourage people from depositing money and encourage them to borrow from banks. On the other hand, due to reduced interest rates, exchange rates also depreciated in relation to other currencies (Ciro 25).
The decrease in interest rates discouraged banks from passing on the credit to consumers because the return to the money was low. However, the banks had a lot of money in their possession and consequently relaxed their lending rules, to increase the chances of getting borrowers (Bernanke 46). On the same note, the decrease in exchange rates and increased money supply increased consumption of local commodities, thus increasing market for local businesses. However, lower exchange rates discouraged imports because they became relatively expensive while encouraging exports. Therefore, as far as international trade is concerned the monetary policy increased net exports (Ciro 65).
Decreased interest rate makes deposits less profitable and therefore most people choose to invest, because investment projects are more attractive, instead of holding deposits. As shown in the diagram below, a decrease in interest rates from r1 to r2, increases investment level from l1 to l2 ceteris paribus. Lower interest rate also makes borrowing relatively cheaper which makes consumers have more liquid to spend. Consumers also prefer current spending as compared to future spending as they are not sure of the future rates of interest, which encourages spending hence increasing both household consumption and investment levels (Doyran 37).
The graph below gives aggregate demand as a function of prices and real GDP. All other factors held constant, a decrease in interest rates indicates stronger economic conditions which makes the banks to loosen their lending regulations hence boosting businesses as well as household spending. Lower interest rates also lead to currency depreciation which makes imports expensive hence increasing demand for domestically produced commodities also boosting exports (Doyran 65). Increase in exports increases earning which in turn encourages consumption. Collectively, these contribute to increase in aggregate demand which shifts the aggregate demand curve rightwards from AD to AD’. AD’
Tax reduction was also implemented. When government chooses to reduce the amount of taxes that are levied, people will have more disposable income and they are likely to increase their spending thus increasing aggregate demand. This will give suppliers incentive to produce more thus increasing output, which will in turn increase the average levels of income. It should be noted that the increase in output is always more than the increase in government spending due to government multiplier. Expansionary monetary policy makes the IS curve to shift to the right due to increase in aggregate demand which in turn increases output (Ciro 87).
Discount Rate and Reserve Requirement
The main aim of the Fed was to encourage consumption in the economy. To achieve this, encouraging banks to give loans was crucial. Consequently, efforts were taken to increase amount of liquidity in the banks. Banks needed to be enticed to continue lending money to people even as interest rates were decreasing. As a result, the Fed reduced its discount rate. Discount rate refers to the interest rates that banks are charged for borrowing from the Fed. Reduction of discount rate implies that financial institutions can get money from the Fed cheaply thus they increase the amount of money that they borrow.
This increases their liquidity and consequently the amount of loans that they can give to customers. As a result, banks reduced their interest rates and increased their lending. This move increased the amount of money that was available in the economy to be used in consumption (Bernanke 76). It should be noted that besides increasing the liquidity of commercial banks, reduced discount rate also encouraged banks to increase their lending though interest rates were low.
Similarly, the Fed reduced the amount of reserves that banks and other financial institutions were required to keep. Reduction of reserve requirement meant that banks had increased cash that they could lend out to clients. It is important to note that all this was being done with the aim of encouraging consumption which was the only way of keeping the economy afloat at that period (Bernanke 79).
Effectiveness of the Measures
The economy was able to regain. Inflation rates have more or less remained unresponsive though fluctuations have been reported mostly due to fluctuating oil and energy prices. The inflation rate was at 3.9% in October 2011 but has been reducing though slightly and it stood at 1.7% in January 2013 (Bernanke 133). However, the Federal Open Market Committee (FOMC) expects the inflation rate for the next two years to be around 0.5% above the committee’s long term goal of two percent. Similarly, the Gross Domestic Product (GDP) growth rate has been slow since 2009 when the GDP deepened to -3.5%. The GDP growth rate improved a bit to 3.0% in 2010 but reduced again to 1.7% in 2011 and further drifted to 1.5% in 2012. Nevertheless, economists have projected the economy to grow by 2.4% this year (Ciro 178).
Factors that Hinder Policy Effectiveness
During crisis, expenditure is paramount to stimulate the economy because many people avoid spending therefore reducing demand. The central bank can boost demand by reducing the interest rates to increase the amount of money in the economy. Unfortunately, commercial banks which act as intermediaries are cautious on who they lend money to and tighten their lending conditions therefore, holding money instead of giving it out to the public for spending (Ciro 165).
This will reduce the confidence of the public since they will not see the money that the central bank will have increased. Central banks therefore need to make some structural reforms to ensure that the cautious attitude of the commercial banks is reduced and the money is passed onto individuals and firms who will then spend it. That way people will be confident that the central bank is really taking positive actions and therefore, investors’ confidence will increase besides increasing future inflation expectations
On top of that, transmission of monetary policy in crisis is difficult due to dysfunctional financial system which prevents proper functioning of any monetary policy chosen. During the 2008 crisis the FED focused on reducing the imperfections in the money market. Therefore, it hastened the transmission process of the monetary policy decisions which led to successful impacts in the real economy (Doyran 223). When the monetary policy decisions are effectively transmitted across the economy, individuals and firms become aware of the decisions in good time and their confidence in the central bank increases.
It is paramount to note that despite the recovery that is being recorded in various sectors of the American economy, the figures are still very low compared to the drop that took place. On the same note, there are still the unpaid, and almost certainly impossible to pay, house mortgages which caused the 2009 financial crisis. Similarly, the euro crisis is likely to spill over to other parts of the world and America’s financial system is at risk. On the same note, there is reduction in spending due to the cut in government expenditure which is slowing down economic growth. All these factors are raising eye brows among economists because they form a perfect recipe for another economic crisis (Ciro 254).
Bernanke, Ben S. The Federal Reserve and the Financial Crisis. Princeton: Princeton University Press, 2013. Print.
Ciro, Tony. The Global Financial Crisis: Triggers Responses and Aftermath. Farnham: Ashgate Publishing, 2013. Print.
Doyran, Mine A. Financial Crisis Management and the Pursuit of Power: American Pre-eminence and the Credit Crunch. Farnham: Ashgate Publishing, 2011. Print.