What Lessons Can Be Learned from the Global Financial Crisis of 2007-08 - Assignment Example

?What Lessons can be learned from the Global Financial Crisis of 2007-08, About the Effectiveness of the Transmission Mechanism of Monetary Policy? Table of Contents Introduction 3 The Transmission Mechanism of Monetary Policies 4 Causes and Consequences of Global Crisis 7 Lesson Learned 10 References 12 Bibliography 16 Appendix 17 Introduction The global financial crisis, which occurred during the year 2007-2008, has been recognised as one of the worst crises ever faced by the word economy. The crisis has adversely affected the financial as well as economic stability of a large number of countries, imposing inevitable unfavourable impacts on the financial institutions, national governmental structures and stock market performances worldwide. It had also created a strong adverse effect on the business world, leading to gradually deepening fluctuations in the housing markets and increased unemployment rates in the majorly affected economies such as the US (as the epicentre of the crisis) and the European nations among the majors. It has been identified the most common cause for the crisis situation was associated with the low interest rate policy practiced by the Federal Reserve along with central banks (Grail Research, 2009). As assumed in the transmission mechanism of monetary policy, such violations in the interests rates are likely to lead towards a severe instability in the housing markets, disposable income disbursements in the economy, credit demand, exchange rate fluctuations, stock market volatility and overall wealth generation obstructions (Bank of England, n.d.). Evidently, the crisis situation also exhibited fluctuations and instability in various other key determinant factors that are supposed to act as major components to economic development, which include subprime mortgages, ineffective regulatory policies and leveraging the banking sector as prima facie (Grail Research, 2009). In this crisis situation, the Federal Reserve and central banks of different countries were identified to focus on building their respective monetary policies on the basis of short-term interest rates, which can also be accounted as a major cause to have a strong influence on the aforementioned factors in the global money market (Lewis, 2010). As can be observed from the brief discussion presented above, the context of the recent global financial crisis 2007-08 represents a complex phenomenon of interest rate based monetary policy measures taken by countries in the post-modern era. To obtain a succinct understanding of the entire occurrence, this essay will base its discussion on the conceptual framework of transmission mechanism of monetary policy. In this regard, the sole aim of the essay will be to conclude on the effectiveness of the transmission mechanism of monetary policy in addressing the lessons learned from the recent occurrence of the global financial crisis in 2007-08. The Transmission Mechanism of Monetary Policies The transmission mechanism of monetary policies depicts that there are different procedures on the basis of which, interest rates in an economy can be identified and assessed to be affecting the economic conditions of a country as a whole (Refer to Appendix Figure 1). As per this theory, the decisions in relation to interest rate are seemed to influence other market interest rates, which include deposit rates of bank and mortgage rates to a significant level; thus, creating a significant effect on the economic stability of the nation. The interest rate policies further affects the expectations along with confidence of the market investors, on the basis of which, these policies tends to influence the future development of an economy (Bolvin & et. al., 2010). Additionally, the interest rate policies influence exchange rates along with asset prices to a substantial extent. Changes in interest rates are further recognised to have an influence on the spending, investment as well as saving behaviour of the people and firms operating in an economy, playing the role of a major determinant of economic stability in the current market prospects. In this regard, it is identified that the changes in the interest rates, proportionately affects the demand in relation to goods along with services that are offered within an economy. The level of demand for goods as well as services in an economy is also assumed to depict the capacity of domestic supply, represented in the labour market and other market areas of an economy to a substantial extent, as per the theory of transmission mechanism of monetary policies. In this context, the demand for products and services in the domestic market constitutes the major factor accountable for inflationary pressures in the national context. Subsequently, the movement of exchange rate is recognised to have a direct impact on the goods along with services that are imported in the domestic markets (Bolvin & et. al., 2010). The theory also propounds that exchange rate is also determined to indirectly affect the prices of goods along with services that are domestically produced, which compete with the imported products along with services of an economy, generating high chances of making the domestic economic hurdles get channelized in the foreign markets as well, with the aid of foreign trade collaborations and incentives (Bank of England, n.d.). Arguably, an illustrative understanding of the concept can be observed with reference to the recently witnessed global financial crisis of 2007-08. The global crisis situation witnessed during the year 2007-2008 has been widely argued as the outcome of different monetary factors, replicating the deficiency of the governments to control interest rates in their domestic markets. Allegedly, the consequences were witnessed in subprime mortgage market fluctuations, fall of the housing market and low interest rate regimes, which constitute the most important factors accountable for the crisis situation on a global context (Angelopoulou & Gobson, 2007). In this regard, it has been identified that there are five major factors that can be accounted for the global crisis, viz. Development of the housing market and increase in sub-prime lending Inappropriate financial structure as well as tax regulations and excessive risk-taking attitudes Easy availability of credit Low inflation Lack of transparency in the process of securitisation Source: (Grail Research, 2009) As can be primarily observed from the above stated causes of the crisis situation, the theory of transmission mechanism of monetary policy can be apparently related with the event. According to Cour-Thimann & Winkler (2013), the global crisis situation is mainly perceived to have commenced from the US, due to the fall of housing market, which was widely considered to be a consequence of low interest rates causing instability and deviation in the domestic market from the third quarter of 2006. Subsequently, the credit demand increased, but also due to the misrepresentation of housing prices and credit rating, the disposable income in the American market became highly instable affecting the investment market and the exchange rate. Gradually, the aforementioned factors led towards the collapse of the stock market and took the shape of a global crisis (Refer to appendix Figure 2) (Grail Research, 2009). The following discussion thus emphasises the causes and the aftermath of the global financial crisis of 2007-08 in order to gain a better understanding of the interrelation persisting between the factors as argued in connection to the theory of transmission mechanism of monetary policy. Causes and Consequences of Global Crisis In order to support the lowering interest rates in the economy, the credit rating policies were made lenient by the US government. As a consequence, credit rating failures in the economy caused massive fluctuations to the disposable income within the American economy, during the 2007-08. Within a short tenure, the fluctuation in the disposable income caused led to massive fluctuations in the sub-prime lending, affecting the housing market severely. The losses in relation to sub-prime mortgages also adversely affected the financial market as the financial institutions were unable to repay the increased debt in the housing sectors of the US, following the reassessment and the subsequent hikes in the housing prices giving rise to the housing bubble situation (Holt, 2009). This implies that lowering interest rates had a significant effect on the housing prices and disposable income of mortgage payers in the US economy during the recently witnessed global financial crisis situation. Deregulation of the fiscal and regulatory policies of the financial sector is deemed to be second key factor responsible for the financial crisis (Calabria, 2009). The central banks of various countries are perceived to be adopting different regulatory and management policies based on their individual situational contexts. Contextually, practicing a lineament credit rating policy and focusing on easy lending in the money market, the central banks as well as the government were being criticised as being ineffective towards the management of the financial institutions efficiently, which resulted in adversely impacting the stock market and resulted in the failure of the Wall Street, the main financial district operating in the US economy (Adair & et. al., 2009). The financial institutions, in lieu of the governmental policies, failed in risk management. It is worth mentioning in this context that the financial institutions, during the period were observed to formulate regulatory as well as management policies on the basis of past records and data, making the entire pricing process in the housing market and fiscal policy as well as mortgage market witness severe downfall (Norgren, 2010). This further exhibits a strong effect of the interest rates on the investment market and wealth distribution within the economy. Collectively, with the downfall in these sectors of the economy, the US also witnessed high inflation, which has been another important factor accountable for the global financial crisis situations. It is worth mentioning in this context that with development of technologies, business organisations have been facilitated in developing their production centres in different countries obtaining the advantages of low production costs. In this manner, the reduced production cost subsequently weakened the bargaining power of the trade unions, which in return backlogged the wage growth of the developed countries. Contextually, the inflation pressure in the domestic market segments dampened, summed up with the expansionary monetary policy that was adapted by the central banks in different countries, focused on lowering the interest rates. Respectively, the low interest rate and high inflation rates resulted in massively increased debt amid households in the US and other Western countries applying the same mechanism. Such fluctuations imposed serious effects on the asset prices in these economies, on a constant basis during the period 2007-2008 (Berg, 2011). This also shows a strong association of the interest rates with the overall economic stability in accordance with the Keynesian theory of transmission mechanism of monetary policy (Refer to appendix Figure 3). The global financial crisis of 2007-2008 is admittedly remarked as the worst crisis, affecting the global economy. In the aftermath of the global financial crisis, the central banks of different countries emphasised adopting a progressive monetary policy framework, with the intention of reviving the market conditions and economic conditions. In this regard, the central banks lowered the interest rates to a significant level, but failed to bring any improvement in the financial output and housing prices (Miller-Betty, 2011). As can be apparently noted in this context, the aforementioned policies those were adopted by the central banks depicted the different mechanisms of monetary policies applied in the US, proved to be ineffective in managing the interest rate policy efficiently, which led to the rise of different factors, accountable for the development of crisis situations in different areas, including housing market, income distribution trends and asset pricing trends among others. Evidently, the above described factors responsible for the 2007-2008 financial crisis situation and the consequent challenges witnessed therefore by the world economy, advocates in favour of the effectiveness of the New Keynesian theory of transmission mechanism of monetary policy. Based on the above discussion, it can be argued that interest rates within an economy has a strong impact on the overall stability of the nation as it is directly related with the housing market and the housing market prices, disposable income held by the mortgage payers, credit demanded, investment market, exchange rate as well as the demand and supply trends, which causes significant impact on the income per capita of any economy (Adair & et. al., 2009). Lesson Learned Accordingly, the lessons learned from the above discussion, relating the assumptions of transmission mechanism of monetary policy with the occurrence of the global financial crisis of 2007-08, directly signifies the overall effectiveness of the theory. To be noted, the theory of transmission mechanism of monetary policy denoted the economic process on the basis of which, interest rates create strong influences on the fruitfulness of these policies to ensure that interest rates are kept under control in order to maintain economic stability (Adair & et. al., 2009). Contextually, the above conducted discussion evidently notifies that as assumed in the transmission mechanism of monetary policy, interest rates do have a strong impact on the overall economic stability. For instance, interest rate is identified to influence the housing market rates as per the transmission mechanism of monetary policy. As assumed, an increase or fall in the interest rate conversely affects the demand and price of housing (Qvigstad, 2010). In this regard, the study of the global financial crisis revealed that the fluctuations ignited with the gradual and uncontrolled fall in the interest rates, further increasing the credit demand in the housing market of the US. In this context, the increased consumption in the housing sector, added with weak credit rating policies, led to the fluctuations in the housing mortgage, or sub-prime mortgage markets in the US, giving rise to the global financial crisis situation (Gourinchas, 2010). Again, the lowering interest rates were also recognised to affect the level of disposal income of the people in the economy. Consequently, the lowering interest rates were identified to raise the level of disposal income amid the people, encouraging their credit demand in the short-run. Thus, in the US, a larger volume of people, with raised disposal income, invested more in the housing markets. But eventually, with the rising debt within the financial institutions of the economy, the housing consumers had to witness a rising pressure of interest rates, in consequence to the realisation that commodities in the housing markets were actually credited at a lesser price in comparison to their actual monetary value. This increased gap between the income and the consumption power of the consumers in the housing market, causing a sudden decline in the demand function of the entire economy (Qvigstad, 2010). Hence, the inflationary rates also began increasing gradually, further deepening the crisis situation within the economy. As the demand and supply trends in the US economy fluctuated, investments in the financial markets also started declining owing to the perplexities as well as lowering consumption power of the consumers, along with a steeply rising inflation trend within the economy (Mishkin, 2011). Therefore, as argued in the transmission mechanism theory of monetary policy, a massive fluctuation was observed in the exchange rates of the economy. Subsequently, the stock market fell in the US, causing severe effects on the stability of the foreign economies and hence, taking the shape of the global financial crisis (Quispe & Rossini, 2010). Conclusion From an overall perspective, it can thus be stated that as interest rates directly influences the purchasing behaviour of the consumers in the housing market of an economy, it causes major influences on the other economic growth drivers including the stock market, exchange rate, inflation, credit market and the demand and supply trends in the domestic economy at large. Therefore, to mitigate future chances of similar economic crisis situations, governments and financial institutions should be focused on controlling the interest rates within the economy. Hence, it can be comprehended that transmission mechanism of monetary policy is indeed an important and effective framework that can be implemented with the intention to develop accurate forecasting of the economic performances in the short run, based on the interest rate fluctuations observed within the domestic market. In a nutshell, it can be argued that interest rate management faults identified within the monetary policy of the US was largely accountable for the crisis situation of the 2007-08. It is worth mentioning in this context that as per the theory, economic growth drivers can be effectively forecasted and managed in the short run, by taking due measures in controlling interest rates. References Adair, A. & et. al., 2009. The Global Financial Crisis: Impact on Property Markets in the UK and Ireland. Report by the University of Ulster Real Estate Initiative. [Online] Available at: http://news.ulster.ac.uk/podcasts/ReiGlobalCrisis.pdf [Accessed December 13, 2013]. Andries, A., 2012. Monetary Policy Transmission Mechanism onto the Real Economy-A Literature Review. The USV Annals of Economics and Public Administration, Vol. 12, Iss. 1(15), pp. 211-217. Angelopoulou, E. & Gobson, H. D., 2007. The Balance Sheet Channel of Monetary Policy Transmission: Evidence from the UK. Working Paper No. 53, pp. 5-30. Bank of England, No Date. The Transmission Mechanism of Monetary Policy. The Monetary Policy Committee. [Online] Available at: http://www.bankofengland.co.uk/publications/Documents/other/monetary/montrans.pdf [Accessed December 13, 2013]. Berg, C., 2011. The Global Financial Crisis and the Great Recession: Causes, Effects, Measures and Consequences for Economic Analysis and Policy. Publications. [Online] Available at: http://www.bankofengland.co.uk/publications/Documents/events/ccbs_cew2011/paper_berg.pdf [Accessed December 13, 2013]. Bolvin, J. & et. al., 2010. How Has the Monetary Transmission Mechanism Evolved Over Time? Publications. [Online] Available at: http://www.federalreserve.gov/pubs/feds/2010/201026/201026pap.pdf [Accessed December 13, 2013]. Calabria, M. A., 2009. Did Deregulation Cause the Financial Crisis?. Cato policy Report, Vol. 31, No. 4, pp. 5-8. Cour-Thimann, P. & Winkler, B., 2013. The ECB’s Non-Standard Monetary Policy Measures the Role of Institutional Factors and Financial Structure. Working Paper Series. Gourinchas, P., 2010. U.S. Monetary Policy, ‘Imbalances’ and the Financial Crisis. Financial Crisis Inquiry Commission Forum. [Online] Available at: http://socrates.berkeley.edu/~pog/FCIC_Gourinchas.pdf [Accessed December 13, 2013]. Grail Research, 2009. Global Financial Crisis. Summary of the Media’s Coverage of the Timeline, Causes, Implications, Impact and Recommended Path Forward. [Online] Available at: http://www.grailresearch.com/Download.aspx?DownloadUrl=/PDF/ContenPodsPdf/Global_Financial_Crisis.pdf [Accessed December 13, 2013]. Holt, J., 2009. A Summary of the Primary Causes of the Housing Bubble and the Resulting Credit Crisis: A Non-Technical Paper. The Journal of Business Inquiry, Vol. 8, No. 1, pp. 120-129. ILO, 2009. The Global Economic Crisis and Developing Countries: Transmission Channels, Fiscal and Policy Space and the Design of National Responses. Employment Working Paper No. 36. [Online] Available at: http://www.ilo.org/wcmsp5/groups/public/---ed_emp/---emp_policy/documents/publication/wcms_113733.pdf [Accessed December 13, 2013]. Lewis, P., 2010. The Global Financial Crisis, 2007-08: Origins, Nature and Consequences. Global Security and International Political Economy, Vol. 1. Miller-Betty, S., 2011. Monetary Policy “Alternatives” in the Face of a Dysfunctional Transmission Mechanism. Monetary Analysis and Programming Department. [Online] Available at: http://www.cemla.org/actividades/2011/2011-02-AsesoresPolitica/2011-02-AsesoresPolitica-04.pdf [Accessed December 13, 2013]. Mishkin, F. S., 2011. Monetary Policy Strategy: Lessons from the Crisis. Working Paper 16755, pp. 2-62. Norgren, C., 2010. The Causes of the Global Financial Crisis and Their Implications for Supreme Audit Institutions. Intosia, pp. 1-49. Quispe, Z. & Rossini, R., 2010. Monetary Policy during the Global Financial Crisis of 2007–09: The Case of Peru. BIS Papers No 54. [Online] Available at: http://www.bis.org/publ/bppdf/bispap54r.pdf [Accessed December 13, 2013]. Qvigstad, J. F., 2010. Lessons from the Crisis for Monetary Policy and Financial Stability. Review. [Online] Available at: http://www.bis.org/review/r100908e.pdf?frames=0 [Accessed December 13, 2013]. Bibliography Demchuk, O. & et. al., 2012. Monetary Policy Transmission Mechanism In Poland. What do we Know in 2011? National Bank of Poland. [Online] Available at: http://www.nbp.pl/publikacje/materialy_i_studia/116_en.pdf [Accessed December 13, 2013]. Nissanke, M., 2009. The Global Financial Crisis and the Developing World: Transmission Channels and Fall-outs for Industrial Development. Research and Statistics Branch Working Paper 06. Were, M. & Tiriongo, S., 2012. Central Bank’s Response to Economic Crises from a Developing African Economy Perspective: Lessons from Kenya’s Experience. Documents. [Online] Available at: http://www.afdb.org/fileadmin/uploads/afdb/Documents/Knowledge/Central%20Bank%E2%80%99s%20Response%20to%20Economic%20Crises%20from%20a%20Developing%20African%20Economy%20Perspective%20Lessons%20from%20Kenya%E2%80%99s%20Experience.pdf [Accessed December 13, 2013]. Appendix Figure 1: Transmission Mechanism of Monetary Policy Source: (Bank of England, n.d.) Figure 2: Subsequent Events Leading To Global Financial Crisis 2007—2008 Source: (Grail Research, 2009) Figure 3: Factors of Global Financial Crisis 2007-2008 Source: (Norgren, 2010) Read More