How Liquidity Traps Affect Policy Options - Essay Example

? The Macroeconomics of Financial Crises: How Risk Premiums and Liquidity Traps Affect Policy Options Part The Emergence of Large and Volatile Risk-Premiums during the Financial Crisis Mostly, business cycle models are affected by the unprecedented large and perhaps risk-premiums, which come during financial crisis (Fontana & Setterfield, 2009, p. 27). If not carefully checked and corrected, the country risk experiencing recession and subsequent depression, a situation that poses a lot of challenges in micro-enterprises, especially during moments of economic crisis (Fontana & Setterfield, 2009, p. 103). Due to this problem, the economists urge business practitioners in different countries to adopt new paradigms. i) Interest Rate Data of the United States, Canada and United Kingdom United States In the United States, the interest rate was reported to be approximately 0.25 percent beginning March 2009 (Trading Economics (a), 2012, p. 1). Fortunately, the country has put several fiscal policy frameworks, which have enabled it to maintain the rate fairly the same till January 2012 (Trading Economics (a), 2012, p. 1). At this rate, doing business in the country is relatively cheaper compared to other countries experiencing exorbitant interest rates as shown. Source: http://www.tradingeconomics.com/united-states/interest-rate As presented in the chart, the authorities mandated to fix the interest rates are the Federal Open Market Committee (FOMC) and the Federal Reserve’s Board of Governors (Board) (Trading Economics (a), 2012, p. 1). In operation, the Board receives recommendations the Regional Federal Reserve Banks (RFRB), after which it carefully reviews and changes the discount rates appropriately (Trading Economics (a), 2012, p. 1). On the other hand, the FOMC makes decisions about the operations at the open market that include the market rate of the federal finances and the levels at which the central bank’s funds should be fixed (Trading Economics (a), 2012, p. 1). Essentially, such policies and frameworks interplay to stabilize the economic development of the country and region at large. As at January 2012, the interest rate stood at 0.25 as shown in the chart below; Source: http://www.tradingeconomics.com/united-states/interest-rate Canada In Canada, as at January 2012, the situation was different and the interest rate stands at 1.0 percent (Trading Economics (b), 2012, p. 1). Here, the authorities mandated to fix the interest rates is the Governing Council of Bank of Canada (BOC) (Trading Economics (b), 2012, p. 1). Therefore, the banks rate is the official country’s interest rate. In choosing the policy option(s), the country has always relied on its interest rates and the risk premiums, comparing them to the ones that other countries adopt (Trading Economics (b), 2012, p. 1). Indeed, this is critical in fixing the rates, a move that could make the country arrive at workable figures, which encourage the local and international investors to start businesses. In addition, the entrepreneurs can obtain loan from the commercial banks, at a lower rate to expand their business (Kindleberger & Aliber, 2011, p. 105). Ideally, this favours the investors and makes the business environment to be competitive. Therefore, the smart entrepreneur would eventually carries the day and strengthen his/her business. Source: http://www.tradingeconomics.com/canada/interest-rate United Kingdom In the United Kingdom, as at January 2012, the situation was different and the interest rate stood at 0.5 percent (Trading Economics (c), 2012, p. 1). Here, the independent authority mandated to fix the interest rates is the Monetary Policy Committee (MCP) (Trading Economics (c), 2012, p. 1). At the same time, the Bank of England oversees the rate that is the MPC fixes and may agree to adopt or reject the proposal (Trading Economics (c), 2012, p. 1). Source: http://www.tradingeconomics.com/united-kingdom/interest-rate ii) The money market risk premiums for each of the 3 countries The risk premiums, which characterize most sectors of finance, are the major contributors to economic crisis in many countries. Indeed, such uncertainties might force the country to adopt conventional fiscal policy and fall victim of liquidity trap that is in most cases could be perceived as ineffective though the interest rate might be high above zero (Gartner & Jung, 2011, p. 15). Notably, Risk premium = Money Market rate – Treasury bill rate United States The money market in the United States has faced tribulations from the unsecured risk premiums, which affected most of the financial operations in the country (Gartner et al., 2010, p. 1). In 2007, the risk premiums became so volatile that it forced the other banks to review their interest rates in line with that of the country’s central bank (Gartner et al., 2010, p. 1). The aim of this move was to harmonize the operations in the commercial banks. Notably, as the premium risks increased, many banks attributed this to liquidity hoarding that threatened the financial in the country (Gartner et al., 2010, p. 1). Source: http://www.eurmacro.unisg.ch/xercises/crisis.html Canada Here, the Canadian risk premiums were more pronounced and reflected in three aspects namely, reflecting credit risk, Canadian financial market risk and liquidity financial support risk (Chadha & Holly, 2011, p. 122). United Kingdom Looking at the results of economic analysis from United Kingdom, one notices the role that the targeted exchange rate problems have on the country’s economy (Kindleberger & Aliber, 2011, p. 147). There is also a significant influence that the tensions arising from interbank activities in the United Kingdom. Usually, this occurs when the country faces financial crisis resulting from liquidity funding problems and credit default. As a result, the situation affects the consistency that the financial market experienced prior to the monetary crisis. Part 2 i) The Mundell-Fleming and the IS-LM models In periods of financial crisis, risk premiums from the income and capital markets give rise to liquidity traps forcing the economic stability of the country to experience recession (Gartner & Jung, 2011, p. 13). This can be best illustrated using the Mundell-Fleming and the IS-LM models as applicable in economics. Notably, global economic downturn has strong affects on the housing sector in most countries. In fact, this can only be understood when the person takes keen interest on concepts such as liquidity traps, interest rates and risk considerations (Gartner & Jung, 2011, p. 13). Moreover, it is the increase in demand that leads to the market crisis, especially when the supply is relatively low. Under normal circumstances, liquidity traps remain dormant, but easily become pronounced as the risks grow (Gartner & Jung, 2011, p. 13). This indicates that liquidity traps might shape the country’s monetary policy, and the open economies are at the highest risk of facing financial crisis. Apparently, the latter economies find themselves in a situation of perfect trap, where only the strong fiscal or monetary policies, central bank and government efforts could offer solution to the problem. As well, the risk premiums, which often characterize the local money market, could further destabilize the country’s economy (Gartner & Jung, 2011, p. 15). The IS-LM Model Under this model, the IS and LM curves are plotted to determine the liquidity trap and show implications and relevance to economic crisis (Gartner & Jung, 2011, p. 14). The financial market equilibrium determines the LM curve, while the goods market equilibrium shows the IS curve (Gartner & Jung, 2011, p. 14). The formulas for calculating the LM and IS curves are indicated below. M =L (i, Y) P Y = C (Y – T) + I (i) + G Where, variables such as P is price levels M is money supply G is government spending I is nominal interest rate Y is real income T is taxes And constants such as L (.) is money demand function C (.) is consumption function I (.) is investment function Having that in mind, there is an assumption that the interest and money elasticity are constants (Gartner & Jung, 2011, p. 14). However, during crisis, the assumptions could be misleading. Underscoring the fact that bonds store value, which increases and decreases according to the then interest rate, they become less beneficial as the rates tend towards zero. In this regard, the LM curve becomes horizontal (Gartner & Jung, 2011, p. 14). At this extent, the effects of money supply on income reduce and subsequently cease. Therefore, the horizontal curve reduces chances of overcrowding, making the fiscal policy to be more potent, particularly during liquidity trap. The Mundell-Fleming Model According to this model, it is clear that the financial crises have impacts across the boarder on matters relating to capital flows and international trade (Gartner & Jung, 2011, p. 18). Through the international trade and capital market, capital mobility is enhanced, thus able to produce expected results. Besides, the results are equalized in many regions, thereby helping the country achieve the equilibrium state (Gartner & Jung, 2011, p. 18). In addition, the model is more practical in small markets than in more advanced economies. For the countries experiencing such economic conditions, the model offers the best abstraction compared to that of IS-LM (Gartner & Jung, 2011, p. 18). This is an indication that the interest rate at the money market is similar in many countries despite the risk premium occurrences. Similarly, there could be a difference between capital and money markets and the difference might also vary among various countries (Gartner & Jung, 2011, p. 18). Consequently, the trends in the current money market and risk premiums shape the political options that the country is likely to adopt. ii) Policies to end Recession Some of the practical and expansionary fiscal policies and/or a combination of various strategies reduce and possibly eliminate recession. First, formulating the fiscal policies, which keep the equilibrium at the horizontal position of the LM, is perhaps the best way to reduce and probably end the recession (Gartner & Jung, 2011, p. 20). Secondly, the economic policy that aims at lowering the prices of essential commodities in the market can also minimize and end recession (Gartner & Jung, 2011, p. 20). Third, the central bank can also put the exchange rate at a fixed level, after which it devalues the country’s currency so that it encourages import and export across the boarder (Dermine, 2009, p. 45). Indeed, this is a measure that is similar to fiscal expansion, especially when practiced on fixed or flexible exchange rates. In this regard, the measure aims at reducing or ending recession. The other policy that the country could apply in eradicating recession is to adopt a coordinated approach through involving the country’s central bank and the government (Dermine, 2009, p. 88). Under the system, the policy applies an accommodative and persuasive fiscal structure and role that is able to increase the market demand for the country’s goods and other available services (Gartner & Jung, 2011, p. 20). The country can also undertake unconventional structural adjustments, which restore the perceived confident crisis that the domestic banks might find their operations in (Prabhakar, 2010, p. 61). When such structural adjustments are done in a proper manner, the practicing country could achieve meaningful step towards reducing recession. Conclusion In summary, there are various ways in which risk premiums and liquidity traps affect the policy options, which the country adopts. First, it is clear that interest rate of the country shapes the policies, which the country adopts. Second, interbank activities also contribute to the final decision that the responsible authorities would make regarding the desirable exchange rate during economic recession. Third, it is apparent that liquidity traps remain dormant under normal circumstances, but easily becomes pronounced as the economic risks increase. Therefore, it calls for flexible exchange rates for the country in order to minimize the impacts risk premiums and liquidity traps, in which the country might find itself. Finally, there are practical and workable policies, which the country should adopt in order to end recession. For example, formulating workable fiscal policies, which keep the equilibrium at the horizontal position of the LM, is possibly the best way to reduce and end the recession. In addition, other measures such as lowering the prices of essential commodities in the market can also minimize and end recession. The central bank of the country can also play an active role by putting the exchange rate at a fixed level, after which it devalues the country’s currency so that it encourages import and export across the boarder. This is a practical way of reducing recession. As well, a coordinated approach that involves the country’s central bank and the government might be applied to reduce recession. References Chadha, J. S. & Holly, S. (2011). Interest Rates, Prices and Liquidity: Lessons from the Financial Crisis (Macroeconomic Policy Making). Cambridge: Cambridge University Press. Dermine, J. (2009). Bank Valuation and Value-Based Management: Deposit and Loan Pricing, Performance Evaluation, and Risk Management. New York, NY: McGraw-Hill Professional. Fontana, G. & Setterfield, M. (2009). Macroeconomic Theory and Macroeconomic Pedagogy New, York, NY: Palgrave Macmillan. Gartner, M. & Jung, F. (2011). “The Macroeconomics of Financial Crises: How Risk Premiums and Liquidity Traps Affect Policy Options.” International Advances in Economic Research. Vol. 17 (1): 12-27. Gartner, M., et al. (2010). An Interactive Primer on the Macroeconomics of Economic Crises. Available at [Accessed 02 March, 2012]. Kindleberger, C. P. & Aliber, R. Z. (2011). Manias, Panics and Crashes: A History of Financial Crises, (Sixth Edition). New York, NY; Palgrave Macmillan. Prabhakar, A. C. (2010). Advanced Macroeconomics: A Rethink in the Era of Global Financial. Equador: LAP LAMBERT Academic Publishing. Trading Economics (a). (2012). United States Interest Rates. Available at [Accessed 02 March, 2012]. Trading Economics (b). (2012). Canada Interest Rates. Available at http://www.tradingeconomics.com/canada/interest-rate [Accessed 02 March, 2012]. Trading Economics (c). (2012). United Kingdom Interest Rates. Available at [Accessed 02 March, 2012]. Read More