Federal Reserve Policy during the Recession and Effects of the Credit Crunch - Assignment Example

? Federal Reserve Policy during the Recession and Effects of the Credit Crunch FEDERAL RESERVE POLICY DURING THE RECESSION AND EFFECTS OF THE CREDIT CRUNCH Part One: Federal Reserve Bank Policy during the 2007-2008 Recession To increase the funds that were available to commercial banks, as well as decrease the rate of fed funds, the US Federal Reserve announced that it had plans to increase to $300 billion its Term Auction Facility (Amacher & Pate, 2012). This was in September 29, 2008 and was in reaction to the US recession. The Fed Reserve, realizing there was a shortage of American currency, in the EU, decided that it would improve swap facilities to $620 billion from $290 billion with central banks from overseas. It also announced that it would buy mortgage and debt, which was worth $800 billion. This would be a separate fund from Troubled Asset Relief Program, which was also formed to combat the effects of the recession and was worth up to $700 billion. By December 2008, the Fed Reserve had independently spent over $1.2 trillion in the purchase of specific financial assets. A significant amount of the funds used by the Fed Reserve was meant to rescue firms deemed ‘too big to fail”. The Fed Reserve used, up to $100 billion, to buy debt from Freddie Mac and Fannie Mae, as well as up to $500 billion to buy mortgage-backed securities from these firms. This intervention by the Federal Reserve went some way in buffeting the banking sector from the economic and financial recession, especially with the over $200 billion given to security holders with the backing of consumer loans like student loans and credit cards. This kind of intervention normally works to unfreeze consumer debt markets (Amacher & Pate, 2012). Part Two: The Effect of Bank Lending on the Economy With the availability of competitively priced loans and cheap loans dwindling, more consumers have become increasingly concerned with regards to their finances (Amacher & Pate, 2012). Because of the issues that have befallen the wider economic and financial market, slightly more than 20% of American consumers are more concerned about borrowing via credit cards and personal loans. For this reason, consumers tend to take steps to reduce their spending as low cost consolidation loans becoming a way of doing this. In addition, increasingly more consumers tend to reduce expenditure because of concerns about increased repayments on loans, spending less money and saving more of their money. The credit crunch also affects business investments since businesses are forced to decrease or even stop investments as they cut down on borrowing. As banks tighten their credit, loans become too expensive and businesses cut back on borrowing (Amacher & Pate, 2012). Since businesses rely on the banking system being healthy, the bailout occasioned by the financial crisis has resulted in a credit crunch, which has seen banks putting money in US Treasury Bills, rather than loaning it to businesses and consumers. Ultimately, the above strangles business investment. The credit crunch also leads to reduction of wealth as consumers and businesses cannot borrow to create wealth, which has a knock on the effect on aggregate demand, shifting it leftward (Amacher & Pate, 2012). The credit crunch eventually leads to decreases in financial and other stocks, leading to decreased expenditures, which shifts to the left the demand curve. The GDP also underperforms when there is a credit crunch since resources are not used effectively due to decreased borrowing, which ultimately hurts business confidence and decreases investment. Finally, the credit crunch also increases unemployment since businesses cannot borrow to pay staff wages and suppliers, which leads to staff lay-offs. In addition, the still employed staff cuts down on their spending, as a result, it affects, the demand for products and services from other companies, which are also forced to lay off staff. This causes a downward spiral that leads to people losing employment (Amacher & Pate, 2012). Discussion #1 Christopher, I think you made some relevant points on why it was essential for the Federal Reserve to take the decisions that they did. It is clear from the argument made that, in your opinion, the enormity of the problems caused by the financial crisis required extra-ordinary measures to return to normal. The scenario presented by the financial crisis was not normal and, as such, it was imperative for the Federal Reserve to come up with new and innovative solutions. I also agree with your view because, whereas the problem was emergent and peculiar, straightening it out with the strategy taken by the Fed Reserve, instead of waiting for the problem to resolve itself was better. It would have been possible, but the economy is too important to allow it to drag on in recession for too long. However, I believe this should be a one-off solution and that the Fed Reserve should look for more long-term solutions. Marketta, While the reasons given for the bailouts given to “too big to fail” firms are sustainable, I think it would also have sufficed to put in place a framework that would avoid any repetition of a financial crisis. For example, the Federal Reserve should have made regulation of the banking sector a priority, especially because they had been too optimistic on the ability of their customers to repay their loans, as well as to re-service their mortgages. I agree with your opinion that buying loans and assets from this firms was a good strategy, as was the lowering of federal funds rate. This acted to stimulate them, and while it was expensive to the American taxpayer, it was necessary, as the repercussions of a failed banking system would have less bearable. As stated in the beginning of your answer, the primary reason why the Fed Reserve exists is to ensure that the banking sector is safe. Given the dire state the financial crisis left the US banking sector in, the actions discussed in your post were best placed to deal with it. Discussion #2 Alan, I think that the opinion given in the post is right since the availability of credit in the country is essential to the growth and sustenance of the economy. In situations such as the discussed credit crunch, decreased availability of loans leads to decreased consumer spending and business investment, which, in turn, lead to increasing rates of unemployment as revenues for businesses are reduced. The government should put mechanisms in place to forecast the probability of a credit crunch, especially because of its adverse effects on the economy. Since the credit crunch was as a result of poor policies by the banks and the government, it would be a big help if policies were put, in place, to curtail the ability of banks to put the economy through such a situation again. Lance, Your response is right on money because it becomes increasingly difficult for consumers and enterprises to get loans when banks offer expensive loans, which they cannot afford. The response is further validated by the fact that the US economy, as is the case with all other economies, has its growth dependent on borrowing and spending, which leads to revenues for other businesses. In turn, the enterprises that get these revenues can go further and spend this money on another enterprise, and so on. This leads to increased revenues for a wide range of industries; therefore, growth of the economy. References Amacher, R. & Pate, J. (2012). Principles of Macroeconomics. San Diego: Bridgepoint Education, Inc. Read More