Feds Policies to Solve the Current Macroeconomic Problems - Case Study Example

Fed’s Policies to Solve the Current Macroeconomic Problems A Review: Introduction The purpose of this study is to have a look into the functioning of Fed (Federal Reserve System), which serves as the Central bank of the country. The study makes an attempt to come out with the factors that are generally considered before taking any decision on monetary policy. The analysis also deals with determining the economic factors which play a major role in establishing the monetary policy. There is also an analysis of the discount rate decision and the steps that can be taken to overcome the current economic crisis the country is going through. Any government has the power to regulate the economy of the country and not only does it regulate the economy, it has a vital role to ensure that the economic condition remains stable. It is the responsibility of the government to ensure that all the aspects of economy maintain a stable level so that the country can grow and expand. Government regulates many things in an economy including inflation, exports and imports, prices of many vital commodities, and many important economic aspects. The government of US has entrusted the job of regulating the monetary policy and interest rates along with the margin requirements. Fed was created by an act of Congress and consists of a seven member Board of Governors who is headquartered in Washington DC with operations spread across the major cities of the US. The primary responsibility of the Fed is to set up monetary policy by setting up a FOMC (Federal Open Market Committee) together with five other members. (The Board of Governors of the Federal Reserve System) Monetary Policy and its Components One of the most important responsibilities for the Fed is that of ensuring monetary stability in the economy, which can be achieved through a combination of stable prices of goods and services across the economy coupled with a low inflation level and level of confidence of the investors in the currency of the country. The Fed comes out with the monetary policy in order to ensure a certain key objectives like, delivering price stability with a low inflation level coupled with an objective to support the Government’s economic objectives of growth and employment. To have a look on how the Fed monitors the price related regulations to keep a check on inflation, we can consider a small example of the regulation on house and property prices. To take any decisions related to interest rates keeping in mind the ongoing inflation rate, the Fed must be thorough with the booming property prices and must take steps to ensure that the prices are not artificial. The current economic crisis facing the US has much to do with the boom in the house prices through out the country, which has led to the Sub prime mortgage crisis. Government intervenes through its central bank to regulate the prices of many commodities, similarly it also regulates the prices of houses like any other important commodity. Fed has the responsibility to keep a check on asset prices including the prices of houses. There can be a number of reasons why the prices of houses shoot up, like the simple rule of demand and supply has a definite impact. We can divide the demand and supply conditions into two parts, first when it is a sellers market and second when it is a buyers market. (Demand and Supply for Housing). In a sellers market there is more demand and scarce supply, which makes it a fine proposition for sellers, as they can wait for their prices to come. In a buyers market, however, the demand is less and property available in the location is more. This phenomenon gives rise to a buyers market, as they can in such a scenario, wait for their prices to come, needless to say that these prices are far too low than the actual prices. (Demand and Supply for Housing). Other reasons behind a change in property prices can be Mortgages. A mortgage is the money borrowed to buy a house, as for most people buying a house is not easy. Over the years mortgage market has picked up greatly and the current scenario is totally different from the one that existed in the beginning. Mortgages were supplied only by the building societies. Building societies were non-profit institutions and encouraged only the members for the grant of loans, so the people who were members and had contributed to an extent for a considerable period of time got loans easily and account with building societies became the only means to get mortgages. Soon these societies had to compete with the banks and other financial institutions specialized in granting housing loans. This price war resulted in a greater demand for owner occupied houses and consequently the demand for houses grew stronger, resulting in a substantial increase in price. (The UK Housing Market - Factors Influencing the Housing Market: Mortgages) Besides the above-mentioned factor of mortgages there are other factors like stamp duty and planning that affect the market for housing. Mortgage interest relief at source (MIRAS) was a tax concession to owning a house. It reduced the house owner’s liability to income tax as the money spent on the interest on mortgage was considered to be tax-free. This made borrowings cheaper and as a result there was a huge demand for housing and the prices shot up. With the introduction of MIRAS in 1990 many people were exempted from stamp duty. (The UK Housing Market - Factors Influencing the Housing Market: Stamp Duty and Planning) The Fed has a monetary policy and uses the same to regulate mechanism of the economy and deal with such erratic swings in the prices of property. Like when it decides to change the interest rate, the government is trying to check the overall expenditure of the economy. A change in interest rates is mostly used to contain inflation, which is the result of lavish expenditure by the country. The Fed sets a fixed interest rate at which it lends money to financial institutions and depending on this interest rate, individual banks and other financial institutions set up their own interest rates, which apply to the whole economy. The point to be noted here is that, this interest rate set is so effective and powerful that it contributes greatly to regulate the whole economy. It affects the stock and bond prices and also influences the asset prices through out the country. This interest rate also regulated the savings in an economy, which eventually results in capital formation and reinvestment. It is note that when interest rates are high, people prefer to invest money in government deposits that are less risky in nature than the stock markets and similarly high interest rates boost up the savings. Lower interest rates make asset and real estate prices go up, as people start ignoring conventional saving instruments and make use of the high growth ventures like shares and houses, which pushes up their prices. Interest rate change also affects exchange rates, as an increase in the interest rate in US will yield better returns to the investors compared to their overseas ventures. This phenomenon usually makes US dollar assets attractive, which pushes up the value of the currency vis a vis other currencies, and a stronger US dollar would mean less money would be shed on imports and less quantity of exports will take place as there will a lesser demand for products made in US because of the currency being strong. It is interesting to have a look at the process of how the bank sets interest rates. The primary step in this direction starts with the estimates of the money flow that takes place between the government and the Central bank, and the Central bank and commercial banks. The Fed makes sure to rectify all the imbalances, which arise along the path on a daily basis. There can be two phases to the money flow that takes place between the system, first, when more money flows from banks to the government and second, when more money flows from government to the banks. In first case, Fed’s liquid assets come down, which affect the short-term instruments of money market. And in the second case the market finds itself with a cash surplus. The Fed is the bank of the government as well as the bank of all the financial institutions and commercial banks, so it chooses the interest rates for the funds to be provided each day, and this interest rate is passed through the financial system, which influences the interest rates of the country. (How Monetary Policy Works). A detailed diagram given below will help to gain a better insight into the concept. The above diagram explains the concept of system regulation. It shows that the official rate, which is set by the Fed, influences many parts of an economy such as market rates, asset prices including the house prices, expectations, and exchange rate. This gives rise to demand, which is the sum total of domestic plus external demand, which in turn gives rise to inflationary pressure resulting in inflation, another important point shown, which deserves a mention is the relationship between the exchange rate and import prices, or the price paid for imports. As explained above, the stronger the exchange rate the lesser the price paid for imports and the weaker the currency the higher the price paid for imports. (How Monetary Policy Works) Keynesian Model Vs Rational Expectations Before 1930, macroeconomics believed that there was a state of full employment in the economy except for temporary disruptions which led to the belief that with full employment, nations output in the short run will be constant. With the assumption that aggregate output remains constant, economists started devoting their time to microeconomics with its emphasis on the determination of the prices and output levels of individual products, but in 1930 the great depression proved that the assumption of full employment and constant output were false as the unemployment rate had climbed to 24.9 percent in 1933 from 3.2 percent in 1929 followed by a huge fall in the gross national product. In 1936 John Maynard Keynes published his book in which he had established a relationship between employment, interest and money mentioning that unemployment could exist for a long period of time and indefinite existence was a probability. Economist around the world took it very enthusiastically and it was known to be “Keynesian Revolution”. Keynesian insisted that to overcome any economic slowdown, the government must interfere and increase its spending encouraging the masses to spend more, so that the overall demand in an economy picks up and the economy recovers from any economic slowdown. Though it was a great phenomenon, but it failed to make an impact independently when it proved to be ineffective in 1970’s and the attention was drawn towards monetarist, rational expectations as well. (MACROECONOMICS AND THE GOALS OF MACRECONOMIC POLICY) John F. Muth of Indiana University coined the theory of rational expectations in the early sixties. He used the term to describe economic situations under which, the outcome depends on peoples’ expectations. For example as discussed by Sargent J. Thomas (Rational Expectations) “The price of an agricultural commodity depends on how many acres farmers plant, which in turn depends on the price that farmers expect to realize when they harvest and sell their crops”. The theory greatly applies to the stock markets around the world, as, if investors expect the price of common stock of a particular company to come down they go on a selling spree and the result is obvious, and when they expect it to go up they buy heavily and hence, the prices spirally. To conclude the cornerstone of the theory, we can suggest that, people behave or take decisions in order to maximize the value of an outcome and they keep getting feedback from the transactions, as to what they expected and what they actually received. In this way there expectations over a period of time tend to stabilize because of the result of the past outcomes. In other words, their expectations become rational. To put the theory in mathematical perspective, let us assume that P* is the equilibrium price (a price at which demand equals supply) in a market, then according to the rational expectations theory (Pe) will be the function of P* + e, where (Pe) is the expected price and e is the random error term, which is independent of P*. (Sargent J. Thomas, Rational Expectations). Fed’s Decision and the Problems of the Economy To ensure transparency in the system and to provide public with greater and timely insight, fed has decided to come out with four economic forecasts each year as opposed to two originally. As Mr. Bernanke has made evident in his decision that, “the new policy is not a step toward the specific inflation targets set by used by other central banks, which would not be appropriate for the fed given its dual mandate to promote sustainable economic growth as well as control inflation”. (Fed will make four expanded economic forecasts per year UPDATE). Fed has four economic goals of Full Employment, Price Stability, Economic Growth and External Balance as explained earlier. External balance is the balance of payments between one country and the rest of the world for the trade negotiated between them. It should be positive in order to be good for the country. Keynesian as well as Monetarist approach can be used to tackle these problems as explained earlier that by using demand side economics (Keynesian model), an economy can fight deflation and unemployment as the overall demand in an economy picks up and the economy comes out of any shock. Similarly the supply side economics or monetarist view can be used to boost up the economic activity by cutting taxes. Both the models have their limitations, but Keynesian model seems to be the better method to boost up an economy. The Discount Rate Decision Discount rate is the rate at which the bank lends money to other financial institutions. These institutions then lend this money to other institutions and corporates and public. Discount rate decision would predominantly depend upon the inflation prevailing in the economy. If the discount rate is left unchanged and the inflation keeps scaling up higher then the money market and fixed income securities will suffer a set back and the people on the street will run towards more risky investments that could fetch them higher returns, as a result there will be a sharp upsurge in the prices of riskier assets like the real estate and shares. Also, in this way people will be able to raise money at lower rates and invest the same money elsewhere. Looking at the recent sub prime mortgage problems facing the US economy and a slowdown in housing sector fed had cut the basic rates twice coming to the rescue of the economy. The crisis started with the subprime lenders lending at higher rates than usual to the borrowers with bad economic history and lesser ability to pay back. The subprime lending functions on the principle of no collateral and higher interests. There debt instruments are then traded and are passed on to other banks or institutions which are ready to take them for the higher interest they get out of them. This had also led to some prominent hedge funds failing to declare their current asset values. The problem has led to a total crunch of liquidity in the US. (How the US Subprime Mortgage Crisis Affect Irish Markets) Impact of Soaring Oil Prices Any increases in oil prices is expected to feed through into inflation over the next few years, and the gap between the value of imports and exports is growing to record levels, prompting expectations of a decline in the value of sterling, which is a welcome sign for the exporters but will hit the importers, as they will have to shell out more money for importing their raw materials leading to a further increase in inflation. Any decision is taken after considering the condition of the whole economy and all sections of the society at large and there are several other methods to tackle the prices of properties, but it is always better to increase the rates at a slower but steady pace, rather than giving a monetary shock. Rising Inflation, if not tackled properly and at the right time may create a cycle, wherein the inflation keeps rising due to no change in interest rates, but looking at the current scenario, the fed has taken the route of cutting rates instead, so that liquidity conditions stabilize in the market and the borrowers have a chance to pay back their loans. With high interest rates and an already slowing housing market, borrowers would have found it much difficult to pay back their loans in time. Works Cited “Demand and Supply for Housing” tutor2u. 18 Nov. 2007. tutor2u. http://www.tutor2u.net/economics/content/topics/housing/housing_demand_supply.htm “How the US Subprime Mortgage Crisis Affect Irish Markets”. 18 Nov. 2007. Irish Mortgage Brokers http://mortgagebrokers.ie/index.php?a=mortgage_article_view&article_id=21 “How Monetary Policy Works” bankofengland. 18 Nov .2007. Bank of England. http://www.bankofengland.co.uk/monetarypolicy/how.htm “MACROECONOMICS AND THE GOALS OF MACRECONOMIC POLICY”. 18 Nov. 2007. http://www.ens.gu.edu.au/AES1161/Topic7R1.htm Sargent J. Thomas, “Rational Expectations” The Library Of Economics And Liberty. 19 Nov.2007 The Library Of Economics And Liberty. http://www.econlib.org/library/enc/RationalExpectations.html “The UK Housing Market - Factors Influencing the Housing Market: Mortgages” 19 Nov .2007. bized. biz/ed. < http://www.bized.ac.uk/current/research/2004_05/090505e.htm> Read More