The United States Economy - Case Study Example

Running head: THE UNITED S ECONOMY The United s Economy Introduction Macro economic factors such as Gross domestic Product, trade deficits, exchange rates and interest rates strongly impact a nation’s overall economy as well as the bottom line of private organizations through the costs and availability of finance, products and services. All these macro economic factors involve the economy as a whole. This paper discusses the major current macro economic events that have occurred in the US in recent times and then explains how they relate to economic theories. Starting from the end of 2007, the US economy began to soften and was gripped with inflationary pressures that threatened to inflate prices at levels that have not been experienced in the country during the last few decades. It is thus important to analyze the macroeconomic causes and implications of price increase of commodities, collapse of the housing market and the ensuing financial turmoil. Main Body The global economy is currently in the grip of the maximum macroeconomic uncertainty in the last 25 years because prices of major commodities such as corn, coal, natural gas and oil have been consistently increasing in being triggered partly by the rapid increase in demand in developing countries such as China and India. However the prices in the housing sector, especially in the US have been declining. Housing prices in the US have fallen by almost 25 percent in relation to the 2006 peak period. The consequent financial turbulence that overwhelmed the world economy after September 2007 continues to retain its intensity in adversely impacting several sectors in the US economy. Although a number of economic forces have worked in creating this adverse macroeconomic situation, the two main causes have been the increase in the prices of basic commodities and the quick weakening of the housing market. In fact, the financial turmoil beginning at the end of 2007 has its origin in the subprime mortgage crisis (Tanous and Cox, 2011). Although oil prices were stable for almost two decades preceding 2008, they rose to levels never observed before; from $20 a barrel in 2003 they increased to over $140 a barrel in 2008. This increase by about 700 percent obviously had its impact on prices of other items such as rice, wheat, corn, steel, coal and natural gas. Prices rose sharply because of many reasons but primarily due to the increasing demand for oil in many developing countries, even while prices of other commodities were rising. It is noteworthy that during the last 20 years global oil demand and consumption has increased considerably. For instance, consequent to the economic downturn in 2008, there was a decline in demand for oil in the US and in many European countries, but the decline was equalized by increased demand for the commodity in countries such as India, Middle East and China. In the US, factors such as poor crop yield, macroeconomic volatility and supply disruption appeared to have contributed in worsening the movement of prices (Jones, 2008). Another major macroeconomic shock to the US has been the large scale decline in housing prices that have been declining since 2006. Housing demand in the US was fuelled by demand created by the new economies of the late 1990s, by low interest rates during the initial years of the 2000s and because of the constant loosening of lending policies. In view of such artificially created economic circumstances, housing prices in the US rose drastically prior to 2006 but soon started declining and by 2008 had declined by 20 percent. The beginning of the financial turmoil and America’s economic woes lies in the position of its housing market after 2006. People were attracted by low interest rates, flexible lending norms and by the perceptions that housing prices will continue to increase. As a result, large number of subprime borrowers who did not meet the credit standards in terms of credit record and application requirements were allowed to take credit and to buy homes. It is on record that during this period about 20 percent of the mortgages were categorized as subprime. Borrowers were offered extremely flexible terms such as adjustable interest rates, low installment payments and the option to only pay the interest component of the mortgage loan. Following two years of extremely low interest rates, the Federal Reserve started increasing the rates it levied on banks. From 1.25 percent, the rate was increased to 5.25 percent in two years because of apprehensions relative to inflationary pressures. High interest rates made borrowing costly and home borrowers were unable to pay interest and loans as a result of which almost 17 percent of subprime mortgages defaulted (Tanous and Cox, 2011). In understanding the ensuing financial turmoil it is helpful appreciating the innovations in finance during recent years. Funding systems during this period involved the amalgamation of large numbers of financial instruments and their subsequent division into different options provided by lenders in order to attract borrowers. In this context, hedge funds adopted extremely risky positions in the expectation of getting very good returns. These instruments known by several names such as collateralized debt obligations, asset backed commercial papers and mortgage backed securities were assumed to diversify the associated risks relative to any given asset (Perelstein, 2009). For example, a subprime mortgage can be made less risky if several thousands of people are provided credit under such systems, whereby default by a few does not entail loss. However, in view of the large number of defaulters the risks intensified and banks were forced to sell off mortgages because of which lending standards began to deteriorate. The Federal Reserve kept increasing interest rates at regular intervals and housing prices started falling, which made mortgages very expensive and borrowers preferred to let creditors take over their assets. Banks too increased their interest rates; investors got frightened and chose to divert their funds into safer options such as treasury bills rather than keep them with banks (Sherry, 2011). In view of these policies and developments there was immense inflationary pressure as commodity prices rose sharply. The Consumer Price Index rose substantially and the performance of the overall real economy began to falter, with increasing unemployment that resulted because of lack of job opportunities. Because of increasing prices, demand declined and productivity also declined, creating lesser job opportunities in the economy. Following the onset of the economic crisis, short term productivity suffered an immediate setback and a negative output gap emerged. The rate of inflation in the US was reported at 3.9 percent in September 2011. It is obvious that the US economy is not faring satisfactorily, which is evident from the following graph: Source: http://www.tradingeconomics.com/united-states/inflation-cpi The unemployment rate in the US was 9 percent in October, 2011, which is much higher than the average rate taken during the last fifty years. It is correct to say under the circumstances that the number of people without jobs in the country is increasing by the day, which is evident from the following graph: Source: http://www.tradingeconomics.com/united-states/unemployment-rate It is evident that the macroeconomic indicators clearly reveal that the US economy has not been performing well and there appears to be no positive indication of any improvements being made in reducing inflation or in improving the employment scenario in the country. Increase in food and energy prices are the main causes of the current inflationary position. The price index for gasoline continues to increase while the index for electricity is also increasing consistently. Similarly, food index has been increasing constantly for the last three months. The US economy is currently suffering from a trade deficit because it imports more than what it exports. The country’s trade deficit in 2010 was $497.9 billion, which means that the economy is not in a strong position. In suffering a current account deficit, it means that the US is consuming more than what it is producing. In the context of consumer spending, government spending and business spending, consumer spending is the largest and it is known that the US has been spending more than its total Gross Domestic Product, currently being as high as 106 percent of GDP. In consuming more than it’s GDP, the US has to borrow the remaining amount, which means it is constantly increasing its liabilities in being indebted to countries such as China, Japan and other developing nations. It is correct to say hypothetically that these countries hold the right to ask for their money anytime. According to Jones (2008), the policy responses towards the current macroeconomic events can be carried out in three ways: The Federal Reserve eases monetary policy The Federal Reserve expands lending and provides for additional liquidity The government introduces a fiscal stimulus by providing concessions to taxpayers In response to the financial turmoil and other macroeconomic developments outlined in this paper, the Federal Reserve had sharply reduced interest rates and the rate of federal funding declined from 5.25 percent to 2.0 percent. New lending policies were introduced to infuse added liquidity to banks and lending institutions. Big investment institutions were permitted to engage in less liquid financial instruments during the short term, in regard to treasury securities. Some economists expressed worry over the moral hazard associated with this kind of government policy, particularly because such policies indicate the readiness of the government to interfere in providing liquidity at times when big banks and lending institutions are in difficulties. The point being that in protecting these institutions from the adverse impacts of their faulty actions can lead these very institutions to get further involved in highly risky investment initiatives in the coming times. From the macroeconomic perspective, this is a genuine apprehension and leads to extra costs in terms of interventions by the government and its agencies. However, from the perspective of the Federal Reserve, the costs associated with not interfering have been much higher than taking remedial measures through interventions, because otherwise the suffering from the financial crisis may have been more severe (Moss, 2010). Conclusion Given the large number of macroeconomic events that have been haunting the US economy during the last tree years it is imperative that proactive measures be taken to leave the recession and financial crisis behind. A major area of concern, relative to improvement in the economy, is the manner in which the Federal Reserve deals with interest rates in the coming times because that will have a strong bearing on the direction in which inflation will be headed. If inflation continues to remain above 2 percent it is better for the Federal Reserve to push for short term increase in interest rates. If inflation declines to less than 2 percent it is better to push for reducing interest rates in the short term. List of References Jones, Charles I. (2008). Current Macroeconomic Events, http://www.wwnorton.com/college/econ/chad/CurrentEvents2008.pdf, Accessed on 13 November, 2011. Moss, David A. (2010). A Macroeconomic View of the Current Economy, http://hbswk.hbs.edu/item/6332.html, Accessed on 13 November, 2011. Sherry, Charles. (2011). Macro Economic Events Still Dominate, http://www.economy-tomorrow.com/2011/06/, Accessed on 13 November, 2011. Perelstein, Julia S. (2009). Macroeconomic Imbalances in the United States and Their Impact on the International Financial System, The Levy Economics Institute. Tanous, Peter J., and Cox, Jeff. (2011). Debt, Deficits, and the Demise of the American Economy, Wiley Read More