Effectiveness of the Transmission Mechanism of Monetary Policy - Example

What Lessons Can Be Learned From The Global Financial Crisis Of 2007-08, About The Effectiveness Of The Transmission Mechanism Of Monetary Policy?" Introduction Financial crisis is considered to be one of the most common terms to define a situation in which certain financial assets suddenly lose a large part of their nominal value. The aspect of global financial crisis has been in evidence in the 19th and early 20th century resulting from investment frights and many downturns emerging from such panics. The other situations that bring about the occurrence of financial crisis can include stock market boom and the fall of other financial sources such as currency crisis and sovereign defaults. Financial crisis is determined to have a direct impact on paper wealth, however it is worth mentioning that such impact does not result in changes in the real economy (Kindleberger & Aliber, 2011). The monetary turmoil of 2007-2008 known as global financial crisis is considered to be one of the vilest financial crises since the Great Depression of the 1930s. It is evaluated that the crisis had a debilitating impact on the global economy. Central banks across the world faced numerous complexities in their financial systems along with a sharp decline in their output, forcing them to adopt progressive monetary policies to ensure proper functioning of the markets. In certain countries, interest rates were brought down to exceptional figures which was nearly zero bound and price did not respond as predicted. In response to the situation, it is viewed that discussions were made on the effectiveness of the policy rate as the only instrument that would facilitate in mitigating the issue (Miller-Betty, 2011). The main objective of this essay is to provide a broad discussion that would help in understanding the fundamental reason that had resulted in the occurrence of the global financial crisis. Furthermore, it would also provide a lucid comprehension which would depict the impact of the financial crisis in a few of the developed and developing countries such as Japan, the UK and China among others. The essay would also provide a view of the policies that many large organisations had implemented to mitigate the issue which would also help in dealing with similar situations in the near future. Discussion Global financial crisis is measured to be one of the gravest financial turmoil’s till date. It is believed that the dynamic stage of the crisis which was termed as a liquidity disaster started from August 9, 2007, when BNP Paribas one of the leading banks in the world ended extractions of three hedge funds mentioning a complete evaporation of liquidity (Elliott, 2012). Transmission Mechanism of Monetary Policy Source: (Bizled, 2012) With regard to the transmission mechanism of monetary policy, it can be referred as a process which enables to determine how the changes in interest rate affect inflation in an economy. Reasons behind the Global Financial Crisis It was predicted that the vital reason behind any financial crisis emanates from the downfall of large financial institutions, the bailout of banks by national government of different countries and a downturn in the stock markets globally. However, the prime reason behind the breakdown of the financial crisis globally was observed to have resulted from the bruising of the U.S. housing bubble (Madubeko, 2010). It is considered to be a real estate economic bubble that tends to occur after the end of a certain period. It can be identified through rapid increase in valuation of real property such as housing until they reach unstable position and then decline (Levitin & Wachter, 2012). The bursting of US housing bubble was observed to be at peak in 2006 resulting in decline of standards of financial aspects that are tied to the US real estate pricing, affecting monetary organisations worldwide. It is observed that the financial crisis was triggered by a complex interplay of policies that encouraged home ownership by providing easier access to loans for subprime borrowers prioritizing short-term deal flow over long-term value creation. There was also a lack of adequate capital holding from banks and insurance to fulfil the financial promises that they made to their customers. This resulted in the decline of the credit availability of all banks which damaged investors’ confidence that caused a diverse impact on the stock market. However, most of the causes are largely outlined to have resulted from low interest rate plans accepted by the Federal Reserve and other banks after the downfall of the technology stock bubble in 2000 and the 9/11 attack in the year 2001. In addition, the desire of Asian Central Banks for securities added to lax credit. These factors resulted in increasing the house price in the United States and certain other countries such as the United Kingdom and China which ultimately resulted in adapting loose monetary policies (Were & Tiriongo, 2012). . Figure: Chart Showing the Rise in House Price before the Global Financial Crisis (Global Property Guide, 2013) During the summer period of 2007, the global financial crisis was linked to the incentive problem in the US loan business. The low interest rate regime together with other policy incentives in the US helped to boost demand for houses which ultimately resulted in increasing the house price. It is worth mentioning that in 2006, the bubble reached its topmost level, which ultimately started decreasing the house price. The bubble was considered to have grown to a large extent affecting other countries as well resulting in large current account deficits in advanced economies (Were & Tiriongo, 2012). Furthermore, it is determined that China implemented excess savings policy that increased the flow of foreign currencies from developing countries which is regarded as one of the factors leading to the global financial crisis. At the same time, it was argued by many economists that large growth of reserve by Emerging Market Economies (EMEs), which was led by China as a strategy of self-insurance in contradiction of rapid reverse of money invasion also, resulted in misalignment of exchange rate. This prohibited the worldwide nations to change their currency interchange ratio (Mohanty, 2011). Figure: Chart Showing The Decrase In Assets Price In USA While Increase In UK During The Global Financial Crisis Period (European Economy, 2009) Impact of the Global Financial Crisis on Economies Such as Japan, China and the United Kingdom (UK) Japan Located in the eastern part of Asia, Japan is considered to be a major financial power. The country is measured to be in the third position in terms of the nominal GDP (Gross Domestic Product) and is the fourth largest when ranked in the purchasing power parity perspective. Additionally, the country is determined to the fourth major exporter and the fourth largest importer. It is stated that even after the financial crisis Japan foreign policy faced numerous challenges (CIA, 2013). Firstly, the major change that Japan faced was a decrease in foreign demand of the goods that were locally produced-manufactured in the country resulting in wiping out many of its policies that was the major reason behind the downfall of Japan’s economy. Secondly, since China was the only major economy that was growing strongly accelerating the closer of the relative power gap with Japan, it had resulted in decreasing the limits of the global financial architecture. However, it was viewed that in spite of the global recession Japan still was the most productive and advanced economy in Asia. Known for its productive and quality products, the country implemented strategies that not only raised high demand for its goods in foreign markets but also implemented strategies that provided high competitive edge to other similar foreign goods. Moreover, it is also recognised that the largest part of Japanese employment and economic activity that included everything from restaurant and entertainment to legal service and finance were actively functioning (Tellis et al., 2009). The currency value of the country fell to a great extent which forced the government to increase its export despite its decreasing value (Trading Economics, 2013). Figure Showing the Fall of Japan’s Currency Value During 2007-2013 (Trading Economics, 2013) In terms of asset price, the bubble economy was followed by a collapse in assets’ value within the country reducing the economic growth, increasing banking problems and ultimately bringing about deflation (Obstfeld, 2009). In addition, it is further determined that the interest rate of the country was reduced as a strategy to decrease government debts during the financial crisis (Iwaisako, n.d.). China China is considered to be one of the fastest emerging economies globally. As of 2013, China has been ranked as the world’s leading exporter and importer of goods and has the second biggest economy both in terms of GDP and Purchasing Power Parity (White, 2013). The impact of global financial crisis on China was considered to be huge. The rise of the economy of China subsided to a figure of 6.8% in the fourth quarter of 2008 from 13% in 2007. At the same time, inflationary pressure evaporated abruptly as the nation faced the risk of deflation. However, the Chinese government countered the situation strategically. In response to the financial crisis, the government of China issued a 4 trillion Yuan package and the Central Bank and People’s Bank of China decreased the interest rate accordingly which resulted in an increase in the credit and onboard rate. With regard to trade channels, the growing trade of the nation suddenly stopped at the third quarter of 2008. Subsequently, a drop in the GDP growth rate from 13% to 9% was faced by the country. Consequently, the government sanctioned huge amount of financial resources to develop the infrastructure of the nation. China’s dependency on external demand to strengthen the financial condition rose by a considerable extent (Yongding, 2010). Figure: Chart Showing China’s Dependency on External Demand (Yongding, 2010) In terms of Foreign exchnage reserve, China had an considrable foreign exchnage reserve during the financial crisis that resulted from its huge foreign export and import of goods. United Kingdom (UK) The United Kingdom is considered to be one of the most revered nations by every individual not because of its history but because of its financial strategies that has helped the nation to become one of the leaders in the world economy. The country is recognised to be placed in the sixth position in terms of biggest economy by nominal GDP and eight biggest by purchasing power. Additionally, the country is considered to be one of the first industrialised nations (CIA, 2013). The impact of the global financial crisis on the UK is considered to be the most, shaping both its commercial and business scenario and creating a large impact on its public service. The impact related to the financial crisis resulting from housing boom is recognised to have affected the UK in 2008 after the US market opened and crisis erupted. This resulted in increasing the interest rates by double in all banks in the UK. Furthermore, it is found that DDW Jones fell down by 500 points which was the most in the UK’s history. The unemployment rate rose extremely as well. It is worth mentioning that the biggest bankruptcy resulting from failing to maintain liabilities by the Lehman Brothers is also considered to be a vital reason behind such negative impact of the crisis in the nation’s economy (LearnHigher, 2010). Current Policies That Can Be Adopted To Mitigate the Issue The world economy is viewed to be facing the worst crisis since the period of Great Depression that mostly occurred from 2007-2008. All the nations are viewed to be implementing policies that would not only help in mitigating the issues that have resulted from the global financial crisis but would also help to maintain their economic position if such aspect arises in the future. A few of the aspects that can be adapted by all nations to mitigate the issues are stated hereunder: 1. Government can focus on conducting research that would help in identifying the aspects that have brought about these problems. Additionally, conducting research would also help the government to identify the loopholes that may affect the economy in similar scenario in the near future. 2. Well-thought-out public-private driven partnership can facilitate in enhancing the relation amid two nations that can be utilized for dealing with such crisis. 3. Initiatives must be taken by government to strengthen the infrastructure of the country and it must provide opportunities that would attract more foreign investors in the country. Moreover, countries must help local industries to compete at the national level as this would facilitate in increasing the export aspect, thus bringing in more foreign currency. 4. Government must also need to focus on implementing long-term and medium-term action plans that would aid in establishing small scale industry by individuals (OECD, 2009). 5. Additionally, initiatives must be taken by the governments of different nations to strengthen the human resource prerogative of the countries as they can be utilized in case of such crisis to increase productivity of the nation. Conclusion Financial crisis is measured to be one of the most complex situations that at times results in decreasing the level of GDP and other monetary aspects. The global financial crisis that took place in 2007 and ended 2008 is considered to be one of the most significant economic downfalls in the history. The study has helped in understanding the way in which a significant mistake in proper planning by the major financial institutes can result in bringing such a situation globally. It is measured that the impact of the financial crisis can still be viewed today and governments of all nations are trying hard to deal with the challenges that have resulted from the crisis. Among all the UK and USA seemed to have faced the major problems resulting in poor currency exchange rate and foreign reserve rate. Furthermore, it has been recognised that the lending rate of all the develop countries was brought down as a strategy to bring in more money from the public. Thus, in terms of key lessons being learnt, it can be concluded that if proper steps are taken by the government and large financial institutions, the grave aspect of financial crisis can be dealt with more efficiently in the future. References Bizled. (2012). Monetary policy committee. Retrieved from http://www.bized.co.uk/virtual/bank/economics/mpol/mpc/theories1.htm CIA, (2013). Welcome to the world factbook. Retrieved from https://www.cia.gov/library/publications/the-world-factbook/ Elliott, L. (2012). Three myths that sustain the economic crisis. Retrieved from http://www.theguardian.com/business/economics-blog/2012/aug/05/economic-crisis-myths-sustain European Economy. (2009). Economic Crisis in Europe: Causes, Consequences and Responses. Contents, 1-87. Global Property Guide. (2013). House price change. Retrieved from http://www.globalpropertyguide.com/real-estate-house-prices/G#greec Iwaisako, T. (n.d.). Challenges for Japanese macroeconomic policy management. Retrieved from http://www.mof.go.jp/pri/international_exchange/kouryu/kou96/kou96_09.pdf Kindleberger, C. P., & Aliber, R. Z. (2011). Manias, Panics and Crashes: A History of Financial Crises. The United States: Palgrave Macmillan. Levitin, A. J., & Wachter, S. M. (2012). Explaining the Housing Bubble. 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