Macroeconomic Policy and Financial Markets - Literature review Example

Macroeconomic Policy and Financial Markets and Macroeconomic Policy and Financial Markets The role of macroeconomics in national economies is the creation of a stable and sustainable economic environment. The government is able to play this rule by using monetary policy interventions. The monetary policy makers often act independently to correct instability in the economy or to ensure that stability continues. The 2008 recession led to an intense debate over the ability of monetary policy to stimulate the economy when the interest rates are already below zero. A majority of the people who engage in discourse on the matter seem to believe that its ability is greatly undermined in such a scenario. However, an evaluation of the response by the Federal Reserve of the United States of America and other governments demonstrates that it can indeed help to revive the economy. Furthermore, the other alternative to monetary policy intervention is fiscal policy that has many political and other issues to consider. As a result, the former is the most effective and easiest response to a weak economy. In order to appreciate the full effect of monetary policy measures in a weak economy characterized by low interest rates, the evaluation of both theoretical and empirical evidence is required. In addition, it is essential to understand the factors that motivate bankers and other financial institutions to invest at a particular time. Literature Review According to Bernanke and Blinder (1992, p. 903), the monetary policy affects the credit channel that significant affects the cost of obtaining new capital. Easing the monetary policy will reduce the cost of borrowing from financial banks. If the banks get credit at a low cost, they can pass the advantage to consumers. The ease of access to capital will enable many people to take credit from their financial banks. Consequently, there will be an increased amount of money available in the economy. Economic activity depends on the flow of money. Consequently, there will be an increase in aggregate demand for goods as people have more purchasing power. The decision to invest by firms depends on their confidence over the quantity of finance available (Bernanke & Blinder 1992, p. 903). When financial institutions have the ability to borrow more money, the clients can be able to access capital. In addition, the low cost of accessing capital enables them to borrow more capital. Weak economies are characterized by difficulty in accessing capital. The increased access to finance will help firms to meet their operating costs. As a result, there will be an increase in aggregate output in the economy. Another feature of a weak economy is the lack of employment opportunities. Firstly, most businesses are faced with reduced revenue in a down economy. As a result, they are forced to reduce their operating costs. The cost cutting measure often involves laying off employees. The increased loss of employment that characterizes a down economy serves to weaken an already hurting economy. The high number of unemployed people creates an economy in which the majority of the people cannot afford to spend money beyond the necessities. The drastic decrease in aggregate demand leads to further loss of employment. Due to the financial hardship, the people are unable to fulfill their financial obligations. As a result, the economy suffers more. In contrast, the implementation of an appropriate monetary policy measure will enhance the ease of financing by banks and their customers. The increased quantity of finances available will enable the firms to keep their employees. In addition, it will enable them to invest in expansion and growth. As a result, there will be increased employment rates in the country. An increase in the employment rate will lead to an increase in aggregate demand for goods and services (Bernanke & Gertler 1995, p. 27). Consequently, the weak economy will be revived due to increased economic activity. Movements in short-term interest rates have a significant impact on the long-term interest rates such as residential and bond rates. The effect is because those rates are a reflection of what the investors expect the short-term rates to be at both the present and current time. The monetary policy influences the inflation and aggregate demand for goods and services (Bernanke & Gertler 1995, p. 27). Its impact on the latter demonstrates that it has a significant bearing on the demand for goods and services. An increase in aggregate demand causes an increase in the demand for employees to produce goods and services. Monetary policy can succeed in stimulating a weak economy even in instances where the interest rates are close to zero. The transmission mechanism of the policy can be used to explain the phenomenon that is in contrast to a popular belief that the ability of monetary policy to revive a weak economy is severely limited in this situation. Expansionary monetary policy can increase the liquidity in the economy through open market purchases. The option is effective because it is not limited to short-term government securities. The purchase of foreign currencies works in the same manner that the purchase of government bonds do. Both measures lead to an increase in liquidity and demonstrate to investors a commitment by the monetary policy makers to pursue expansionary monetary policies. As a result, the economy is stimulated through the rise in price level expectations. The prices of other assets are deflated. The two outcomes create a situation in which there is increased aggregate demand. An increase in demand fuels economic activity. Consequently, monetary policy can be said to be an effective intervention measure when the economy is experiencing deflation and the interest rates are below zero. According to the Economist’s View (2008) the performance of the Japanese economy can be used as an effective example to illustrate the need for expansionary monetary policy when the interest rates are near zero. The article was written in 2008, at the height of the financial meltdown in the United States of America. There was a heated debate over the best intervention measures to respond to the crisis. However, in order to appreciate the comparison between Japan and America, it is important to note that the American economy was not having a problem with the deflation. Moreover, the real estate rates in the United States were low. Before 1990, it seemed as if Japan would have a higher per capita income than the United States of America. However, the country has experienced a largely stagnant economy. According to the Economist’s View (2008), this stagnation can be explained by the failure by the Japanese government to pursue a monetary policy due to the low interest rates in the country. The Japanese monetary authorities took the view that the monetary policy in the country was expansionary enough due to the falling interest rates. However, the interest rates fell to negative rates. As a result, the real interest rates in the country were quite high and the monetary situation in the country was actually tight in contrast to the belief among the people the policy makers that it was easy. An evaluation of the situation shows that had the monetary policy makers taken a monetary policy intervention despite the low interest rates in the country then the Japanese economy could not have stagnated. If they had taken the monetary measures then they would have stimulated demand by raising asset prices in the country while also raising inflationary expectations. The key take away from the Japanese case is that monetary policy can be an effective intervention when the interest rates are low. In contrast, the Economist’s View (2008) reports that officials in the Bank of England have often claimed that the low interest rates make them helpless in using monetary policy as a weapon against the stagnant economy. Keynes postulated that the decision that individuals make in regards to whether to hold all the cash or all the bonds based on what they believe the future interest rate will be (Dwivedi 2010, p. 253). James Tobin made a modification to the Keynesian Theory of liquidity stating two things. Firstly, investors hold their assets in both cash and bonds (Dwivedi 2010, p. 253). Secondly, their investment decisions are influenced by uncertainty as opposed to individual expectations about market performance (Dwivedi 2010, p. 253). Tobin’s portfolio optimization theory states that investors hold into a combination of bond and cash assets to minimize their risk while maximizing their gain (Dwivedi 2010, p. 253). An economic environment of low interest rates creates a scenario where the interest rates can only go up. A rise in interest rates causes a drop in bond prices that result in a capital loss for the investor. As a result, in this economic climate they may be tempted to hold more cash assets as opposed to bonds. The failure by the owners of capital to invest creates a shortage in the financial market and undermines the growth of the economy. Monetary intervention causes a change in the status quo that forces the investors to rebalance their combination of cash and bond assets. All monetary policies aimed at improving the methods of implementation may be different. The policies are aimed at creating a favorable financial climate for investment through favorable interest rates. The 2008 financial meltdown happened at a time when interest rates in the United States of America were already close to zero. As a result, the Federal Reserve Bank was forced to use an untraditional monetary policy. It undertook to purchase long-term mortgages that had been backed by government securities and the notes that had been issued by various government owned enterprises. The measure reduced long-term interest rates that eased the cost of getting capital in the country. The quantity of finance available to in the economy plays a significant role in the investment decisions of a firm (Bernanke & Blinder 1992, p. 903). Firms expand and invest more during periods when they can access capital with ease. In contrast, they are cautious when the amount o capital available in the market is limited. The calculation of the net present value involves the interest rate. A high interest rate increases the difficulty in achieving a high return while a low interest rate enhances the ability of a firm to achieve its financial goals. The monetary policy plays a significant role in the determination of interest rates. As a result, there is a direct relationship between monetary policy and the ability of firms to invest. Furthermore, an economy in which there is ease of accessing capital creates a favorable climate that encourages both firms and individual investors to invest. The increase in investment activities creates an increase in aggregate demand for goods and services. Increased economic activity lead to increased employment levels in the country. When more people are taking part in economic activities that means that more households with incomes to not only meet their needs but also have disposable incomes exist. As a result, both the cost of capital channel and the credit channel contribute to the creation of a strong economy. Sustainable output and stable price levels characterize a strong economy. The monetary policy interventions by the Central Bank and other Central Banks around the world succeeded in stopping a global financial meltdown. The measures that they took sought to increase liquidity in the market to increase the quantity of finance in the global financial system. The interventions succeeded to increase the amount of credit available to firms. It achieved this by lowering the cost of accessing credit to minimal levels. According to Bernanke and Blinder (1992, p. 901) Cheap credit encourages economic activity. It is important to note that the 2008 financial meltdown was averted through a combination of both monetary and fiscal measures. However, it is clear that the monetary policies that were instituted helped to revive the economy from recession. Monetary transmission functions through both bank loans and deposits (Bernanke & Blinder 1992, p. 903). The effect of monetary policy takes a while before it is felt in the giving and receiving of loans. It happens at about the same time as the effects of monetary policies have on the unemployment rates in the country. Despite this limitation, credit transmission of monetary policy serves to stabilize the economy. Moreover, one of the main functions of monetary policies is to restore investor confidence in the country. The economic crisis of 2008 was not only caused by the lack of regulation of Wall Street but also due to the monetary policy that created cheap credit. Due to the low interest rates, financial institutions were able to access cheap capital. The large quantity of finance available to banks led encouraged them to invest more and to lend more. Some of the investments bets that they made turned out badly. Moreover, a majority of the customers started to default. These events contributed to the collapse of the economy. As a result, the monetary policies should be used carefully to ensure that that low short term interest rates do not create another financial meltdown. The general opinion is that low short-term interest rates demonstrate monetary expansionary policies. On the contrary, low short-term interest rates do not necessarily reflect the same. For example, an evaluation of the monetary policies before the fall of 2008 reveals that the monetary policies were in fact contractionary. As a result, monetary policies can be an effective intervention measure even in this scenario. The actions of monetary policy makers are determined by the state of the economy (Taylor, 1995). A weak economy is bad for employment and aggregate output in the country. It calls for measures to stimulate the economy. In the event of a weak economy, the economy can be stimulated in two ways. The first one involves fiscal measures that increase the national debt levels. The second one involves monetary interventions. The latter response can be taken even in situations where the interest rates are close to zero. Conclusion Expansionary monetary policy is the most effective means of stimulating an economy that is experiencing deflation. This is due to the political constraints and the potential complex issues that have to be considered when using fiscal policy. The measure serves to increase the quantity of money available to firms that enables them to create employment. In addition, it pushes the owners of capital to free some of their cash assets into the economy. List of References Dwivedi, D., 2010. Macroeconomics: theory and policy. New Delhi, Tata McGraw Hill Education Pte Ltd. Economist’s View., 2008. Monetary policy can be effective in reviving a weak economy even if short-term interest rates are close to zero?, viewed 25 August 2014, Taylor, J. B., 1995. Monetary policy implications of greater fiscal discipline. Stanford, California Bernanke B. S & Gertler, M., 1995. Inside the Black box: The Credit Channel of Monetary Policy Transmission. Journal of Economic Perspectives. Vol 9, no 4. pp. 37-48 Bernanke B.S & Blinder, A.S., 1992 The Federal Funds Rate and the Channels of Monetary distribution. The American Economic Review. Vol 82, no. 4.pp. 901-902 Read More