The US Economy Through the Period of 2002-2004 - Essay Example

Introduction to Economics At the end of June 2003, the Federal Reserve cut interest by a quarter-point to 0 per cent, their lowest level in 45 years. This was the 13th reduction in short term US interest rates, from 6.5 per cent at the start of 2001. The aim of the work is to explain, what the three main channels through which the interest rate will influence aggregate demand are, and how these impacts are applicable to the US economy through the period of 2002-2004. Theoretical basis Interest rates and aggregate demand are related indirectly, but taking into account the three main components of the aggregate demand in the economy, - consumption, investment and government spending, these appear to be the three main channels, through which interest rate influences aggregate demand. The decrease of the interest rates accounting other factors being stable, leads to the increase of the new equipment among firms, which they plan to purchase, it also increases the number of new houses, and the goods of long-term use. Changes in the price levels through the impact on the amount of money in use also influence interest rates. Changes in the interest rates, caused by the changes in the price levels, changes the aggregate demand on goods and services; however, in graphic form this does not make the aggregate demand curve shift; it only reflects the movement along the already existing line. (Handa: 2000) However, interest rates also create another impact. No matter what may be the reason of the interest rates change, their level impacts aggregate demand as a whole. Separately from the price level change, the aggregate demand curve shifts with the changes in interest rates. For example, if the government comes down to the higher expenditures and loans to cover the deficit, with the other conditions stable it leads to the increase of interest rates and negatively influences the plans of expenditures for the firms and individuals. If the supply of the finances for loans increases abroad, the interest rates stay stable, keeping aggregate demand from decrease. (Handa: 2000) Consumption is the most considerable part of the aggregate demand, and it is wise to start the discussion of the interest rates decrease with the impact it creates on consumption. Individuals acquire their incomes in the form of salary, and the capital profits. A portion of the income is spent for paying taxes to governmental structures. On the other hand, government also provides individuals with subsidies (social insurance, unemployment payments, etc.). The decision about consumption lies in the choice – whether to consume at present, or to save and to consume in the future. The main factor, which defines consumption, is the income at disposal. Thus, with the interest rates decreasing, individuals take decisions to consume, and moreover, they take the decision to get more loans for the development and satisfaction of their long-terms needs, which ultimately causes the increase of the aggregate demand. This is the first channel, through which the decrease of the interest rates increases aggregate demand in the country. (Makin: 2000) Investments depend on the interest rates directly. This relation is explained by the fact, that investments are performed with the account of the perspective, thus investment decisions are based on the existing interest rate. Firms face a certain number of the investment opportunities, which are different by their inner yield. Firms compare the yield of different projects with the costs of their financing, that is, with the interest rates. Interest rates for investments appear to be the cost of investments. The rates, which are published in mass media, are nominal, as they are measured in the financial indices. Economics makes special accent on the fact, that individuals dont concentrate on the financial cost of goods, but tend more to look at how many goods can be bought for a certain amount of money. Taking investment decisions, firms take into account real interest rates. They compare real yield of the investment project (how many additional goods can be produced, having refused of buying some other goods today) with the real costs. Investment function connects the demand on investment with the real interest rate. Interest rate influences the desire of firms to self-investment, and defines the investor optimism, which Keynes called animal spirits. (Makin: 2000) Thus, with the decrease of the interest rate, the desire to invest on the side of firms grows, which means that the aggregate demand also increases; this is the second channel of increasing AD through the interest rate decrease. Government spending includes purchases of goods and services by central, local and regional governments and governmental structures. Government spending does not include transfers; transfers influence aggregate demand indirectly through the on consumption. The decisions of the government about the decrease or increase of interest rates define its fiscal and budget policies. With the growth of the budget deficit the fiscal expansion is aimed at increasing the aggregate demand, which includes the decrease of the interest rate. This is the third channel, through which interest rates influence the aggregate demand. The US economy and interest rates decrease in the period of 2002-2004 The Federal Reserve System, having decreased interest rates, has continued its active aggressive campaign aimed at the economic growth in the country. The effect of the low interest rates may display itself only in case, if its low level makes the firms take loans, in order to spend more in future. However, since the moment the FRS has started the decrease of the interest rates, the process of giving loans to the companies and individual consumers has almost stopped. The rhythm of stable growth has been left stable only in relation to the mortgage loan activity, which has even increased after the events of 9/11. The question, which appears in connection with the situation, is as follows: is it that low interest rates are not able to increase the aggregate demand in the country and appear not to work in accordance with the basic economic laws, and is it that the consumers in the US with the decreasing interest rates won’t be able to spend as much as to increase this demand and take the economy of the country out of its recession? It appears that the effectiveness of the fiscal policy becomes doubtful each time economy appears in the stage of recession. (Maggs & Kyer: 2003) The last time it happened was during the period of 1990-1991. However, since the WWII, low interest rates always pushed the economy out of crisis. There have also appeared evidences to the fact, that low interest rates will ultimately make individual consumers buy the goods of long-term use (cars, for example), but FRS has never faced such difficulties in connection with interest rate regulation. The consequences of the 9/11 events cannot even be compared with the recession and loan activity crash after Iraq has conquered Kuwait. Terrorist acts of September, 11th, have made the existing economic problems even more serious. The decreasing trust of consumers has become a serious challenge for the standard methods of curing the economy, which were traditionally used by FRS. The level of national trust is the category, which does not have anything in common with the changes in interest rates. Japan is one of the bright examples of the economic giants, which keeps fighting with low aggregate demand, and it appears that low interest rates in this country have not created any positive effect. (Bergsten: 2005) The bigger portion of economists supposed that low interest rates would bring economy back to life, and that the fiscal policies didnt lose their urgency. General Motors was one of those to believe in the power of low interest rates, having decreased it to zero for its consumers. This was the step to expand the demand for its cars, which will work for the aggregate demand growth through the growth of consumption as its basic component. The talks about the risk to stay without any potential for further economic curing activity were very well spread among the economists in 2002. The core of those talks lay in the expectation that too low interest rates would not leave any space for further stimulation of the weak economy, but the FRS representatives also had fears of other kind – too low interest rates could cause inflation. There was a number of factors, which braked the reaction of economy for the interest rates decrease, and which were not usually described in the economic text-books – first of all, the stock prices didn’t increase as much as it usually happened after similar FRS actions; second, the US dollar exchange rates didn’t fall, which was also unusual and negative for the exporting agents. The long-term bonds yield, which was always the principal stem of interest rates level, has not decreased as well. Partially the reason for that was in the fact that they had already decreased the year before, with the expectations of the future FRS actions. The impact has also been caused by the stimulating taxation programs, created by the White House and Congress, which took the budget surplus, and thus the state debt will be repaid by the Government very slowly. (Gamber: 2005) It was expected, that the interest rates decrease would ultimately make the economy come out of the recession. These hopes were crashed with the crash of Enron, Worldcom and Arthur Andersen. The level of prices at the American stock exchange has rapidly decreased 15-20%. The difference between the interest rate for governmental loaning and loaning of private corporations has increased. FRS understood that the interest rate decrease could be correct with the Dow-Jones index equal to 10,000, but not to 8,500. The further decrease of the short-term interest rates could be either taken as the temporary phenomenon, with understanding that the level of interest rates at that time was already as low as possible; or it could create panic in the financial markets, and even if FRS supposed such step as wise, it would cause not the increase, but the decrease of the investment on the side of firms and individual consumers – this would work against the increase of the aggregate demand. (Bergsten: 2005) Interest rate decrease is not the reason, but it is the consequence, and this is actually the reaction of the US government at the economic recession. It is not a secret, that the US after having been in the period of constant growth for more than 9 years before 2001, at that time faced the decrease of the absolute production volumes. This meant that the government and its structures had to use the instruments they had at their disposal to stimulate the inner economy. Aggregate demand is the principal instrument for such stimulation, and interest rate decrease works for the fulfilment of this task. This step was meant for making the loans for banks and firms cheaper, which ultimately makes loans more attractive and leads to the increase of aggregate demand. Interest rate decrease also makes investment into stocks and bonds less attractive – their yield decreases with it being tied to the nominal interest rate. However, it was still doubtful that interest rates decrease would cause certain changes in the level of savings – it is not used to keep cash in the modern world, but the decrease of interest rates usually stimulate less savings, and push people towards spending their current incomes, which ultimately supports aggregate demand at high level. Already before the events of the 11th of September, FRS used to decrease interest rates, and it acquired constant character through a certain period of time. This has become the principal instrument of making the American economy grow. Numerous and frequent interest rates decreases didnt lead to the desirable results. After 9/11 FRS has made this process more active, and ultimately these rates appeared at the level lower than that of the annual inflation rate. It should be added, that the situation in the US economy by that time was already described by the term stagflation, which meant that the rates of economic growth were decreasing at the background of the growing inflation. The main instrument, which FRS decided to use at the time was making loans cheaper for the attraction of the additional finances by corporations and purchasing of stocks by common consumers, but with the use of loaned finances. If it happened immediately after the measures were taken, it could lead to rapid decrease of US economic capitalization. As far as all markets are mutually dependent and interrelated, with the decrease of interest rates, money may become cheaper, on the one hand it will stimulate economic growth, but on the other hand, this growth may become partially based on inflation. The aspect to which US economists had to pay the biggest attention, was not to let economy of the US to go deeper into recession and not to cause global economic crisis. In such situation all measures could be appropriate, and White House with Congress was wise enough to add the tax stimulation to the interest rate decrease. It is doubtless, that the decrease of interest rates leads to the growth of aggregate demand, and thus to the growth of economy in general, but as the example of the US shows, real conditions in each period of time change the existing economic laws and make governmental structures think of any other new or additional methods of economic stimulation. Interest rates are decreased when the Government wants to revive the economy of the country. The aggregate demand and the consumer demand as its integral part has always been an important growth factor. The events of the 11th September have negatively impacted the moral climate and expectations of the American population. Moral state of US people was close to the state which is characteristic to the beginning of war. As a rule, in such conditions population does not tend to buy long-term goods or realty. Thus, they should be pushed to increase this demand and to make them buy. Decreasing interest rates is the very means of performing this task. However, it was not possible to predict clear consequences of such actions, because there were other additional factors, as well as the state of war didnt exist. The possible consequence of interest rate decrease could be increasing interest towards Euro among the international investors. They always decide between the two currencies, as the risks in both the US and Europe are compatible. More frequent choice of Euro by investors would lead to the weaker position of the US dollar, but at present this process seems to be inevitable. (Gamber: 2005) If the interest rate decrease took place in the conditions, which were not close to war, it could lead to the growth at American stock exchanges, which would ultimately cause the similar growth at other world markets; but taking into account the preceding events, it didnt lead to the direct expected effect, though it was the means of avoiding deeper recession in the American economy. Real consequences of the long-term interest rates decrease in the United States were as follows: according to the official statistics, USA was characterized by the highest inflation rates among the leading world economies by the middle of 2004. Bearing in mind, that inflation is the direct cause of the interest rates decrease, it can be stated that the FRS might not have been cautious in relation to any changes of interest rates in the country; however, the effect of this action was vivid by the end of 2004 – the country was our of recession, or at least it was able to make the firms invest and consumers buy. It has increased the aggregate demand, though it is clear that FRS was able to exercise only two of the possible channels available in terms of aggregate demand growth. Another factor has become clear – economic laws and relations appear not to be effective if taken solely without addition of other measures of healing economy. The war conditions in which the country used to exist, have contributed much into the customer demand, which in its turn greatly influenced the aggregate demand in general. The expectations of the consumers appeared to be so strong, that the interest rate decrease didnt play the necessary role for a long time. Thus, this channel, being the most effective among all three, was the evidence of the growing importance of the aspects, which are not directly connected with the financial side of aggregate demand, but is rather known as a non-price factor. The Federal Reserve System was able to undertake all steps necessary to make economy grow and finally succeeded in it, absolutely changing its policy in the middle of 2004, increasing interest rates to stop inflation growth. The US economy is rather flexible to face the increase of interest rates, because now it is the FRS which faces the necessity to decrease inflation. Despite the decreasing interest rates, American economy is flexible enough to go through the interest rates increase and to stop further development of inflation. Conclusion The work has defined the three main channels, through which interest rate decrease may influence aggregate demand and make it grow. These three channels were defined as the three principle components of the aggregate demand, and theoretically interest rates and their change can impact consumer demands, investments or government spending. Consumer demand, being the most important component of the aggregate demand, appears to be vulnerable to the interest rates changes, as well as the investments. The US government used interest rates decrease as the basic instrument of making the economy grow, as well as to stimulate the demand. It appeared that stimulation of demand through interest rates is not efficient with the impact of consumer expectations. It is also important, that too much decrease in interest rates resulted in high inflation, and could even bring panic into the American stock exchanges. Thus, after the period of stagnation and with the relative stabilization of the demand, the FRS has come down back to the increasing interest rates, as it happened in the middle of 2004. Consumer demand in the US was used as the basic channel of changing aggregate demand towards its increase. References Bergsten, Fred C. (2005). The United States and the world economy. Institute of International Economics. Gamber, Edward N. (2005). The Federal Reserves response to aggregate demand and aggregate supply shocks. Southern Economic Journal, 63, 3, 680-687 Handa, Jagdish. (2000). The monetary economics. London: Routledge. Maggs, Gary E. and Kyer, Ben L. (2003). A comment upon Does the aggregate demand curve suffer from the fallacy of composition. American Economist, 47, 2, 92-98. Makin, Tony. (2000). Global finance and the macroeconomy. Houndmills: Macmillan. Read More