The Effect of Monetary Policies on Financial Institutions - Essay Example

TABLE OF CONTENTS PAGE NO. Introduction ……………………………………………………………… 2 Overview of how monetary policy is structured …………………………,, 2 What is a monetary policy? ………………………………………………. 2 Who takes charge of the monetary policy? …………………………….. 3 How does monetary policy affect the U.S. economy? ……………………. 3 How do these policy-induced changes in real interest rates ……………………. 4 affect the financial institutions and the economy? ………………… 5 The inflation and the monetary policy …………………………………….. 5 Effect of interest rate to long term investment ………………………………….. 6 Government Spending……………………………………………………….. 7 Where does the federal government get all the funding to support these expenditures? …………………………………………. 7 Monetary Policy in the Financial Crisis …………………………………….. 10 Conclusion …………………………………………………………………. 10 Work Cited…………………………………………………………… 12 - The effect of monetary policies to financial institutions and government Introduction. I have chosen to discuss the U.S. monetary policy as it has wide effect to the economy that transcends to other countries. First, I will show the structure of the US monetary policy, its goals and tools. Second part, I will discuss how it affects the U.S. economy, particularly, the financial institutions and government spending. This paper examines the effect of monetary policy in changing environments of financial institutions and to the fiscal policy of government. Changes in the economic environment like the financial crisis necessarily need to modify monetary policies. This makes investigation of how monetary policies affect the financial institutions and government spending decisions. important. Overview of how monetary policy is structured The functioning of the financial institutions are affected by monetary policy as changes will either slow down or spur up economic activity, affect inflation, production and employment For instance, there is a basis to believe that the recent economic crisis has made an impact to the monetary policy. The crisis has led to the fall of asset prices and decline in their value, making it difficult for financial institutions to fund their operations. Second, there is a shift of investor’s interests to government securities that marks the decline in financing operation. Third, access to credit had become more difficult and expensive. What is a monetary policy? A monetary policy is defined “as a government process of managing money supply to achieve specific goals, such as constraining inflation, maintaining an exchange rate, achieving full employment or economic growth. Monetary policy can involve changing certain interest rates, either directly or indirectly through open market operations, setting reserve requirements, or trading in foreign exchange markets. A monetary policy can be an expansionary one that increases supply of money in the economy and a contractionary policy decreases money supply. An expansionary policy is used to fight unemployment during a recession period by lowering interest rates, while a contractionary policy raises interest rates to control inflation. Who takes charge of the monetary policy? The US Central Bank, called the Federal Reserves has the primary responsibility of conducting monetary policy. The goals of the US Monetary policy are to “promote maximum sustainable output and employment and to promote stable prices” T his monetary policy has considerable effect to inflation and employment as it has the power to raise or lower short-term term interest rates, called ”federal funds” rate. How does monetary policy affect the U.S. economy? Nominal and real interest rates. There is a great difference in the application of the nominal and real interest rates in the financial system. Real interest rate is the difference between nominal rates and expected inflation rate. Fed explains that the point in implementing policy through raising or lowering interest rates is to affect people’s and firms’ demand for goods and services which in turn affect real interest rates, output, employment and inflation. Fed illustrates this in inflation example, that demand for goods and services are not affected by nominal rates but are more affected by the real interest rates. Consider, as an example, when a borrower took a housing loan at 8% when inflation rate is close to 10% (say in 1990), than when the inflation rate is close to 1% in 2009. In this case, borrower would be happy as he will have to pay back lower than the value of money when it was borrowed. The lender, (the bank) in this situation will be reluctant to lend. Fed can set nominal rates for short term loans as it is the only supplier of reserve funds, but it cannot control inflation directly, and the real interest rates. It has an indirect effect on long term loans because when the financial people perceived Fed does not make a move to control inflation in the near future, they will add risk premium to long-term rates making loans higher. Fed explains this as “the market expectations about monetary policy tomorrow have an impact on long=term rates interest today.” If I get a loan today, payable in 30 years, there is a possibility that the long term rates for my loan will be higher because of market expectations. How do these policy-induced changes in real interest rates affect the financial institutions and the economy? The effects of monetary policy changes to financial institutions and to the economy are the reduced demand for goods and services. It has a chain reaction that revolutionizes the borrowing costs, availability of bank loans, household income and the foreign exchange rate. This is like a cycle that moves other economic factors/ Consider for example when FED lowers the lending rate. A decreased lending rate increases business investment spending, that leads to additional household income. An additional income leads to buying of new homes and cars and increase of consumer spending. Banks are more willing to lend to businesses and households, and other sources of credit will also follow. When there is lower real interest rate, common stocks and other similar securities become much more attractive than bond investments. As a result, investors are happier when they find the value of their stocks is higher and their wealth have increased. When the price of stock is high, businesses begin to think of investing in plants and equipment by issuing more stocks. The low real interest rates in the U.S, lowers also the exchange value of the dollar. This in effect raises the price consumers pay for foreign goods, but lowers the price of US produced goods. The economic effect to US is that aggregate spending on goods and services becomes higher. The increase in demand for supply and goods domestically produced raises production and employment, businesses to spend on capital goods and expansion that promotes higher level of economic output. The inflation and the monetary policy Fed sets a principle “that in the long-run, output and employment cannot be set by monetary policies.” Fed explains that wages and prices will begin to rise at a faster rate if monetary policy continues to stimulate demand “enough to push labor and capital markets beyond their long term capabilities” This is because a monetary policy that attempts to keep short term real rates low will lead to higher inflation and higher nominal interest rates when there are no corresponding increase in the growth of out or decrease in employment. An inverse relation is also expected when interest rates go up. Let us see the following scenario of monetary policy when inflation begins. Chart below shows the effect of changes of monetary policies to lending activity to household and companies from 2006 to 2009 It shows movement of borrowing activities in various periods that shows a rise and decline of demand. In 2006, there was an expansionary monetary policy which allowed loose credit that led to high lending activity to household. The economic crisis began in 2008, leading to a contractionary monetary policy that limited supply of money and credit.. The survey done by MPR supports this finding as respondents answered finding difficulty in borrowing due to tightening of credit policies. Banks have also reduced lending activities to lessen the risk. (risksbank.com) Effect of interest rate to long term investment. There has been a capital flight from the short term security to longer term as fear on the economic stability continues. This has been noted by analysts (McMahon, C.. 2009) as he said lack of returns in stock markets drives interest down. As a result, people stay on the bond market on the speculations that stock markets are not doing good. According to the Treasury International Capital Data Report (McMahon), that tracks international capital flows, net foreign purchases of U.s. long term-securities rose up to $66.2 billion as of November 18, 2008 from $21 billion in August. China is the largest holder of US Treasuries with $585 and still continues buying; followed by Japan with $573. Japan in August 2004 had peaked at $694 billion during the time that they are in the process of revaluing their yen. Analysts worry that with a very large investment, China will have more bargaining power, and that they can easily dump the U.S. Treasuries. The increase in demand for bonds unexpectedly drive the yield to a lower level of return while prices gone up to an unprecedented high. There are also concerns coming from China and Japan saying that the U.S. Fed interest rates are too low. Analysts at this point commented that “Japan and China…have warned that the central bank risks spurring speculative capital which may inflate asset prices and derail the global economic recovery”. Concerns coming from Asia that “the US pledge of keeping rates near zero for an extended period may lead to another financial crisis” because it will create a dollar speculation arbitrage GOVERNMENT SPENDING Government spending is the expenditures allotted to buy goods and services for the different units of the government through a budget. In 2009, total budget expenditure is divided into education, defense, welfare, health and other services. In the chart, expenditure is highest and forecast to level off in 2010 to 2011. Annual deficit is also highest in 2009 with significant forecast of going down in 2010 to 2011. Total debt shows a yearly increase towering at 2011. Where does the federal government get all the funding to support these expenditures? A large portion of the government’s budget comes from taxes, composed of Individual income taxes, payroll taxes, corporate income taxes, excise taxes, estate and gift taxes, customs duties, and miscellaneous receipts (earnings of the Federal Reserve System and various fees and charges) make up the balance. In 2008, according to Tax Policy Center the Federal government had collected $2.5 trillion, an amount equal to 17, 7 percent of GDP. Chart below shows the expenditure of the government for 2008. Expenditure / Pie Chart Deficit / Debt Charts http://www.usgovernmentspending.com/ From the chart above, it looks like the U.S. taxpayers will have a rough time in paying government deficits, as government debts continue to rise. Revenue collections in 2008 are only $2.5 trillion as against $12 trillion debt. Chairman Bernanke admitted in his testimony, that the U.S. economy really suffered a slowdown that resulted to unemployment and company losses. He assured however, that the economy is slowly turning favorably as consumer spending is already on the move. This, he said, is a result of the economic stimulus package of the government done to curb inflation and offset effect of economic crisis. However, he noted the big gap of debt deficits, expenditures and the revenues, and admitted that there should be limit to an indefinite borrowing because of the question of sustainability. Chairman Bernanke stated that there is a need to make difficult choices and decisions on how large a share of the economy’s resources should be devoted to government spending and said “tax rates must be set at a level sufficient to achieve an appropriate balance of spending and revenues in a longer term to achieve fiscal sustainability” Monetary Policy in the Financial Crisis The monetary policy adopted by the Fed during the financial crisis is by reducing the target federal funds rate to nearly zero and making credit available to institutions and markets not previously done by the Fed. The Fed, during the crisis, cut the federal rate target to a range of 0 to ¼ percent. Vice Chairman Kohn said that this monetary policy helped partially offset the effects of lending to households and businesses. The Fed had entered into a new territory of direct lending to financial institutions.(Kohn) For example, Fed approved a bail-out package to AIG in the amount of $85 billion. Fed’s reserve according to Malone, Noreen (2008) is $200 billion, down from previous balance this year of $800 billion. But it can always raise reserves by selling securities The Fed earns money through their lending program that adds up to their reserves. For instance, Fed enters into a “repurchase agreements” wherein it buys a certain amount of securities, say $ 50 billion securities and will sell it back to the issuing banks at an agreed upon date. Conclusion Based on the reviewed studies and announcements from the Fed Chairman and Vice-Chairman, the outcome of monetary policy to financial the financial market in a changing environment has been found to be significant. Both the expansionary and contraction policies have an effect on the economy. Any policy adopted works in cycle of economic activities that is felt in both short term and long term. The lending activities as shown are influenced by credit policy of high and low interests and other economic factors as well. As the Chairman of the Federal Reserves admitted, the economy has slowed down and some monetary policies still have to be done in the near future, as he said, that the government cannot continuously borrow, and there has to be an end to it. At this point, we can expect another round of monetary policy as he insinuated tax measures. We will wait for this new policy and expect another effect to us. The Fed Bank at the moment stays with their position of a near zero rate of interest and intends to do this on an extended period. But whether this policy would be good or bad to the economy is being questioned by analysts saying that this will lead to dollar speculation and a second round of financial crisis. I can only give a comment here as I am not in a position to make a conclusive statement as to what works well for the economy. The monetary policy requires a balancing act of the economy, a little of everything and not too much of something. It could be fairly concluded that monetary policy affects decisions as it is used as guide in transaction in day to day activities. Works Cited Bernanke, Ben S. 2009 Current economic and financial conditions and the federal budget Testimony. Before the Committee on the Budget, U.S. House of Representatives, Washington, D.C. Web. 25 November 2009 Kohn, Donald L. 2009 Monetary Policy in Crisis Speech at the Conference in honor of Dewey Daane, Nashville, Tennessee. Board of Governors of the Federal Reserve System Web. 25 November 2009 McMahon, Chris. 2009 Interest rate Outlook: less zero January 1, 2009. Futures Cedar Falls, IOWA .All Business. Web 17 November 2009. Noreen Malone, (17 September 2008) Where Did the Government Get $85 Billion?Was it just lying around somewhere? Web. d 25 November 2009 Policy Center. The Numbers: What are the federal government’s sources of revenue? Web. 25 November, 2009 from Riksbank.com 2009. The financial crisis and its effect to monetary policy Monetary Policy Report 2009 Web. 25 Novembre 2009 U.S. Government Spending. Expenditure Pie Chart, Debt/Deficit charts. Web. 25 November 2009 Read More