The Role of the Federal Reserve in the Most Recent Crisis - Dissertation Example

Buoyed by the booming housing market, banks granted loans to subprime borrowers who under ‘normal’ conditions, would have been rejected.  With the rise in interest rates, these subprime borrowers failed to pay back on their house payments which resulted in a plethora of loan foreclosures. The rising defaults led to a credit crunch because financial institutions suddenly became very wary of lending to each other.  For example, a steep rise in liquidity costs resulted in the “first bank run” in Britain in over 150 years.

The enduing credit crisis was the result of a sustained period of global imbalances and bubbles in asset prices.  The Federal Reserve continuously kept interest rates at unprecedented low levels for a significant part of the decade, setting the stage for cheap credit.  Many business leaders and financiers across the world considered U.S. households as “consumers of last resort” to sustain the global boom.  Robert Brenner described the demand-boosting policies of the Fed and Treasury as ‘market Keynesianism’ (Blackburn, 2008, p.63-66)

1.2 Monetary Policy

The global economy is slowly recovering from one of the worst recessions since the Great Depression.  Currently, there is an ongoing debate about the factors that led to the recent credit fiasco and the steps that should be adopted to avoid similar situations in the future.  The role of monetary policy, in particular, has once again been brought under heavy scrutiny.  More specifically, certain economists are calling for a modification of how monetary policy is currently used.  Instead of primarily being a weapon for inflation targeting, more relevance should be given to the effects it can have in promoting financial stability.  Milton Friedman, in his paper, The Role of Monetary Policy, argues that after the Great Depression, Keynesian economics became wildly popular and it was often accepted that monetary policy was impotent.  As Friedman states, “Monetary policy was a string.  You could pull on it to stop inflation but you could not push on it to halt the recession.  You could lead a horse to water, but you could not make him drink.”  Keynes believed that in times of high unemployment, real interest rates cannot be lowered merely through monetary policy.  If investment and consumption are only minimally affected by interest rates, lower interest rates would not have much of an effect.  Keynes and his colleagues were in favor of using fiscal policy over monetary policy in order to achieve financial stability.  Monetary policy was not given much attention until the early 1950s when Pigou and others showed that changes in the real quantity of money can affect aggregate demand, even if it does not alter interest rates.  According to some, the expansionary form of monetary policy pursued by the Fed after 2001 laid the foundation for the housing crisis.