Government and Economy

Government andEconomy

Literature review

The financial crisis thatpeaked in 2008 is the most important financial challenge in themodern economies since the great depression in the 1930. The crisisthreatened the financial system in the United States and otherinterdependent economies with collapse. However, actions by thefederal government through appropriate financial policies saved thefinancial system. However, the financial crisis had a huge impact onthe economy. It resulted into high levels of unemployment due tostagnation of the economy resulting into reduced disposable incomeand decreased demand in the commodity market. The declining consumerwealth resulted into failure or decline in major business activitiesin the economy. Nonetheless, an important aspect of the financialcrisis was what precipitated the crisis, how to save the financialsystems and measures to prevent similar crisis in the future. Thereare various factors that have been attributed to the financial crisis(Hausken &amp Mthuli,2013). One of the mostpublished causes of the financial crisis was the busting of thehousing bubble in the United States. The complex interplay betweenincreased deregulation and emerging trends in the financial industryresulted into creating of mega financial investments in the housingindustry which was interdependent with the financial industry. Thisresulted into ease and overvaluation in subprime mortgages andunethical trading activities (Paolo,2011). Due to theadverse effects of the crisis on the United States and the globaleconomy, the federal government adopted short term palliativepolicies as well as long term fiscal policies. The immediate actionwas to invent ways to end the financial crisis. Additionally, newregulatory reforms to avoid future crisis was essential.

Federal policy

Since the advent of the2007/2008 financial crisis, there are several financial policies thathave been adopted by the federal government through the relevantinstitutions, mainly the Federal Reserve Bank to remedy the problem.The financial crisis threatened the United States and the globaleconomy. Thus, the federal government used all means to end thefinancial crisis and stimulate economic growth (Hausken&amp Mthuli, 2013).This paper looks at quantitative easing, one of the major monetarypolicy adopted by the United States government during the financialcrisis. The project will mainly involve a study of both primary andsecondary sources to collect information and data.

One of the short termpolicies adopted by the federal government was quantitative easing.Quantitative easing is a monitory policy by the Federal Reserve Bankto stimulate the economy which eases the negative impacts of afinancial crisis. Quantitative easing is employed as a last resortwhen other monitory policies are ineffective due financial problemsin the economy. The Federal Reserve Bank employs quantitative easingby purchasing selected financial assets from selected financialinstitutions, mainly commercial bank. This will lower the yield ofthe financial assets by increasing their prices. Additionally, themonetary base in the financial institution will be increased.Although quantitative easing is significantly different from othershort term and long term polices such as government bonds tradingwhich regulates bank interests, they had a huge impacts in the UnitedStates economy during the financial crisis (Hausken&amp Mthuli, 2013).

During the late 2000sfinancial crisis, quantitative easing was used in both the UnitedStates, Eurozone especially in United Kingdom, and Japan. The mainreason why the Federal Reserve opted for quantitative easing policieswas the near zero federal funds otherwise known as the “risk freeshort term nominal rates” (Joyceet al, 2010). When thefinancial crisis was at its worst in 2008, the balance sheet of theFederal Reserve expanded radically. This was done through addition ofnew financial assets as well as liabilities. Before the financialrecession, it is estimated that the Federal Reserve held over sevenhundred billion dollars on its balance sheet. This was in forms oftreasury notes. In late 2008, the federal government made a decisionthrough Federal Reserve, made a decision to use quantitative easing.By November, the Federal Reserve had started buying financial assetsvalues tat 600 billion dollars. These financial assets mainlyincluded mortgage backed securities (Wright,2011). By early 2009,the financial assets held by the Federal Reserve had increased to1.75 trillion dollars. These assets included mortgage backedsecurities, bank debts and treasury notes. By mid 2010, the amounthad increased to over two trillion dollars. However, in the mid 2010,there was a significant improvement in the United States economy, andthus quantitative easing was reduced. However, it resumed in the late2010 when the federal government note that the growth of the economywas not as robust as the government expected. This was an indicationthat the economy had not fully recovered from the financial crisisand more needed to be done. Additionally, the debts in the firstquantitative easing were maturing and thus the holding of the FederalReserve were falling. It was projected that by 2012, the holding willfall up to about 1.7 trillion dollars. This was not good for therecovering economy and therefore the federal government decided tomaintain the holding slightly higher (Thornton,2012).

Consequently, the FederalReserve embanked on the second round of the quantitative easingpolicy, commonly know as QE2. The first round was therefore known asQE1. The federal reserved made a decision to by financial securitiesworth 600 billion dollars by mid 2011. Later in 2012, the third roundof quantitative easing, QE3, was announced. In the third round ofquantitative easing, the Federal Reserve made a decision to purchase40 billion dollars worth of mortgage backed securities every month tocushion to stimulate further economic growth. This was essential incushioning the financial sector from the debt risks in the mortgageindustry, mainly the housing market. Since the third round ofquantitative easing was open ended, it became very popular andrestore confidence in the United States economy. As a result of thepositive impacts, the Federal Reserve increased the monthly purchasesto 85 billion dollars (Neely,2012).

Due to its contribution ineasing the impacts of the financial crisis and stimulating theeconomy, quantitativeeasing policies have been views as effective last resorts. Therefore,they should be employed sparingly, when other monetary policies areineffective. Through quantitative easing the Federal Reserve was ableto maintain a stable and health rate of inflation. While employingquantitative easing to maintain a health inflation rate, there is arisk of very high inflation due to increased money supply.Additionally, the quantitative easing policies will not be effectiveif the banks are unable to lend the additional reserve as a result ofthe policy (Hausken &ampMthuli, 2013).Quantitative easing also has a huge impact on the exchange rates,which affects international trade. Quantitative easing increasesmoney supply in the economy which leads to depreciation of theexchange rates relative to major currencies in the internationalmarket. This benefits debtors and exporters while harming creditorsand importers. Economists, including the International MonetaryFund, agree that quantitative easing policies were effective inmitigating and cushioning the economy from the financial crisis. Thisis through reduction of the inherent risks in the mortgage backedsecurities following the collapse of major financial and investmentinstitutions (Krishnamurthyand Vissing-Jorgensen, 2011).The market confidence that was restored by reduced risk initiationeconomic activities which eased the impacts of the financial crisis.For example, the second round of quantitative easing had a hugeimpact on the stock market. The resultant increase in consumption hasbeen attributed to the strong growth of the United States economy in2010. However, it is important to note that although quantitativeeasing stimulated the economy, there are other policies adopted bythe Federal Reserve. Through synergy, a combination of interventionrevived the United States economy (Gagnonet al 2011).

In conclusion, quantitativeeasing was one of the effective way through which the federalgovernment saved the economy. This emphasizes the important role ofthe government in stimulating economic activities during financialcrisis. It also emphasizes the role of the government in regulatingand monitoring the activity of major business organization, whoseactivities have an impact on the economy. However, the action of thegovernment may have positive or negative impacts on a strugglingeconomy. Therefore, the government should use the last resorts, suchas quantitative easing, sparingly during desperate situations. Thegovernment also has a huge responsibility of cushioning the domesticeconomy from external forces.

References

Gagnon, J., Raskin, M.,Remache, J., and Sack, B., (2011) “The Financial Market Effects ofthe Federal Reserve`s Large-Scale Asset Purchases,” InternationalJournal of Central Banking,7(1), 3-43.

Hausken, K &amp Mthuli, N.(2013). QuantitativeEasing and Its Impact in the US, Japan, the UK and Europe,New York, NY Imprint: Springer.

Joyce, M., Lasaosa, A.,Stevens, I., and Tong, M. (2010). The Financial Market Impact ofQuantitative Easing. Bank of England Working Paper 393.

Krishnamurthy, A., andVissing-Jorgensen, A. (2011) “The Effects of Quantitative Easing onInterest Rates: Channels and Implications for Policy,” BrookingsPapers on Economic Activity,Fall, 215-65.

Neely, C.J. (2012). TheLarge-Scale AssetPurchases Had Large International Effects,Federal Reserve Bank of St. Louis Working Paper No. 2010-018D.

Paolo, S. et al (2011). Globalfinancial crisis: global impact and solutions,Burlington, VT: Ashgate.

Thornton, D.L. (2012).Evidence on thePortfolio Balance Channel of Quantitative Easing,Federal Reserve Bank of St. Louis, Working Paper, 2012-015A.

Wright, J.H. (2011). Whatdoes Monetary Policy do to Long-Term Interest Rates at the Zero LowerBound? NationalBureau of Economic Research Working Paper 17154.

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