Good Research Paper On Economics Of Global Money Markets

Introduction

The Federal Reserve acts as the guardian of the United States economy. It watches over the largest economy in the world. As a bank of the United States government, the Federal Reserve is authorized to regulate the financial institutions in the country. It dictates the monetary and economic policies, which have profound impacts on citizens around the country. Financial crises are essentially caused by the imprudent lending and borrowing hence it is the role of the Federal Reserve to ensure that the economy returns to normalcy. The present paper explores the role of the Federal Reserve in the economy during the latest financial crisis, starting in 2008. The paper also utilizes the open market operations, reserve requirements, discount rate, and moral suasion tools in elucidating the role of Fed in meeting the economy’s goals on inflation, unemployment, and economic growth. The other part of the paper discusses the non-traditional Federal Reserve’s tools used during the 2008 financial crisis as well as, the fiscal policy initiatives that the U.S government used over the same period. The last section of the paper elucidates the steps the current Fed Chairman is likely to and ought to pursue in the next 1-2 years.

The Role of the Federal Reserve in the Economy During the 2008 Financial Crisis

The Fed ensures that there are enough money and credit in the economy to sustain economic growth without inflation. It also ensures that the country’s payment system is effective and efficient and that it supports the citizen’s economic needs. During the financial crises, the Fed is required to take aggressive actions to save the economy. Many economists have described the 2008 financial crisis as the most harsh shock to financial markets that US experienced ever since the Great Depression. It had immense effects on the Federal Reserve. In addition, this financial crisis had dramatic effects on the country’s economy and was the most prolonged and profound financial shock since the Second World War. The 2008 financial crisis resulted in a considerable loss of output, a deflationary scare in many nations, and an increase in unemployment (Carvalho, Stefano, and Christian Grisse 1). The slowing in the labor markets and the subsequent slowing of the US economy followed the market disruptions and financial crisis. The Fed took a series of extraordinary actions to offer liquidity to the country’s financial sector, maintain the price stability expectations, and stabilize the economy. The Federal Reserve actions needed to be innovative because the financial distress was so pervasive and profound and because it occurred in the financial markets whose structure had dramatically evolved.
The Federal Reserve utilized the traditional tools of fiscal and monetary policy to dampen the recession. The traditional tools looked appropriate to handle the financial crisis through at least the end of 2007 (Kroszner and William 7). FOMC responded to the financial crisis by cutting the target federal funds rate to zero to stimulate the economy, but this became impossible. As an alternative, the Fed utilized Quantitative Easing and Forward policy guidance unconventional monetary policies. Under the forward guidance, the FOCM tried to decrease the longer-term interests (Thornton 4). The Federal Reserve also provided backup liquidity to both the financial institutions and nonbank financial institutions as a method to fight the financial crisis and support the financial markets. The Fed usually gives loans to only the institutions, which take deposits, and examples of these institutions are the commercial banks. Nonetheless, in early 2008, the investment banks just like the commercial banks also experienced trouble when obtaining the temporary funding and became susceptible to the credit-cutoffs comparable to bank runs. It expanded its collateralized lending to the financial institutions as short-term markets frozen to make sure that these financial institutions continued with their daily operations. The Fed created two programs in March 2008 to offer temporarily secured loans to the primary dealers. As a result, the conditions improved significantly in the markets during 2009.
The Federal Reserve provided support to the key financial institutions as a way to combat the financial crisis. The key financial institutions during the period played an imperative role in the US economy hence their failure could result in a cascade of failures and ultimately a meltdown of the worldwide financial system. For instance, the investment bank Bear Stearns were about to fail during the 2008 financial crisis. Ideally, this risked a domino effect, which would have sternly disrupted the financial markets. The Fed helped JPMorgan Chase purchase the Bear Stearns by giving loans financed by particular Bear Stearns assets to contain the damage to the financial markets. In September 2008, the financial system was unraveling rapidly (Mui N.p). The collapse of the Lehman Brothers investment bank in the same period caused financial panic to the other crucial financial institutions such as the American International Group. However, the Federal Reserve offered secured loans to AIG and other relevant financial institutions to contain the threat.
In the fall of 2008, the two imperative markets, short-term lending to businesses and money market mutual funds broke down. The money market mutual funds put money into unsecured, short-term loans to the companies and treasury bills after collecting it from the investors. The unsecured, short-term loans are referred to as commercial paper. Ideally, the commercial paper market is an important source of finances for numerous businesses. The financial crisis caused bankruptcy in the Lehman Brothers investment bank, and this caused fear of failures among the investors (Ivashina and Scharfstein 320). As a result, the investors started pulling money out of the money market mutual funds, which held commercial paper, and this resulted in the increase of interest rates on the commercial paper. The Fed acted to improve the conditions in these markets. It gave institutions in these markets secured loans, guaranteeing that there was adequate funding.

The Role Of Fed In Meeting the Economy’s Goals on Inflation, Unemployment, and Economic Growth

The Federal Reserve System has a control over the interest rates and money supply in the economy. Its primary goals are inflation and unemployment reduction and promotion of economic growth. It is the responsibility of the Federal Reserve to set the monetary policy. In essence, the primary mission of the Federal Reserve is to make sure that there are enough credit and money to sustain the economic growth without inflation. For this reason, the Fed has the power to control the supply of money in the economy. In particular, the Fed makes use of a number of tools including the discount rate, moral suasion, open market operations, and reserve requirements to control the supply of money in the economy. Through the four tools, the Federal Reserve can raise the interest rates and reduce the money supply to reduce the inflation. On the other hand, the system can lower interest rates and raise the money supply to counter a recession.
The monetary policy strives to attain the three macroeconomic goals of stability, full employment, and economic growth. The FOMC sells and buys the government securities through the open market operations (Labonte, Marc, and Gail E. Makinen 3). Such selling and buying affect the amount of excess reserves, which banks have in their possession to create money and make loans. The Fed sells the government securities to the banks if it wants to decrease the supply of money in the economy. On the other hand, it buys the same securities from the banks if it wants to increase the supply of money in the economy. When the Fed sells the government securities to the banks, it decreases the money that is available in the economy. Consequently, this results in a decline in spending and investment, slowing down the economic growth. On the other hand, the Fed increases the supply of money by purchasing securities from the banks. As a result, the banks can give businesses and people loans because the rates are low, leading to greater investments that stimulates the economy.
The Fed adjusts the interest rate, which it charges the commercial banks for borrowing reserves through the discount rate monetary tool. The Fed might need to decrease the money supply in the economy if it feels that inflation is threatening the consumers’ purchasing power. It decreases the money supply by increasing the discount rate. The high discount rate decreases the banks reserves and increases their interest rate. As a result, the banks make fewer loans thus decreasing the money supply. On the other hand, the Fed increases the money supply by lowering the discount rate. As a result, the banks borrow more reserves that they use to make additional loans at low-interest rates.
The Federal Reserve can also adjust the proportion of reserves, which the banks should keep backing their outstanding deposits through the reserve requirements monetary tool. The rise of the reserve requirements by the Fed decreases the supply of money as banks use their current reserves to make fewer loans. On the other hand, the Fed increases the money supply by decreasing the reserve requirements. Lastly, the Federal Reserve can use the moral persuasion monetary tool to request that the bank take specific action to control the supply of money in the economy.
The non-traditional Federal Reserve’s tools employed during the 2008 financial crisis and the fiscal policy initiatives that the U.S government used over the same period
The Fed officials came up with a number of ways after the traditional interest rate tools proved to be ineffective (Cecchetti 20). Fed had to use non-traditional tools to help deal with the financial shock. The Federal Reserve put in place numerous non-traditional tools to help combat the crisis. Some of these instruments included Money Market Investor Funding Facility, Term Asset-Backed Loan Facility (TALF), Term Auction Facility, Maiden Lane (Bear Stearns), Term Securities Lending Facility Options, and Commercial Paper Funding Facility, among others. Each of the non-traditional tools was classified into three different descriptive categories including purchasing longer-term securities, providing liquidity to the basic credit markets, and lending to the financial institutions.
The Term Auction Facility (TAF), Term Securities Lending Facility (TSLF), and Primary Dealer Credit Facility (PDCF) tools are closely tied to the role of the central bank as a lender of last resort. These instruments involve lending to the financial institutions. For instance, the Fed created TSLF during this time to alleviate the liquidity pressures within the secured, short-term funding markets (Brave and Genay 6). The Commercial Paper Funding Facility (CPFF), Money Market Investor Funding Facility (MMIFF), Term Asset-Backed Securities Loan Facility (TALF), and the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF) tools involve the provision of liquidity to the basic credit markets (Board of Governors of the Federal Reserve System N.p). For instance, the Fed set the MMIFF tool to address the issues in the commercial paper market. In addition, The Federal Reserve set up TALF instrument to lend to the financial institutions for the securities purchase. The Fed expanded its old instrument of OMO by the use of a third set of tools. In particular, these tools helped in putting down the pressure on the longer-term rates of interest. They also made the far-reaching financial conditions extra accommodative through long-term security purchase. In addition, the tools supported credit markets functioning. In essence, the Federal Reserve started purchasing Freddie Mac and Fannie Mae’s mortgage-backed securities to support the mortgage market.
The United States government also employed substantial fiscal policy initiatives to combat the 2008 financial crisis. The government responded to the financial shock by trying to boost the economic activity through fiscal stimulus and automatic stabilizers (Tcherneva 4). It offered a fiscal stimulus package, which was designed to boost the economic activity. It is worth noting that the US government was closely involved in sustaining the stability of the country’s financial system. In essence, the government provided direct aid to a number of leading financial firms such as AIG. The government protected the taxpayers from excessive losses, supported mortgage finance availability, and provided stability to financial markets by helping the leading financial firms. The US government purchased the impaired assets from banks’ balance sheets after experiencing a likelihood of financial system collapse. The conditions of the financial market continued to deteriorate even after the passage of Emergency Economic Stabilization. As a result, the Treasury decided to invest directly in corporations instead of buying assets from these companies’ balance sheet. In addition, the government directly purchased the commercial paper from the private market to stimulate it for temporary lending among the companies. The other government program to combat the financial crisis included raising the FDIC bank deposit insurance to allow the financial institutions offer short-term bonds.

The steps the current Fed Chairman is likely to and ought to pursue in the next 1-2 years

The US labor market has progressed. The FOMC expects that progress to continue. According to the Fed, the job creation over the past two years in the United States has been strong despite slowing in March. The current decreases in the energy prices have boosted the consumer purchasing power hence the consumer expenditure is increasing. However, the Fed reported the weaknesses in the growth of export and a slow recovery in the housing sector. In addition, inflation has dropped further below FOMC’s longer-run objective. At the moment, the Federal Reserve seeks to foster maximum employment and price stability. The Fed chairman is likely to follow a monetary policy, which will keep inflation stable to foster maximum price stability and in the next 1 to 2 years. Inflation targeting would ensure that the country enjoy greater price stability and maximum employment in the next 12-24 months. The chairman should maintain the credit aggregate and long-run monetary growth commensurate to foster maximum employment and price stability.
I do agree with the economists who maintain that the US economy is undergoing a “new normal’ because of the financial crisis. The recovery of the United States economy has been hampered by various economic complications caused by the financial crisis itself. These complications have primarily kept the growth of output and jobs slow. In addition, the debt ceiling and federal budget solutions added an uncertainty to the nation’s economy. In essence, the potential growth rate in the United States has declined since the financial crisis. The unfavorable factors brought about by the financial crisis have hampered the United States growth rate.

Works Cited

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Brave, Scott A., and Hesna Genay. Federal Reserve policies and financial market conditions during the crisis. DIANE Publishing, 2011.
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Cecchetti, Stephen G. Crisis and responses: the Federal Reserve and the financial crisis of 2007-2008. No. w14134. National Bureau of Economic Research, 2008.
Ivashina, Victoria, and David Scharfstein. "Bank lending during the financial crisis of 2008." Journal of Financial economics 97.3 (2010): 319-338.
Kroszner, Randall, and William Melick. The response of the federal reserve to the banking and financial crisis of 2007/2008. working paper, 2009.
Labonte, Marc, and Gail E. Makinen. "Monetary policy and the Federal Reserve: current policy and conditions." Congressional Research Service, Library of Congress, 2008.
Mui, Y. Q. "Transcripts show Federal Reserve’s struggle to deal with 2008 financial crisis as it unfolded." The Washington Post 21 Feb. 2014: n. pag. Web. <http://www.washingtonpost.com/business/economy/transcripts-show-federal-reserves-struggle-to-deal-with-2008-financial-crisis-as-it-unfolded/2014/02/21/3408a468-9b1d-11e3-ad71-e03637a299c0_story.html>.
Tcherneva, Pavlina R. "Fiscal policy effectiveness: Lessons from the Great Recession." (2011).
Thornton, Daniel L. "The Federal Reserve's response to the financial crisis: what it did and what it should have done." FRB of St. Louis Working Paper No (2012).