Running head: MONETARY POLICY 1 Monetary Policy Raunak Kumar Capella University Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. MONETARY POLICY 2 Monetary Policy: An Overview Economies respond to economic fluctuations primarily by implementing monetary policy. Monetary policy cannot be discussed without discussing money. Money can be defined as “the set of assets in an economy that people regularly use to buy goods and services from other people” (Mankiw, 2012). The total quantity of money that circulates within an economy in different forms such as currency, demand deposits, and so on, is referred to as the money stock of that economy. The government of that economy may implement policy to regulate the money stock and to stabilize prices. This policy is known as monetary policy. The regulation of the money stock in an economy is controlled by the central bank. The Federal Reserve, also called the Fed, is the central bank of the United States. The Fed formulates and executes monetary policy and uses economic tools to influence the total money supply, which in turn affects macroeconomic variables like interest rates, investment, inflation, and so on. In addition to understanding the specific tools and instruments of monetary policy, it is important to measure how effective monetary policy is at achieving economic stability and maximizing social welfare in an economy. It is vital that an economy’s monetary policy is wellequipped to counter unanticipated events. The importance of designing sound monetary policy can easily be realized when trying to gauge the impact of it going wrong. The financial crisis of 2007–2008 is an example of the failure of monetary policy. During the course of the crisis, the Fed not only recognized certain shortcomings of monetary policy that were seen during the Great Depression, but also the ones that were only discussed in theory till then. Financial Crisis of 2007–2008 The financial crisis of 2007–2008 was triggered by the recession of 2001, which followed the bursting of the dot-com bubble. As a result, the Fed resorted to quantitative easing and Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. Comment [A1]: You did a good job in explaining how declines in real estate values, subprime mortgage loans, and mortgage-backed securities relate to a financial crisis using real world examples. Your points were well taken when discussing the crisis you mentioned the role of the rating agencies, the mortgage bankers, the borrowers who willingly got into mortgages that they could not afford. MONETARY POLICY 3 systematically lowered its interest rates to 1% in 2001 to boost liquidity and demand in the U.S. economy (Labonte, 2016).Monetary Policy: Economic Analysis

Along with low interest rates, the decision of the government to reduce income inequality by making housing affordable and available to all led to an increase in the demand for housing in the economy. Given the limited supply of houses, this increase in demand led to an increase in housing prices. Expectations of additional rises in housing prices in the future further pushed up demand and current prices in the housing market. The increased liquidity in the market resulted in an exponential rise in subprime lending. Borrowers with low creditworthiness and poor credit ratings are called subprime borrowers; such borrowers are considered risky as they are highly likely to default on their loans. Expecting housing prices to continue to rise, money lenders launched innovative mortgage loans, such as adjustable-rate mortgages (ARMs), for the previously unattractive subprime borrowers. These loans were characterized by zero down payment and low adjustable interest rates with a provision for the interest to be added to the principal amount of the loan in case of failure to pay monthly interest (Kolb, 2010). To meet the continually rising demand for credit fueled by the rising demand for real estate and to comply with regulatory capital requirements, lending institutions decided to free up their capital tied up as mortgage loans by selling these loans to third parties as mortgage-backed securities (MBSes). An MBS could be issued either by private institutions like American Insurance General (AIG) or quasi-government organizations like Fannie Mae and Freddie Mac. Issued as a bond, an MBS carried a guarantee by the issuing agency against default. For ease of investment, MBSes were pooled together and divided into tranches on the basis of the risks associated with them. Loans with high risks yielded higher interest and were pooled together as collateralized debt obligations (CDOs). Safer loans, which yielded lower interest than the risky Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. MONETARY POLICY 4 ones, were pooled in separate tranches. The risks of MBSes were gauged by credit rating agencies, mostly by the “Big Three”—Moody’s, Standard and Poor’s, and Fitch Ratings—which inaccurately accredited the bulk of risky and default-prone CDOs with the highest ratings. Since all the agencies involved charged a huge fee for the processing the loans, the disbursement of risky loans and MBS with lower credit worthiness was further encouraged. Thus, banks originated these loans, transferred them to investors and had no stake in the final outcome of the loan. Therefore, a rise in liquidity, an increase in credit growth, and an increase in the trade in risky derivatives in the wake of the increase in housing prices led to a deviation of housing prices from their inherent value (Kolb, 2010). This over-inflation in housing prices was termed as the housing bubble. As the bubble kept growing, financial institutions and investors borrowed more money to finance their purchase of mortgage-related securities. According to the Financial Crisis Inquiry Commission (2011), from 1978 to 2007, the amount of debt held by the financial sector soared from $3 trillion to $36 trillion, more than doubling as a share of gross domestic product. By 2005, the 10 largest U.S. commercial banks held 55% of the industry’s assets, more than double the level held in 1990. On the eve of the crisis in 2006, financial sector profits constituted 27% of all corporate profits in the United States, up from 15% in 1980 (p. 18). By June 2006, the Fed had increased the interbank lending rate to 5.25% to control the increasing inflationary pressure in the economy. As the interest rates increased, housing prices started declining (Amadeo, 2016). Another reason for the decline in housing prices was that, while the supply of houses kept increasing, the demand for them was exhausted. With the decline in housing prices, the lenders of short-term collateralized credit suffered a setback as borrowers could not pay back their debts. This left most lending institutions with little capital. These Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. MONETARY POLICY 5 institutions had to resort to selling off their assets at the same time, which pushed down the prices of those assets. As banks started running out of capital, people rushed to them to withdraw their funds. Therefore, the decline in housing prices acted as a catalyst in bursting the housing bubble (Kolb, 2010).Monetary Policy: Economic Analysis

Ineffectiveness of Monetary Policy: Liquidity Traps and Cyclical Asymmetry With the bursting of the housing bubble, the U.S. economy and markets all over the globe crashed. Individuals across the globe, especially in the United States, expected the Fed to take charge of the situation as the world economy was on the verge of a recession. The inability of the Fed to ease the economic situation highlighted the ineffectiveness of anti-recessionary monetary policies. During recession, consumption expenditure and investment tend to decline and speculations about a further dip in prices initiate a deflationary spiral. To stimulate the economy, the Fed cuts down interest rates and introduces more money into the economy by way of open market operations, which require the purchase of government shares from the public. During the crisis, the Federal Funds Rate, the interbank lending rate, hovered between zero and twenty five basis points for some time starting December 2008 (The Financial Crisis Inquiry Commission, 2011). However, the efforts of the Fed were upset by the uncertainty in the economy, which discouraged investors from spending and banks from lending. The public preferred to use the money injected by the Fed to pay off existing loans. This inability of expansionary monetary policy to counter recession is termed as cyclical asymmetry. In severe cases, such a policy may even push the interest rates below zero. This may happen because low interest rates discourage the public from holding bonds as they offer lower returns. With speculations that interest rates would rise in the future, both the savings rate and the chances of the economy being plunged into Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. Comment [A2]: One of the requirements of the assessment was to analyze the notion that monetary policy can exhibit cyclical asymmetry and explain why that is significant for policymakers. This was done very well. It was good that you mentioned the liquidity trap, as this has become problematic today as monetary policy has become ineffective. MONETARY POLICY 6 a deflationary spiral increase manifold, and the economy may go into a liquidity trap (Dornbusch, Fischer, & Startz, 2014). Such a situation occurred during the Great Depression when expansionary monetary policy failed to stimulate the economy. It is important for policymakers to know that, when it comes to contractionary monetary policy, the Fed can effectively achieve its goal by curbing the money stock of the economy and by suppressing economic activity.Monetary Policy: Economic Analysis

However, when it comes to stimulating the economy during recession, the use of expansionary monetary policy fails to fulfil its objective. Therefore, a lot of care should be taken while formulating expansionary monetary policies as they are not only capable of triggering asset bubbles, as they did during 2007–2008, but are also ineffective at combating non-periodic economic fluctuations. Conclusion The financial crisis of 2007–2008 demonstrated that monetary policy can be inhibited by cyclical asymmetry. The lack of regulatory actions against subprime lending, the unprecedented rise in the sale of mortgage-backed securities, and the tremendous growth in trading activities were early clues to the crisis that were ignored by the Fed. Once the crisis began, monetary policy failed to contain it. This highlighted the importance of anticipating cyclical asymmetry and liquidity traps while formulating policy. It is important for the Fed to have a strong hold on the financial institutions and agencies within the economy and to encourage all financial institutions to maintain transparency in economic activities. This is vital for economic stability (The Financial Crisis Inquiry Commission, 2011). Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. MONETARY POLICY 7 References Amadeo, K. (2016). How hedge funds created the financial crisis. Retrieved from https://thebalance.com/how-hedge-funds-created-the-financial-crisis-3306079. Dornbusch, R., Fischer, S., & Startz, R. (2014). Macroeconomics (pp. 65–75). (n.p.): McGraw Hill Education. Financial Crisis Inquiry Commission, Authorized Edition (2011). The Financial Crisis Inquiry Report (pp. 16–18). PublicAffairs. Retrieved from Monetary Policy: Economic Analysis http://ebookcentral.proquest.com.library.capella.edu/lib/capella/reader.action?docID=679 869. Baily, M. N., Litan, R. E., & Johnson, M. S. (2010). The origins of the financial crisis. In Kolb, R. W. (Ed.). Lessons from the financial crisis: Causes, consequences, and our economic future (pp. 79–81). (n.p.): Wiley. Retrieved from http://ebookcentral.proquest.com.library.capella.edu/lib/capella/reader.action?docID=588 959. Labonte, M. (2016). Monetary policy and the federal reserve: Current policy and conditions. Congressional Research Service (p. 10). Retrieved from http://fas.org/sgp/crs/misc/RL30354.pdf. Mankiw, N. G. (2012). Principles of economics (p. 620). Mason, Ohio: South-Western Cengage Learning. Copyright © 2016 Capella University. Copy and distribution of this document is prohibited. Comment [A3]: Correctly formats citations and references using current APA style with no errors. .Monetary Policy: Economic Analysis