Apr 01 2008
SAS student David Xu explains the Fed’s latest tricks…
Published by Jason Welker at 12:30 pm under Macroeconomics,Monetary Policy,Recession
This article was originally posted by SAS senior David Xu at the SAS Economists Blog.
I have posted it here because David does a good job of explaining the tools the US Fed has developed and deployed to combat the economic slowdown in the United States.
Thanks to David Xu for writing this excellent piece.
The Fed has begun to institutionalize a new revolution of monetary policy.
Previously, the Fed has only really been a big factor by lending out to banks, or by being the bankers’ bank. Right? Well not anymore! The Fed has begun to pursue a policy of keeping the economy afloat with new radical measures.
In the short run, Bernanke is waging a war to keep the financial markets from collapsing. The biggest move so far: On Sunday, Mar. 16, the Fed brokered the fire sale of troubled investment bank Bear Stearns (BSC) to JPMorgan Chase (JPM) and announced that it would be willing to lend directly to major Wall Street brokers, which have never before had access to loans from the central bank.
Now, the Fed will be able to DIRECTLY inject new money into the economy and affect firm’s ability to invest in new capital. Before, firms had to borrow from banks to invest and because of the slump-approaching-recession, banks have been less willing to lend out money. Now, the Fed can actively keep the money supply high and investment growing.
At the same time, by stepping in so aggressively, Bernanke is pouring an enormous slug of money into the financial system. To be sure, its full impact won’t be felt right away, because banks are reluctant to lend and consumers are afraid to borrow. Indeed, consumer spending is likely to lag, leading to job cuts in coming months and a deepening of the recession.
Eventually, though, the Fed’s stimulus will show up as some combination of stronger economic growth and higher asset prices. It also could boost inflation, further eroding the value of the dollar and raising the risk of a run on the world’s most important currency. The possibility that a primarily domestic crisis could quickly become global highlights the need for international cooperation.
Inflation would be a deadly impact of injecting so much money into the system. As the price level is already rising due to high energy prices, the Fed, which basically just prints new money and pours it into the system, could exacerbate the situation. With the dollar falling in value, more dollars in circulation further depreciates its value. But the idea is to get investment back on track and to improve productivity in essence, what we discussed in increasing investment to shift the aggregate supply back out and offset its inward shift due to high energy prices.
The engine that eventually pulls the U.S. out of recession will most likely not be consumption but corporate investment. That will be good for big global corporations with clean balance sheets and access to markets around the world. The very fact that they already have plenty of cash will likely make investors all the more eager to fuel their expansion.
The Fed surely is taking a revolutionary stand here but the worry is, once the Fed gets involved, how can it pull itself back out once the economy is back-on-track? If it calls in the loans it is making to the companies, it could effectively cause another slump. It is up to you though whether the ends are worth the means.
About the author: Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course.
Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this authorRelated posts:
Wow, this situation seems quite intense. I'd say the Fed is trying to provide relief when it injects money directly into the economy because this measure can only be temporary or else the economy would inflate endlessly. This measure might be able to sustain a level of investment that can ensure a high level future growth, but on the down side, further inflation hurts the world's economy even more. Exporters to the U.S find their products more expensive, and countries that use U.S currency as a standard medium experiences a lost of monetary assets every time they trade.
Since the policy relies more on increased investment than increased consumption, it lies more towards supply-side economics. If this is the case, I don't see too much of a problem with the Fed pulling out because simply it stops making loans. It will not cause another slump because the money that it previously lent out has already went into investments, thus increasing productivity. If the policy relies on increased consumption though, it WILL cause another slump when the Fed pulls out.
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…and people still deny that the US is in a recession. In fact, it's quite scary to see the Fed NEED to implement all these new steps in order to stimulate the flagging economy. This has a few scary implications though. If the FED needs to actually interfere and directly put money into the economy, inflation will soar sky high, which is of course bad for the people if wages do not also increase. Also, this might set a precedence, and make the economy even more dependent on the FED steppng in than manipulating things with Monetary Policy.
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I just want to point out how expertly this post was written. The author clearly demonstrates advanced knowledge in addition to passion in the economic field. (aka he deserves bonus points).
Anyways, I had an argument with a friend whether Bernanke should be doing this. Is it ethical to pull out creditors who gave out bad loans? I mean shouldn't they be forced to take the consequences of their actions? But at the same time you wouldn't just let a person drown. Likewise, the economy does need help. But at the same time, Bernanke cannot send the message that: "oh everytime you make a bad loan, don't worry about it because the fed will bail you out".
People need to be fiscally responsible, both households and banks.
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Psh David you don't deserve bonus points.
hahah i'm just kidding. This article is really interesting.
The Fed is definitely desperate right now. I had no idea they are even ALLOWED to do this. I understand the ethical concerns about the Fed bailing out creditors who give out bad loans. But I think that right now, it is appropriate. Whether this revolutionary monetary policy will work I can't say for sure, but the U.S. economy DOES need help, and obviously none of the other economic policies are working at this point. I'm expecting the Fed to pull back out once the economy is back on track, and I'm pretty sure it will. But if it doesn't, then at that point, it IS unethical.
It'd be interesting to see the people's and banks' reaction when the Fed pulls itself out. Will they get too "spoiled" by the Fed's policies? Wouldn't this cause another economic slump?
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Whoa there david i was about to say what a good post this was. but then. i saw what you said and well. lets just say i retract my words LOL
Anyways i guess that the fed’s actions should be pretty effective in the short run, but after the economy has revived itself, the fed extracting itself would be quite difficult. I guess it depends on how much it decides to involve itself in the economy. But one problem is, if the Fed tries to stay safe by injecting only a small amount that it won’t hurt to pull out later, then less stimulus will be provided in the short run. The opposite is also true. So it’s another one of those tradeoff things like the phillips curve.
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hahah no bonus points for david plz…
"Revolutionary" is quite the word to describe the Fed's actions here. I'm wondering if "risky" might be a better adjective. Although it's true that the economy needs help at this point, I'm wondering to what extent should the Fed step up their powers to revive the economy? As Jessica pointed out, are they even allowed to this? Apparently, yes; and to all victims of the recession, it seems to be a great idea since the Fed is stepping in to stimulate the economy and save them from the impacts of their fiscal irresponsibility. What scares me a little however is the threat of inflation that comes with such an action, especially since the U.S. dollar is already so weak among international currencies. Coupled with the difficulties that may arise when the Fed pulls out (another question: is there any limit to how much they can directly inject? Is there a time or monetary constraint for when they'll stop doing this, a.k.a. are they going to stop after the recession? Or when the U.S. reaches a certain level of economic recovery? What level, specifically?), it seems like a risky battle plan.
or maybe i'm just too paranoid..
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yes, desperation it seems. but what if the injection is what the economy needs for a lift out of the spiral of recession? i mean i think the fed is banking on the prospect that this injection would help people back on track, and once they are back on track, money will make more money…people will be investing, there will be money flow…BUT how long would that take? so i guess there is a huge risk since no one can predict how much or for how long the fed has to be injecting money. And this risk is probably apparent to most people, which means people's expectation of an on-going recession would not translate into the best possible scenario…
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