In the last three months, the Japanese Yen has appreciated 15% against the US dollar. At the same, the dollar itself has appreciated 25% against the euro.

The appreciation of these two major currencies seems strange in a time when both country’s economies are experiencing major slowdowns. In most cases, currencies appreciate when one of two things happens:

• If foreigners demand more of a country’s exports, demand for its currency drives up its value, causing appreciation.
• If a country’s interest rates rise relative to other country’s, then demand for its currency rises as investors want to buy assets in that country to earn the higher interest rates.

Lately, however, the Yen and the Dollar have seen staggering rises in the absence of rising exports or rising interest rates in Japan or the US. So what IS causing the rapid and drastic appreciation of these two currencies? The Economist newspaper explains:

Many investors have been following a version of the “carry trade”, borrowing money in a low-yielding currency. All they had to do was earn a higher return from assets than the cost of their financing. Since the two big currencies with the lowest yields over the past year have been the dollar and the yen, those were the natural ones to borrow.

When asset prices fall, however, this strategy is disastrous. Investors dash to sell assets and repay their debts. Since those debts were incurred in dollars and yen, that means they have to buy back those two currencies—hence their sharp recent rises.

In the midst of today’s global financial meltdown, it seems that every day, phenomena new to mainstream economic theory are being witnessed. It would seem that from now on, when we learn about the determinants of exchange rates, we may have to take a look at the “carry trade” example.

In this case, it would seem, LOW interest rates combined with falling stock prices can lead to a currency’s appreciation. An investor looking to make a deal would borrow Yen from a Japanese bank charging low interest rates, convert it to, let’s say Brazilian real, to buy stocks in a Brazilian company. As long as the stocks gain value at a rate higher than the interest rate in Japan, the investor is making an easy profit. He can pay back the money he borrowed from Japan at the low interest rate, earn a high return on his investment in Brazil, and pocket the difference.

The problem arises when the value of the assets the investor has bought in Brazil begins to fall. With stock markets plummeting between 20-50% this year in most countries, asset values have fallen through the floor, meaning those investors who borrowed yen to buy foreign assets have rushed to sell the falling assets as quickly as possible to pay back their Japanese lenders before it’s too late. This causes a huge increase in demand for Yen on foreign exchange markets in a very short period, hence the yen’s appreciation.

Recently, the Yen and USD have managed to appreciate for a reason not conventionally understood. The rapid and drastic appreciation of these currencies is further exacerbating the weak aggregate demand in Japan and the US. A strong currency, while good for consumers for whom imports appear cheaper, can have debilitating effect on a country’s export sector. Not surprisingly, both the US Fed and the Japanese central bank have both cut interest rates in the last week in the hope of slowing their currency’s appreciation and protect export demand.

Wow! What a week for the world economy….stocks down by 4% one day and then up by 4% the next day in response to the uncertainty in the global economy!

In class today we talked about the historical week and how our financial systems & banks are “freezing up”, having difficulty making new loans to households and businesses as the banks are focused on paying off their their own creditors (lenders) who are demanding payment from the banks before they might fail.

And …..along comes the Government to the rescue in our “mixed economy”….lending money to the banks and, in several cases essentially buying the companies! The financial markets (stocks) believe generally that the strong government leadership is needed…not to save the companies…but to save the entire economy from a deep recession! Bad news has a tendency to “freeze up” everyone!

Most economists think the US Government’s Federal Reserve Bank (FED) and Treasury Department have done a pretty good job. 

Here’s a report card for the government out of the Wall Street Journal’s blog:  

      Economists Back Government Moves

As the government’s efforts to save the financial system from impending ruin reached a high-water mark Friday, economists took a step back and offered tentative assessments of the Federal Reserve’s conduct through this year-long crisis.

By and large, they say, the central bank, in conjunction with the Treasury Department, has responded appropriately to an unprecedented stream of crises, and has likely warded off a truly monumental meltdown.

Bernanke

To be sure, it is far from clear that the worst has passed, and much uncertainty surrounds the outlook, particularly given the lack of detail in the government’s sweeping rescue plan. Still, economists say there are plenty of reasons to be hopeful.

“The way the financial markets were heading threatened to create the sort of permanent damage to the financial system we saw in the 1930s,” when the Fed reacted passively to failing banks, said Dana Johnson, chief economist with Comerica.

“To head off the potential damage… it was appropriate to do everything in [the Fed’s] power” to avoid a similar outcome, he said. Johnson views the Fed’s historic initiatives as a “magnificent reaction” to what policy makers have confronted.

Industry group the Business Roundtable said in a statement that Friday’s actions were “appropriate and timely,” and it argued for a “comprehensive” review of the nation’s financial regulatory structure.

Tyler Cowen, an economics professor at George Mason University, said Fed Chairman Ben Bernanke and Treasury’s Henry Paulson “have been making good decisions, relative to a very bad starting place.” Given the nature of the troubles, the two officials started in a “very unfortunate position,” so “it’s very hard to second guess particular decisions,” he said.

One Federal Reserve veteran sees the Fed’s response throughout the crisis as entirely appropriate, but less dramatic than others. Indeed, for CarnegieMellon Tepper School of Business economics professor Marvin Goodfriend, a former Richmond Fed top economist, “the central bank has always had at its disposal two broad policies.”

One is very well known and understood. Monetary policy aims to control inflation and influence growth via the control of short term interest rates, he said. Then there’s the less understood and codified credit policy, which has come into play as the Fed’s extended loans to various parts of the financial system. He reckons officials will need to think about and explain more fully this part of their arsenal, and that illuminating this issue will feature prominently in central banking analysis as the crisis is resolved.

Still, not all are happy with the path charted by the Fed and Treasury. Former St. Louis Fed president and current Cato Institute scholar William Poole said in an interview he believes the Fed did the right thing when it bailed out Bear Stearns last spring and granted an emergency loan to AIG this week, and it was correct in letting investment bank Lehman Brothers go into bankruptcy.

But moves to support the money market funds in a fashion similar to what’s afforded bank deposits, along with mechanisms to gather up and dispose of bad securities — that’s a bad thing, Poole said. He reckons the money market fund support will unnecessarily drive risk-taking in a competitive sector of the market, now that fund managers know their investors will be bailed out in the event of bets gone sour.

But the bigger problem is the plan to buy stricken assets from banks. “The euphoric market reaction to this vague idea doesn’t make that much sense to me,” Poole said. The government will have an extremely difficult time finding appropriate prices for the troubled securities and is likely to be saddled with the absolute dregs of the financial system that will prove very expensive to unload, he said.

“I don’t think it’s possible to do it right,” Poole said, and “when the costs become obvious there will be a whole lot of finger pointing.”

Paulson

Poole also argued it’s entirely possible that the resolution mechanism may not even be needed, and that the recent string of bank failures may well be coming to an end.

Others worried about the risks the Fed’s balance sheet may be facing, although some central bank officials have sought to downplay such fears. They can even point to the $29 billion in securities the Fed acquired as part of the Bear Stearns bailout, which thus far have not lost value.

The American Bankers Association was also negative on the most recent Fed and Treasury actions, saying that they “will undermine the role of banks during this credit crisis and [have] the potential to have an extremely negative impact in the future.”

Still, those views do not appear to hold dominate sway among economists. CarnegieMellon’s Goodfriend said the nation has been “quite fortunate” in having Bernanke at the Fed’s helm, with his academic career so heavily based in understanding the lessons of the Great Depression. “No one could have expected him to do better,” Goodfriend said. –Michael S. Derby

Federal Reserve sees slow economy, higher prices - Sep. 3, 2008

Weak aggregate demand and rising costs due to still high energy and food prices put the US economy in a tricky situation, one in which the Federal Reserve is forced to make the tough decision between tackling the unemployment problem (jobless rates have risen to 5.7%) or the inflation problem (price levels have also risen 5.7% this year, the highest inflation in 17 years).

The nation struggled with slow economic growth and still-high prices that are weighing on consumers and businesses alike…

Fed Chairman Ben Bernanke and his colleagues are all but certain to leave a key interest rate alone at 2% when they meet next on Sept. 16 and probably through the rest of this year.

Given the fragile state of the economy, the Fed isn’t in a hurry to boost rates to fend off creeping inflation. A growing number of analysts believe the economy is likely to hit another dangerous rough patch later this year as consumers and businesses curtail their spending even more.

Heading into the fall, economic activity continued to be slow, the Fed said. Businesses described the climate as “weak” or “soft” or “subdued.”

Consumers, the lifeblood of the economy, showed caution. Shoppers “concentrated on necessary items and retrenchment in discretionary spending,” the Fed observed.

In the short-run, as year 2 IB students know, society faces a trade off between high inflation and high unemployment. Rising prices and rising joblessness are both harmful to the economy, but when energy and food prices drive up the price level, while week investment and consumer spending lead lead to falling overall demand in the economy, the conditions exist where joblessness and prices can rise simultaneously. This is America’s situation at present.

The Fed must chose which problem to address. Ben Bernake, America’s central bank chief, could chose to tackle rising inflation by raising interest rates, which would discourage new investment and reduce demand for resources by firms in the economy. Investment spending by firms and consumption by households would decline, putting downward pressure on prices across the economy.

In the short-run, however, the decline in investment and consumer spending that would result from higher interest rates would exacerbate the already weak level of aggregate demand in the economy, driving unemployment even higher.

By keeping rates low, Bernanke hopes to encourage investment and consumption, which will contribute to overall demand in the economy. By encouraging new spending and investment, however, the threat that inflation will rise even more remains present.

In the trade off between unemployment and inflation, the Republican White House and the Democratic Congress made it clear that unemployment was the most important problem to address when they announced the $160 billion expansionary fiscal stimulus package earlier this year. By keeping rates at a low 2%, America’s central bank is also indicating that increasing employment is of greater importance than lowering the price level.

Discussion questions:

1. Low interest rates are clearly a demand-side policy, since they should lead to higher investement and consumption. But how might lowering interest rates result in positive supply-side effects for the economy?
2. Why do you think increasing employment is of a higher priority to policy-makers than bringing down the inflation rate? Does the fact that it’s an election year matter?
3. “Workers’ wage gains - characterized as ‘modest’ - aren’t raising
   inflation worries. Wary employers have cut jobs every month so far this
   year and aren’t inclined to be overly generous in their compensation to
   workers amid ‘a general pullback in hiring,’ the Fed said. If wages continue to rise even as unemployment rises, is it likely that the US economy will ever “self-correct” from in times of an economic slowdown?
   

Update: Once again I have updated this post with a few minor changes. Notably, I have added to graphs illustrating a separate shift in supply and demand for loanable funds. Based on discussions with readers via email, it appears that my previous graph illustrating in one diagram the shifts of both supply and demand was confusing and could be considered double counting the effect of an increase in deficit spending. Thanks again to Professor Chuck Orvis for his valuable input.

*Click on a graph to see the full-sized version

Two markets for money, right? Yes… so do they show the same thing? NO! You must know the distinction between these two markets. First let’s talk about the Money Market diagram.

This market refers to the Money Supply (M1 and M2). The Money Supply curve is vertical because it is determined by the Fed’s (or central bank’s) particular monetary policy. On the X axis is the Quantity of money supplied and demanded, and on the Y axis is the nominal interest rate. A tight monetary policy (selling of bonds by the Fed) will shift Money Supply in, raising the federal funds rate, and subsequently the interest rates commercial banks charge their best customers (prime interest rate). On the other hand, an easy money policy (buying of bonds by the Fed) shifts Sm out, lowering the Federal Funds rate and thus the prime interest rate.

You should also know why a tight money policy is considered contractionary and why an easy money policy is considered expansionary monetary policy. Higher nominal interest rates resulting from tight money policy will discourage investment and consumption, contracting aggregate demand. On the other hand, an easy money policy will encourage more investment and consumption as nominal rates fall, expanding aggregate demand.

Government deficit spending and the money market: Does an increase in government spending without a corresponding increase in taxes affect the money market? You may be inclined to say yes, since the Treasury must issue new bonds to finance deficit spending. After all, when the Fed sells bonds, money is taken out of circulation and held by the Fed, thus it’s no longer part of the money supply.

When the Treasury issues and sells new bonds, however, the money the public uses to buy the bonds is put back into circulation as the government spending is increased. Therefore, any leftward shift of the money supply curve caused by the buying of bonds by the public is offset by the injection of cash in the economy initiated the government’s fiscal stimulus package takes effect (be it a tax rebate or an increase in spending). Therefore, money supply should remain stable when the government deficit spends.

Now to the loanable funds market. Loanable funds represents the money in commercial banks and lending institutions that is available to lend out to firms and households to finance expenditures (investment or consumption). The Y-axis represents the real interest rate; the loanable funds market therefore recognizes the relationships between real returns on savings and real price of borrowing with the public’s willingness to save and borrow.

Since an increase in the real interest rate makes households and firms want to place more money in the bank (and more money in the bank means more money to loan out), there is a direct relationship between real interest rate and Supply of Loanable Funds. On the other hand, since at lower real interest rates households and firms will be less inclined to save and more inclined to borrow and spend, the Demand for loanable funds reflects an inverse relationship. At higher interest rates, households prefer to delay their spending and put their money in savings, since the opportunity cost of spending now rises with the real interest rate.

Government deficit spending and the loanable funds market: We learned above that only the Fed can shift the money supply curve, but what factors can affect the Supply and Demand curves for loanable funds? Here’s a few key points to know about the loanable funds market.

• When the government deficit spends (G>tax revenue), it must borrow from the public by issuing bonds.
• The Treasury issues new bonds, which shifts the supply of bonds out, lowering their prices and raising the interest rates on bonds.
• In response to higher interest rates on bonds, investors will transfer their money out of banks and other lending institutions and into the bond market. Banks will also lend out fewer of their excess reserves, and put some of those reserves into the bond market as well, where it is secure and now earns relatively higher interest.
• As households, firms and banks buy the newly issued Treasury securities (which represents the public’s lending to the government), the supply of private funds available for lending to households and firms shifts in. With fewer funds for private lending banks must raise their interest rates, leading to a movement along the demand curve for loanable funds.
• This causes crowding out of private investment.

Another, simpler way to understand the effect of government deficit spending on real interest rates is to look at it from the demand side.

• Deficit spending by the government requires the government to borrow from the public, increasing the demand for loanable funds. In essence, the government becomes a borrower in the country’s financial sector, demanding new funds for investment, driving up real interest rates.
• Increased demand from the government pushes interest rates up, causing banks to supply a greater quanity of funds for lending. The private, however, now has fewer funds available to borrow as the government soaks up some of the funds that previously would have gone to private borrowers.
• This leads to the crowding out of private investment, in which private borrowers face higher real interest rates due to increased deficit spending by the government.

What could shift the supply of loanable funds to the right? Easy, anything that increases savings by households and firms, known as the determinants of consumption and saving. These include increases in wealth, expectations of future income and price levels, and lower taxes. If savings increases, supply of loanable funds shifts outward, increasing the reserves in banks, lowering real interest rates, encouraging firms to undertake new investments. This is why many economists say that “savings is investment”. What they mean is increased increased savings leads to an increase in the supply of loanable funds, which leads to lower interest rates and increased investment.

On the other hand, an increase in demand for investment funds by firms will shift demand for loanable funds out, driving up real interest rates. The determinants of investment include business taxes, technological change, expectations of future business opportunities, and so on (follow link to our wiki page on Investment).

It is important to be able to distinguish between the money market and the market for loanable funds, as both the AP and IB syllabi xpect students to understand and explain the difference between these concepts.

FT.com / Columnists / Wolfgang Munchau - Inflation and the lessons of the 1970s

It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.

So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.

In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.

Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.

The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.

…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.

Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.

The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:

In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.

…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:

The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.

Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.

In the words of billionaire investor and economic sage Warren Buffett just today:

“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”

“It will be deeper and longer than what many think,” he added.

Discussion Questions:

1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
2. What impact do rising energy prices have on the behavior of individual firms?
3. Why are low interest rates likely to make the inflation problem even worse?

Question about the money multiplier - Welker’s Wikinomics Page

The following question was submitted by “blobber008″ to the discussion forum at our class wiki:

When I need to find the maximum increase in the total money supply, where the money deposited is $100 and the reserve requirement is 10 percent, do I multiply the total money deposited by the money multiplier, or do I multiply the excess reserves by the multiplier to find the increase, or does it depend on the situation? I thought that I would multiply the initial deposit by the multiplier, thus getting an increase of $1000. My answer key, though, said that increase is $900. When I asked my teacher, she said that you subtract out the original $100 from the $1000 to get the increase in money supply.

The reason I’m confused is that another question asking for an increase resulting from the Fed buying securities from the public doesn’t subtract out the original value. Do you do something different when dealing with money in a bank/checking account and the purchase of securities? Or, do I really subtract out the initial deposit? If so, can you explain why?

This is a good question and one that often comes up among students and even teachers via the AP Economics teacher email group.

The basic difference between an individual depositing $100 and the Fed buying $100 worth of bonds from a commercial bank is that when the individual deposits money, it was already part of the money supply. This is is why the amount of new money created is only $900 when an individual deposits $100 in the bank. We multiply the $100 by the money multiplier (1/required reserve ratio), and then subtract the original deposit, since it was already held by the public, thus part of the money supply.

In the case of the Fed’s purchase of bonds, on the other hand, the $100 of new reserves at the bank are themselves new money, since money held by the fed is not part of the money supply. In this case, we multiply the change in deposits by the multiplier, and the new money created includes the initial change in deposits, which came from the Fed.

Thanks for your submission, hope that helped!

Carmen submitted the following through the “Econ Help Desk“

Please help me with a student question. If the FED pursues expansionary monetary policy, lowering the nominal interest rate in hopes of spurring investment and increasing aggregate demand, how does this connect to the loanable funds market? If nominal interest rates are down, won’t real ones go down too, causing people to save less? In this case, where will the supply of loanable funds to meet investment demand come from?

Below is my reply to Carmen:

Good question… here’s my understanding, so take it as you will…

To expand the money supply the Fed will buy bonds on the open market. This increases demand for bonds, raises their prices, lowering the effective interest rate on bonds, making these securities less attractive to investors, who will sell them back to the Fed in exchange for liquid money that is now part of the money supply.

Investors will put some of their new money into banks, where interest rates are now relatively more attractive than the declining rates on government bonds. Some of the new money created by the Fed’s purchase of bonds therefore ends up in the loanable funds market, shifting the supply of loanable funds out, lowering real interest rates, increasing the quantity demanded of funds for investment and consumption, hence the expansionary impact on Aggregate Demand.

If any readers has another take on the transition from expansionary monetary policy to a decline in the real interest rate in the LF market, please leave your ideas in a comment below.

~Jason Welker

Judging by today’s headlines, things aren’t looking too hot for the US economy:

• Job losses, unemployment both worse than forecast - Apr. 4, 2008
• Dollar slips against euro, yen on jobs - Apr. 4, 2008
• BBC NEWS | Business | Oil price edges up on Opec stance
• FT.com / Asia-Pacific / China - US economy is ‘down sharply’, Paulson says
• Bernanke Nods at Possibility of a Recession - New York Times

From the last article:

In his bleakest economic assessment to date, the Federal Reserve chairman, Ben S. Bernanke, said Wednesday that the American economy could contract in the first half of 2008, meeting the technical definition of a recession, and he encouraged Congress to help homeowners caught up in the mortgage crisis.

For the first time during his three years in the job, Bernanke has admitted we could be in a recession, defined as two consecutive quarters of negative GDP growth. By June, we could very well have experienced just such a decline in output; every central banker’s nightmare!

The source of America’s economic woes? Weak housing market. In fact, house prices have fallen around 10% nationwide over the last 12 months. To understand why, we need to recall the basic microeconomic principles of supply and demand. Quite simply, too many homes were built over the last decade, as low interest rates and optimism about the continued strenght of the housing market (rooted, of course, in the irrational exuberance about the economy as a whole) led builders to expand the suburban sprawl like never before, anticipating growing demand forever into the future. Problem was, demand couldn’t keep up with supply, and now the price is starting to reflect this basic economic principle.

To make things more complicated, many home buyers over the last seven years should never have been given loans based on their credit histories and household incomes. Many of these buyers were thus given “sup-prime” loans, many with adjustable interest rates, which means that today people who were too poor to get a normal loan four years ago are seeing their monthly payments increase just as the economy is slowing down. Rising unemployment puts downward pressure on wages, and inflation (caused by rising energy and commodity prices) forces poor homeowners to allocate more of their wages towards food and electricity, making it doubly hard to make their monthly mortgage payments.

The outcome is predictable: foreclosures. Banks that made loans to uncreditworthy buyers are now taking the houses back and putting them on the market for really low prices, putting even more downward pressure on all home prices. Since their homes make up the majority of Americans’ wealth, and since wealth and disposable income are the main determinants of consumption, inflation and falling home prices both lead to huge decreases in consumption.

The cycle continues: declines in household consupmtion signals to firms that it’s a bad time to invest, so investment spending declines. As consumption and investment fall, aggregate demand shifts in, causing output and employment to fall, hence our current recession.

“It now appears likely that real gross domestic product, or G.D.P., will not grow much, if at all, over the first half of 2008 and could even contract slightly,” he said. “We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies.”

For now, however, judging by today’s headlines, conditions will continue to worsen for the American worker, homeowner, consumer and firm.

Powered by ScribeFire.

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.