Question

For the Portfolio Project, in a well-constructed paper, identify four policies the government enacted following the financial crisis. Evaluate what effect these policies would have on the economy from both a short-run and a long-run perspective. Be sure to include:

• The distinction between the short-run and long-run economic views and what determines economic output in the relative time periods
• A definition of the measures used to determine economic success in the different time periods
• A link from each policy back to these distinctions and measures.

Answer 1

The Fed’s Monetary Policy Response to the Current Crisis

The sub-prime crisis has been immediately followed by a monetary response from the Federal Reserve System in collusion with the finance wing of the government. They have promised to “employ all available tools to promote economic recovery”

Interest rate actions
The fed’s action on the interest rate from has been consistent. It is based on statistical analysis of the impact on inflation and unemployment. The so called Taylor rule advocates lowering the funds rate by 1.3 percentage points if core inflation falls by one percentage point and by almost two percentage points if the unemployment rate rises by one percentage point. During 2007 and 2008, Fed’s lowed of the funds rate by over five percentage points.

The likely impact of such policy is most probably lower inflation and persistent level of high unemployment. By this reckoning the Fed will probably have to reduce interest rate to well near or below zero. However, nominal interest rates cannot fall below zero.

But the Economy is in a deep recession and it may take several years of strong growth before the fund-rate can return to positive levels. Economic theory also suggests that policy rates are meant to keep up expectations and according to Keynes. Expectation play a major role in economic activity. Bank interest rate projections may help a central bank achieve its policy goals.

Fed’s balance sheet actions
Feds policy rate cut was meant to stimulate asset-price increases and renewed activity in credit markets. However, these measures failed to revive credit market and it fell into disfuctionality. Fed rate cuts did not affect illiquidity and risk spreads.

Fed started to lend directly against collaterals in order to enhance liquidity and restore confidence to the credit market.
Fed started buying long-term securities from the open market. The idea was to reduce long term rates further. This has helped the long term borrowers and households by lowering the mortgage rates.
Forward Guidance
Essentially the Fed tired to play on the Expectation angle in finance managementof the economy. Communications emerging from the Government and Fed laid out clear strategies to show how they will enact an impact the economy.

Quantitative Easing
QE is another term for printing money to buy assets, like government bonds. When the Fed buys assets from investors, with newly printed money, these use the proceeds to rebalance their portfolio by rebalancing their risk profile. This boots asset price and lowers interest rate. QE also hasa fiscal effect. Lower interest rates reduce government borrowing costs and so lower future taxation. Further QE also reduces expectations of inflation.

Evaluation of policies.

In the short-run, these policies have shown very little impact on inflation and unemployment. The US economy is still in deep recession and forecasters are uncertain about the medium term
Regarding the long-term, economists and pundits in general are agreed that this will be a long-drawn out recovery process. But the measure taken by the FED and the Government are in the right direction.