However,shortly after house prices started to fall from their all-time high, subprimemarket began collapse.
March 2007 was marked with the failure of Bear Stearns,which was followed by Lehman Brothers bankruptcy and many others. The FederalReserve implemented monetary policies to put downward pressure on long-terminterest rates and help the financial stability of the economy. This was doneby buying securities, such as ten-year bonds and mortgage-backed securitiesusing quantitative easing, forcing interest rates down and rescuing troubledfirms and institutions.
19 The balance of money demand and supply in an economyis crucial. Equilibrium of these both can let the economy grow in a smooth pathand with relatively stable prices.The financialcrisis of 2008 made all sectors of our economy unstable. The money demand andmoney supply equilibrium was in disorder. Because of the rapid growth ofmortgage backed securities, housing prices and low interest rates, thefinancial sector was booming. Banks, companies and individuals wanted to investand there was a great demand for money. The Federal Reverse purchased MBS(Mortgage Backed Security) products essentially increasing the money supply andboosting the economy. 18.
Frederic S. Mishkin (1997). The Causes and Propagation of FinancialInstability: Lessons for Policymakers.
Pp. 75-91 The centralbank uses money to indirectly influence the economy, using monetary policy itcan help to stabilize the economy assuming that money demand is stable. On theother hand, money demand can become volatile and monetary policies will alsoinfluence real and nominal interest rates and there is a big chance of economicfluctuations.
If monetary and credit conditions are too relaxed, then there maybe higher levels of spending which would cause prices and in turn inflation toincrease. High money supply can cause inflation and high inflation erodes thevalue of money and assets. Germany in the 1920s, Zimbabwe in 2004 and a morerecent example – Venezuela in 2013 all experienced hyperinflation, which causedmajor economic instability and social unrest.18 17.Everycrsreport.com. (2018).
Monetary Policy and the Federal Reserve: CurrentPolicy and Conditions. online Available at:https://www.everycrsreport.com/reports/RL30354.html Accessed 8 Jan. 2018.16.
Geert Bekaert, Marie Hoerova and Marco Lo Duca (2013). Risk, Uncertainty andMonetary Policy. Pp. 760-78715.Tejvan Pettinger.
(2015). The link between Money Supply and Inflation,14.Robert L. Hetzel. (1984). A Monetarist Money Demand: Function.
Pp. 15-1913.Taradas Bandyopadhyay and Subrata Ghatak. (1990). Current Issues in MonetaryEconomics. Pp.
12-15 To counter thisthe central bank implements contractionary monetary policy. By raising the bankrates, increasing reserve requirements or using open market operations, centralbanks effectively decrease the money supply and in turn slow down economicgrowth, spending and borrowing and increase unemployment, but its main purposeis to target inflation. The target inflation rate is near 2 percent, which isconsidered to be the best for price stability and maximum employment.17 Notes: graphshows Us interest rate changes. After the financial crisis of 2008, BenBernanke, former chairman of the Federal Reverse, pushed the interest rate tonearly zero.
The centralbank can use expansionary monetary policy to stimulate the economy, increasingthe money supply it in turn will increase consumer spending, economic growthand decrease unemployment. As a result interest rates will go down and moneydemand will go up. However, the central bank risks triggering inflation if itinjects too much liquidity. In that case demand increases faster and businessesstart to up their production and hire additional workers. If businesses expectprices to rise they will in turn raise the prices of their products or servicesto counteract inflation.
If the central bank doesn’t intervene inflation mayincrease even more and there is a risk of hyperinflation.16Having saidthat, raising money supply because of money demand increase caused by a pricejump rather that an output increase is unwise, as that would most likelyintensify the problem of inflation, rather than stabilizing it.15Nonetheless, aslow increase in money supply will have a stabilizing effect on the economyover time. Real GDP growth will increase money demand and will in turn increasenominal interest rate.
If the money supply and money demand both increase, thecentral bank can stabilize nominal interest rates.Notes:If there was an increase in nominal income, it would shift the money demandcurve, and raise the equilibrium interest rate. Because theelements that influence money demand are difficult to calculate directly,central banks judge how monetary policy affects money demand using statistics.
Nevertheless, because money demand fluctuates considerably in short-term, therelationship between inflation and money supply is weak. If, forexample, interest rates are too high to begin with, it means that quantity ofmoney supplied is greater than the demand for it. The response to this would bea purchase of bonds by the government which would reduce money and the greaterdemand for the bonds would push interest rates down.14