Question

MINI CASE STUDY The Federal Reserve Is Lauded By Most Observers For Its Quick And Innovative ... Question: MINI CASE STUDY The Federal Reserve is lauded by most observers for its quick and innovative acti... MINI CASE STUDY The Federal Reserve is lauded by most observers for its quick and innovative actions during any financial crisis and severe recession. Nevertheless, some economists contend that the Fed contributed to the financial crisis by holding the federal funds interest rate too low for too long during the recovery from the 2001 recession. These critics say that the artificially low interest rates made mortgage and other loans too inexpensive and therefore contributed to the borrowing frenzy by homeowners and other financial investors. Other economists counter that the low mortgage interest rates resulted from huge inflows of savings from abroad to a wide variety of U.S. financial markets. Using your knowledge of economic indicators that include: GDP, CPI, Unemployment and Home Sales, along with your understanding of the role of the Federal Open Market Committee, respond to the following points in a two- page typewritten analysis using the MLA or APA style of writing and a minimum of 3 sources: Do you agree or disagree with the contention that the Federal Reserve is innovative and useful, particularly as relates to matters of the social and ethical impact of their federal funds rate decisions? Why or Why not? Explain how each of the indicators above assist in the decisions made by the Federal Reserve Open Market Committee? How do these indicators contribute to the research needed to determine cause and effect and how are these indicators currently calculated? What is the current position of the Federal Reserve Chairman Powell regarding Interest rates and the state of the economy? Do you agree or disagree with his position? Why or why not?

Answer 1

Answer:-

Federal Reserve Authority to stimulate economy:-

The government has two tools which it uses to influence the economy:-

1. Monetary Policy which is controlled by Federal Reserve Board to determine the money supply in economy,
2. Fiscal Policy which is controlled by President and Congress to determine the government spending and taxation.

The Federal Reserve Board tries to stimulate economy through the business cycle by adjusting money supply and interest rates. The Fed will stimulate economy by:-

1. changing reserve requirement of member banks (member banks has to keep a percentage of deposit in an account in Federal Reserve known reserve requirement for maintaining certain level of liquidity),
2. changing discount rate charged to bank (in an effort to guide economy through business cycle. The discount rate is the rate Fed charges member bank on loan. With change of discount rate, all interest rate changes with it. For stimulating economy, Fed will reduce discount rate, all interest will fall and cost of loan would be lower. With lower interest rate, borrowing and demand in economy will increase stimulating economy. Again to control the over spending in economy, Fed will increase discount rate).
3. setting target loans for Federal fund loans
4. open market operation of buying and selling US Government Securities, (Federal Open Market Committee FOMC is Fed's tool to buy or sell Government Securities in secondary market for controlling money supply in economy. In view of stimulating economy and reducing rates Fed will buy Government Securities. The money post buy out will enter banking system, bank's will have money to lend bringing interest down and increase borrowing, demand thereby stimulating economy. To control the over spending in economy Fed has to sell Government Securities leading to cooling effect in economy)..
5. changing the amount of money in circulation
6. using moral suasion

Controlling or stimulating economy by reserve requirement is the least tool used by Fed.

Housing Bubble:-

A 'housing bubble' is a run-up of housing prices which fuelled by demand and speculation. It starts with increase in demand due to limited supply which takes long period of time to replenish and increase. Speculators drives the demand further. After few periodic gap, demand decreases or stagnates with an increase in supply causing sharp drop of prices causing bubble burst.

In year 2000, Housing bubble started to form as real estate price started to rise when people started to abandon stock market post it's dot com burst and stock market crash. Over 6 years, the mania for homeownership grew to alarming level as interest rates plummeted and strict lending rates were abandon. Around 56% of purchases made during that period were by those citizens who would not had be able to do so in normal lending requirement and are recognised as subprime borrowers. The majority of loan were adjustable rate mortgages with low interest rate and schedule for reset in 3-5 years. The government encouragement of broad homeownership induced banks to reduce their rates and requirement which spurred home buying activity and drove prices by 50-100% in few parts of country. Speculators stepped in and where driving the market and in year 2005-2007.during its peak time; it was of estimated 30% of market was driving by speculators. During same time stock market started to rebound and interest rate started to go up. Adjustable rate mortgage began resetting at higher rates as signs that ecoonomy slowing emerged in year 2007. The investor stopped buying houses and as home prices plummet there was massive sell off in mortgages backed securities. With massive mortgages default, millions of foreclosure were observed for many years.