Economic and Financial Crisis (2008-2009), the Federal Essay

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economic and financial crisis (2008-2009), the Federal Reserve took exceptional measures in order to combat the effects of the crisis on the American economy. These measures translated into an expansionary policy that included pumping money in the economy and purchasing assets that were in trouble. Through its expansionary work, the government was able to balance some of the effects of the crisis.

The question that seems to be on everybody's mind (and lips) today is where does it all end? One thing everyone can agree on is that this type of expansionary policy cannot last forever. The United States economy functions as a free market economy where the laws of supply and demand govern the realities of the market. A continuous and permanent intervention of the Federal Reserve is neither possible, nor healthy. What nobody can agree on, however, is when the expansionary approach should stop: now, in the near future, in the medium or even long-term?

The question to this paper can only be answered through an assessment of the state of the economy. This article supports the idea that the economy has not yet entered a phase of sustained recovery and that, as a consequence, the expansionary approach should be continued for a certain amount of time. It argues that, despite some positive signs, many of the figures remain dwindling. Unemployment is still significant and economic growth remains small. This article also proposes that the Federal Reserve put aside, for a while, its continuous focus on inflation, and look into some of the measures that need to be taken in order to combat the growing unemployment.

Expansionary policy is a policy that aims to "expand the money supply," usually done to encourage economic growth (Investopedia, n.a.). From a monetary perspective, this is done when the Federal Reserve increases the money supply available in the economy. From a fiscal perspective, this can be done with decreased tax rates that help boost the economy. In either case, governmental spending is also used to finance project, thus creating jobs. From a monetary perspective, this is also where the multiplier effect is used. When the Federal Reserve increases its monetary base (by printing money), other monetary aggregates, like bank deposits, increased by a lot more. The respective different is the multiplier effect.

What does ending the expansionary policy mean for the Federal Reserve? An exit strategy will include several components. First of all, it would mean divesting some of the investments that the Fed has helped finance in 2009. These are the famous bailouts that the government committed to and that meant that, in a highly unusual fashion, the state purchased parts of private entities. Second of all, it is all about interest rates: raising interest rates would allow the Fed to reduce the money supply, because there will be greater incentives to place money in bank deposits rather than spend them (which would actually encourage consumption and, potentially, inflation). Keeping interest rates low, however, would lower that incentive: people would likely not place money in deposits, but would rather spent or invest in the economy.

Beyond these theoretical considerations, in order to defend this point-of-view, a useful place to start is the Federal Reserve's own position on this topic, as expressed by Janet L. Yellen in a testimony before the Senate Banking Committee. She stated that time for an exit had not come (Mankiw, 2013). In her view, unemployment remained too high and the Fed still needed to help. She turned away from arguments that this could foster inflation, because, in her opinion, inflation was below the 2% benchmark.

Even someone like Mankiw, who opposes this approach, admits that numbers support the story. Unemployment is 3% higher than in 2006, just two years before the crisis. The employment to population ratio is 5% lower (Mankiw, 2013). Unemployment seems to be the core issue in this case and it cannot, as Mankiw does, be attributed to an aging population. Let's look a little closer into this unemployment issue.

What does unemployment basically mean? People who are not working will not be able to earn money. In the end, this in turn leads to a decreased consumption, which means that the products and services that companies are making and launching on the market have no demand.

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No demand eventually means lower supply and lower economic activity. As it is obvious, this will lead to a continuous economic crisis, with dramatic consequences.

Unemployment can also mean, as Paul Krugman commented, hysteresis (Krugman, 2013). Hysteresis is a phenomenon whereby unemployment becomes structural. Structural unemployment is almost perpetual: the problem becomes so systemic that it is difficult, if not impossible, to combat it, no matter what the policies that the Fed adopts. This is a real and dangerous threat. An unemployment rate of 10% during a year can be a problem, but it is still a problem that can be solved. A systemic, continuous 10% unemployment will translate into lower economic activity and decreased economic growth rates.

Mankiw's arguments against Fed continuing its expansionary policies are pertinent, but limited in that they look only at the figures that help support the idea that this policy should be stopped. One such figure is the average hourly earnings of production and nonsupervisory employees, which grew to around 2.2%, from 1.3%.

Another figure he prefers is the vacancy rate, which, in his opinion, also favors the view that the economy is back to normal. In Mankiw's opinion, if analyzed more profoundly, the labor market is not a depressed market: the signs are there to show that the labor market, and, to a larger degree, the entire U.S. economy has actually rebounded. His approach is, however, a mild one: he does not suggest the Fed should stop the expansionary policy straightaway, he merely suggests that the Fed Chairman should be flexible and ready to change her position, if the case may be.

The arguments against continuing the expansionary policy should actually be related more to inflationary threats. Employment and inflation rates are closely linked, to the degree to which some support the idea of a relationship of inverse proportionality (when one decreases, the other rises). So, the expansionary policy, according to some opinions, will lead to an inflationary pressure. The U.S. is adverse to inflation since, probably, the days of Jimmy Carter, when inflation was at double-digit levels. Democrats or Republicans have subsequently rigorously followed on Reagan's conservative policies aimed to combat inflation.

However, as Krugman points out, these are different times. The danger of economic stagnation and high unemployment is a greater threat today than inflation. As the Fed Chairman showed, the inflation rate is well below 2%. It should be allowed to grow slightly higher, maybe even to 3% or 3.5%. With the effects of the economic crisis still looming, it is not inflation that the authorities should be focusing on, but actually sustainably restarting the economy. The positive figures of the labor market that Mankiw has delivered are not enough to conclude that the economy is up and about.

Another issue is housing. Some argue that the Fed is too focused on housing. An expansionary monetary policy could encourage an increase in housing prices, because of higher consumption rates and greater revenue because of higher employment rates.

A greater problem with the expansionary policy is deciding when to actually stop it. This article has already concluded that now is not the time, because unemployment is still too high and because the economy has not really showed the best signs of rebound. However, everybody is in agreement that expansionary policy cannot run forever.

So, the Fed's challenge is this: when to stop pumping money into the economy? This is difficult to evaluate. Likely, the Fed should look at the economic growth and take the foot off the pedal when consecutive quarters of economic growth are confirmed. It should probably also look at how big this rate is: a 0.5% rate is not really enough to conclude that the economy is working properly again.

The Fed could also take into consideration alternative or complementary measures that could be implemented beyond an expansionary policy. Regulation that would allow the banks to relax their crediting policy can be implemented without necessarily pumping more money into the economy. Once the economy has been restarted, it should function on its own, so some of the Fed's policy should also be directed to what comes after......

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