Demand-Side Policies and the Great Recession of 2008, Essay Example

The changing business cycles that characterize free and fair markets lead to the development of recessions. Economic recessions are periods of economic decline characterized by a reduction in industrial and trade activity. This is defined by a decline in the gross domestic product (GDP) within a period of two financial quarters. Economic recession is caused by a number of factors, most of which can be influenced by the implementation of economic policy. However, there are some instances when government involvement in economic facets causes the tendency towards a recession. It is important that government maintains the balance in these conflicting economic facets.

Fiscal Policy

Balance of Trade

The balance of trade is an important indicator as to the health of a given nation’s currency. The balance of trade is the difference obtained from the monetary value of exports and imports. This is an important economic indicator as to how the country can sustain itself from its own production activities relative to the amount of commodities or raw materials it is importing from external sources. The value of a given nation’s currency largely depicts the strength of the economy. In order for the United States to realize economic stability, it has to ensure a positive balance of trade (Hubbard & O’Brien, 2013). This is because a negative balance of trade depicts negative implications on the value of the dollar.

China is one of United States’ biggest trade partners. Considering the current political relations between the two countries, it is essential that the balance of trade between the two countries be analyzed. There is a general negative balance of trade between the United States and China as most the United States imports more from China than it exports to. There was a temporary decrease in the negative balance of trade position from 2008 to 2009, however, this negative balance of trade has continued to increase since then at $-226,877,204,877 in 2009 to $ -318,417,203,265 in 2013 (International Trade Administration, 2014).

Deregulation of Markets (Capitalism)

Too much market regulation causes the tendency towards a recession. In order for government to ensure a positive economic environment, some industries have to be deregulated, especially those that are controlled by monopolies (Blanchard & Johnson, 2013). By creating an environment where competition dictates the trends the markets assume, prices will go down, as quality increases and variety is brought into the different markets. This allows consumers to choose between a wide range of products at an affordable cost. By deregulating the markets, the government will have triggered an increase in output that will translate to an increase the flow of currency within the economy. This will trigger an increase in consumption that is as a result in increased demand.

Monetary Policy

There are several instruments that the Federal Reserve has used to conduct monetary policy. Each instrument affects the size of the monetary reserves available to depository financial institutions. The institutions are required to maintain reserves against the amount of money deposited by retail and corporate clients, such as checking accounts, savings accounts or certificates of deposit. The reserves can be held in the bank’s vault or by depositing the cash in one of the Federal Reserve banks. The sizes of the amount of deposits relative to the amount of assets the financial institution can acquire are set by the Federal Reserve. These assets are often referred to as credits as they may form loans made to consumers and businesses (Marc Labonte, 2013, p. 3)

There are three ways in which the Federal Reserve can expand or reduce the supply of money and credit.  The main way is called open market operations. In this method, the Federal Reserve buys existing United States Treasury bonds and bills or securities that have already been bought and sold privately. It purchases these with newly issued Federal Reserve Notes. This increases the amount of reserve base and allows lending institutions to make more loans and increase credit since their leverage ratio is improved. The reverse is true if they sell securities.

The second method is for the Federal Reserve to change the reserve requirements by managing the amount of deposits a financial institution must hold in their vault or on deposit with the Federal Reserve Bank. This affects available capital in the market for loans. In later 2008, the Federal Reserve started to pay interest on the required and excess reserves. This reduced the cost of holding the money versus lending it out. The third method of influencing the money supply is through permitting certain financial institutions to borrow from the Federal Reserve Bank on a temporary basis. They are charged a discount rate which is lightly higher than the federal funds rate to check default risks. These transactions are usually on an overnight basis. This method was an important source of reserves for many institutions during the recent financial crisis (Marc Labonte, 2013, p. 3).

Effectiveness of Monetary and Fiscal Policy

The quantity theory has not effectively worked in the situation of the great recession. This is because the theory assumes that when money is injected into the economy, this would trigger the full employment of resources that would increase expenditure and output. However, the funds used to bail out banks in the great recession was not completely directed to boosting investment and expenditure. Most of the bailed out banks paid out huge bonuses to employees.

While the Fed has opted to sweep the Federal Reserve so as to bail out banks, lending has considerably decreased as most investors have opted out of trading the riskier financial instruments that led to the eventual great recession. The multiplier is currently not working as it should owing to the fact that all resources have not been fully employed.

The recent money supply growth raises concerns as to the effect it has on the currency itself. Other international currencies are gaining strength of the US Dollar, making the U.S, Market less competitive as investors and traders look to trade with Asia. This is largely due to the fixed value of most Asian currencies such as China’s.

The Fed’s eventual exit strategy would be the gradual restoration of interest rates that the commercial banks loan from the Fed. This would gradually and steadily ease the economy back to the market-determined position. This can be seen in the end of the “Bush Tax Cuts” that would restore tax and interest rates to a market-determined position. The eventual risks associated with this exit strategy include a sharp increase in taxes and a devaluation of the U.S. Dollar as it faces competition from alternative markets.

References

Blanchard, O., & Johnson, D. R. (2013). Macoreconomics. Boston: Pearson.

Hubbard, G. R., & O’Brien, A. P. (2013). Economics. Boston: Pearson.

International Trade Administration. (2014, April 1). 2013 Balances with China for NAICS Total All Merchandise.Retrieved May 29, 2014, from TradeStats Express: http://tse.export.gov/TSE/ChartDisplay.aspx

Marc Labonte. (2013). Monetary Policy and the Federal Reserve: Current Policy and. Washington: Congressional Research Service.