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Money and Banking Essay

The US Economic crisis brought with it- decline in employment rate, slowed economic growth and hardships for both businesses and households. It also revealed some large discrepancies in the overall financial system and the heavy burden that was put on the fiscal and monetary policy of the nation to cope up with the spillover effects. With this paper, we aim to have a second look on how monetary policy of United States was a precipitating factor for the sub-prime crisis and how the latter affected the former.

The greatest burden on the financial regulators was to recover the monetary policy in a way that does not increase the risk of inflation, yet reducing the risk of downturn. Monetary policy prior to the financial crisis An overly expansive and unconventional monetary policy adopted by the banks and Federal Reserve in United States contributed to the financial debacle. Excessive poor leveraging, absence of collateral and underestimation of market risk exposed large financial institutions to debt instruments and credit uncertainty. Since the 2000 technology meltdown, lion’s share of the US currency is held outside the nation.

There has been much of monetary aggregate growth than real economic growth in United States, coupled with evidences of

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excessive liquidity in financial markets like Asia. The Federal Reserve is claimed to observe very loose monetary policy during the period 2002-2006, low interest rates actually gave rise to the housing bubble (Boyd & Gertler 1994). An accommodative policy accompanied by sustained inflationary trend instilled confidence in US banks that they could limit the interest and inflation rates indefinitely, resulting in excessive risk taking and risk underestimation.

Anticipating ample liquidity and all favorable trends, banks failed to assess market risks with ignorance towards surprise elements in the policy. Easing of the monetary policy not only resulted in loosening of standards but also in elevated prices of assets across the globe. This further resulted in dilution of risks and pressures. The economic crisis originated in the credit market but soon diffused to debt and money markets. This percolation was due to the following reasons: • Asymmetric relationship between borrowers and lenders where the lender did not possess sufficient knowledge of the credit quality of borrower.

• Using automated computer models to finance mortgage loans, rather agents and brokers that could collect and judge more information about the credit quality of borrowers. • Loosening of bank regulations and over exposure to prime lending without accounting for embedded risks in the instruments. Monetary policy after the crisis Maintaining economic growth amidst inflationary trend was the major challenge ahead Federal Reserve and monetary policy of United States. The biggest difference between the Great Depression of 1930 and the current US economic crisis was the fact that there was much of money supply in the latter case (Lothian 2009).

As the economic crisis unfolded, central banks started providing liquidity injections to the debt-struck financial institutions to meet their heightened liquidity needs. Especially the Federal Reserve and the European Central Bank deciphered that the existing policies are not adequate and developed new ways of dealing with inflationary pressures and modifying the lending rules. In order to improve the functioning of financial markets, the federal funds rate was lowered down from 5. 25 percent to 2 percent to help recover the broader economy from disruptions.

Money supply is the characteristic of the banks where balance is to be achieved in loans being taken and loans and interest being paid. For US, the mortgage crisis left the banks with no alternative option to secure liquidity and cash position. Failing to determine the actual credit quality of borrowers, banks started lending aggressively and finally, when borrowers defaulted in paying off the liabilities, banks run out of cash (Mohan 2007). There has been a statutory limit of reserves placed on banks which makes it mandatory for them to hold a certain percentage of cash.

However, US banks started taking loans for repayment of interest and old loans that were actually defaulted by borrowers. This resulted in higher interest rates and banks insufficient to provide further credit and loans to borrowers. Simultaneous increase of money supply by central banks and debt resulted in devaluation of purchasing power which ultimately led to inflation. How this was triggered by the financial forces is as under: • After the current crisis evolved, there was much emphasis on short-term liquidity recovery which was accomplished by printing more money.

This automatically resulted in inflation and hyper-inflation. • Failure of banking system led to the shrinkage of transactions and absence of tradable money, disabling exports and imports. • Difficulty in trading against goods and services further worsened the situation in the way that prices sky rocketed and there were increased stances of civil unrest. Recommendations Summing up, world is still struggling to restore the financial and economic conditions pre-recession. Banks have run dry, unemployment rising and prices soaring high.

Amidst such turbulences, debt conditions have been affected significantly and the US policy makers now need to take prudent steps in reducing the harsh repercussions. As seen from Fig. 1, it is clear that the scale of debt and money supply problem is quite high for US and the probable solutions that stem out are differentiation between mandatory and non-mandatory spending, along with stringent and close supervision of banking policies and practices (Elmendorf 2010). Fig. 1: Source: IMF Fiscal Forum 2010 Conclusion

Need of the hour is to tighten the norms and regulations over commercial banks regarding lending powers and maintaining statutory liquidity conditions. To be able to manage capital effectively, it needs to increase with risk and drop down with losses. A fundamental reform in the Fed Reserve policies is demanded where both the government and the private sector has to play an equal role. It should consider not only the benefits that come out of the reform, but also the potential spillovers that result from situation getting out of control (Nanto 2009). Annotated Bibliography

Boyd, J & Gertler, M “The Role of Large banks in the recent US Banking Crisis. ” Federal Reserve Bank of Minneapolis Quarterly Review. 18. 1 (1994) This paper is an elaborative study of the crisis that happened during 1930 and its replication in 2007. From unemployment to interest rates, from inflation to failure of banks and from liquidity injections to bail out packages, the paper provides a squarely view of the crisis and its minute implications on various sectors and functions of economy. Elmendorf, D. W “US Fiscal Policy after the Financial Crisis and Recession.

” International Monetary Fund Fiscal Forum. (2010) The paper in discussion throws light on recent implications of financial crisis, especially from the Fiscal and Monetary Policy perspective. Through the use of graphs, charts and diagrams, it has been instrumental in clearing the concepts and providing better insights into how figures were manipulated, changed and impacted the economy. Suggested recommendations and their respective facts supported by data make it worth referring. Lothian, J. R “US Monetary Policy and the Financial Crisis. ” CenFIS Working Paper. (2009)

This paper in particular discusses the US Monetary and Fiscal Policy both prior and after the economic crunch. It brings a new dimension to the US monetary policy by conducting a comparison between the Great Depression of 1930 and the 2007 crisis. Subsequently, what the regulators had to do to overcome the obstacles have been discussed along with difficulties faced. In all, the paper is apt to know the basic differences in how policies have taken tectonic shift from 1930 to 2007 period. Mohan, R “Recent Financial Market Developments and Implications for Monetary Policy.

” Valedictory Address at IIF’s Inaugural Asia Regional Economic Forum. (2007) This paper is an eye-opener to some of the most implicit and unknown facts about the economic crisis of 2007. From the surrounding environment to the probable causes and policy changes before and after the turmoil are clearly explained and accounted for. Subsequently, steps and changes incorporated by policy makers are also elaborated to further equip the readers of the economy recovering from it. Nanto, D. K “The Global Financial Crisis: Analysis and Policy Implications. ” Congressional Research Service. (2009)

The present article discusses the widespread furore and unveiling weaknesses in the financial system prevailing in the economies. The article emphasizes on four basic steps to cope up with the crisis across countries, starting from extending the government reach to tightening the financial regulations and last but not the least, determining and recovering from the economic, political and social implications of the economic downturn. The paper helped in gaining a wider picture of how the crisis has affected not only US but also other nations and the role of private and commercial banks in resolving the same.

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