Abstract
After the Great Recession, policy makers implemented fiscal and monetary policies to manage the aftermath of the catastrophic market crash. By analyzing macroeconomic principles such as inflation, alterations in unemployment, price levels, gross domestic product, and national income, this paper identified the key monetary and fiscal policy actions that were enforced by the Federal Reserve in response to the Great Recession. Furthermore, by examining the knowledge from lecture and other economic concepts including automatic mechanisms, equilibrium, supply shock, and currency, this policy project reported the essential facts and statistics in regard to the success of the Federal Reserve’s economic policy decisions during the financial crisis.
Keywords: Great Recession, Economics, Fiscal policy, Monetary Policy
The Great Recession was a horrific tragedy that involved a swift economic decline, which occurred from December of 2007 to June of 2009. During the mid-2000s, the American housing boom, financial institutions started to sell complex derivatives and mortgage-backed securities at an enormously high rate. However, in 2007, the real estate market plummeted, which resulted in a substantial number of these derivatives and securities to lose immense value (Investopedia, 2018). The crash produced a lack of solvency in financial institutions and banks across Europe and the United States. At the time, the global economy was already experiencing the unraveling of the credit crisis, but things began to culminate when the fourth strongest investment bank declared bankruptcy. Financial contamination quickly developed in a multitude of countries, especially Europe. The Great Recession incurred tremendous effects on the United States, such as the loss of seven and a half million jobs, unemployment skyrocketing, and the extreme destruction of household finances as a result of the stock market (Investopedia, 2018). Nonetheless, policy makers established countless fiscal and monetary policy actions, in order to alieve the havoc and chaos of the Great Recession.
Fiscal Policy
As a result of the 2008 financial crisis and the consequent recession, the United States began to implement abnormally constant and high budget deficits. Some parallels are able to be drawn between the recent fiscal policy decisions in the United States, with the two world wars and the Civil War (Martin, 2012). The connections and distinctions between these events are able to shine some light on the United States’ financial position and display the current unease about the potential of utilizing higher inflation rates to finance the nation’s debt. According to the most recent approximations of the Office of Management and Budget, “the primary deficit—outlays net of interest payments minus revenue—averaged 8.6 percent of GDP between fiscal years 2009 and 2011” (Martin, 2012). Furthermore, the primary deficit of gross domestic product from years 1955 to 2008 was nearly zero percent (Martin, 2012). Similar to the primary deficit to GDP ratio during the Great Recession, the average deficit during the Civil War was eight and a half percent. The rates during World War I and World War II are the highest primary deficit ratios to be recorded, even after the Great Depression in which the New Deal legislation of 1933 to 1936 was enacted (Martin, 2012). Furthermore, one of the repercussions of steep liabilities is considerable surges in government debt. Fernando Martin states, “At the end of the FY 2001, debt held by the public—net of holdings in Federal Reserve Banks—was estimated at about 56 percent of GDP” (Martin, 2012). Merely the years during World War II and directly after hold the highest debt to gross domestic product ratio (Martin, 2012).
Although there are striking similarities between the debt to GDP and primary deficit to GDP ratios, there are three crucial variations in the government’s response and policy resolutions in the most recent recession and the three wars. To start, deficits that are incurred during war periods can be justified by momentary, yet generous raises in expenditures of the defense. Nevertheless, revenues begin to rise for much longer duration than expenditures, which creates a fiscal surplus after the war is over (Martin, 2012). The prevailing larger deficits are following a pattern of growing expenditures and shrinking revenues. The article declares, “the average of five years preceding the financial crisis and recession (2004-08), outlays net of interest payments increased by 5.0 percent of GDP” (Martin, 2012). A majority of the total increase was because of individual transfer payments from the local and state governments. In addition, the article claims, “revenue fell by 2.8 percent of GDP as a result of combined tax cuts, credits, rebates and also likely due to depressed economic activity” (Martin, 2012).
Secondly, the article presents a graph that demonstrates the real gross domestic product per capita that are deviations from the normal trends. During the three wars, the chart displays a significant boost in output, yet it is present status is below trend (Martin, 2012). The deviation from the current can be related to the heavy dependence on government transfer payments instead of purchases.
Thirdly, the essay contains another chart that depicts the substantial expansion of inflation rates during all of the three wars. In the subsequent events after World War II, the real value of compiled debt was dwindled by the utilization of the high inflation rates. In comparison to the aftermath of the most recent recession, inflation rates were nominal and averaged nearly 1.3% annually (Martin, 2012).
As demonstrated throughout this article, the Federal Reserve is committed to preserve low inflation rates and will do so by gaining more independence. Although there has been a sharp incline in national debt, the desire for assets that are issued by the government in the United States continues to escalate. Furthermore, in order to avoid the troubling scenario that followed World War II, the Federal Reserve needs to monitor the accumulated debt and ensure that inflation rates do not expand, in order to relieve the fiscal strains (Martin, 2012).
Monetary Policy
Not only did fiscal policy play a large role in the Great Recession, but monetary policy as well. The years during and after the Great Recession presented a new era for monetary legislation in the United States. Before 2008, there was an excess of five hundred basis points in the Federal Reserve’s policy rate. However, in the year 2008, that rate plummeted by four hundred and seventy-five points, and has continued to remain at twenty-five basis points (Andolfatto, 2015). Furthermore, preceding 2008, the Federal Reserve’s security holdings and liabilities were beneath one trillion dollars, which equates to nearly seven percent of GDP. Today, the Federal Reserve’s balance sheet towers over four trillion dollars and accounts for twenty-five percent of gross domestic product (Andolfatto, 2015). The Federal Reserve began to sail unexplored waters because of the rising sum of debt that was incurred due to the surplus of reserves in the banking system. Before the Great Recession, these excess reserves were non-existent. Since the Great Recession, the United States’ economy has slowly recuperated. In 2009, the economy’s unemployment rate peaked at ten percent; however, that rate has dramatically decreased and now resides around four or five percent (Andolfatto, 2015). Although there were raises in consumption expenditures and the supply of base money, the inflation rate missed the Federal Reserve’s two percent goal during the majority of the restoration period.
In 2008, interest rates collapsed and were caused by not only the Federal Reserve, but natural market forces as well. Many of these forces were actively forcing interest rates to decline, which is a common occurrence when the perspective of the economy appears to be distressed. The negative outlook on the economy produced illogical fears and pessimism, which in turn caused businesses to invest at a lower rate and people to save a greater percentage of their income. Both of these factors contribute to a lower interest rate (Andolfatto, 2015). The Federal Reserve’s monetary policy actions after the Great Recession should be deemed correct and effective because they attempted to adapt to the economy’s desire for a lower interest rate. If the Federal Reserve did not pursue an adjustment, the interest rates would have skyrocketed to an obscenely high level, which would have only further intensified the lack of investment and consumption spending by businesses and people.
Furthermore, during the Great Recession there was a dramatic rise in base money, yet this increase does not clearly effect the inflation rate or price levels. The Federal Reserve’s policy rate was directed downwards, which allowed for more effective routes to be enacted in these lower bounds. In this case, many of the Treasury’s government liabilities were converted and re-labeled as Federal money, due to the increase in supply of low interest-bearing money (Andolfatto, 2015). Therefore, the increase in overall government liabilities during the Great Recession had a direct impact on balancing price levels. The Federal Reserve then began to create Quantitative Easing Programs that did not have an effect on the deficit; however, the programs changed the amount of reserves in the banking system and configuration of the debt. Due to the liquidity quagmire, the rise in base money did not influence price or inflation levels. Moreover, the conversion from Treasury liabilities to Federal debt increased the money that remains in the reserves of the banking system (Andolfatto, 2015). Although it seems that this new money will pose a problem to inflation rates, the Federal Reserve acquires a multitude of monetary policy mechanisms such as reversing the effects of the QE programs and increasing the interest on required reserve balances and excess balances rate that will control inflation.
The 2007-2009 Great Recession took a tremendous toll on the citizens around the world, especially the United States. Millions of people lost their homes, jobs, and quality of life; however, the policy makers in the Federal Reserve constructed monetary and fiscal regulations to aid in the stabilization of the economy. The Federal Reserve continues to demonstrate the willingness to strive towards decreased inflation rates and stimulate more activity in the economy. If inflation remains stable and market activity increases, the economy will continue to rebuild and soon start to prosper.