Introduction
Monetary Policy is one of the powerful economic instruments, which a central bank employs to realize various kinds of economic and political-economic objectives. Generally, economies/countries prefer monetary strategies and instruments to stabilize the economy and to ensure economic progress, as the cost of employing economic strategy/instrument is quite low. In contrast, the cost of implementing fiscal policy is higher and frequent reliance on fiscal policy, to realize political-economic objectives, complicate economic realities. Naturally, monetary policy is favored as an economic strategy/instrument to 1) bring about change and 2) stabilize economy (first line of defense) (Solow, 1999).
When a sub-prime economic crisis, which transformed into The Great Recession, appeared, economies around the world strived to address this challenge by emphasizing monetary policy. For instance, the Federal Reserve, of the United States, devised expansionary monetary policy, which intended to increase the size of investment and general price level by reducing interest rates (Amadeo, 2018).
Interest rates are negatively associated or related to investment, which implies that when interest rate increase, the size of investment in an economy decreases (mostly) and vice versa. Countries/economies usually devise expansionary monetary policy when the deflationary period, which could be periodic or seasonal, begins. However, when an economy starts to heat-up (inflation increases), the contractionary monetary policy is devised and implemented.
The monetary policy, which the United States devised and implemented during the sub-prime mortgage crisis, produced its results gradually and it was able to core economic issues, which were 1) economic growth and 2) high or full employment. As long as this policy was in force, general price level and consumption (the engine of growth) also augmented. The increase in general price level was encouraging to a point, but now when the price level is indicating to breach the upper threshold, Federal Reserve seems worried. The Federal Reserve has claimed that signs of heating up of the economy have appeared which demand an increase in interest rates (contractionary monetary policy). This claim has started a debate among economists about whether the projection of the Federal Reserve, about the economy, is valid or not (Baumeister & Benati, 2013).
In this academic exercise, we will examine the claim of the Federal Reserve and analyze how the economy is working. Also, we will also project how the economy will perform in short and midterms.
Literature Review
Capitalist economic systems are prone to economic crisis. In fact, the capitalist system is inherently flawed, which is why it periodically produced extraordinary periods of economic activity. However, when we study various economic crises, which affect the global economic system, we learned that usually, it is either the reckless behavior of industries or imprudent economic policies that cause an economic crisis. Sometimes, it is both reckless behavior of industries and imprudent economic policies that yield economic crisis (Amadeo, 2018).
One such example is the sub-prime mortgage crisis, which evolved into a global economic recession (The Great Recession). Large firms influence economic systems to devise such policies that impaired systems of check and balance (economic). The impunity to be reckless and greedy adversely affected the financial and economic system of the United States, which gradually broke-down to the point where the economy could not expand at the desired and projected rate (Baumeister & Benati, 2013).
This unusual and adverse economic situation demanded a proactive role of the Federal Reserve, which had already failed to project economic crisis. The Federal Reserve devised an expansionary monetary policy, which aimed to increase 1) volume of investment and 2) general price level. Expansionary monetary policy reduced interest rates, reserve ratio, and increased money supply, which intended to act as an incentive for investors. However, in the initial phase of the crisis, the economic condition did not change, as a reduction in interest rates failed to excite investors to invest in the economy. Also, because of a decrease in investment, employment level also dwindled, which reduced both consumption and inflation rate (Feldstein, 2018).
In the absence of effective monetary policy, the emphasis shifted towards fiscal policy. Obama Administration introduced a fiscal stimulus package, American Recovery, and Reinvestment Act) that offered tax cuts of $288 billion and increased spending around $224 billion. In addition to that, the act also allocated around $275 in the form of different kinds of grants and loans.
This expansion was in force, until very recently. The Federal Reserve has increased interest rates, for the third time, in a decade. The latest increase is of 0.25%, which has increased the interest rate to 2%. This increase will affect short-term loans and mortgages, which will directly impact on economic activity within the United States. The rationale provided by the Federal Reserve, for this hike in interest rates, is signs that the economy is heating up. For instance, the increase in investment, because of changes in economic policy, has not increased employment much; however, it has affected wages slightly. It is taken as evidence, by the Federal Reserve, that the American economy is at full employment (Mathews, 2016). However, many economists disagree with this projection that the economy is heating up. They assert that though unemployment might be at its natural rate, wages are still low, which affects savings and consumption. The increase in interest rates will reduce the size of investment in a resuscitating economy, which affects both prices and consumption (Long, 2018).
Economic Analysis
It is very apparent that the economy is at full employment level, which means that any increase in investment will not increase output. As there will be no increase in output, economic growth (regarding goods and services) will remain the same. It may affect the quality of the economy and international trade.
The above graph depicts the situation in the labor market. It is quite apparent that supply of labor is fixed after a certain point, which the United States’ economy reached in January of this year. The shift in the demand for labor is the result of expansionary fiscal policy (fiscal stimulus), which has been introduced by Trump Administration. This increase in demand, because of exogenous factors, has pushed the wages upwards, as reported in economic reports published by economic/financial institutions.
The Federal Reserve is of the viewpoint that increases in investment, at the current rate, will increase inflation, which affects the economy adversely in the long run, especially the size of consumption and savings. Therefore, interest rates must be increased to avoid an extraordinary increase in the general price level. The Federal Reserve also projects an increase in the volume consumption size, which is the engine of growth. If it couples with an increase in wages, this may increase the general price level at an unusual rate.
Reports suggest that wages are not desired level, which is adversely affecting the economy. The low wage rate is affecting the quality of the economy, which is why it is essential to let both wages and prices increase. Currently, the inflation rate is above 2% and below 4%, which is considered healthy. Federal Reserve, it seems, intends to keep inflation ate at this point; however, this policy is affecting wages that directly affect the quality of economy.
United States Inflation Rate Graph
United States Inflation Rate Graph adapted from Trading Economics. (2018, July 28). United States Inflation Rate. Retrieved from https://tradingeconomics.com/united-states/inflation-cpi
As per the analysis, if the Federal Reserve allows the economy to heat-up a little, it will positively affect wages, which is a real concern right now. Wages seem to very stagnant and sticky upwards, which is heating up of the economy will not dramatically affect general price level, but rather gradually it will affect it. Also, the general price level is around 2.8%, which means that the Federal Reserve has room to experiment and take the risk. It is essential to understand that the real issue for an economy is not inflation, but rather deflation. When a large economy, like the United States, has an inflation rate of 5-6%, then it is a real concern. However, if the inflation rate is below 4%, it is considered healthy. Also, increases if increases in wages will be greater than the inflation rate, real income will increase, which will increase the size of savings. Savings are very important for the economy, as they eventually translate into investment.
Conclusion and Summary
In the end, it is concluded that the expansionary fiscal and monetary policies have addressed various challenges, which the United States’ economy was facing. Fiscal stimulus, in the form of ARRA and Trump’s Economic Stimulus, has increased the size of investment and facilitated the economy to reach full employment level. However, the wages remain the issue, as they have increased as per expectations. The contraction policy, devised out of fear of possible inflation, will negatively affect investment and wages, which will deteriorate the quality of the economy and reduce real income (eventually consumption and savings). Therefore, the Federal Reserve’s contractionary economic policy is uncalled for, and it will adversely affect the economy in the long run. As per our projection, the economy must be allowed to heat up so that it can push wages up and improve the quality of the economy. It will not affect trade drastically, by making exports expensive, as products that the US economy exports are unique and are mostly technological products. It is essential to increase wage in the United States, as it directly influences consumption size, which affects the size of the industry.
The Federal Reserve has increased interest rates, as it fears that an increase in investment will increase general price level, as the economy is at full employment. However, it ignores that wages are still low (not at the desired level) and the inflation rate is only 2.8%, which reduces the size of risk associated with the strategy to allow the economy to heat up.
References
Amadeo, K. (2018, June 30). Subprime Mortgage Crisis, Its Timeline and Effect. Retrieved from https://www.thebalance.com/subprime-mortgage-crisis-effect-and-timeline-3305745
Baumeister, C., & Benati, L. (2013). Unconventional monetary policy and the great recession: Estimating the macroeconomic effects of a spread compression at the zero lower bound. International Journal of Central Banking, 9(2), 165-212.
Feldstein, M. (2018). Normalizing Monetary Policy. Cato Journal, 38(2), 415-422.
Long, H. (2018, June 13). Federal Reserve bumps up interest rate, signals two more hikes likely in 2018. Retrieved from https://www.washingtonpost.com/news/wonk/wp/2018/06/13/federal-reserve-bumps-up-interest-rate-signals-two-more-hikes-likely-in-2018/?utm_term=.8d8d2de1eb6d
Mathews, C. (2016, February 5). The U.S. Economy Is Finally at Full Employment. Retrieved from http://fortune.com/2016/02/05/full-employment/
Solow, R. M. (1999). Inflation, Unemployment, and Monetary Policy. MIT Press.
Trading Economics. (2018, July 28). United States Inflation Rate. Retrieved from https://tradingeconomics.com/united-states/inflation-c
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