MONETARY POLICYHow the Global Financial Crisis 2007 was a result of

Loose Monetary policy in the US

MROL

AGENDAS FOR THIS PRESENTATION

What is Monetary Policy and types of Monetary PolicyKey Events Influencing to the Global Financial Crisis 2007

How Expansionary Monetary Policy led to the GFC 2007The Response of the Federal Reserve

Conclusion

WHAT IS MONETARY POLICY

Expansionary or Loose Monetary Policy

• Attempts to promote aggregate demand growth.

• Reserve bank encourages private consumption by Increasing the amount of money in the economy,

• When the quantity of money in circulation is being rapidly increased, interest rates are thus being pushed down which encourages lending and investment.

• The increase in consumption and investment leads to a higher aggregate demand.

Contractionary or Tight Monetary Policy

• Attempts to slow aggregate demand growth.

• The central bank discourages private consumption by decreasing the amount of money in the economy.

• The quantity of money available is being reduced, the interest rate increase, which discourages lending and investment.

• Higher interest rate promotes saving, which further discourages private consumption. The decrease in consumption and investment leads to a decrease in growth in aggregate demand.

Actions by the Reserve/Federal Bank to affect the price as well as the quantity of money and credit in order to influence economic activity

KEY EVENTS INFLUENCING TOWARDS THE GFC 2007

• The bursting of the dot-com bubble, which saw the booming NASDAQ over 1998–2000 burst in 2001.

• Fearing a downturn and possible deflation, the US Federal Reserve eased monetary policy in 2001 in a series of steps till 2004.

• Boom in house prices followed and a period of high growth in credit and leveraged loans due to easy credit and a rising housing market

• Rising demands from China (and, to some extent, India), plus a booming world economy saw commodity prices rise across oil, minerals and food from late 2004 to late 2007. The shock to the global economy from this commodity price boom was as big as the first oil shock in the 1970s.

• Rising prices and inflation caused monetary authorities to tighten policy from mid-2004 to June 2006.

HOW DID LOOSE MONETARY POLICY LED TO GFC 2007 IN THE US?

Due to the long term application of Expansionary Monetary policy by the Federal Reserve• Started in 2001-2004• Gave rise to the asset price bubble and commodity price spike.Led to the creation of the US housing bubble

• Low interest rates• Adjustable-rate mortgages appeared to be very attractive to potential

buyers or prime buyers (responsible borrowers)• The Federal Reserve continued to liquidity into credit markets to ensure

that credit would continue to flow at low rates of interest• Support for the Sub-prime (most risky borrowers) market

• Easier and cheaper low interest rate of from 2.8 in 2001 to 1.3% in 2007 (House of Commons Library 2009)

House of Commons Library (2009)

US National Home Price Index 1987-2008

HOW EXPANSIONARY MONETARY POLICY LED TO THE GFC 2007

Loose monetary policy also led to imprudent mortgage lending caused by the web of financial instruments.• When prices began to fall, loans started going bad.

Consequences:• The house prices started to fall• Number of foreclosures of houses rose dramatically• Bear Stearns announced a large loss, the fall of Lehman Brothers and a

series of fall of investment and insuring companies like AIG

THE RESPONSE OF THE FEDERAL RESERVE

Prior to September 2008Governing institutions in the US primarily pursued to address liquidity concerns, stimulate demand and prevent mortgage foreclosures. The main policy responses included: • Lowering interest rates as well as a introducing number of liquidity-

enhancing schemes to abate the emerging credit crisis by the Federal Reserves

• The orderly takeover of failed investment bank Bear Stearns • Stimulate demand and mitigate mortgage foreclosure.

THE RESPONSE OF THE FEDERAL RESERVE CONT.

Response after October 2008The Federal Reserve and the US Treasury became a key body in administering the Emergency Economic Stabilization Act passed by Congress in October 2008. The central features of the post-September response included: • Continuing efforts from the Fed to lower interest rates and increase liquidity; • Federal Reserve and US Treasury decision not to bail out investment bank Lehman

Brothers• Treasury-administered capital injections into troubled financial institutions in exchange

for preferred stock and common equity stakes• Sequence of bailouts by the Fed and Treasury for the insurance giant AIG; • The temporary suspension of the short-selling of financial institutions by the Securities

and Exchange Commission; • The Homeowner Affordability and Stability Plan, which permitted struggling

homeowners to refinance their mortgages

THE RESPONSE OF THE FEDERAL RESERVE

APPLICATION OF QUANTITATIVE EASY (QE) POLICY

• Lower interest rates encourage people to spend, not save. But when interest rates can go no lower, a central bank's only option is to pump money into the economy directly, this quantitative easing (QE).

• To revive consumer spending and economic growth• Cutting interest rates to raise the amount of lending and the economy indirectly• The way the central bank does this is by buying assets - usually government

bonds - using money it has simply created out of thin air.• The institutions selling bonds (either commercial banks or other financial

businesses such as insurance companies) will then have "new" money in their accounts, which then boosts the money supply.

CONCLUSION• GFC revealed the importance of establishing conditions to

ensure the continuous functioning of the financial system

• A long period of expansionary monetary policy should be avoided as they could produce inadequate incentives

• Central banks and other regulators should have a tight framework of mortgage

THANK YOU!