According to Knittel, the effects of the financial crisis which originally developed form the sub-prime lending is further compounded by worries of global inflation in the broader U.S. economy(Knittel 2007). The worries regarding global inflation are the main cause of the ineffectiveness of the stimulus package drawn by Fed in the beginning of the year. The origin of the crisis was as a result of lax lending in the property market which at the time was further fuelled by easy monetary policies in 2001. The speculation in the property market proved to be very disastrous for the U.S. economy. The approach taken by Fed at the time was to encourage low interest rates boosting consumer spending fuelled by low mortgage prices. This enabled a property boom that saw the U.S. register a record surge in house ownership. This in turn increased spending which further pushed housing prices up. This implies that instead of Fed averting one problem, it introduced an even greater problem.
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Instead of eliminating and reducing undisciplined spending, the Fed encouraged another round of speculative spending. The world's most sophisticated financial tool, the CDO was used to package and securitize mortgage loans and then sold to equity markets across the globe. The predications of Fed were that as long as house prices maintained their stability or kept on rising, the housing bubble could not bursts and that the economy could survive on its indiscriminately spending. Fed was also encouraged by home owners, central bank, speculators, lenders and investors implying that the continued borrowing by these parties would finance their spending.
This trend reached the height characterized by default rates becoming apparent and the wide-spread euphoria of a hike in house prices disappearing. The whole system of the mortgage lending and borrowing to finance spending eventually collapsed leading to an apparent economic crisis. The impact of the collapse of this system is not limited on the household income but spilled over to financial institutions and other government backed mortgage lenders such as Fannie Mae and Freddie Mac.
Generally, the economy is facing a slowed growth momentum and a possible recession complicated further by global inflation. This is at a time when customers are facing financial difficulties leading them to cut on expenses due to high debt level and a reduction in value of the property assets. The purchasing power of consumers is further undermined by global inflation rates which have been mainly caused by depreciating dollar value. This creates a cycle of crisis leading to further erosion in the purchasing power of consumers as well as imported inflation. This raises the question whether the stimulus package by Fed and the cut of interest rates by central bank will revive the aggregate demand which is the economic engine in current economic times.
What should Congress do?
During this time of economic crisis, the congress should address economic policies that affect near and long term economic performance. One of the areas that the congress can address is the tax policy. The congress should signal today what it expects to do on taxes in some few years to come. Maintaining lower taxes encourage labor and capital leading to increased economic activities. Another area that congress should address is mortgage market regulation by not extending new subsidies in the housing sector. This is because, an efficient mortgage credit industry is central to the country's economic future.
What Fed should do
Right now, the effectiveness of the stimulus package by Fed is dependent to some extent by foreign power. According to Bernanke, easing monetary policies by fed would further cause increased inflation and increased recession. One tool which Fed can use is change the reserve ratio. This will allow banks to lend less reducing the supply of money hence reduce inflation. Fed can also reduce the money supply through open market operations. The interest rates play an influential role in the economy. Fed's signal regarding the rate of interest in the financial market will hence address consumer behavior as well as regulate spending.
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