A recession is a business cycle contraction. At this time the economic activities are very slow (Sidlow 2010). During recession many macroeconomic indicators fall. These indicators include production, employment, household incomes, business profits, inflation, and investment spending and capacity utilization. On the other hand, bankruptcies and the unemployment rate rise.
Recession generally occurs when there is a widespread drop in spending. Governments usually respond to recession by adopting expansionary macroeconomic policies (William 2010). These policies fall under monetary policy and fiscal policy.
Monetary policy is the process by which the monetary authority of a country which happens to be the central bank under the government controls the money supply most of the times targeting a rate of interest for the purpose of promoting economic growth and stability. Monetary policy can either be expansionary or contractionary.
An expansionary policy increases the total supply of money in the economy more rapidly than usual while the contractionary policy expands the money policy more slowly than usual or even shrinks it. Fiscal policy is the use of government expenditure and revenue collection to influence the economy. Fiscal policy has three stances. Namely; neutral, expansionary and contractionary.
A neutral stance implies a balanced economy. This results in large tax revenue. Government spending is fully funded by tax revenue and overall the budget outcome has a neutral effect on the level of economic activity. An expansionary stance of fiscal policy involves government spending exceeding tax revenue. A contractionary fiscal policy occurs when the government spending is lower than tax revenue.
The recession in America was caused by considerable amounts of capital inflows from China, India and some of the oil rich countries whose economies were growing at a faster rate (Weller 2010). In addition, the low rate of interest in America economy encouraged easy lending by the commercial banks even to non-credit worthy customers. In the housing market the high prices had attracted heavy investment in mortgage backed securities. There were also major irregularities in the financial institutions bordering to fraudulent banking practices. Investment banks and hedge funds began encroaching onto the role of commercial banks acting as depositories and providing loans to non-credit worthy customers.
By late 2007 both credit and housing markets, bubbles burst as housing prices began to decline steadily and interest rates began to rise causing a decline in home values and raising mortgage repayment. The ability of commercial banks to lend money significantly declined and houses were repossessed as the public defaulted on repayment. Economic activities declined resulting in slow down in the country's GDP growth. Foreign countries that had invested in the American money market were the first to be affected by the crisis which later spread indirectly to other nations.
Monetary policy adapted during the great recession
During the great recession, the government adapted expansionary monetary policy. Expansionary monetary policy decreases the rate of interest which in turn increases private investment. This is because the demand for investment is downward sloping in relation to the interest rate. An increase in investment starts the multiplier process and increases national income by a multiple of the amount that investment increased. The rise in investment causes income to rise since it is one of the components of aggregate expenditure. Expansionary monetary policy tends to increase money supply, decrease the interest rate, increase investment and increase both income and output.
The Central bank began cutting interest rates in December 2007. This was followed by a series of aggressive reductions until the policy rate reached one-quarter of one per cent in April of last year the lowest it can effectively go and lowest it has ever been in the Bank's 75-year history.
The policy response, coupled with the conditional commitment to keep the rate that low for a fixed period of time, allowed real interest rates to go negative and helped to re-establish confidence among businesses and households. This is because when the rate of interest went down the business people could now invest more. This led to short term relieve in the economy by increasing the level of income.
The domestic income increased leading to a high volume of import but exports remained unaffected. In the long-run,this led to a balance of trade deficit worsening the balance of trade and causing outward movement of foreign exchange. The exchange rate fell leading to the depreciation of the dollar.
The decline in the domestic interest rates led to capital outflow which in turn led to increase in demand for foreign currency resulting to the dollar's depreciation pushing the exchange rates downwards. America's competitiveness in the interest rate was reduced.
The domestic prices were pushed up relative to the foreign prices. The domestic export became expensive and America lost international competitiveness.
Fiscal policy adopted during the great recession
The fiscal policy adopted during recession was an expansionary fiscal policy. This is where the government increases spending or reduces taxes. This results to an increase in money demand raising the interest rates which in turn leads to a decline in investment demand and hence aggregate output falls.
During the great recession in America income tax rebate checks were mailed to households in early 2008. Other measures adopted were the cash-for-Clunked tax incentive for auto purchases, the extension and expansion of the housing tax credit through mid-2010, the passage of a new jobs tax credit through year-end 2010, and several extensions of emergency unemployment insurance benefits.
In the short run, America experienced stable prices, increased economic growth and increased levels of employment. This is because there was increase in money supply leading to increased investment.
The expansionary fiscal policy decreased net exports in America. This had a mitigating effect on national output and income. Because of the government borrowing the interest rates increased thus attracting foreign capital from foreign investors. This is because; other things held constant, the bonds issued from America were offering a higher rate of return. In other words, companies that wanted to finance projects had to compete with the American government for capital so they were offering higher rates of return.
To purchase American bonds, foreign investors must obtain American dollars. Therefore, when foreign capital was flowing into America demand for American dollars went up. The increased demand caused American dollar to appreciate. Once the American dollar had appreciated, goods originating from America costed more to foreigners than they did before and foreign goods now were costing less than they did before. Consequently, exports decreased and imports increased.
This essay looks at the monetary and fiscal policy measures undertaken by the United States during the great recession. It also looks at the short-run and long-run effects of the policies undertaken. It also looks at the definition of key words used.