The impact of fed on real gdp and price level term paper example

In 2008 the world, and the U. S. in particular, were hit by what is referred to as the worst financial crisis since the Global Depression. Unusually severe crisis provoked unusually aggressive response from the Federal Reserve, and their actions still remain the topic of numerous debates – some argue that the response neglected long-term consequences focusing only on stabilizing the situation in the short perspective (Meltzer, 2012), while the others point out that had the government not intervened, 2010 GDP would have been 11, 5% lower and number of people employed would been lower by 8, 5 million (Blinder & Zandi, 2010). The two points of view are not necessarily mutually exclusive as the latter demonstrates short-term effectiveness of the policy, but advocates of Fed’s policy would argue that 2008 was not the right to give longer perspective too much thought.
Keynesian economics developed during the Great Depression, widely used between 40s and 70s, then forgotten after 80s in favor of free-market consensus and then remembered again after the 2008 financial crisis, calls for government intervention to stimulate economy after certain shocks to aggregate demand. Keynes advocated widening budget deficits by lowering taxes or/and increasing government spending. IS-LM-BP model, a late interpretation of Keynes’ ideas, under the assumptions of perfect capital mobility and flexible exchange rates (both applicable to the United States), implies that monetary policy should be extremely effective for altering level of output, as it eventually gets combined with expansionary fiscal policy, meaning that monetary expansion leads to increase in real GDP in the short run. It happens under the assumption that prices are sticky in the short run – when it comes to the medium run, AD-AS model suggests that the real output returns to initial level as prices adjust. However, as the crisis was pretty much unprecedented, the events hardly followed any of known theories strictly – if it did (meaning that the theories have predictive power) the crisis would not have happened in the first place.
While Congress is mostly responsible for fiscal policy, effective monetary policy is the task of Federal Reserves, though such division may an oversimplification. The first measures taken by Fed are dated back to September 2007, when federal funds rate was lowered by 50 percentage points to 4, 75% after it had peaked 5, 25% in June 2006. After that, the rate have been lowered virtually every month until it went down to zero by the end of 2008. Having noticed that the markets were not adapting quickly to changes, the range of other measures known as Quantitative Easing (QE) have been introduced. While until 2008 Fed was buying short-term government bonds in order to lower interest rates, this tactics soon exhausted itself, and QE were seen as an alternative way to stimulate the economy and prevent deflation. QE-1 included purchases of mortgage-backed securities with the aim to heal the security market. Fed’s holdings reached the level of USD 2, 1 trillion by the June 2010, when further purchases were put on hold as the economy started to recover. QE-2, the second round of quantitative easing started in November 2010 (that is when actually the name was given – the first round was called QE-1 retrospectively) – it consisted in buying USD 600 billion of Treasury Securities, as opposed to short-term bonds, in order to impact long-term yields also. QE-3 was launched in September 2012 and was aimed at further stimulation of mortgage securities market with purchases of mortgage-based securities planned to be at USD 40 billion per month level until 2015.
The measures mentioned above were aimed at stimulating economy via lowering interest rates and returning confidence to financial markets. As money supply went up, the demand for American dollar decreased and the currency depreciated against other currencies, which made imports more expensive, but exports more competitive leading to increase in GDP. Lowered interest rates also supported private investments, which allowed the output recover in the short run, supporting aggregate demand and therefore preventing deflation.

Impact of open market sales on the price level

Open market sales, or open market operations, refer to set of activities undertaken by Central Banks to trade government bonds. Open market sales are key for implementation of monetary policy with the main aim to influence interest rates and money supply in the economy. The vector of the activity depends on a specific target, which can be expressed in desired level of interest rate, inflation, or exchange rate. It needs to be mentioned that the capacity of open market sales can be fully exploited with flexible exchange rate regime – with fixed exchange rate the only purpose of monetary policy is to maintain it against currencies it is pegged to.
In the United States, the Federal Reserve has been controlling the money supply by changing the reserve account in Federal Reserve Bank of New York – Fed makes purchases and sales of securities via the System Open Market Account from and to commercial banks, in this way ” creating” or “ destroying” money in the economy: when Fed buy securities, the money exchanged for them can be loaned to the firms and individuals with reduced rates (as supply increases), while in case of sale of security, the money can no longer be loaned and are out of circulation.

The picture below demonstrates the short-term equilibrium in money market:

Source: Central Marco
MS stands for money supply – it is fixed in the short run (controlled by government). When Fed buys securities through open market sales, it increases money supply. Correspondingly, MS curve shifts to the right leading to new market equilibrium, with lower nominal interest rate and higher level of output.
The next graph demonstrates the short-term effects of monetary policy in the economy (on IS-LM model which shows equilibrium in goods market and money market):

Source: Ideal Logic, Ideological Logistics

LM curve represents equilibrium in money market, IS – in goods market, while BP stands for balance of payments. On the graph flexible exchange rate together with nearly perfect capital mobility are assumed (which is true for the U. S. economy). When Fed purchases securities from commercial banks, LM curve shifts to the right, which leads to decreased demand on U. S. dollar and thus depreciation of it. Depreciation of dollar is favorable for exports, which means that net exports increase, therefore both BP and IS curves shift to the right creating new equilibrium with higher level of output and lower interest rate.

The next graph demonstrates the effects of monetary expansion in medium run:

Source: MNMEconomics
AD curve represents aggregate demand, while AS – aggregate supply. As it was shown before, expansionary monetary policy increases aggregate supply, which results in the AD curve shifting to the right resulting in new market equilibrium with higher nominal GDP, but also higher price level.
Monetary policy may be an effective tool for short-term recovery from certain market shocks and recession, however, in longer perspective it inevitably leads to increase in prices returning real GDP to the initial level.

References:

Blinder, A. S., Zandi, M. (2010). “ How the Great Recession Was Brought to an End”. Working paper. Available at: http://www. princeton. edu/~blinder/End-of-Great-Recession. pdf
Central Marco. How do markets determine interest rates. Available at: http://centralmacro. blogspot. com/2013/02/25-how-do-markets-determine-nominal. html
Ideal Logic Ideological Logistics (2012). What Chicago Doesn’t Know. Available at: http://quantstocktrader. blogspot. com/2012/07/what-chicago-doesnt-know. html
Meltzer, A. H. (2012). “ Federal Reserve Policy in the Great Recession”. Cato Journal, Vol. 32, No 2. Available at: http://www. cato. org/sites/cato. org/files/serials/files/cato-journal/2012/7/v32n2-3. pdf
MNMEconomics (2011). Short and medium run effects of a monetary expansion. Available at: http://mnmeconomics. wordpress. com/2011/07/04/short-and-medium-run-effects-of-a-monetary-expansion/