Running head: MONETARY POLICY
1
Monetary Policy
Raunak Kumar
Capella University
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MONETARY POLICY
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Monetary Policy: An Overview
Economies respond to economic fluctuations primarily by implementing monetary
policy. Monetary policy cannot be discussed without discussing money. Money can be defined
as “the set of assets in an economy that people regularly use to buy goods and services from
other people” (Mankiw, 2012). The total quantity of money that circulates within an economy in
different forms such as currency, demand deposits, and so on, is referred to as the money stock
of that economy. The government of that economy may implement policy to regulate the money
stock and to stabilize prices. This policy is known as monetary policy. The regulation of the
money stock in an economy is controlled by the central bank. The Federal Reserve, also called
the Fed, is the central bank of the United States. The Fed formulates and executes monetary
policy and uses economic tools to influence the total money supply, which in turn affects
macroeconomic variables like interest rates, investment, inflation, and so on.
In addition to understanding the specific tools and instruments of monetary policy, it is
important to measure how effective monetary policy is at achieving economic stability and
maximizing social welfare in an economy. It is vital that an economy’s monetary policy is wellequipped to counter unanticipated events. The importance of designing sound monetary policy
can easily be realized when trying to gauge the impact of it going wrong. The financial crisis of
2007–2008 is an example of the failure of monetary policy. During the course of the crisis, the
Fed not only recognized certain shortcomings of monetary policy that were seen during the Great
Depression, but also the ones that were only discussed in theory till then.
Financial Crisis of 2007–2008
The financial crisis of 2007–2008 was triggered by the recession of 2001, which followed
the bursting of the dot-com bubble. As a result, the Fed resorted to quantitative easing and
Copyright © 2016 Capella University. Copy and distribution of this document is prohibited.
Comment [A1]: You did a good job in
explaining how declines in real estate
values, subprime mortgage loans, and
mortgage-backed securities relate to a
financial crisis using real world
examples. Your points were well taken
when discussing the crisis you
mentioned the role of the rating
agencies, the mortgage bankers, the
borrowers who willingly got into
mortgages that they could not afford.
MONETARY POLICY
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systematically lowered its interest rates to 1% in 2001 to boost liquidity and demand in the U.S.
economy (Labonte, 2016). Along with low interest rates, the decision of the government to
reduce income inequality by making housing affordable and available to all led to an increase in
the demand for housing in the economy. Given the limited supply of houses, this increase in
demand led to an increase in housing prices. Expectations of additional rises in housing prices in
the future further pushed up demand and current prices in the housing market. The increased
liquidity in the market resulted in an exponential rise in subprime lending. Borrowers with low
creditworthiness and poor credit ratings are called subprime borrowers; such borrowers are
considered risky as they are highly likely to default on their loans. Expecting housing prices to
continue to rise, money lenders launched innovative mortgage loans, such as adjustable-rate
mortgages (ARMs), for the previously unattractive subprime borrowers. These loans were
characterized by zero down payment and low adjustable interest rates with a provision for the
interest to be added to the principal amount of the loan in case of failure to pay monthly interest
(Kolb, 2010).
To meet the continually rising demand for credit fueled by the rising demand for real
estate and to comply with regulatory capital requirements, lending institutions decided to free up
their capital tied up as mortgage loans by selling these loans to third parties as mortgage-backed
securities (MBSes). An MBS could be issued either by private institutions like American
Insurance General (AIG) or quasi-government organizations like Fannie Mae and Freddie Mac.
Issued as a bond, an MBS carried a guarantee by the issuing agency against default. For ease of
investment, MBSes were pooled together and divided into tranches on the basis of the risks
associated with them. Loans with high risks yielded higher interest and were pooled together as
collateralized debt obligations (CDOs). Safer loans, which yielded lower interest than the risky
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MONETARY POLICY
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ones, were pooled in separate tranches. The risks of MBSes were gauged by credit rating
agencies, mostly by the “Big Three”—Moody’s, Standard and Poor’s, and Fitch Ratings—which
inaccurately accredited the bulk of risky and default-prone CDOs with the highest ratings. Since
all the agencies involved charged a huge fee for the processing the loans, the disbursement of
risky loans and MBS with lower credit worthiness was further encouraged. Thus, banks
originated these loans, transferred them to investors and had no stake in the final outcome of the
loan. Therefore, a rise in liquidity, an increase in credit growth, and an increase in the trade in
risky derivatives in the wake of the increase in housing prices led to a deviation of housing prices
from their inherent value (Kolb, 2010). This over-inflation in housing prices was termed as the
housing bubble. As the bubble kept growing, financial institutions and investors borrowed more
money to finance their purchase of mortgage-related securities.
According to the Financial Crisis Inquiry Commission (2011),
from 1978 to 2007, the amount of debt held by the financial sector soared from $3
trillion to $36 trillion, more than doubling as a share of gross domestic product. By 2005,
the 10 largest U.S. commercial banks held 55% of the industry’s assets, more than double
the level held in 1990. On the eve of the crisis in 2006, financial sector profits constituted
27% of all corporate profits in the United States, up from 15% in 1980 (p. 18).
By June 2006, the Fed had increased the interbank lending rate to 5.25% to control the
increasing inflationary pressure in the economy. As the interest rates increased, housing prices
started declining (Amadeo, 2016). Another reason for the decline in housing prices was that,
while the supply of houses kept increasing, the demand for them was exhausted. With the decline
in housing prices, the lenders of short-term collateralized credit suffered a setback as borrowers
could not pay back their debts. This left most lending institutions with little capital. These
Copyright © 2016 Capella University. Copy and distribution of this document is prohibited.
MONETARY POLICY
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institutions had to resort to selling off their assets at the same time, which pushed down the
prices of those assets. As banks started running out of capital, people rushed to them to withdraw
their funds. Therefore, the decline in housing prices acted as a catalyst in bursting the housing
bubble (Kolb, 2010).
Ineffectiveness of Monetary Policy: Liquidity Traps and Cyclical Asymmetry
With the bursting of the housing bubble, the U.S. economy and markets all over the globe
crashed. Individuals across the globe, especially in the United States, expected the Fed to take
charge of the situation as the world economy was on the verge of a recession. The inability of the
Fed to ease the economic situation highlighted the ineffectiveness of anti-recessionary monetary
policies.
During recession, consumption expenditure and investment tend to decline and
speculations about a further dip in prices initiate a deflationary spiral. To stimulate the economy,
the Fed cuts down interest rates and introduces more money into the economy by way of open
market operations, which require the purchase of government shares from the public. During the
crisis, the Federal Funds Rate, the interbank lending rate, hovered between zero and twenty five
basis points for some time starting December 2008 (The Financial Crisis Inquiry Commission,
2011). However, the efforts of the Fed were upset by the uncertainty in the economy, which
discouraged investors from spending and banks from lending. The public preferred to use the
money injected by the Fed to pay off existing loans. This inability of expansionary monetary
policy to counter recession is termed as cyclical asymmetry. In severe cases, such a policy may
even push the interest rates below zero. This may happen because low interest rates discourage
the public from holding bonds as they offer lower returns. With speculations that interest rates
would rise in the future, both the savings rate and the chances of the economy being plunged into
Copyright © 2016 Capella University. Copy and distribution of this document is prohibited.
Comment [A2]: One of the requirements
of the assessment was to analyze the
notion that monetary policy can exhibit
cyclical asymmetry and explain why that
is significant for policymakers. This was
done very well. It was good that you
mentioned the liquidity trap, as this has
become problematic today as monetary
policy has become ineffective.
MONETARY POLICY
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a deflationary spiral increase manifold, and the economy may go into a liquidity trap
(Dornbusch, Fischer, & Startz, 2014). Such a situation occurred during the Great Depression
when expansionary monetary policy failed to stimulate the economy.
It is important for policymakers to know that, when it comes to contractionary monetary
policy, the Fed can effectively achieve its goal by curbing the money stock of the economy and
by suppressing economic activity. However, when it comes to stimulating the economy during
recession, the use of expansionary monetary policy fails to fulfil its objective. Therefore, a lot of
care should be taken while formulating expansionary monetary policies as they are not only
capable of triggering asset bubbles, as they did during 2007–2008, but are also ineffective at
combating non-periodic economic fluctuations.
Conclusion
The financial crisis of 2007–2008 demonstrated that monetary policy can be inhibited by
cyclical asymmetry. The lack of regulatory actions against subprime lending, the unprecedented
rise in the sale of mortgage-backed securities, and the tremendous growth in trading activities
were early clues to the crisis that were ignored by the Fed. Once the crisis began, monetary
policy failed to contain it. This highlighted the importance of anticipating cyclical asymmetry
and liquidity traps while formulating policy. It is important for the Fed to have a strong hold on
the financial institutions and agencies within the economy and to encourage all financial
institutions to maintain transparency in economic activities. This is vital for economic stability
(The Financial Crisis Inquiry Commission, 2011).
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MONETARY POLICY
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References
Amadeo, K. (2016). How hedge funds created the financial crisis. Retrieved from
https://thebalance.com/how-hedge-funds-created-the-financial-crisis-3306079.
Dornbusch, R., Fischer, S., & Startz, R. (2014). Macroeconomics (pp. 65–75). (n.p.): McGraw
Hill Education.
Financial Crisis Inquiry Commission, Authorized Edition (2011). The Financial Crisis Inquiry
Report (pp. 16–18). PublicAffairs. Retrieved from
http://ebookcentral.proquest.com.library.capella.edu/lib/capella/reader.action?docID=679
869.
Baily, M. N., Litan, R. E., & Johnson, M. S. (2010). The origins of the financial crisis. In Kolb,
R. W. (Ed.). Lessons from the financial crisis: Causes, consequences, and our economic
future (pp. 79–81). (n.p.): Wiley. Retrieved from
http://ebookcentral.proquest.com.library.capella.edu/lib/capella/reader.action?docID=588
959.
Labonte, M. (2016). Monetary policy and the federal reserve: Current policy and conditions.
Congressional Research Service (p. 10). Retrieved from
http://fas.org/sgp/crs/misc/RL30354.pdf.
Mankiw, N. G. (2012). Principles of economics (p. 620). Mason, Ohio: South-Western Cengage
Learning.
Copyright © 2016 Capella University. Copy and distribution of this document is prohibited.
Comment [A3]: Correctly formats
citations and references using current
APA style with no errors.

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