How Governments Monetary and Fiscal Policy Affected the Cost of Capital - Research Paper Example

?How Government’s Monetary and Fiscal Policy Affected the Cost of Capital of A Company Journal in Study: Gartner, Manfred and Jung, Florian. The Macroeconomics of Financial Crises: How Risk Premiums and Liquidity Traps Affect Policy Options. International Advances in Economic Research, Feb2011, Vol. 17 Issue 1, p12-27, 16p I. Introduction: General Concept about the government’s Macroeconomic tools, the Fiscal the Monetary Policy The fiscal and monetary policies are the two most common tools available to the government to stabilize the economy during an economic crisis. This was an idea of John Maynard Keynes who posited that the extreme swings in the economy is caused by the excessive or lackluster aggregate demand for goods and services and causes and economy either towards expansion or recession. To control this aggregate demand, the government uses two macroeconomic policies – fiscal and monetary policies to control economic swings. During a time of recession, governments typically resorts to expansionary measures through its fiscal policy by increasing government spending and lowering taxes to stimulate aggregate demand. Through its Monetary Policy also, it can increase money supply and lower interest rates to push for an expansionary economy. The reverse can happen during an overheated expansion of the economy where government’s reduces its spending and increasing taxes to control the stabilize the economy. It can also increase interest rates to “mop out” excessive liquidity in the market to abate the effect of an “overheated” economy. II. Synopsis The journal tackled about the macroeconomics of an economic crisis. It demonstrates how risk taking in money and capital markets can create a “liquidity trap” or a situation where government’s monetary policy cannot stimulate the economy because nobody still wants to invest even with positive interest rates. This also showed that fiscal policy instead works in a “liquidity trap” or a situation where the governments’ monetary policy cannot stimulate the economy as nobody wants to invest. The discussion is important as it demonstrates how a crisis can affect not only the cost of money but also its availability to companies and how crisis can be resolved that will stabilize capital and the cost associated to it. III. Specification of Thesis In this paper, the undersigned elected the journal “The Macroeconomics of Financial Crises: How Risk Premiums and Liquidity Traps Affects Policy Options” (Gartner and, 2011) as a subject for discussion as the journal tackles the timely issue of the recent Financial Crisis which did not only raised the cost of capital for companies but also reduced the global economy into a recession. This was the recent 2009 Financial Crisis where no financial institutions were willing to lend money thus exorbitantly raising the cost of capital. In a thesis by “Gartner and Jung”, they posited that when confidence in credit seeking institution vanishes, the application of the government’s monetary policy may not work. This happens because nobody wants to invest despite of the premium interest and as such, there will be no money for reinvestment thus raising the cost of borrowings. This may be bearable in a smaller scale but when the risk for investors significantly increases due to massive loss of confidence towards financial institutions, this will precipitate a crisis whereby merely increasing interest rates to encourage investment will not work. In a company’s perspective, this can be devastating as the availability of capital will not only contract but also will become expensive. This will have a ripple effect when companies begin to dig in for the defensive and adopt a conservative stance to conserve resources affecting the entire industry in general. In a crisis like this, the government’s monetary policy tool of increasing interest to encourage investment may not work as investors are just unwilling to invest due to a loss of confidence. When done on a massive scale, this can assume a global dimension that will slide the global economy towards recession. IV. Three supporting opinions/reasons  A. During a financial crisis, interest for risk taking in the capital market will increase. But this will just feed further the liquidity trap as it will pronounce the crisis more and the economy stuck with high interest rates making capital perpetually expensive for companies. B. When this crisis happens, government’s monetary policy will not work as investors just do not trust the system to be capable of giving returns even if rate of returns for investment is raised. C. Fiscal policy can address this. When the economy contract and adopts a conservative stance, merely stimulating it through spending will make the economy go back to a pre-crisis situation. V.  Three opposing opinions/reasons  A. Confidence is subjective and is relative depending on where you are coming from. Financial crisis may not really be an economic issue but a political issue as it emanates from a “loss of confidence”. The situation in one financial institution is not necessarily the same with the others. The public may have just overreacted and the government was not able to handle it. As a result, the crisis took a life of its own, making everybody look bad when it was not. B. The emphasis on “liquidity trap” is exaggerated. There will always be investors who would be willing to take risk in the capital market if the interest rate is increased. In fact, this crisis may be looked at as an opportunity for many investors to make money in a crisis like this as the return is higher. C. Deficit spending will just put governments in debt. The root of the issue is perspective which is political in nature. If investors and the public in general still distrust the system, no amount of excessive spending can cure the crisis. Thus, what needs to be done is to restore public confidence in the credit seeking institutions to address the crisis. VI. Summary and Opinion of Thesis The recent response of the government with the crisis, the most pronounced of which is US President Obama’s “Stimulus Package” validated that indeed there has to be spending needed to revive the economy and make the cost of capital reasonable. In fact, with companies who already folded due to unavailability of credit or excessive cost of capital, government stepped in and pumped in money to save key industries. Without government intervention and its macroeconomic tools, the cost of capital would have remained excessive with many more companies folding up which will slide us further to a damning downward economic spiral leading to a collapse. Read More