Financial Institutions and Markets - Coursework Example

?FINANCIAL S AND MARKETS Table of Contents Problems faced by countries in developing a balance between mortgage rates and expansionary economy 3 Introduction 3 Expansionary Monetary Policy 4 Effect on mortgage rates 5 Short Run vs. Long Run 6 Mortgage Crisis on Money Supply 7 Problems with Expansionary Monetary Policy 7 Conclusion 8 References 10 Problems faced by countries in developing a balance between mortgage rates and expansionary economy Introduction Monetary policy can be defined as the process by which money supply in a country is controlled by the corresponding monetary authority in the country. Every country tries to formulate an optimum monetary policy to ensure economic stability and growth of the country’s economy. While doing so, the interest rates are mainly targeted. Good monetary policy helps stabilize the prices and curb unemployment. Monetary policies of a country are different from the fiscal policies in a way that, fiscal policies make use of government expenditures and taxation and not interest rates. A monetary policy employed by a country can either be an expansionary monetary policy or ‘contractionary’ monetary policy. Expansionary monetary policy helps in increasing the money supply in the economy of a country at a faster rate than normal and in case of ‘contractionary’ monetary policy, the money supply increases at slower rate or even fall behind in the economy. Expansionary monetary policy is often employed to prevent unemployment during recession. It happens because of interest rates going lower which therefore attracts credit facility to be available easily for the business concerns to help themselves expand. In the United States, expansionary monetary policy is implemented through the combination of three things. They are: a) Using Open Market Operations, by purchasing securities in the open market. b) Federal Discount Rate is lowered. c) Reserve Requirements are also lowered. Now, all these three steps have a direct impact on the interest rates, including mortgage rates. This leads to increase in borrowing of mortgage loans, as well as increase in rates of capital investments by business concerns. Most countries follow an expansionary monetary policy to ensure higher economic growth and go on decreasing the interest rates. It helps in growth of employment opportunities but at the same time has its limitations too. This can only have a short term effect on the economy. In the long run, it will lead to higher inflation rate and would also affect the economy in an adverse way (Mishkin, 2007, p.39). Thus, effect on long term mortgage rates are less predictable and the effect is on a lower proportion as compared to the extent of expansionary economic measures taken by a country. This happens mainly due to two reasons. Firstly, real factors like market demand influences the long term mortgage interest rates more than the monetary factors. Secondly, the effect or impact of monetary factors operates mainly on the expected future long term mortgage rates (Gwartney, et. al. 2008, p.301). Although the expansionary economic measures reduce the short term mortgage interest rates, it may lead to a rise in interest rates in long term. This unpredictability problem creates a surmounting problem in creating a balance between the mortgage rates and expansionary economic measures followed by a country. Expansionary Monetary Policy Expansionary monetary policies are used by countries to help stimulate the economic growth of the country. It leads to increase in supply of money in the country. It usually leads to lowering of interest rates in the country. This in turn reduces the borrowing cost and also reduces the return on savings. This helps in increasing the aggregate demand of goods and services in the economy. People are more attracted towards investing in housing by taking loans at lower interest rates. These types of expansionary monetary policies are often employed in countries to counter the recessionary gap. It helps in reducing or preventing unemployment problem in the country but at the same time leads to higher average inflation rate (Sexton, 2010, P.547). An expansionary monetary policy leads to rise in price of products at a higher rate than its production cost in a shorter term. As a result of this, the business concerns will earn more and more profit, thereby leading to expansion in the business with increased investments. But for all this to happen, the implementation of the expansionary policies must be timed properly. Improper timing can have an adverse effect on the economy in a longer run. The lowering of interest rates due to expansionary monetary policy, results in reducing the demand of domestic bonds and thereby increasing demands for foreign bonds in a country. The domestic currency of a country also depreciates, that is, the demand for foreign currency increases due to the fall in demand of domestic currencies. Expansionary monetary policy also leads to improvement of balance of trade of a country by increasing the demand for exports as compared to imports. Thus expansionary monetary policy results in curbing the interest rates and increases the money supply in the economy, which finally helps in boosting the economy. Effect on mortgage rates An expansionary monetary policy by a country leads to the decrease in interest rates, including the mortgage rates. Now the mortgage rates can either be adjustable mortgage rates or fixed mortgage rates. In case of adjustable mortgage rates, a lowering in mortgage rate due to expansionary measures taken in the monetary policy will benefit people or homeowners with mortgages to a larger extent. This is because homeowners would have to pay less interest amounts then. Thus they will enjoy more disposable income in their hands, which they will utilize by spending on goods and services. But, in case of fixed-rate mortgages, the fall in interest rates would not give benefit to the homeowners on a larger scale because majority of them already have mortgage loans and they have to pay higher interest rates which they were supposed to pay when they took the loan. Thus, aggregate demand is affected more if adjustable rate mortgages are more prevalent in the country than the fixed rate mortgages. In countries like USA, where the legislation permits the issuance of securities which are mortgage backed, the effect of capital inflows due to expansionary monetary policy stretches to a large extent and this leads to increase in price of houses (Sa, 2011). Short Run vs. Long Run As discussed earlier, more and more countries are following expansive monetary policy which is leading to greater domestic demand in these countries. This increase in demand has a positive effect on the GDP of the country and it certainly helps to increase employment opportunities in the country. In the long run though, rise in inflation takes a toll on the economy. This minimizes the effect on GDP in reality or in employment. This abnormal behavior in the long run can be explained through two main reasons. Firstly, in short run, it is very difficult for adjustment in prices to occur in line with rapid increase in money supply in the market. Secondly, only slow adjustment to the changes in monetary policy is possible with respect to the expectation level of people. Rigidities in prices occur as a result of this slow adjustment. As a result of these rigidities, the changes in aggregate demand caused due to changes in money supply and credit facilities, the output levels and level of employment in a country are hugely affected. But with time, adjustment of expectations takes place and the prices start rising in accordance with the change in demand. This minimizes the effect of changes in output and employment. Thus, expansionary monetary policies are quite effective in the short run but not of much influence on GDP and employment in the long run (Labonte, 2010, p.5). Mortgage Crisis on Money Supply Mortgage crisis was one of the reasons of global financial crisis and recession all across the world in the recent past. Various financial institutions issued huge amounts of money to people for acquiring homes. This was the case mainly in USA and was in accordance with expansionary monetary policy led by US government. It resulted in increase in lending of money to individuals to facilitate them with buying of houses. Equity in ownership of houses was a result of this strategy. But at the same time, it resulted in financial imbalance in the economy because more and more number of homeowners could not afford to repay back the loans which they borrowed. Thus it became very difficult for the financial institutions to get back surplus liquid money in the hands of people in the society. Problems with Expansionary Monetary Policy The problem with expansionary monetary policy is that it does give a boost to the growth of the economy of a country, but it is very tough to predict when these effects will take place. It may occur very quickly, or it may take years or it may even lead to addition of inflationary woes for the economy. So instead of recovering from recession, it may lead to inflationary pressure on the economy. It is very difficult to have a perfect and optimum monetary policy for a country. An expansionary monetary policy can lead to lowering of mortgage rates but only for a short period of time. In the long run, the inflation will rise, which will again lead to rise in the mortgage rates. The borrowing costs will rise and the demand for houses will thus decline. Moreover, people will find it difficult to repay back the borrowed amount easily. So the correct timing of implementing the expansionary policy is the key to its success in creating economic growth for the economy. Expansionary monetary policy can be a problem in a few cases. They are: a. In spite of low interest rates, people may be reluctant to spend or invest if they find lack of confidence in doing so. b. Even if the central bank reduces interest rates, it may be difficult to get loans from banks if there is a crunch credit situation in financial institutions; where in there may be a shortfall of funds to lend in the financial institutions. c. It depends on aggregate demand situation in the market. In case of global recession, expansionary monetary policy may fail to increase consumer spending. d. Time lag can be an issue while implementing expansionary monetary policy. Conclusion Thus, it is very difficult to strike a balance between the mortgage rates and expansionary economy. Lowering of interest rates does not always imply that the status of economy is expansionary. Also, an expansionary policy adopted by an economy does not always lead to reduction in mortgage rates. The initial effect of an expansionary monetary policy followed by an economy is of course the reduction in mortgage rates. But on a longer run it gets reversed, that the interest rates start rising. Initially with the steps taken to implement expansionary monetary policy, reduces the mortgage rates, which enables homeowners to purchase houses by taking loans at cheaper rates. This results in the increase in demand of houses as well. The prices of the houses start rising as well. But with time, inflation creeps up in the economy and the mortgage rates also start rising. A small change in mortgage rates prevents people from taking mortgage loans. Thus people find it difficult to repay back the borrowed amount at higher mortgage rates. Defaults in repayment occur, leading to a setback to the expansionary measures of the economy. In the event of recession, expansionary monetary policies are often adopted by economies, to stimulate demand and fasten the recovery process. Then, once the recovery process begins, financial institutions start using up more and more of their financial reserves to extend loans to individuals and also to increase investments. This will again lead to the woes for economic development, because excess money supply in the economy will lead to rapid growth in inflation. The concerned authority will then have to shift their expansion policy. The problem is not with the expansionary policy adopted by the policy makers but with the proper timings in shift of policies. An expansionary monetary policy thus does not always lead to lowering of mortgage rates and has its own problems in lowering the interest rates. References Gwartney, J.D. (2008). Economics: Public and Private Choice. (Ed.12). USA: Cengage Learning. Labonte, M. (2010). Monetary Policy and the Federal Reserve: Current Policy and Conditions. Retrieved on March 7, 2012 from http://fpc.state.gov/documents/organization/141603.pdf. Mishkin, F. S. (2007). Monetary policy strategy USA: MIT Press. Sa, F., Towbin, P., & Wieladek, T. (2011). Low interest rates and hosing booms: The role of capital inflows, monetary policies, and financial innovation. Retrieved on March 7, 2012 from http://www.voxeu.org/index.php?q=node/6195. Sexton, R. L. (2010). Exploring Macroeconomics (Ed.5) USA: Cengage Learning. Read More