Stimulating Economic Activity - Essay Example

? The article that I have chosen to analyze is en d “Political Pressure Wouldn’t Halt More Fed Easing” written by Scott Lanman and published lastOctober 5, 2011 in Bloomberg. Federal Reserve Chairman indicated that he would continue to use monetary policies to stimulate economic activity, which is primarily reflected upon interest rates. This is amidst the probable recession for the US due to its debt debacle and credit downgrading which triggered a panic-stricken market. As many economists have already noted, the leading indicator for a recession, or a downturn of the US economy is the growth of Gross Domestic Product (GDP). GDP is the increase in the amount of goods and services produced by an economy over time. According to the Economic Cycle Research Institute (ECRI), more than three years ago, the 2008 financial crisis already triggered studies on longstanding pattern of slowing growth, characterized by higher cyclical volatility and lower trend growth. In layman’s terms, in the short run, we may be having higher upswings of economic growth but at the cost of having equally strong downswings which are hard to anticipate. However, when you try to see patterns as far as from 1970, the long-run trend is down. A part of this trend is shown on the graph below: As one can notice, there was a steep upward change in GDP growth by the end of the 3rd quarter in 2009. The GDP growth figures for 2011 is 2.2% and 1.6% for eth 1st quarter and the 2nd quarter respectively. The graph above may be misleading insofar as it suggests an upward sloping imaginary trend line, but as far as the ECRI is concerned, two implications are possible: First, the fall of GDP will even be steeper than perhaps the -5% in the 2nd quarter of 2009. This means that it’s only a matter of time before GDP growth hits a -5%. If this is the case, since the economy has its own lags and assuming that this debt problem has no clear end, the US economy will be flirting within -5% range or even lower by next year. The second probable case is that though the dip in GDP will only be slight, it will be more frequent resulting in persistent recession perhaps every 2-3 years as the interval of the 2008 crisis with the current crisis. Given that GDP will be fallin short, another index that significantly goes together with this is employment, which can be expected to decrease as well. The index that is commonly used for this is the unemployment rate. The unemployment rate then is defined as the number of unemployed divided by the total labor force while the labor force can be defined as the number of people employed plus the number unemployed and is seeking work. This on the other hand was expounded on by Okun’s law, which verifies that employment, a factor of production, affects output, albeit with a lag. Okun’s law states that a one point increase in the unemployment rate is equated with two percentage poonts of negative growth in real GDP. So if this the case, if GDP falls in the near future, the unemployment rate may be breaching the 10% line. The unemployment rate is pictures below with the graph showing an upward trend from the start of 2006 to the 2nd half of 2011. As one can see, the unemployment rate has been very high, close to 10%, since mid-year of 2009. Alas, this is a signal that the economy is not producing goods and services the best that it could or at full capacity, because of the many jobless citizens. This is the reason why the Fed, with Bernanke at the lead, is using monetary to expand the economy through the use of interest rates. Monetary policy operations include controlling some overnight or short-term interest rates and these rates to lend money to commercial banks influencing mortgage rates and other types of loans. The logic of controlling interest rates is this: lower interest rates means lower costs for companies who wish to borrow money. The lower cost for borrowing is an incentive for more companies to borrow money and invest in capital expansion and businesses. More capital put up would mean not only more employment or jobs in the market but also stimulate economic activity, thereby increasing GDP. The 10-year interest rate of the US, of the more commonly used benchmark rate, is given below: The prevailing 10-year rate in the market is at 2% per annum, with the latest figure for September 2011 hitting a historical low of 1.98%. Now this might sound good, but there is one more index that is very important to consider as an economist, one that has an inverse relationship with interest rates: inflation. Inflation is the rise of general prices of goods and services in an economy over a period of time. Keeping inflation at a low and stable rate is important because companies plan their output keeping in mind future prices which signal consumer demand. This is so because high inflation would tend to lower the purchasing power of the income of many and would lead to lower demand. Having a very volatile inflation would means companies will not be able to plan properly their level of production then. The relationship between inflation and interest rates is inversely proportional, that is, as one increase, the other decreases and vice versa. The policy rate that the Fed issues is deeply associated with the rates that banks also offer for the savings and deposits of the public. With lower interest rates, there is less incentive for people to save, and they would rather use up their money for consumption. Higher demand for consumption would then push prices higher. Inflation rates for the US is graphed below: Republicans are very wary of Bernanke’s policy moves as this might stoke inflation. According to the Bloomberg article, the price index of the Fed, the personal consumption expenditure index, excluding food and fuel, otherwise known as core inflation, rose 1.6% in August from a year earlier, up from 1% last March. The index including all prices, or headline inflation, rose 2.9% in August compared with 2% in March. Bernanke defended the moves of the Fed by saying that its isn’t monetary policy that is fanning inflation but rather supply side factors such as oil, gasoline and electricity price hikes and that the upward trend for inflation is temporary if not moderate according to previous years’ expectations. The graph that interposes inflation and interest rates together is shown below: Though it is not obvious, the high points of the inetrest rate line is usually the low points of inflation, albeit with some lag. The trade-off however is not necessarily constant through time. The more apparent crux of the problem for the Fed however is the fact that it has a dual mandate of keeping unemployment low but at the same time keeping inflation stable as well. In economics however, we know that there is an inherent trade-off between inflation and unemployment, that is, lowering one raises the other, as represented by the Phillips curve which is picture below: The graph above summarizes that a 4% inflation rate corresponds with a 7% unemployment rate. A 6% inflation rate meanwhile corresponds to a 2% unemployment rate. Notably, the higher the inflation the lower the unemployment and the lower the inflation the higher the unemployment. In this particular graph, the trade of is 5 percentage points of unemployment for 2 percentage points of inflation. There seems to be a discrepancy in theory and data when it comes to the reltaionship between inflation and unemployment. There seems to be no clear trade-off between inflation and unemployment form the start of the 2006. However the trend comes in by mid 2008 when the gap between the two indices widened. With this in mind, I must say that the monetray policy of the Fed may become successful in stimulating the economy without the pressure of inflation being too high. However, if the unemployment rate is persistent and has other social, cultural or ideoligical factors affecting it, then monetary policy may not be that effective afterall. Bibliography: Lanman, Scott. (2011). Bernanake Signal Political Pressure Wouldn’t halt More Easing. Bloomberg News. Retrieved from http://www.bloomberg.com/news/2011-10-05/bernanke-signals-pressure-from-congress-wouldn-t-halt-additional-easing.html Economic Cycle Research Institute. (2011). Retrieved from http://www.businesscycle.com/reports_indexes/reportsummarydetails/1091 Bureau of Labor and Statistics. Unemployment Data. Retrieved from http://data.bls.gov/timeseries/LNS14000000 Inflationdata.com. Inflation data. Retrieved from http://inflationdata.com/inflation/inflation_rate/currentinflation.asp Federal Reserve. Interest Rates Data. Retrieved from http://www.federalreserve.gov/Releases/h15/data.htm Tradingeconomics.com. GDP data. Retrieved from http://www.tradingeconomics.com/gdp-growth-rates-list-by-country Read More