How Has the Financial Crisis Affected the Economy - Literature review Example

Name: Instructor: Course: Date: Financial Crisis and the Economy The term financial crisis has been defined differently by different authors. Generally, it is described as a condition in which the hypothetical value of financial assets drops unexpectedly Bernanke (10). It can also be defined as a situation in which the demand for money is more than its supply. Financial crisis is, therefore, a broad term that can be applied to a variety of situations such as recessions and bank runs. Currency crises, financial bubbles and crushes and sovereign defaults can are all termed as financial crises. Regulatory failures, imperfections in human reasoning, asset-liability mismatch, ignorance and increased borrowing are the leading causes of financial crises in the world economies. Financial crises are contagious since they spread from one state to another. The 2010 annual report by the bank for international settlement financial crises cause recessionary effects Mcdonald (56). McDonald (24), points out that governments play significant roles in extenuating financial crises through monitoring the financial departments. According to Smithers, the main objective is to achieve transparency and ensure that institutions have sufficient assets to meet their fiscal targets (123). Some scholars argue that excessive regulation is the major cause of financial crises. On the other hand, other scholars have blamed major financial crises on insufficient monetary regulation. For instance; the crisis of 2007-2008 is attributed to regulatory failure. This is resulted into the global recession.One of the most common regulatory measures is the reduction of interest rates. This crisis threatened the complete fall down of major financial institutions globally James (123). Recently, interest rates have been maintained at low levels Nordhous (123). The rationale behind low interest rates is to ward off the risk of financial disturbance and offset deflationary forces. Similarly, given that fiscal disruption which led to what is commonly referred to as ‘the great recession’; low interest rates have been effective in countering high borrowing costs due to widening monetary spreads. It is evident that, financial policy measures promote borrowing and discourage saving King (145). According to most economists, the principal advantage of reduced interest rates is economic stimulation. By lowering the interest rates, the government assists in encouraging business expenditure on principal goods which plays a significant role on the long term performance of the economy. It can also help to prompt domestic spending on homes and consumer long lasting assets such as automobiles. For instance, there is a higher home sale at the interest rate of 5% than at 10% Mark (145). In James (129), the profits on secure fiscal assets have been depressed. The implication is that savers looking for secure investment prospects are forced to accept excessively low rates of returns which are otherwise negative when adjusted for inflation. On the contrary, reduced interest rates favor households and business organizations with constructive net wealth by raising asset prices. An increase in the supply of money results in more money than the public can hold. Consequently people will use this extra money to buy services and goods in addition to assets such as homes and corporate equities. Since the demand for these assets increase, their prices increase as well. The correspondence between the reduced interest rates and low returns on secure monetary assets imply an underlying account. Actually, low ostensible yields on long term secure bonds are caused by low levels of interest rates. The central banks have therefore supported borrowers. The low interest rates are thus seen as decreasing borrowing costs for firms as well as consumers. Financial institutions such as banks benefit greatly from low interest rates. Reduced interest rates improve the banks power to lend and its balance sheets. Financial crises lead to undercapitalization of the banks thus decreasing their ability to give out loans during the earlier stages of recovery. For instance the collapse of the Northern Rock bank of the UK in 2008 was as a result of a financial crisis. Maintaining low interest rates plays a significant role in raising the net interest margin in the banking sector which boosts the banks’ retained earnings and its capital McDonald (46) . Low asset profits and poor investment prospects are indicators of deep economic recession. In such situations, flexible financial policy conditions are not aimed at favoring the borrowers but are responses to stabilize the economy. Apart from benefiting the savers, increasing the interest rates would depress the economy, delay the process of recovery and add to downside threats to price steadiness. Consequently asset profits would stagnate for longer and savers would be disadvantaged for longer Bernanke (190). Interest rates were comparatively constant in the 1990s as well as 1980s. However, at the start of the twenty first century the trend decreased remarkably. The decrease was further sharpened by the starting of the financial crisis. The financial crisis was a global concern as it affected many countries in the world. It has also occurred over a number of years. Economists have debated on the probable grounds for this tendency. There are different views that have been put forward to explain this scenario. The increase in global savings level from oil producing countries, and the emerging economies. Another contributing factor is the fiscal policy that was negligent before the years of the crisis Benoit (45). Benoit believes that currently one of the hottest economic debates is about the fate of interest rates in the next few years (10). The big question is about the future of the interest rates. Are interest rates going to increase or just remain constant? The focus of the debate is on the stance for the coming few years. From the economic markets, the rates will stay low for the coming few years. The international monetary fund asserts that the interest rates will rise up but at a very slow rate. They rates will probably take quite some years to go back to the levels that prevailed before the crisis. A lower rate of growth is predicted for the rising economies which will most probably decrease surfeit savings. This will however not raise interest rates. According to the IMF, investment in developing countries is not likely to cause an increase in interest rates because it is predicted to undergo a slow recovery. This is a manifestation of a financial crisis. The fiscal policy needs to stay lax as the capacity of redundant production will be high in developed countries Bernanke ( 45). For the economy to attain complete employment and lower inflation rate of approximately 2%, interest rates have to stay low. This argument is based on the scrutiny of certain facts. During the years preceding the financial crisis, the interest rates were down. Correspondingly, the rate of unemployment was relatively high and inflationary forces were limited. Another important factor to note is the rate at which the economy is recovering. Though the interest rates have been kept low, the rate of recovery is very slow and presently the inflationary forces are minimal. It can be argued that stimulating the economy is quite challenging due to this condition. Financial policies stimulating the private demand could play a significant role in economic stimulation James (23). However, maintaining interest rates below the normal rate is costly. According to some Bernanke (3) the low interest rates between 2003 and 2004 was the principal cause of the housing boom and the domestic debt. Without sturdy commitment to keep inflation in check, low interest rates could result in higher price rises. For instance the great inflation of the 1970s is attributed to failure of the fed to increase interest rates quick enough to thwart it. Since low interest rates discourage saving and encourage spending, they are likely to punish savers and those who depend on income profit in the long run. Nonetheless both borrowers and savers in beleaguered countries have been adversely affected by the penalty of financial crumbling King (67). The subsequent flight to safety has caused high returns and lending rates in the hassled countries as well as low yields in heart countries. Consequently financial disintegration has adversely affected the borrowers in the frazzled countries and lenders in hub countries James (10). Given the benefits and costs of keeping low interest rates, the answer to the question on the future trend s of interest rates is not indisputable. Nonetheless, it is certain that the recovery rate is quite slow and the interest rate will be retained at low levels for some time Smithers (56). In conclusion, the main objective of low interest rates is not o favor a certain group in the economic chain. It is rather an essential remedy which is quite effective in keeping inflation in check. However, low interest rates may lead to inflation sometimes. On the other hand, increasing interest rates is no better option as it will only worsen the situation. To effectively stimulate the economy, interest rates must therefore remain low. Correspondingly given that the rate of recovery is relatively slow, it is essential to retain low interest rates. Though there are costs of low interest rates, it is advisable to maintain low levels of interest rates as its benefits cannot be overlooked. Low interest rates play a significant role in reducing unemployment as well as inflation Smothers (43). Works Cited Bank for International Settlements. 80th Annual Report, June 2010. Benoît, C. Public Lecture ECB, at the International Center for Monetary and Banking Studies, Geneva, 9 October. 2013. Bernanke, Ben S. "Monetary Policy and the Housing Bubble." At the Annual Meeting of the American Economic Association, Atlanta, Ga., Jan. 3, 2010. James, B. "Seven Faces of the Peril.' " Federal Reserve Bank of St. Louis Review, September-October 2010, Vol. 92, No. 5, pp. 339-52. McDonald, L. and Robinson, P. A Colossal Failure of Common Sense: The Inside Story Of the Collapse of Lehman Brothers. New York: Crown Publishing Group, 2010. Smithers, A. The Road to Recovery: How and Why Economic Policy Must Change. West Sussex: Wiley, 2013 Nordhous, W. The Climate Casino: Risk, Uncertainty and Economics for a Warming World. New Haven: Yale, 2013. King, S. When the Money Runs Out: The End of Western Affluence. New Haven: Yale 2013 Mark, B. Austerity: The History of a Dangerous Idea. Oxford: OUP, 2013. Morris, C. The Two Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash. Newyork: Public Affair, 2008. . Read More