MACROECONOMICS

ECONOMIC PROBLEMS THAT THE POLICY TRIES TO ADRESS

In this part, economic problems and solutions proposed by the monetary policy will be explained in chronicle order, so that we see the evolution of the crisis as monetary policy was being applied.

Financial crises arosefromessentiallylowinterestrates and anexpansion of financial and investmentopportunities. The objective of the monetary policy is achieving price stability, which depends on the inflation rate; Interest rate is determined when money supply is equaled to money demand.

In early 2007, crisis began and interest rate reached a minimum, it was near 0%.

Inflation rate in 2007

In this map we see the inflation rate among the different countries of the world in 2007. In the USA, where the financial crisis started, and in some countries of the Eurozone such as Spain, Ireland and Sweden, inflation rate was below 0%. In this cases it is called deflation instead of inflation because instead of increasing the price level over the years, it decreases. In the other countries of the Eurozone it was not negative but between 0 and 2%, value also considered too low.

Therefore, between March and July of this same year, the ECB decided to decrease money supply in order to increase the interest rate. Consequently,, if we look at the graphs below, we see that aggregate demand increases too and LM curve shifts up along the IS curve.

In July 2007, the crisis started to expand all over the world and the financial markets fell.

In the first half of 2008, Eurozone countries’ economies had been contracted by 2%.

Interest rate rose too much, getting to more then 3%, which is the maximum interest rate that is considered correct. Therefore, between October 2008 and May 2009 there was a decreasing trend of interest rate (3.25%), led by an increase of money supply. Consequently, the aggregate demand increased and the LM curve went down, as seen in the graphs.

Later in 2008 it was estimated that in 2009 there would be a global recession, and it surely happened.A recession is determined after two continuous quarters of deflation, which means negative inflationand in 2009, inflation rate reached -0.5%. This inflation rate was accompanied by a -1.8 economic growth.

Between May 2009 and May 2010 interest rates remain unchanged and in middle 2009 large economies such as France and Germany achieve positive growth, putting and end to the recession.

Interest rates and money supply aren’t the only issues the monetary policy had to deal with. Because of the financial crisis, people didn’t feel confident having their money in the banks so many of them preferred to hold it in hand. This lack of confidence with banks occasioned a drop of their liquidity. Monetary policy had to address to this too by setting a higher liquidity reserve ratio.

References:

www.investopedia.com/university

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