Presented by : Mahmoud Arab

Craig K.Elwell

Government take actions to support current aggregate spending that exerts upward pressure on the price level to counterforce a negative demand shock.

• Macroeconomic policy•The Fed’s traditional role of “ lender last resort ”

General classes of policy responses:

How to fight deflation ?

•Most frequently used tool to influence credit conditions, economic activity, and the price level.

•Implemented by targeting ( raising or lowering) the short-term federal funds rate.

•Fed buys or sells Treasury securities for cash to increase or decrease liquidity in the financial markets.

•Fed purchased securities for cash and pushed down the federal funds rate from 5.25% to 0.25 in 2007.

Monetary policy:

“ Unable to get traction”:•Monetary stimulus's lack of effect on real economic activity in times of financial crisis when the demand for liquidity increases sharply.

• Banks’ lack of the needed degree of confidence.

•Increase banks’ reserves and liquidity rather than increasing lending activity.

•Keeping an adequate flow if credit (liquidity) moving to support spending in the non-financial sectors.

Fed is prevented from using normal operating procedures of targeting interest rate to apply the degree of monetary stimulus needed to increase aggregate spending and counter inflation.

Fed could try to change financial market interest rate expectation:

If central bank can persuade the public that it will hold down the short-term interest rate to near zero for longer than had been expected, interest rates across the whole term structure should also fall, stimulating spending.

Fed could alter the composition of its balance sheet shifting from liquid short-term low-risk assets toward less liquid long-term assets or other riskier assets “ qualitative easing”:◦ Selling short term treasuries. ◦ Buying long term treasuries or other log term

assets such as asset-backed securities.◦ Could lower long term yields to provide stimulus

to economic activity.

Feds’ balance sheet since 2008 and 2009 shifted from consisting 100% Treasury securities to having two-thirds of it holdings in agency related securities.

The average maturity of the fed’s investment portfolio has increased from 3.5 years to nearly 7 years.

Fed could expand the size of the Fed’s balance sheet, by increasing its monetary liabilities through buying securities to increase the supply of reserves in the banking system

Fed undertook a huge increase of its balance sheet from about 900 billion in late 2007 to about 2.3 trillion in mid-2010

“ quantitative easing”

Fed may also require to shift from its operating procedure fir conducting monetary policy from targeting interest rates to targeting inflation rate by announcing a target path for the price level.

Successful inflation targeting policy needs:◦ Fed must convince the markets that it is credible by

vigorously and transparently pursing policies that are consistent with reaching the inflation target.

Fed’s open market committee indicate that the Fed would begin to make available to the public the committee’s long-term inflation projections

Fed offers credit to solvent but temporarily illiquid financial institutions

Another form of qualitative easing (changing composition of feds’ balance sheet)

The borrowers are financial institutions with assets exceeding liabilities

The Fed’s “discount window” is its facility for making loans to financial institutions with short term liquidity problems charging them an interest rate called “ discount rate”.

To bolster the liquidity of the financial system during 2008-2009, the Fed took a variety of actions that more than doubled reserve bank credit by injecting 1.5 trillion of new reserves into the financial system.

Support aggregate spending and exert upward pressure on the price level through increasing budget deficit.

Fiscal policy has a direct impact on economic activity.

Fiscal policies responses to the financial crisis:

•120 billion dollars package that provided tax rebates to households and accelerated depreciation rules for businesses.

•787 billion dollars package with 286 billion dollars tax cuts and 501 billion dollars of spending increases that were projected to add fiscal stimulus equivalent to about 2% of GDP in 2009 and 2.5% of GDP in 2010.

•Unemployment Compensation Extension Act of 2010 was enacted.

Deflation is generated by a negative demand shock.

The experience of the US during the Great Depression and that of Japan since 1990’s gives strong testimony of the economic costs of deflation.

Deflation risk indicators:◦ Low inflation rate and decelerating.◦ Large output gap persists.◦ Slowing money supply growth.◦ Continuing zero bound nominal short term

interest rate.

Monetary and fiscal stimulus are the macroeconomic policies needed to fight deflation by directly or indirectly increasing aggregate demand to boost economic activity.

Monetary and fiscal policies will also work in theory to shift consumer and business expectations from deflation to inflation

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