Central Bank, Monetary Policy, Financial Institutions, Lender of Last Resort, Financial Crisis, Short-Term and Long-Term Interest Rates

You are a manager of a company and you have a task to explain different viewpoints of low interest rates; the role of the Fed and capital flows in the run-up of housing prices and the subsequent financial crisis. You decide to explain in detail what the Fed has done to short-term and long-term interest rates and then review global factors, how it has changed over time:

Financial Crisis: The onset of the 2007-2009 financial crisis in August of 2007 led to a massive increase in Federal Reserve lenders of last resort facilities to contain the crisis. In mid-August 2007, the Federal Reserve lowered the discount rate to 50 basis points (0.5 percent) above the Fed fund target from the normal 100 basis points. In March 2008, it lowered the discount rate to 25 basis points above the Fed fund rate target. In September 2007 and March 2008, the Fed extended the maturity of discount loans to 30 days and to 90 days in March.

In order to provide more liquidity for the market, the Fed also set up a temporary Term Auction Facility (TAF) to provide discount loans with the rate determined through competitive auctions. In addition, the Fed created the term Securities Lending Facility (TSLF) in which the Fed could lend money to primary dealers helping dealers to have sufficient collateral, thereby helping the orderly functioning of financial markets. As the crisis deepened the Fed lender of last resort was growing to a wider range, as even investment banks could borrow on similar terms to depository institutions using the discount window facility.

Through expansion of the Fed's policy short-term interest rates dropped to almost zero percent. We also have the Fed's unconventional "quantitative easing" by purchasing of $1.25 trillion of mortgage-backed securities and $900 billion of longer term Treasury bonds to keep long-term interest rates low to encourage more borrowings.

Global Imbalances: In the 1920s, capital began flowing from state to state, a process that continued until after World War II. Beginning in the 1950s capital moved out of the United States, to Mexico, India, and Malaysia. Capital has long moved to where it can be used most productively, and by and large, that has been a good thing. Through much of the history, the major capital flows have been from rich to poor countries. That's no longer the case. Given low saving rates in the U.S, high trade and high budget deficits, and national debts, capital exporting countries with large dollar reserves found the U.S. to be a safe place to invest. Some argue that such capital inflow has contributed to low U.S. interest rates as well.

a. How can low interest rates help economic recovery? Make sure to include the impact on consumption, investment, government spending, value of securities, value of dollar, exports and imports, and GDP.

b. What is meant by "global imbalances"? What is the standard view of those imbalances?

c. How might those global imbalances have contributed to the financial crisis?

d. What are some reasons that capital from around the world flow into the United States?

e. Under what conditions can such capital inflow be redirected to other countries? What are potential consequences of that to the U.S economy?

f. Why is it unlikely that "global imbalances" contribute to the housing market crisis and subsequently to the financial crisis?