Fed and Asset Bubbles
Question 2
Part 2 (50 points)
The Financial crisis
- Identification of the bubble
An asset bubble occurs when there is a sudden increase in prices of commodities such as stocks, bonds, real estate, and commodities (Evanoff, Kaufman & Malliaris, 2012). In this case, the housing bubble is the rise of housing prices, which is greatly fueled by real estate increased demand and the future speculations of the importance of houses in an area. Increased demand for houses causes a rise in the price level, which in return causes much effect in the equilibrium prices because most of the time, it is not easy to go back to the equilibrium price. Many asset bubbles occur temporarily, but according to the international monitory funds (IMF), the housing bubble can go for a period, which might be for several years. It is very important to identify between the case of inflation and asset bubbles, and it is not always easy to do so unless the fact is well proved. Increased prices of housing characterized the housing bubble in different areas
- How can the fed react to the bubble
There have been arguments among economists about how the Fed should react to the emergence of a housing bubble. Some economists thought the fed should stop the asset bubbles when they start forming before they burst. Others thought that in so doing, the fed could be much risking the welfare of the economy as, in due time, the economy could heal itself. It is important to understand that identifying an asset bubble is not easy; this may make it challenging to curb the bubble formation in the initial state due to lack of facts (Labonte, 2005). Fed has its initial obligation of protecting the United States’ economy; this is through the stabilization of the economy’s aggregate growth rate and inflation. On the emergency of an asset bubble, the fed finds it hard to intervene with the bubble because doing that will compromise its principal duty of stabilizing inflation and growth rate. The only way that the Fed can use is flexing the interest rates in the economy and other monetary policies. However, these policies place the welfare of the economy at risk of inflation and retarded growth rate. Most of the time, the Fed is forced not to intervene with the process of asset bubble formation and effects as with time; this tends to go back to the normal.
- Cost/benefit analysis of the Fed reaction to a bubble
An asset bubble, and especially that of housing, has great impacts on every economy; some impacts are volatility in investment spending, consumption, and financial instability. Due to these factors, it is the significance of the Fed reaction on the situation. It must be noted that the Fed will only react to the economic asset bubble if and only if it affects the inflation and the growth rate, otherwise not. The main benefit of the Fed reaction to a bubble is the reduction of economic recession in the economy and improvement of the quality of life by increasing citizens’ purchasing power (Roubini, 2006). According to fed, its reaction to an asset bubble could result in negative implications such as an increased level of inflation in an economy; this might result from reduced interest rates, which makes money more readily available in the market hence leading to a sudden rise in prices of other commodities.
- Recommendations
The only recommendations to be made is how to make the economy healthy, even in the presence of bubbles by making them more silent. Although the Fed says that the bubbles occur temporarily, it is bad to undermine their capabilities to worsen the condition of the economy. Therefore, the fed should reduce the number of asset bubbles and the frequency at which they occur, hence mitigating their adverse effects. Controlling the pricing mechanism in the economy is the other factor altogether. However, the market forces are allowed to give the equilibrium prices, subsidizing the products to control prices, and giving pricing regulations is paramount as the prices should revolve around the marginal cost of production.
Part 3 (10 points)
Banking
Banks are special places where the money is deposited for saving and also lenders money to their customers. The banks earn through interest charged to their customers; those depositing can earn through interest rate while those that are borrowing pays to the bank at a higher interest. The bank also earns through other private investments in the economy.
Bank consolidation
It is the merging of two or more banks to form one stronger bank that could thrive in the economy hence increasing the chances of thriving in the market (Weiß, Neumann & Bostandzic, 2014). Below are the pros and cons
Pros and cons of Bank consolidation
Everything that benefits must in any way have costs in it. There are several advantages associated with bank consolidation. They include merging of different branches of banks in an area; this is significant in low populated areas where there are very few bank users, hence making the survival of many branches of banks impossible because it is uneconomical. Another advantage is that consolidated banks join hands in the business; hence the specialization, innovation, invention, and improved banking services are more likely to be experienced (Weiß, Neumann & Bostandzic, 2014). There is also effective use of resources and validity in the business activities, hence maximizing the chances of business development.
As said earlier, bank consolidation has demerits, too, such as loss of jobs to some members of the different branches of banks. This is because fewer posts are required in the merged bank hence firing some workers. Another demerit is difficulty in the consolidated bank; due to differences in working culture between the banks, this may take a very long time, hence affecting the bank’s capital formation negatively.
References
Evanoff, D. D., Kaufman, G. G., & Malliaris, A. G. (2012). Asset Price Bubbles: What are the Causes, Consequences, and Public Policy Options? Chicago Fed Letter, (304), 1.
Labonte, M. (2005). US housing prices: Is there a bubble? Congressional Information Service, Library of Congress.
Roubini, N. (2006). Why central banks should burst bubbles. International Finance, 9(1), 87-107.
Weiß, G. N., Neumann, S., & Bostandzic, D. (2014). Systemic risk and bank consolidation: International evidence. Journal of Banking & Finance, 40, 165-181.